Q1 2023 Telos Corp Earnings Call
Participants
Allison Phillips
G. Mark Bendza; Executive VP & CFO; Telos Corporation
John B. Wood; Chairman, President & CEO; Telos Corporation
Mark D. Griffin; EVP of Security Solutions; Telos Corporation
Bradley Reiss Clark; Senior Associate; BMO Capital Markets Equity Research
Rudy Grayson Kessinger; Senior VP & Senior Research Analyst; D.A. Davidson & Co., Research Division
Zachary Cummins; Equity Research Analyst; B. Riley Securities, Inc., Research Division
Presentation
Operator
Good day, and thank you for standing by. Welcome to the Telos Corporation Q1 2033 Earnings Call. (Operator Instructions) Please be advised that today's conference is being recorded.
I would now like to hand the conference over to your speaker today, Allison Phillips. Please go ahead.
Allison Phillips
Good morning. Thank you for joining us to discuss Telos Corporation's First Quarter 2023 Financial Results. With me today is John Woods, 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. John will begin with brief remarks on our first quarter 2023 results and Telos' strategic priorities. Then Mark will cover the financials and guidance for second quarter and full year 2023 before turning it back to John to wrap up. Then we'll 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 Telo's 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 John.
John B. Wood
Thank you, Allison, and good morning, everyone. Let's begin today on Slide 3. Mark Bendza will discuss the details of our financial performance later on the call but overall, we executed ahead of plan in the first quarter. We delivered $35.2 million of revenue, and our gross margin expanded 66 basis points to 38.3%, both above the top end of our guidance range. Adjusted EBITDA was $846,000 loss and was also above the top end of our guidance range.
We experienced program-specific year-over-year headwinds as expected and as communicated on our fourth quarter earnings call, partially offset by the significant cost actions we have taken since the beginning of the year.
Now let's turn to Slide 4. As discussed on our last earnings call, the Board and I are fully aligned with our immediate priorities for the next several quarters, specifically rebuilding and growing our backlog in core revenue base through strong renewal rates on existing business and the cultivation of the centralized and more productive business development capability.
Starting with renewal rates, I'm pleased to report that we achieved 100% renewal rates on major customer contracts across the portfolio. We ensure renewals on existing exactly contracts with the U.S. Air Force, the Department of Homeland Security, the Department of State, the Department of the Interior, the Department of Energy, the Defense Intelligence Agency, Amazon Web Services, Ernst & Young are a few among others that we also were awarded.
The AMHS team also continued its outstanding customer service record with the achievement of several major contract renewals with government customers in the quarter. Turning to new business development. We continue to provide cyber, cloud and enterprise security solutions to the world's most security-conscious organizations in both the government and commercial end markets. Over the next several quarters, we believe our most productive and direct path to rebuild and grow our backlog and core revenue base is through the end market we know best, which is the federal government.
Numerous mission priority and well-funded several customers trust and value the solutions that Telos brings to the fight. We believe our mutation and decades-long track record in the federal market will be the foundation of our return to growth. Our newly centralized business development team is currently focusing their efforts on opportunities in this market segment. We have seen robust activity and opportunity within the government for services and technology improvements in cyber, cloud and network security.
These customer requirements have been the basis for government request for information known as RFIs and request for proposals known as our RFPs in recent months, which may ultimately lead to new contract awards over the next several quarters. Our business development pipeline has grown meaningfully in size and quality since the end of 2022.
Based on the current volume of customers, RFIs and RFPs, we continue to expect new contract awards to be heavily weighted to the end of 2023 and into 2024. In the meantime, we have won new multiyear contracts with the National Geospatial-Intelligence Agency for Xacta products and services and have grown our designated aviation channeling services business with the addition of new airport customers to our existing portfolio.
And we continue to transform our newly consolidated business development team through new leadership, talent, operational rigor and strategies to drive enhanced focus that we believe will improve productivity over time. We have a strong belief in our business, our products, solutions and services that we provide. Our support of the company's national security and commitment to the mission remains steadfast. Those fundamentals have not and will not change.
I'll now turn the call over to Mark Bendza, who will discuss the first quarter 2023 financial results and guidance for the second quarter and full year for 2023. Mark?
G. Mark Bendza
Thank you, John, and thank you, everyone, for joining us today. Let's turn to Slide 5. As John mentioned, we're off to a sound start to the year with revenues, gross margin and adjusted EBITDA all above the high end of our guidance range. Total revenues were $35.2 million. Revenues for our Security Solutions business declined 27% to $19.8 million approximately the top end of our first quarter guidance range.
