Telos Corporation (TLS) Q2 2024 Earnings Report, Transcript and Summary

Good day and thank you for standing by. Welcome to the Telos Corporation Second Quarter 2024 Financial Results Conference Call. At this time all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today's conference is being recorded. I would now like to hand the conference over to Allison Phillipp, Director of Corporate Communications. Please go ahead.

Good morning. Thank you for joining us to discuss Telos Corporation's second quarter 2024 financial results. With me today is John Wood, Chairman and CEO of Telos; and Mark Bendza, Executive Vice President and CFO of Telos. Let me quickly review the format of today's presentation. Mark will begin with remarks on our second quarter 2024 results. Next, John will discuss business highlights from the second quarter. Then Mark will follow up with third quarter guidance before turning back to John to wrap up. We will then open the line for Q&A, where Mark Griffin, Executive Vice President of Security Solutions, will also join us. The earnings press release was issued earlier today and is posted on the Telos Investor Relations website, where this call is being simultaneously webcast. Additionally, we have provided presentation slides on our Investor Relations website. Before we begin, we want to emphasize that some of our statements on this call are forward-looking statements and are made under the safe harbor provisions of the federal securities laws. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could materially differ for various reasons, including the factors described in today's earnings press release and the comments made during this conference call and in our SEC filings. We do not undertake any duty to update any forward-looking statements. In addition, during today's call we will discuss non-GAAP financial measures, which we believe are useful as supplemental and clarifying measures to help investors understand Telos' financial performance. These non-GAAP financial measures should be considered in addition to and not as a substitute for or in isolation from GAAP results. You can find additional disclosures regarding these non-GAAP measures, including reconciliations with comparable GAAP results in our earnings press release and on the Investor Relations portion of our website. Please also note that financial comparisons are year-over-year unless otherwise specified. The webcast replay of this call will be available for the next year on our company website under the Investor Relations link. With that, I'll turn the call over to Mark.

Thank you, Allison, and good morning, everyone. Let's begin today on Slide 3. I'm pleased to report that Telos has again over delivered on key financial metrics in the second quarter, exceeding both revenue and profit guidance. We delivered $28.5 million of revenue in the second quarter or approximately $500,000 above our guidance range of $25 million to $28 million. First half revenues were $58.1 million, and we're comfortably ahead of the $55 million of first half 2024 revenues that we forecasted in our fourth quarter 2023 earnings presentation. Returning to the second quarter. Security Solutions delivered $17.9 million of revenues, which was approximately in line with the top end of our guidance range due to strong performance across the portfolio. Secure Networks delivered $10.6 million of revenue, exceeding the top end of our guidance range and representing the entirety of the revenue beat for the company. The outperformance in Secure Networks was driven by excellent program management on a program that ended as scheduled in the quarter. GAAP gross margin was 34.1%, above our guidance range of 30% to 33.3% due to better-than-forecasted mix within Security Solutions and strong margin performance on multiple Secure Networks programs that ended as scheduled in the quarter, partially offset by higher amortization. Security Solutions generated nearly 63% of total company revenues in the second quarter of 2024 versus 52% in the second quarter of 2023, a favorable variance that is expected to widen in the second half. Cash gross margin was 42%, expanding 326 basis points year-over-year and representing one of our highest-margin quarters since our IPO in 2020. Revenues and gross margins, both above forecast resulted in gross profit above what was incorporated into our adjusted EBITDA guidance range. In addition, R&D and SG&A expenses were better than forecasted due to lower cash expenses, including timing of some expenditures, and higher-than-forecasted capitalization of software development costs. As a result, adjusted EBITDA also exceeded the top end of our guidance range. Adjusted EBITDA was a $2.9 million loss compared to our guidance range of an $8 million loss to a $6 million loss. Lastly, cash flow from operations was an $8 million outflow, and free cash flow was an $11.3 million outflow. The year-over-year decline in free cash flow was in line with the year-over-year decline in adjusted EBITDA. I will now turn it over to John for an overview of recent business highlights. John?

