Telos Corporation (NASDAQ:TLS) Q3 2023 Earnings Call Transcript
Telos Corporation (NASDAQ:TLS) Q3 2023 Earnings Call Transcript November 9, 2023
Telos Corporation beats earnings expectations. Reported EPS is $-0.12465, expectations were $-0.15.
Operator: Good day, thank you for standing by. Welcome to Telos Corporation Third Quarter 2023 Earnings 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 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’ strategic priorities, then Mark will cover the financials in more details and discuss guidance for the fourth quarter and full year 2023 as well as providing high level comments on 2024, before turning it back to John to wrap up. Then we will 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 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 will turn the call over to John.
John Wood: Thank you, Allison, and good morning, everyone. Let's begin today on Slide 3. I am 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 the 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 $1.3 million loss and was above the top-end of our guidance range of negative $8 million to negative $6 million. Lastly, we have 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 and Secure Network 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 am pleased to announce that Telos in close coordination with TSA achieved the formal launch of our TSA PreCheck program in the third quarter. Telos' 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 U.S. State Department, the Defense Intelligence Agency, the Social Security Administration, the U.S. 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 U.S. Department of Homeland Security.
Additionally, we secured new award for our automated message handling system with the Joint Crypto Logic Mission Simulation Program through the National Security Agency. Lastly, the Secure Networks team obtained a new contract with the U.S. Air Force for a new secure network installation building on our three decades long relationship with the U.S. Air Force. I'll 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 cybersecurity 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 and 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 in Telos ID. Combined these three programs represented $16.6 million year-over-year headwinds 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 and 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 and secure networks partially offset by margin contraction in 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 onwards.
In accordance with GAAP accounting, we expect 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 cost that has been capitalized over the last 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 rating 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 reserves that we disclosed on our prior earnings call. Now let's turn to free cash flow and liquidity. We have 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 $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 adjust 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 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 is highly dependent on two pending new business opportunities in 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. These headwinds need 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 in two long-term recurring revenue opportunities in 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 in Secure Networks over the course of 2024. Lastly, turning to gross margin. 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 and each of Security Solutions and Secure Networks in part as a result of higher amortization of capitalized software to cost of sales and revenue mix within each segment.
With that, I will pass it back to John who will wrap 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 over performance. 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 and a competitive advantage, well positioned to support the company both operationally and strategically. And with that, we're happy to take any questions. 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.
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