Security Solutions contributed 56% of total company revenues, up slightly from 54% in the comparable period last year. The year-over-year revenue drivers for Security Solutions were consistent with our expectations as previously communicated on our fourth quarter earnings call. Growth in our Information Assurance business was offset by contraction in Secure Communications and Telos ID as a result of a program loss in Secure Communications at the end of 2022, and lower revenues on 2 ongoing programs in Telos ID. Combined, these 3 programs represented a $7.6 million year-over-year headwind in the quarter.
Turning to Secure Networks. Revenues declined 34% to $15.4 million, exceeding the top end of our first quarter guidance range by $2.2 million and representing the entirety of the guidance beat for the company overall. The $2.2 million outperformance was primarily the result of better-than-expected supply chain performance late in the quarter that resulted in a pull forward of revenue from the second quarter to the first quarter. Elsewhere in the secure networks portfolio, the year-over-year revenue headwinds were consistent with our expectations as previously communicated on our fourth quarter earnings call. 3 large programs that primarily came to a successful completion in 2022 and lower revenues on an ongoing program drove a $10.6 million headwind in the quarter.
Turning to profitability. Gross margin expanded 66 basis points to 38.3% due to margin expansion in secure networks and a slightly more favorable weighting of revenues to our higher-margin security solutions business, partially offset by margin contraction in security solutions.
Gross margin in both segments benefited from lower share-based compensation and cost of sales year-over-year. Gross profit exceeded the high end of our guidance range by approximately $2 million and gross margin exceeded the high end of our guidance range by approximately 380 basis points. Gross margin for our Security Solutions business contracted 395 basis points to 52% due to lower revenues on higher-margin programs, partially offset by lower share-based compensation and cost of sales, but exceeded the high end of our guidance range due to better-than-expected utilization of billable labor and lower-than-expected labor costs on fixed price programs.
Gross margin for our Secure Networks business expanded 433 basis points to 21% due to lower revenues on lower margin programs and lower share-based compensation and cost of sales, and also exceeded the high end of our guidance range due to a more favorable mix of labor and materials on select programs and overall excellent program management, including risk mitigation and expense management on fixed-price contracts. Adjusted EBITDA buffered by our expense management actions and ongoing restructuring initiatives was a loss of $846,000 and exceeded the top end of our guidance range by approximately $3.7 million due to the previously described $2 million of higher gross profit as well as $1.7 million of lower below-the-line expenses. Below-the-line expenses were lower due to ongoing expense management initiatives and higher capitalization of R&D expenditures.
Adjusted EBITDA excludes the impact of 2 nonrecurring items including a $1.4 million noncash gain reflected in other income and associated with the wind down of a customer contract as well as a $1.2 million charge associated with the implementation of our ongoing restructuring initiatives. The 2 adjustments approximately netted each other out in the quarter.
Now let's turn to free cash flow and liquidity. Cash flow from operations was nearly breakeven in the quarter. Free cash flow was a $4.1 million net outflow, down slightly from a $3.1 million net outflow in the comparable period last year. We ended the quarter with over $112 million of cash, no debt and an undrawn $30 million senior secured revolving credit facility with an additional $30 million expansion feature. Our balance sheet is a competitive advantage and remains well positioned to support the company through a wide range of operating conditions and strategic opportunities.
Now let's turn to Slide 6 to discuss our guidance for the second quarter. For the second quarter, we forecast sales in a range of $28 million to $32 million and an adjusted EBITDA loss of $6 million to $8 million. The midpoint of guidance implies a $5.2 million sequential decline in revenues primarily due to the previously mentioned pull forward of secure networks revenue from the second quarter to the first quarter.
We forecast Security Solutions revenues to decline high 40% to mid-50% year-over-year and secure networks revenues to decline mid 30% to low 40% year-over-year both due to the same large program dynamics that will persist throughout the year. Gross margin is expected to contract by approximately 600 to 950 basis points year-over-year primarily due to revenue pressure on high-margin programs and security solutions as well as revenue recognition on a short-term, low-margin program in secure networks, partially offset by lower share-based compensation and cost of sales.
Gross margin is also expected to be down sequentially due to lower revenues on high-margin programs in Telos ID, a higher proportion of revenues coming from our lower-margin secure networks business and revenue recognition on the previously mentioned short-term low-margin program in secure networks.