Thanks, Mark. And good morning, everyone. Let's turn to Slide 4. I'd like to begin with our recent progress on TSA PreCheck program. I am pleased to report we have successfully and significantly accelerated the expansion of our network of enrollment centers in the second quarter. Our footprint has nearly tripled in size from 28 locations out of our last earnings call to 83 locations today. Additionally, it's important to point out that we have focused our expansion in key markets geographically distributed across 23 states around the country. These states comprise approximately 70% of the population of the United States. TSA PreCheck is well on track to becoming our single, largest program in 2024. We plan to build on this progress and continue the growth through our footprint in the coming quarters with the expectation of reaching 500 locations in 2025. Most importantly, we are thrilled to be working with TSA to effectively grow this important national security program and provide this critical service to the community of U.S. travelers. Next, I'd like to provide an update on the status of the program award protests discussed on our prior earnings calls. As previously communicated, Telos has teaming agreements in place with prime partners who, in the first quarter, received two new program awards from the federal government worth up to $525 million in the aggregate to Telos Security Solutions business over five years. Also, as previously communicated, it is not uncommon for award decisions of this magnitude to be protested by incumbents or other bidders as part of a customary post award protest period provided by the government. And that is the case here. Both awards have been protested and finalization of the award is subject to resolution of the protest. As of today, both programs remain under protest. The protest on the first program, as expected, was resolved by the Government Accountability Office, or GAO, by the end of June. The award was reevaluated and reawarded to our prime partner. We believe the government has shown confidence in our collective team for this program by awarding it to our prime partner a second time. An incumbent on this program has since submitted a subsequent protest on the re-award. This new protest is expected to be resolved by the GAO at the end of September based on their process timetable. Separately, the award on the second program remains under protest directly with the customer or what is referred to as an agency level protest. Resolution on this protest is expected in the fourth quarter. Although, we're not able to communicate a firm and definitive time line for the final completion of the protest, we currently anticipate minimal impact on 2025 revenue potential for these programs if both protests are favorably resolved by the end of 2024. As we have communicated previously, history indicates a small percentage of protests are ultimately sustained and our confidence in a favorable resolution has not changed. We look forward to the conclusion of these protests as these awards relate to pre-existing programs requiring a timely and smooth transition to ensure uninterrupted service to the federal government. In addition, I'd like to report on several other business outcomes since our last earnings call. Our Xacta business has received new orders with the New Zealand government, Five9 and a Fortune 100 technology company. The Xacta business has also achieved renewals with several key customers, including the Government Publishing Office, the National Endowment for the Arts, the National Archives, several other U.S. government customers and a Fortune 100 company in the technology sector. The company has received new cyber services orders from a commercial space technology company and a federal government customer. Finally, our automated message handling systems business achieved new orders from the New Zealand Defence Force as well as renewals from the Federal Aviation Administration, several other U.S. government customers and a foreign government customer. I'll now turn the call back to Mark, who will discuss third quarter guidance. Mark?

Thanks, John. Let's turn to Slide 5. For the third quarter, we expect revenue in a range of $22 million to $24 million and an adjusted EBITDA loss of $8 million to $6.5 million. The third quarter guidance includes a revenue reduction of approximately $7 million compared to our prior internal forecast as a result of the extended protests that John described earlier. Accordingly, we forecast Security Solutions revenue to be down mid-teens to high single-digit percent year-over-year primarily driven by a short-term customer program in the second half of 2023 that is not reoccurring in 2024 and revenue fluctuations in various Telos ID programs, partially offset by year-over-year growth in TSA PreCheck. We forecast Secure Networks revenue to decline high 60% to mid-60% year-over-year due to the completion of programs and resulting step down in revenues during the second half that we previewed in our prior two earnings presentations. GAAP gross margin is expected to be down approximately 475 basis points to 275 basis points year-over-year, primarily due to a short-term high-margin customer program in the second half of 2023 that will not reoccur in 2024, partially offset by a more favorable revenue contribution from our higher-margin Security Solutions business in 2024. Cash gross margin is expected to be down 75 basis points to up 50 basis points year-over-year. Cash below-the-line expenses, which adjust for capitalized software development costs, stock-based compensation, restructuring costs and D&A are forecast to be slightly lower year-over-year. We continue to assess opportunities to reduce our cost base in order to maximize our operating leverage, incremental margins and cash flow as we return to growth in 2025. Our guidance does not include any restructuring charges that could result from additional cost actions. Lastly, we expect the fourth quarter to be similar to the third quarter with potential for modest sequential growth if protests are favorably resolved early in the fourth quarter. And with that, I’ll turn it back to John.

