Q2 2023 Telos Corp Earnings Call
Participants
Allison Phillipp
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
Alexander Henderson; Senior Analyst; Needham & Company, LLC, Research Division
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 Second Quarter 2023 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 host today, Allison Phillipp.
Allison Phillipp
Good morning. Thank you for joining us to discuss Telos Corporation's Second Quarter 2023 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. John will begin with brief remarks on our second quarter 2023 results and Telos' strategic priorities. Then Mark will cover the financials and guidance for the third 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 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 John.
John B. Wood
Thanks, Allison, and good morning, everyone. Let's begin today on Slide 3. Telos executed well in the second quarter and over delivered on key financial metrics. Mark will discuss the details of our financial performance later in the call. But at a high level, we delivered $32.9 million of revenue in the second quarter, above our guidance range of $28 million to $32 million. Gross margin was 37.6%, above our guidance range of 28% to 31.5%. And we delivered breakeven adjusted EBITDA above the high end of our guidance range of negative $8 million to negative $6 million. The sale of a large perpetual software license in security solutions helped drive the overperformance. Additionally, the restructuring plan we initiated earlier this year, strong program management and other cost actions have enabled us to limit the impact of lower year-over-year revenue on adjusted EBITDA. Given our first half performance and our outlook for the remainder of the year, we have raised the midpoint of our full year revenue, gross margin and adjusted EBITDA guidance ranges.
We continue to view 2023 as a transition year to begin rebuilding our backlog and revenue base for future growth. We are fully focused on elevating the performance of our business development operation. With the addition of high-caliber senior business development personnel, who have a long and successful record of closing government opportunities and the implementation of business development best practices, we are working to improve substantially our pipeline, win rates, backlog and revenue over time. Additionally, we are aligning our investments in our solutions portfolio to the demands of the end markets and customers we know best. In particular, we are focusing on expanding our already well-established and successful managed cybersecurity services business as well as prioritizing growth in our Telos advanced cyber analytics offering. The Board and I are committed to this plan and are confident we are taking the correct actions to position the company for growth over time.
Now let's turn to Slide 4 to discuss our recent business highlights and updates. Within the Security Solutions business, we continue to achieve high renewal rates with our attractive customer base including the Central Intelligence Agency, U.S. Department of the Treasury, the U.S. Department of the Interior, the Office of Naval Intelligence, the National Archives, the U.S. Environmental Protection Agency, Oracle and SAP. The company was also awarded new contracts with NASA, the Virginia Department of Education and the National Endowment for the Arts. The Telos team secured 2 new awards of our automated message handling service. One was with a foreign government customer and the other was with a federal government customer. We inked several major AMHS contract renewals, including with the Drug Enforcement Administration and the U.S. Department of the Treasury. We also secured a new contract with a federal government customer for our Telos Advanced Cyber Analytics or Telos ACA.
Finally, I have some noteworthy updates on the TSA PreCheck program. We recently achieved several operational milestones in close coordination with TSA. Telos' official TSA PreCheck enrollment website is operational. We are pleased to have reached this milestone and have included the website address in our earnings slides and press release. Additionally, 7 enrollment sites are now open across 4 states. We look forward to steadily growing this offering in the coming months and years. I will now turn the call over to Mark Bendza, who will discuss the second quarter 2023 financial results and guidance for the third quarter and full year 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 completed the second quarter with revenues, gross margin and adjusted EBITDA all above the high end of our guidance range and we are, therefore, able to raise the midpoint of our full year guidance while also narrowing our original ranges. Getting into more detail on the second quarter, total revenues were $32.9 million. Revenues for our Security Solutions business declined 44% to $17.2 million and were above the top end of our second quarter guidance range due to the sale of a large perpetual software license that was not included in our forecast and drove the entirety of the revenue guidance beat for the company overall.
Security Solutions contributed 52% of total company revenues, down slightly from 55% in the comparable period last year. The year-over-year revenue drivers for Security Solutions were consistent with our expectations as previously communicated on prior earnings calls. Stable recurring revenues in our Information Assurance business were offset by revenue 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 $15.3 million year-over-year headwind in the quarter.
Turning to secure networks. As expected, revenues declined 37% and to $15.7 million, near the top end of our second quarter guidance range due to continued strong supply chain management. The year-over-year revenue headwinds in secure networks were also consistent with our expectations as previously communicated on prior earnings calls. 3 large programs that primarily came to a successful completion in 2022 and lower revenues on an ongoing program drove a $10 million headwind in the quarter.