Cash below-the-line expenses, which adjusts for capitalized software development costs, share-based compensation, restructuring costs and D&A are forecasted to be approximately $1 million lower year-over-year, primarily due to lower labor costs. From a free cash flow perspective, we're expecting approximately $6 million of discrete vendor payments in the second quarter that we did not have in the first quarter. So all else held equal, we expect free cash flow to be down sequentially in the second quarter, but in line with our original plan for the year.
And lastly, on Slide 7, we are reaffirming our full year guidance.
With that, I'll pass it back to John, who will wrap up on Slide 8. John?
John B. Wood
Thanks, Mark. Let's move to Slide 8. In summary, we executed ahead of plan in the first quarter of 2023 with key financial metrics exceeding the high end of our guidance range. We delivered $35.2 million of revenue and expanded gross margins by 66 basis points to 38.3%. We actively manage expenses to buffer adjusted EBITDA in the quarter. We maintain a highly liquid balance sheet with $112 million of cash, no debt and an undrawn $30 million revolving credit facility. Our balance sheet is a competitive advantage and remains well positioned to support the company through a wide range of operating conditions and strategic opportunities.
2023 will be a transition year focused on rebuilding and growing our backlog and core revenue base -- through strong renewal rates on existing business and the cultivation of a centralized and more productive business development capability.
And with that, we're happy to take questions.
G. Mark Bendza
Operator, please open the line for Q&A.
(Operator Instructions).
Question and Answer Session
Operator
(Operator Instructions)
And for your first question, it comes from the line Zach Cummins from B. Riley.
Zachary Cummins
Mark and John. And congrats on most all of the Q1 results. I mean Mark, can you walk me through just kind of the puts and takes of your reaffirmed full year guidance, especially considering the upside that you had on the adjusted EBITDA line here in Q1?
G. Mark Bendza
Yes, sure, Zach. So in terms of puts and takes between our last earnings call and this earnings call, I really wouldn't say there are any significant puts and takes. I think our outlook for the year is pretty consistent with where we were in our last earnings call. Yes, first quarter came in above the high end of our guide. A lot of that was a pull forward from the second quarter to the first quarter. So on a first half basis, we're in a similar place to the implied first half on our original full year guide. I'd say as we get to our second quarter earnings call in August, we'll certainly be looking to take a harder scrub at that second half based on first half of actuals, and we'll be looking to narrow the range at that point in time.
Operator
And for the next question, it comes from the line of Brad Clark from BMO.
Bradley Reiss Clark
I wanted to dive in, I believe in the prepared remarks, you mentioned some improvement in business development activity since the beginning of the year. We're just hoping you could perhaps provide some granularity. Where are you seeing some improvement in business development opportunities as it relates to new business more so than our renewals?
John B. Wood
This is John. Generally speaking, what we decided to do is to focus on our core and our core strength is the federal government, and there are a just a bunch of opportunities for us that are enabling us to see the pipeline increasing relatively substantially. And so that's going to be our plan in the near term to round out our revenue to get back to a growth phase.
Operator
And for your next question, it comes from the line of Rudy Kessinger from the D.A. Davidson.
Rudy Grayson Kessinger
Maybe try to get 2 into 1. I didn't hear a single word about TSA, any update there? And then secondly, when do you believe you can get this business back to free cash flow breakeven or positive?
John B. Wood
Rudy, it's John. I'm going to pass that question or the first part of the question over to Mark Griffin.
Mark D. Griffin
Rudy, Mark Griffin. Yes, we are still in soft launch phase with TSA. However, we fully expect booked revenue to begin in the second half of this year. So we're confident things are moving in the right direction with that.
G. Mark Bendza
Yes. And then, Rudy, on free cash flow, I would say the answer to your question is very much a function of how our business development efforts play out over the course of late '23, early '24. If we see the productivity there that we're working towards, I'd say there is a good probability we can return the free cash flow positive sometime over the course of 2024, especially if a couple of key opportunities in the pipeline work out in our favor.
Operator
So at this time, there are no further questions. I would like to turn the conference back to John Wood for closing remarks.
John B. Wood
Well, first of all, I want to thank our shareholders for your ongoing support. Our mission remains unchanged. Telos Empower and protects the world home security conscious organizations, and that's going to continue to be our mission. We've got robust recession-resistant end markets. We have well-funded customers. We have a decade-long track record of serving the world's most security-conscious organizations and honestly, Telos is a strong foundation for the future.
And finally, I'll just say that the Board and I are fully committed to taking the necessary actions to capture the opportunity in front of us and rebuild and grow our revenue base for the future. So thank you all very much for your participation today. Have a great day.
Operator
Right. Thank you. And this concludes today's conference call. Thank you for participating. You may now disconnect.