Thanks, Mark. Let’s turn to Slide 6. In summary, we once again exceeded expectations and delivered results above the high end of the guidance range on key financial metrics in the second quarter. Additionally, we expanded our network of TSA PreCheck enrollment locations to 83, nearly tripling our footprint since the last earnings call. We continue to expect we’ll reach 500 locations in 2025. Finally, we look forward to the conclusion of the protest on the new business awards to our prime partners, and we expect minimal impact on the 2025 revenue potential for these programs if both are favorably resolved by the end of 2024. And with that, we’re happy to take questions.

Operator, please open the line for Q&A. Thank you.

[Operator Instructions] Our first question will come from the line of Zach Cummins with B. Riley Securities.

Hi, good morning, Mark and John, congrats on a solid quarter, and appreciate you are taking my questions. John, I wanted to start off with the protest process. I mean, I appreciate all the additional insight that you gave us on both the programs. But can you give us a sense of maybe the size of each of these opportunities? Is it meaningfully different from one to the other?

Sure, Zach. Thanks for the question. The first opportunity is 90% of the total of the $525 million. The second opportunity is about 10%.

Got it. That’s helpful. And I’m just curious, in terms of the time line, I mean, is there a window where this eventually closes where you can't keep protesting? It feels like if it's been reawarded already, I guess, it just feels odd that they can keep protesting, especially on the first award.

Well, it is a tactic that incumbents tend to use to try and extend out their runway of revenues as long as they can. They can't bring back new topics. So my confidence level remains very high that we'll get through this process within the time frame that we talked about on the call earlier.

Got it. And then just shifting over to TSA PreCheck. I mean, great to see nearly tripling your amount of locations here in recent months. I mean, can you talk about any new learnings as you're really starting to expand out the footprint? Kind of how are these new locations performing versus maybe some of the ones that were there near the start of the program when you started ramping?

Sure. If we were to interpolate the run rate of enrollments that are going through the current footprint and we look – and we blow that out against the 500 that we have coming, that we're going to be bringing forward through 2025, I think we'll get to the market share that we talked about previously that – with you and the other investors, our one-third market share we think we'll get to.

Understood. And then final question for me, maybe geared towards Mark. Any sort of changes to key assumptions we should be thinking about going into 2025? Obviously, the time line of the protest is a key factor to this. But just curious on maybe other factors that you're seeing when it comes to potentially new business pipeline beyond TSA PreCheck expansions and these protests.

Yes. So Zach, it's Mark Bendza here. Why don't I start, and then if Mark Griffin has something to supplement with, he'll jump in. So I think as 2025 as having a few key components if you were to build up a forecast for 2025. There's the core business we have today excluding PreCheck and excluding the programs that are under protest. That core business next year will generate somewhere around $60 million to $65 million of revenues at high 40% cash gross margins. Then you have the protested programs that we're talking about. We've previously talked about those programs being worth up to $525 million over five years, which could mean as much as $100 million or more in a given year. But for now, we're modeling that at somewhere around $60 million to $85 million in a typical year. And that's kind of in the mid to high 30% cash gross margins. Then you have PreCheck. We've outlined previously that we believe that market is approximately a $200 million-plus market. We think we can get to approximately our pro rata market share once we are fully ramped. And so you can back into an assumption for what PreCheck revenues could be next year as we continue to ramp our enrollment locations to approximately 500 by the end of the year – to 500 by approximately the end of the year. And you could think of that as that's probably a kind of a mid-50% cash gross margin revenue stream. And then, of course, any new business that comes in over the course of the government buying season, which is typically late in the calendar year or early the following calendar year. A little – certainly too early to give any sort of forecast there, but our BD teams are busy with proposals ramping here to be submitted over the next several months. And then hopefully, we'll have an update for you at sometime early next year and how that plays out. I'll let Mark – okay, Mark doesn't have anything. I think I've covered it. So does that answer your question, Zach?

