Q3 2023 Telos Corp Earnings Call
Participants
John Wood; Chairman of the Board, President, & CEO; Telos Corporation
Mark Bendza; CFO & EVP; Telos Corporation
Mark Griffin; EVP of Security Solutions & President, General Manager of Telos Identity Management Solutions LLC; Telos Corporation
Allison Phillipp; Director of Corporate Communications; Telos Corporation
Zach Cummins; Analyst; B. Riley Securities, Inc.
Rudy Kessinger; Analyst; D.A. Davidson Companies
Alex Henderson; Analyst; Needham & Company, LLC
Nehal Chokshi; Analyst; Northland Securities, Inc.
Presentation
Operator
Good day, and thank you for standing by, and welcome to Telos Corporation's third-quarter 2023 earnings call. (Operator Instructions) Please be advised that today's conference is being recorded. I would now like to turn the conference over to your first speaker today, Allison Phillipp. Please go ahead.
Allison Phillipp
Good morning. Thank you for joining us to discuss Telos Corporation's third-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 third-quarter 2023 results and Telos's strategic priorities. Then Mark will cover the financials in more detail and discuss guidance for the fourth quarter and full-year 2023, as well as provide some high-level comments on 2024 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 wanted 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 in 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'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 financial 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 Wood
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 all key financial metrics in the third quarter. Mark will discuss the details of our financial performance later in the call.
At a high level, we delivered $36.2 million of revenue in the third quarter above our guidance range of $30 million to $34 million. Gross margin was 36%, above our guidance range of 30.4% to 34.2%. Adjusted EBITDA was a $1.3 million loss and was above the top end of our guidance range of negative $8 million to negative $6 million. Lastly, we returned to positive cash flow from operations this quarter.
Many factors enabled our team to achieve these results, including better-than-expected performance from key programs and security solutions like TSA PreCheck, strong program management in secure networks to support margin performance, and management of operating expenses to support profitability while also funding growth investments.
With three quarters complete, we have successfully managed 2023 to better-than-originally-expected results year to date. Given this performance and our outlook for the remainder of the year, we are again in a position to raise our full-year guidance on all metrics.
Now let's turn to slide 4 to discuss our recent business highlights and updates. First and foremost, I'm pleased to announce that Telos, in close coordination with TSA, achieved the formal launch of our TSA PreCheck program in the third quarter. Telos's official TSA PreCheck enrollment website is operational, and the website address is in our earnings presentation and press release.
Our capability to process TSA PreCheck renewals is fully operational, and our capability to process new enrollments will continue to ramp up as we onboard physical sites across the country over the next several quarters. We look forward to steadily growing this offering in the coming quarters and years into a long-term steady value-creating program for Telos.
Beyond TSA PreCheck, we continue to achieve high renewal rates with our Xacta customer base, both in government and commercial sectors. Government customers included the National Geospatial Intelligence Agency, the Federal Bureau of Investigation, the US State Department, the Defense Intelligence Agency, the Social Security Administration, the US Environmental Protection Agency, and a classified customer.
Commercial customers included Zscaler, Ernst & Young, stackArmor, and a large confidential customer in the technology sector. We were also awarded renewals for cyber services at the Defense Health Agency, the General Service Administration, and the US Department of Homeland Security. Additionally, we secured a new award for our automated message handling system with the joint CryptoLogic Mission Simulation program through the National Security Agency.
Lastly, the Secure Networks team obtained a new contract with the US Air Force for a new secure network installation, building on our three-decades-long relationship with the US Air Force.
I will now turn the call over to Mark Bendza, who will discuss the third-quarter 2023 financial results, guidance for the fourth quarter, and full-year 2023 and a preliminary outlook for 2024. Mark?
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 third quarter with revenue, gross margin, and adjusted EBITDA all above the high end of our guidance range. And we are therefore, again, able to raise the midpoint of our full-year guidance while also narrowing the guided ranges.
Getting into more detail on the third quarter, total revenues declined 43% year over year and grew 10% sequentially to $36.2 million due to sequential growth in both security solutions and secure networks.