Turning to profitability. Gross margin expanded slightly to 37.6% and due to 222 basis points of margin expansion in security solutions, partially offset by a slightly less favorable weighting of revenues to our higher-margin security solutions business and 13 basis points of margin contraction in secure networks. Gross profit exceeded the high end of our guidance range by approximately $2.3 million and gross margin exceeded the high end of our guidance range by over 600 basis points. Gross margin for our Security Solutions business expanded to 55.5%, primarily due to higher software sales lower indirect costs from ongoing expense management actions and lower stock-based compensation and cost of sales and significantly exceeded the high end of our guidance range primarily due to the previously mentioned sale of a large perpetual software license, a more favorable mix of labor and materials on select programs and expense management on fixed-price contracts.
Gross margin for our Secure Networks business at 17.9% was comparable to last year but exceeded the high end of our guidance range due to ongoing expense management actions driving lower indirect costs. Adjusted EBITDA was approximately breakeven and exceeded the top end of our guidance range by $6 million due to the previously mentioned $2.3 million of better-than-expected gross profit as well as $3.7 million of lower than previously forecasted below-the-line expenses, excluding depreciation and amortization. Below the line expenses were lower due to ongoing expense management initiatives and higher capitalization of R&D.
Now let's turn to free cash flow and liquidity. Cash flow from operations was a $4.1 million outflow in the quarter. Free cash flow was an $8.6 million outflow, down from a $5.4 million inflow during the comparable period last year due to lower earnings, higher capitalized development costs and less favorable working capital dynamics. As expected and mentioned in our prior earnings call, discrete vendor payments created a sequential headwind for cash flow from the first quarter to the second quarter. We ended the quarter with over $103 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 continues to be a competitive advantage and remains well positioned to support the company through a wide range of operating conditions and strategic opportunities.
Let's turn to Slide 6 to discuss our guidance for the third quarter. For the third quarter, we forecast sales in a range of $30 million to $34 million and an adjusted EBITDA loss of $8 million to $6 million. We forecast Security Solutions revenues to decline mid-50% to mid-40% year-over-year and secure networks revenues to decline low 50% to mid-40% year-over-year both due to the same large program dynamics that will persist throughout 2023. Gross margin is expected to be down approximately 250 basis points to up 125 basis points year-over-year with the range driven by mix and timing of revenue recognition on programs of varying margin profiles within the quarter. Gross margin is also expected to be down sequentially and primarily due to the previously mentioned sale of a large perpetual software license in the second quarter. Cash below-the-line expenses, which adjusts for capitalized software development costs, stock-based compensation, restructuring costs and D&A are forecasted to be approximately $2 million higher year-over-year, excluding management reserves, primarily due to planned growth investments in the second half focused on business development, information assurance, Telos ACA and TSA PreCheck. Including management reserve, cash below the line expenses are projected to be approximately $3.5 million to $4 million higher year-over-year.
Let's turn to Slide 7 to discuss our updated guidance for the full year. We're raising the midpoint of our full year guidance and also narrowing our original ranges. Our revised guidance includes revenues in a range of $122 million to $137 million, and we're raising the midpoint slightly from $127.5 million in our prior guidance to $129.5 million in our updated guidance. Revised guidance also includes adjusted EBITDA ranging from a $19 million loss to a $14 million loss, and we're raising the midpoint from a $22 million loss in our prior guidance to a $16.5 million loss in our updated guidance. The improved full year guidance reflects new business wins in AMHS and Telos ACA, lower revenues on pre-existing programs in Telos ID, higher revenues on pre-existing programs in secure networks, higher gross margins, higher capitalization of R&D and second half growth investments focused on business development, information assurance, Telos ACA and TSA PreCheck. 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. To summarize, we exceeded quarterly expectations and delivered results above the high end of our guidance range on key financial metrics. We continue to actively manage expenses and have seen that focus, drive and improve profit outlook. Based on our first half performance and outlook for the second half, we're raising the midpoint of our full year guidance and also narrowing our original ranges. We continue to focus on elevating the performance of our business development operation by investing in new and existing personnel and implementing standardized best practices, which will enable us to improve our pipeline, win rates, backlogs and revenue over time. Additionally, we are aligning investments in our solution portfolio to the demands of customers and end markets that we know best. The Board and I remain fully committed to this plan and are confident we're taking the correct actions to position the company for growth over time. And with that, we're happy to take questions.