Yes, very helpful. Thanks for that Mark. And I’ll go ahead and pass the line. So thanks so much for taking my questions.

Thank you.

Our next question will come from the line of Rudy Kessinger with D.A. Davidson.

Hey guys. TSA PreCheck, could you share with your current market shares?

No. Rudy, we're not going to give that detail. But what I will say is that we are very pleased with the level of productivity we're currently seeing out of our pre-existing new enrollment locations. And I indicated we're targeting a pro rata market share when we're fully ramped at 500 locations.

I guess if you think you can get a third of 500, I guess are you tracking towards that given the number of locations you've rolled out today?

Sorry, can you repeat that for me?

I guess if you're targeting a one third market share once you get to 500 locations, if we were to extrapolate based on how many locations you have today, are you tracking towards that one third market share with your existing footprint?

Yes.

That's exactly what I was trying to say earlier.

Yes, based on the sample set we have today, yes, we feel like we are on track.

Okay. And then on the core business, you said the core business should be $60 million to $65 million next year. I mean, you guys did a couple of years ago over $65 million in a quarter. So – and I know you've had a lot of onetime programs, but it seems like all we've heard in the last couple of years as contracts come into completion and no new contracts of size starting. So why does the core business ex-PreCheck in excess [ph] to potential large contracts if these protest get resolved? Why is the core business continuing to shrink? I mean, I go back five years in my model, in 2018, you guys did twice that amount. So where are you guys missing the mark in your core business?

It's in the – really, what's happened is it's in the Secure Networks side of that business. The other side of the business, Security Solutions is growing – will be growing quite nicely, So that's the side of the business that we have a bunch of additional bids in them, and that's the business that is really largely contracting.

Okay, that’s it for me. Thank you.

Our next question comes from the line of Alex Henderson with Needham.

Great. And I appreciate that we've gone from a single question per analyst to more of an open mic process. Thanks for doing that. I just wanted to talk a little bit about the mechanics around the per location on the TSA. How does that feather in? What is the kind of expectation on a per site location in terms of revenue? How long does it take for a site to open to actually reach normalized revenues?

Well, Alex, Mark Griffin. What we’re seeing today is as we open, we’re getting significant and acceptable volume almost day one after we open. So we’re working very closely with TSA on the locations and the strategic locations of where we’re allowed to place sites. But really, we’re seeing that volume and that adoption of those sites because of the convenience of our locations with Office Depot. They’re very acceptable and welcomed by the communities that they serve.

Okay. So it’s fairly rapid within the quarter that they opened that they hit normalized revenues. Can you talk about the mechanics around the time line for opening them, 500 by the end of 2025? Is it 100 a quarter? Is it heavily skewed to the first half because they’re already set up and ready to go? What’s the shape of that opening curve?

So Mark Griffin again. What you’ve seen based on the last performance for the last quarter, it is a ramp. And what you’ll continue to see is as the cadence and the acceleration of the schedule that TSA has approved for us, you’ll see an increase in that schedule throughout the balance of this year and into next.

So an increase in the ramp.

Yes, increase in the ramp cadence on a weekly basis. So typically, we open on a weekly basis. And that’s what you see posted to TSA’s website is what we not only announced in our press release, but also in the cadence that we opened. So it is weekly primarily, and what you’ll see is an increase in the store volume that we open throughout the balance of this year and into next to get to the 500 sites.

Right. So is it reasonable to think that it’s – if we just used a straight line of 500 less which you’ve already got divided by six quarters, that we get a general sense of the mechanics around it then?

Yes, I would – yes.

Okay. And then I wanted to go back to the closures conversation. Is there any contracts that are going to roll off in the back half of the year that we should be aware of or in 2025 that we should be aware of? And what would be the timing of those?

Yes. Mark Bendza will give you that detail, but I think he sort of handled that earlier. But Mark, please go through that.