Revenues for our security solutions business declined 39% year over year and grew 15% sequentially to $19.8 million. Security solutions revenues were above the top end of our third-quarter guidance range due to outperformance on important programs, including higher-than-forecasted TSA PreCheck renewal volume, a rebound in customer mission activity on a confidential program, and revenues on a cyber security program that accelerated from the fourth quarter to the third quarter.
Security solutions contributed 55% of total company revenues up from 51% in the comparable period last year. The large year-over-year revenue drivers for security solutions were consistent with our expectations as 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 two ongoing programs and Telos ID. Combined, these three programs represented a $16.6 million year-over-year headwind in the quarter.
Turning to secure networks, as expected, revenues declined 47% year over year and grew 4% sequentially to $16.4 million, in line with our third-quarter guidance range. The year-over-year revenue headwinds in secure networks were also consistent with our expectations as communicated on prior earnings calls. Three large programs that primarily came to a successful completion in 2022 and lower revenues on an ongoing program drove a $17 million headwind in the quarter.
Turning to profitability, GAAP gross margin expanded over 300 basis points to 36% due to a higher weighting of revenues from our higher-margin security solutions business and more than 500 basis points of margin expansion in secure networks, partially offset by margin contraction and security solutions.
Amortization of previously capitalized software development costs was a meaningful year-over-year headwind to GAAP gross margin in the third quarter and will remain an important component of our cost of sales from the third quarter onward.
In accordance with GAAP accounting, we expense software development costs as research and development expense until we meet certain milestones, after which we begin to capitalize software development costs as an intangible asset on our balance sheet. Lastly, we amortize the intangible assets related to revenue-generating activities through cost of sales after the software has completed its development phase.
As a result of the successful formal launch of the TSA PreCheck program in the third quarter, we have now started amortizing the TSA PreCheck software development costs that have been capitalized over the past few years. Accordingly, going forward, we will report gross margin on a GAAP basis as well as on a non-GAAP basis, excluding stock-based compensation and depreciation and amortization.
We believe non-GAAP gross margin is a useful, supplemental, and clarifying measure to help investors better understand the core economics of gross margin during the current reporting period, excluding non-cash expenses and sunk costs expended in prior quarters and years. We will continue to guide gross margin on a GAAP basis.
With that background, non-GAAP gross margin expanded 684 basis points to 41.5% due to a higher weighting of revenues from our higher-margin security solutions business, 626 basis points of margin expansion in security solutions, and 480 basis points of margin expansion in secure networks. GAAP gross profit exceeded the high end of our forecasted range by approximately $1.2 million, and GAAP gross margin exceeded the high end of our guidance range by 180 basis points.
GAAP gross margin for our security solutions business contracted 77 basis points to 47.3%, primarily as a result of the commencement of amortization of previously capitalized software development costs associated with the TSA PreCheck program. Security solutions' GAAP gross margin was consistent with our forecasted range. Security solutions' non-GAAP gross margin expanded 626 basis points to 57.4% due to more favorable revenue mix.
GAAP gross margin for our secure networks business expanded 509 basis points to 22.3% due to the successful completion of lower-margin programs at the end of 2022 and exceeded our forecast due to margin outperformance on multiple programs across the portfolio due to strong program cost management. Secure networks' non-GAAP gross margin was not meaningfully different from GAAP gross margin.
Adjusted EBITDA was a $1.3 million loss and exceeded the top end of our guidance range by $4.7 million due to $2.9 million of better-than-forecasted gross profit, excluding depreciation and amortization, as well as $1.8 million of lower than previously forecasted below-the-line expenses, which primarily represents the management reserve that we disclosed on our prior earnings call.