G. Mark Bendza
Operator, please open the line for Q&A, and we ask the call participants to please be mindful of others in the queue by asking only 1 question. Thank you.
Question and Answer Session
Operator
(Operator Instructions) Our first question comes from Zach Cummins of B. Riley Securities.
Zachary Cummins
John and Mark, congrats on the solid results here in Q2. I guess I'll just ask this as a 2-part question. But I mean first, John, can you just talk about some of the new business activity, nice to see some incremental wins within AMHS and ACA. I mean can you talk about the progress that you've seen with your new business development initiatives? And then part 2 is just really expectations around TSA PreCheck, it seems relatively early, but still encouraging that their website is now up and live.
John B. Wood
Sure. Thanks for your questions, Zach. So with regard to our advanced cyber analytics activity, there are basically 2 sides to what we provide as a service. The first is looking for 0 day and pre-0 day activities and the second is really a surveillance kind of a capability. And customers buying both of those kind of very interesting. So our first real customer of size has seen that as a real positive for them, and that's going to be something that we're going to stay focused on delivering as we go down this path of providing much more active sort of related -- active cybersecurity activities, if you will. The second thing I'll say about the automated massage handling system is that it really is the standard of secure messaging in the -- in our government. But as our government does business with other governments around the world and particularly as we plan operations government to government around the world, I think there's an opportunity for AMHS to be sold to those other governments that are allies of the United States. So I think that's something that we'll see more of as we head down the path. Now as it relates to our business development activity, what I would say in general is that we're really raising up the focus on that activity. And I'm going to ask Mark Griffin to address that as well as the -- where we are with TSA PreCheck. So I think Mark really is the person who have asked to take over that and take on that responsibility for the company.
Mark D. Griffin
Zach, Mark Griffin. And as we have previously indicated, some of our objectives this year was the restructuring of the business in growth and practice. With that, we added the, as we indicated, senior professionals to increase the high caliber of talent we had to increase that. We also are in seeing and wanted to add contracts to our portfolio so that we could then bid on additional vehicles and expand our pipeline in that space. One of the other objectives was not only partnering but adding additional companies that we could team with both on these pipeline opportunities, but also on strategic kind of growth objectives. The pipeline in general from a '22 to '23 has increased to kind of an ex multiple. So we're seeing significant improvement in the unfactored pipeline to date. So we're confident that we're going in the right direction. A lot of the opportunities close or get awarded this quarter and into the end of the year. So that's really when we start seeing results of some of this, but it'll obviously continue into '24 as we continue to grow that organization. On the TSA PreCheck side, yes, we are happy the official website that was in the slide deck have been launched. We also indicated 7 enrollment sites are now open. We look forward to expanding that nationwide presence in the coming months. And so the volume that we've seen primarily on the renewal side has been decent for what we've -- since we've launched. And so we expect that to continue to grow. So the next steps are expansion nationwide so that we can service the customers in locations and in areas that are more convenient.
John B. Wood
And Zach, just to remind you and the rest of the people on the call here, this contract is way back when was awarded because we had several proof points that were important. One was we had won the Census contract. And just to remind everybody, over a course of 4 months during the high COVID, we were able to take in 1 million enumerators to do the Census process itself. That was a big past performance qualification for us. The second was around our ability to win at airports across America. So I think the -- but that first point is important. Once we build out that network, there'll be other activities that we can push through that network. That was our plan, and that continues to be our plan.
Operator
One moment for our next question. Our next question comes from Rudy Kessinger of D.A. Davidson & Company.
Rudy Grayson Kessinger
Great. I want to ask another question on TSA. Just how much revenue are you expecting in the second half of this year? And then could you remind us of the fixed cost structure and the potential margin flow-through at scale? And just at this point, do you have any time line to when you expect to get to material share of sign-ups and renewals?
John B. Wood
So Rudy, if you don't mind, I'll ask Mark Bendza to handle the first part of your question. And as it relates to the scaling question, I'll ask Mark Griffin to handle that later in the -- after he -- mark Bendza Griffin, addresses your first question, okay?