Yes. Alex, it’s a good question, and it was embedded in the numbers that I commented on earlier. So there’s two pieces to that. So there’s the second half of 2024 versus the first half. You will see a meaningful step down in revenues in Secure Networks from the first half to the second half. That was something we previewed on prior earnings calls. And then next year, yes, embedded in the $60 million to $65 million of revenue on the core business excluding PreCheck, that includes further step-down in Secure Networks prior to new business wins.

Yes. The real question there is – I mean, yes, you gave me that detail, but what’s the timing of it? I mean, which quarters do they end in? Because we’re forecasting a quarterly model, we need to know when things end.

Yes. So approximately midpoint of the year.

So most of this is around the – the end of the second quarter is when it rolls off?

Yes.

Okay. That's helpful. Thank you very much. And can you just explain why you've increased the estimate for capitalization and the size of the OpEx spending that was timing-wise shifted out?

Yes. So you'll see the OpEx spend step up a bit in the second half, largely driven by TSA PreCheck and the investment we're making there and the ramp of TSA PreCheck as well as some additional spend on our growth initiatives within business development.

Yes. The question was why was the capitalization shifted out or reduced? And what was the magnitude of the timing issues that were shifted out?

The timing was more on the OpEx side, not so much on the capitalization side, Alex.

No. I know those are two separate items that you called out for the reason why you beat on the OpEx. And I'm asking what was the reasoning for the CapEx, the capitalization increase? And second, what was the magnitude of the push out of the timing and the – and which we should then expect in 3Q to normalize?

So on the capitalization, really we have a couple of key buckets on the R&D spend. One is on the Xacta side, the other is on the TSA PreCheck side. And it's just the cadence of those two projects and the timing of the spend and the associated capitalization, Alex. That's really just those two items. And then the OpEx, I think the OpEx I've already addressed.

Okay. Thanks. I'll leave the floor.

Sure.

Our next question will come from the line of Nehal Chokski with Northland Capital Markets.

Yes. Thank you. Program number one described on the slide deck, when does that incumbent's contract expire?

I think it's in September.

Okay. And that's why you're relatively confident that they will not have an incentive to submit yet another protest?

Correct.

Okay. And when did you learn that the incumbents submitted a subsequent protest for program number one?

I'm sorry, Nehal. Can you repeat the question?

Yes. When did Telos learn that the incumbent for program number one submitted subsequent protest?

When we learned the subsequent protest, I don't remember. Do you remember?

Nehal, this is Mark Griffin. When it was published on GAO at the same time, that most of the prime knew as well.

Okay. And then on the 1Q 2024 earnings call, you guys have cited data that overturning an award decision is around 5% as a guide to how low the magnitude of risk is that the awards would be resolved unfavorably for Telos. Do you guys still believe that, that historical data is a good guide to sizing the risk?

I do. I also think it's notable that on the first protest, the customer rewarded the program to our prime partner after the protest. So that's also a good fact as far as our concerns.

Got it. Okay. Cool. And then what percent of that $200 million TSA PreCheck market is done on-site versus an online renewal?

80% is – we estimate the market to be 80% on-site and 20% renewal online.

Okay. Great. All right great. Thank you very much.

Thank you, Nehal.

This will conclude today's question-and-answer session. I will now turn the call back to John Wood for closing remarks.

Well, I just want to thank our shareholders for your ongoing support. We're very pleased with the progress that we've made in the second quarter on PreCheck, and we're going to continue ramping this program to full operating capacity as soon as possible and it remains a huge priority for my team. We're saying we're going to get it done by the end of 2025. I'm hoping we'll get it done earlier, but as we're saying for purposes of The Street, end of 2025. Additionally, we look forward to growth from our new business awards that we communicated previously. And obviously, we have got to get through the whole – the protest process, which I feel confident we will. And these contracts have the potential to significantly and obviously positively impact our financial performance in a big way in 2025. And finally, our team remains very focused on expanding our pipeline and driving new business capture to enable additional growth for the company beyond what the programs that we already have in place can do for us. So in general, I remain very excited about the outlook for the company and just thank everyone for their time and for their investment. Thank you.

This concludes today's conference call. Thank you for participating. You may now disconnect.