Now let's turn to free cash flow and liquidity. We returned to positive cash flow from operations in the third quarter due to favorable working capital dynamics. Cash flow from operations was an $846,000 inflow and free cash flow was a $3 million outflow. We ended the quarter with approximately $100 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 fourth quarter. For the fourth quarter, we forecast sales in a range of $30 million to $34 million and an adjusted EBITDA loss of $6.5 million to $4.5 million. We forecast security solutions revenues to decline high 30% to low 30% year over year and secure networks revenues to decline low 30% to mid 20% year over year, both primarily due to the same dynamics that have persisted throughout 2023.
GAAP gross margin is expected to be down approximately 350 basis points to 225 basis points year over year, primarily due to higher amortization of capitalized software development costs. Cash below the line expenses, which adjusts for capitalized software development costs, stock-based compensation, restructuring costs, and depreciation and amortization are forecasted to be approximately $3 million higher year over year, primarily due to planned growth investments focused on business development, information assurance, Telos ACA, and TSA PreCheck.
Let's turn to slide 7 to discuss our updated guidance for the full year. We are again raising the midpoint of all full-year guided metrics and also narrowing our guided ranges. During our three earnings calls of 2023, we have now reaffirmed our full-year guidance once and raised the midpoint of guidance twice.
Our fourth-quarter guidance implies full-year revenues of $134 million to $138 million, representing a $6.5 million increase to guidance at the midpoint. We're forecasting full-year GAAP gross margin in a range of 36.8% to 37% or a 125-basis-point increase at the midpoint.
Lastly, updated guidance includes adjusted EBITDA ranging from a $9 million loss to a $7 million loss or an $8.5 million increase at the midpoint. Over the course of 2023, our revenue guidance has improved due to strong renewal rates in information assurance and secure communications, new contract wins in secure communications, better-than-expected performance on TSA PreCheck, favorable supply chain performance in secure networks, and expanded revenues on a pre-existing program in secure networks.
GAAP gross margin guidance has improved due to high-margin new business wins and revenue outperformance on higher-margin programs and security solutions and strong program management in secure networks.
Lastly, adjusted EBITDA guidance has improved over the course of the year due to improved gross profit from higher revenues and gross margins combined with multiple quarters of cost management that started with our restructuring in the first quarter.
Now before I turn the call, back over to John, I'd like to provide an overview of some of the key variables that will ultimately determine the 2024 guidance that we will provide on our fourth-quarter earnings call in March.
At this stage, we believe our total 2024 potential revenue opportunity exceeds $200 million, and it's highly dependent on two pending new business opportunities and security solutions and the ramp of our TSA PreCheck program, all of which should become more visible before our fourth-quarter earnings call in March.
Let's break this down into two components: pre-existing programs and pending new business opportunities. Starting with pre-existing programs, as communicated on our second-quarter earnings call in August, there is a 2024 revenue headwind of approximately a few tens of millions of dollars embedded in our pre-existing programs, inclusive of growth from TSA PreCheck.
This headwind needs to be backfilled with new business wins late this year or early next year. The ultimate size of the headwinds embedded in pre-existing programs will primarily depend on the performance of TSA PreCheck, in particular, the pace and timing of opening new enrollment locations and annual fluctuations in overall market transaction volume.
Turning to pending new business opportunities, again, as communicated on our second-quarter earnings call in August, new business award decisions tend to be seasonally weighted to late in the calendar year or early the following calendar year.
We are currently awaiting final award decisions on numerous pending new business proposals, representing approximately $610 million of total contract value and approximately $115 million of potential 2024 revenue. The ultimate revenue contribution realized in 2024 from pending new business opportunities will depend on win rates and program start dates.
Approximately 85% or nearly $100 million of potential 2024 revenue from pending new business opportunities is concentrated into long-term recurring revenue opportunities and security solutions with award decisions anticipated before March of 2024. There may also be additional opportunities to generate revenue from task orders on new contract vehicles and secure networks over the course of 2024.
Lastly, turning to gross margins, substantially, all pending new business opportunities reside in security solutions. And substantially, the entire revenue headwind on pre-existing programs resides in secure networks. Accordingly, security solutions revenue could represent as much as 70% to 80% of total company revenue in 2024.