G. Mark Bendza
Hey, Rudy, so on PreCheck, listen, we're in the early stages of ramping PreCheck. So in the second half year in the guide, we have a pretty modest level of revenue. Think of it as very low single-digit millions to start. Regarding the ramp over time, I think we're probably looking at -- it's split between renewals and new enrollments, right? So renewals, I would say, will ramp much more quickly because that's an online process as opposed to an on-site process. New enrollments will ramp over a longer period of time. Think of it more like a 1-year ramp because that will involve the rollout of a nationwide network of physical locations which will take more time. And then in terms of once the program is fully ramped, I think well could see gross margins in the 50s and adjusted EBITDA margins in the 30s when you get to a full run rate program.
Mark D. Griffin
And Rudy, Mark Griffin. As far as market share, Obviously, there are 3 contract awardees at this stage, of which ourselves and the current provider are -- have websites that are operational. So I'm not able to draw conclusions yet on what ultimately we could be market share, but the conclusion currently is there are 2 players with live websites to do both enrollment and renewals.
Operator
One moment for our next question. Our next question comes from Alex Henderson of Needham.
Alexander Henderson
I just wanted to clarify upfront the contract that you signed that was on the software side, I assume that was exact. And to the extent that, that was perpetual, I guess it doesn't recur. So can you give us some sense of, a, what kind of customer that was? Was it a government agency? Was it a partner? Was it an enterprise and what the scale of that was so that we can anticipate that falling out of the numbers next year as a large contract in the comp.
John B. Wood
Sure. Alex, that was a foreign government that made that purchase. It was a purchase of the automated massage handling system. That has a tail of about 20% per year as it was a perpetual license. And it was -- I don't think we have said exactly what the number was did we?
G. Mark Bendza
It was low single-digit millions, Alex.
John B. Wood
Yes.
Operator
Okay. One moment for our next question. Our next question comes from Brad Clark of BMO Capital Markets.
Bradley Reiss Clark
On the Secure Networks business, clearly, revenues and growth are being impacted by contract completions from 2022 you mentioned 3 in particular. How should we be thinking about sort of the go-forward run rate of contract completions and secure networks basis new contracts that have been awarded since then as we anticipate what the growth potential of secure networks might be over the next few years?
G. Mark Bendza
Yes, Brad. So I think your question was on networks there and the outlook for networks. So as you referenced, we've had a meaningful step down in networks this year as a result of a couple of very large contracts coming to a successful completion at the end of last year. Those were contracts that grew -- that drove 89% growth for networks on the top line in 2021 and then ramped down -- have been ramping down since then. As we look forward into 2024 and beyond, I think not just for networks, but for the company overall, yes, I'd say it's still too early to provide detailed visibility into 2024. But keep in mind, at this point in any given year, we typically have somewhere around call it, a few tens of millions of dollars of revenue headwinds embedded in our backlog across the portfolio for the upcoming year, which then needs to be backfilled with new business, especially in secure networks. So that's part for the course. And new business tends to be seasonally weighted to late in the calendar year or early in the following calendar year. Now the headwind that you're referring to that we had coming into 2023 was it was unusually large and we weren't able to backfill the revenue as we've previously discussed. But I'd say at this point, the revenue we need to backfill not only in secure networks, but just in general across the company for 2024 is much more typical roughly in the range of a few tens of millions of dollars. So the conversation we were having with Zach earlier around the investment in our growth and business development organization is an important one because in order to grow next year, we'll need to backfill the usual revenue headwind in the backlog and we need to convert our pipeline and win additional business later this year and early next year as we do every year. Thanks.
Operator
Right. I am showing no further questions at this time. I would now like to turn the conference back to John Wood for closing remarks.
John B. Wood
Thank you, operator. I just want to thank our shareholders for your ongoing support. Our first half results reflect our team's diligence and focus on delivering results that exceed our original outlook for 2023. And I just want to assure you that the Board and I remain fully committed to taking the necessary actions to improve performance and return to growth. So we are in robust and recession-resistant end markets, we have very well-funded customers, and we do have a decade long track record of serving the world's most security-conscious organizations. So as a result, we feel that Telos has a strong foundation for the future, and we hope you share that point of view as well. Thanks a lot, everybody.
Operator
This concludes today's conference call. Thank you for participating. You may now disconnect.