The overall company gross margin profile in 2024 is expected to be roughly comparable to 2023 as the margin benefit of higher revenue contribution from our higher-margin security solutions segment will be offset by margin contraction in each of security solutions and secure networks in part as a result of higher amortization of capitalized software through cost of sales and revenue mix within each segment.
With that, I'll pass it back to John, who will wrap up on slide 8.
John Wood
Thanks, Mark. Let's move to slide 8. In summary, we exceeded quarterly expectations and delivered results above the high end of the guidance range on all financial metrics. Our TSA PreCheck program formally launched this quarter and was a key factor in our overperformance. We look forward to steadily growing this offering into an important source of recurring revenue in the coming quarters and years.
We raised full-year guidance for the second consecutive quarter as we continue to focus on managing 2023 to better than originally expected results through high-margin new business wins, program management, cost discipline, implementation of our restructuring, and reinvestment in growth.
As we look ahead, the potential revenue opportunity for 2024 is encouraging as we eagerly await the outcome of pending new business opportunities in security solutions. Lastly, our balance sheet remains highly liquid at a competitive advantage, well positioned to support the company both operationally and strategically.
And with that, we're happy to take any questions.
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 one question. Thank you.
Question and Answer Session
Operator
(Operator Instructions) Zach Cummins, B. Riley Securities.
Zach Cummins
Yes, hi. Good morning, Mark and John, congrats on a solid quarter here and appreciate the additional color around the puts and takes for 2024. Just to that point, I mean, it seems like the opportunity is really concentrated in two large programs within security solutions. So John, can you go ahead and handicap how you're feeling about your chances of winning in each of these engagements and kind of give us a sense of how you're progressing through kind of the decision process at this point?
John Wood
Yes, I think these are two opportunities that of customers that we've known well for a long time and feel good about the potential of the outcomes for sure, Zach. I also mentioned that -- we mentioned task orders and other contract vehicles. When we go after contracts, there are really two types of contracts. One contract vehicle has a financial amount for sure per year, and these are the two contracts we're talking about.
But other contracts have a significant ceiling. So previously, we had a contract called [NetFence], which had a lot of ceiling on it. And over the course of roughly 18 to 20 years, we did about $1.6 billion or $1.5 billion on that contract. So we're really pursuing both kinds of contracts. We're emphasizing these two because they have financial certainty around them.
Zach Cummins
Understood. Well, thanks for taking my question and best of luck with the year end.
John Wood
Thank you.
Operator
Rudy Kessinger, D.A. Davidson.
Rudy Kessinger
Hey, guys. Thanks for taking my questions or question. On TSA PreCheck, can you give any color about how much it contributed to the quarter? Where are you trending on your market share on renewals, and also on -- with new enrollments, how many sites are you up to? When do you think you'll be fully rolled out? And just again, what's the timeline you're thinking of to get to full one-third market share? since that.
Mark Bendza
Hey, Rudy. It's Mark Bendza here. So I'll try to give some color there. Keep in mind, though, we're not really going to be giving a lot of detail on PreCheck financial performance. We don't really do that on any other program. So we're not going to go into a lot of detail on this call or future calls on PreCheck financial performance.
But what I will say is that we feel we're off to a good start here. The performance on PreCheck was the single largest driver of our beat in the quarter. The market overall is currently trending very well, both on new enrollment and renewals. What we're seeing is that the market is quite a bit bigger today than it was from the pre-COVID highs. New enrollments, for example, are approximately double what they were during the pre-COVID high.
So we're pleased so far with how that program is ramping for us. Like I said, it's (inaudible) to speak in the quarter, and we're encouraged by what we're seeing so far. On the more operational aspects of the program, let me turn it over to Mark Griffin.
Mark Griffin
Yes, thank you. One of your questions was how many sites we currently have. That's 26 sites. I wanted to remind everyone that our ability to ramp to the full complement of sites that we have talked about will occur by the end of 2024.
We also wanted to remind everybody that our experience level in ramping the sites is shown in the effort and work we did on the 2020 Census, also the sites that we have at over 100 facilities in the aviation security space at airports, and also are experienced at the DoD where we have well over 100 biometric sites that were deployed on numerous contracts. So our ability to ramp quickly and expeditiously with our partner, Office Depot, we're confident that that will progress very rapidly as we move forward.
Rudy Kessinger
Okay, great. Thanks for taking my questions.
Mark Bendza
Thanks, Rudy.
Operator
Alex Henderson, Needham.
Alex Henderson
Thanks. I was hoping you could talk about what is in these contracts a little bit. Is it Xacta? Is it [HAMHS]? What's going on within the mix of what you're trying to sell to these customers, and something -- give us any update on Ghost too, while you're at it.
John Wood
Hi, Alex. This is John. So broadly speaking, the vast majority of everything we're bidding on is inside of our security solutions segment. And it's a combination of different capabilities that we deliver from cybersecurity services to identity applications. Those are the kind of things that we're focusing on these days, which we think as -- which we think we're well positioned for.
And Ghost we see as becoming more of a feature of some of the capabilities that we have out there, where we're able to hide what we're doing, if you will, from people that are interested in finding out what we're up to. So I would say the vast majority of everything we're doing is security solutions.
Alex Henderson
So no mention of Xacta on that?
John Wood
No, Xacta would be a component as well. So anytime we can, Alex, and I think I said that previously, anytime we can, we're going to be bundling our security solutions together, which gives us a differentiated offering to our customers.
Alex Henderson
Okay, thanks.
John Wood
You're welcome.
Mark Bendza
Thanks, Alex.
Operator
Nehal Chokshi, Northland Capital Markets.
Nehal Chokshi
Yes, thank you, and congratulations on the second straight quarter, the (inaudible) as well as a strong TSA initial ramp here. My question is on the initial view on CY24, especially the swings of those two contracts. In order for them to contribute up to $100 million in calendar '24, what would be the presumption of those contract start times?
Mark Bendza
[Start time is around] Q1.
John Wood
Late Q1, early Q2, Nehal.
Nehal Chokshi
Okay. And when you say an AC -- $115 million of total -- of calendar '24 revenue contribution from the various contracts are up and then $610 million of total contract value, that implies you're basically talking about average five-year duration for these contracts that are in their mature phase of the pipeline?
John Wood
I think that's fair. However, when you when you look at our complete pipeline, our complete pipeline is well in excess of $3 billion, and that pipeline can range from a couple of years to 10-year kind of contracts.
Nehal Chokshi
Okay. Within that pipeline, the remaining $2.4 billion, how much of that do you think will be awarded sometime in calendar '24 that could start to ramp within calendar '25?
John Wood
I don't know that off the top of my head. Do you know that stuff? [Can you check again?] I don't know that answer off the top of my head. I would say that the -- what we're giving you in terms of the dollars of -- $600 million, those have been submitted and those are pending award. So we're giving you, if you will, the tail end of the pipeline. There will be a continuous input of additional opportunities in the pipeline each quarter. So I would expect that pipeline to continue to mature. And as it matures, we'll continue to update the market.
Nehal Chokshi
All right. Great. Thank you.
Operator
Thank you. I'm showing no further questions at this time and would now like to turn the call back to John Wood for closing remarks.
John Wood
Thank you, operator. First of all, I just want to thank our shareholders for your ongoing support. We had a second consecutive quarter of raising our full-year outlook, and that's a testament to my team's unwavering commitment to delivering for our customers and our shareholders in 2023 and beyond.
We've made good progress during '23 to rebuilding our core revenue base through -- we have had really strong renewal rates on our existing business. We've cultivated and centralized a very productive business development and new business development pipeline. And we've continued to invest in really solid future growth opportunities.
And the basic point I want to make is we're really just getting started. With robust recession-resistant end markets and well-funded customers and a decade-long track record of serving some of the world's most security-conscious organizations, we think Telos has a really strong foundation for the future. So we just want to thank you again for your support. Thanks a lot, everybody.
Operator
Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.
