Telos Corporation

Good day, and thank you for standing by. Welcome to the Telos Corporation third quarter 2024 earnings call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during the session, you will need to press star 1 1 on your telephone, and then you will hear an automated message advising you that your hand is raised. To withdraw your question, please press star 1 1 again. Please be advised that today's session is being recorded. I would now like to hand the conference over to your first speaker today, Allison Phillips.

Allison, you have the floor. Good morning.

Thank you for joining us to discuss Telos Corporation's third quarter 2024 financial results. With me today is John Wood, Chairman and CEO of Telos. and Mark Benza, Executive Vice President and CFO of Pelove. Let me quickly review the format of today's presentation. Mark will begin with remarks on our third quarter 2024 results. Next, John will discuss business highlights from the quarter. Then, Mark will follow up with fourth 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 third quarter financial results were issued earlier today and are 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 financial results summary 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 TELUS's financial performance. These non-GAAP financial measures should be considered in addition to and not as a substitute for or an isolation from GAAP results. You can find additional disclosures regarding these non-GAAP measures, including reconciliations with comparable GAAP results in our third quarter financial results summary 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 three. I'm pleased to report that Telos has delivered revenue near the top end of the guidance range and the Justice EBITDA above the top end of the guidance range. We delivered $23.8 million of revenue in the quarter compared to guidance of $22 million to $24 million. Security Solutions delivered $18.3 million, or 77% of total revenue, which was in line with the top end of our guidance range due to strong performance across the portfolio relative to forecast. Security Solutions revenue grew 3% sequentially due to double-digit sequential growth in Telos ID, primarily as a result of the ongoing ramp of our TSA PreCheck program. We expect sequential growth in our Security Solutions business to accelerate in the fourth quarter as our large program with a Defense Manpower Data Center, or DMDC, begins to ramp. DMVC is the large program award that was under protest earlier this year and has since been resolved and is currently generating revenue. Secure Networks delivered $5.5 million or 23% of total revenue in line with guidance. Secure Networks revenue declined sequentially and year over year as expected due to the ramp down of existing programs. As previously reported, Secure Networks has gained access to new contract vehicles in recent quarters and has cultivated a large pipeline of new business opportunities that we are currently pursuing to replenish the backlog. Turning to margins, as we mentioned on our last earnings call, 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. As we also stated on our last earnings call, our guidance does not include any charges that could result from such actions. During the quarter, we assessed our cost structure and investment priorities to reduce costs and reallocate resources to support large programs that are currently ramping in security solutions. As a result, we discontinued the development and sale of selected solutions or parts of solutions that were not generating acceptable returns. The restructuring, as well as an assessment of our intangible assets, resulted in an $11.7 million non-cash impairment of capitalized software assets, including $5.3 million in cost of sales, and a $1.4 million restructuring charge, including $400,000 in cost of sales. We took a $13.1 million charge in the quarter, $5.7 million of which was recorded in cost of sales and impacted GAAP gross margin. GAAP gross margin was 13.2%. Excluding the $5.7 million impairment and restructuring charge in cost of sales, gross margin expanded 130 basis points year over year to 37.3%, and was above the top end of our guidance range. In addition, cash gross margin expanded 250 basis points year over year to 44%. Cash gross margin was above our guidance range and was also the company's highest cash gross margin since the IPO in 2020. Strong revenue, cash gross margin over performance, and cost reductions resulted in adjusted EBITDA above the top end of the guidance range. Adjusted EBITDA was a $4.1 million loss compared to guidance of an $8 million loss to a $6.5 million loss. Lastly, cash flow from operations and free cash flow both improved sequentially. Cash flow from operations was a $7.1 million outflow, and free cash flow was a $9.9 million outflow. I will now turn the call over to John for an overview of recent business highlights. John?

Thanks, Mark, and good morning, everyone. Let's turn to slide four. We continue to make steady progress on the TSA PreCheck program. As Mark previously indicated, this program is the main driver for the sequential growth in the third quarter in our TELUS ID business, and it remains well on track to becoming our single largest program in 2024. We have continued to successfully accelerate the expansion of our network of enrollment centers by more than doubling our footprint from 83 to 173 locations over the past three months. Additionally, it's important to point out that we continue to prioritize our expansion in key markets geographically distributed across 29 states around the country. These states comprise approximately 79% of the population of the United States. We plan to build on this progress and continue the growth of 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. The first program is with the Defense Manpower Data Center, or DMDC. It's within the United States Department of Defense and is worth up to $485 million to TELOS over five years. As expected, the protest on this program was resolved in favor of Telos and our prime partner by the end of September, and we are currently generating revenues as the program operations ramp. We look forward to working with our partner to provide exceptional support to our customer on this program for years to come. The second program is with the Department of Homeland Security, or DHS. This program with DHS is worth up to $40 million to TELOS over five years, and as previously communicated, we expect this protest to be resolved in the fourth quarter. In addition, I'd like to report on several other business outcomes since our last earnings call. Our executive business has received new orders with several new customers, including the United States Air Force Office of Special Investigations, as well as renewals from the Social Security Administration, the Federal Bureau of Investigation, the Defense Intelligence Agency, Infor, Siemens, and other key customers. We received renewals for cyber services from the General Services Administration, the Defense Health Agency, and other government customers. The automated message handling system business continues to achieve high renewal rates with its customer base. In particular, this quarter, the business realized renewals from the Department of Homeland Security, the Department of the Treasury, and several other government customers. Finally, we received a new contract with the United States Army in our secure networks business. I'll now turn the call over to Mark, who will discuss fourth quarter guidance. Mark?

Thanks, John. Let's turn to slide five. For the fourth quarter, we expect revenue to grow 3% to 11% sequentially to a range of $24.5 million to $26.5 million. And we expect an adjusted EBITDA loss of $4.5 million to $3.5 million. Sequential revenue growth will be driven by security solutions. We forecast security solutions to grow low teens to low 20% sequentially, driven by the accelerating ramp of TSA pre-check enrollments and our new program with the Defense Manpower Data Center, or DMDC, that I mentioned earlier. We expect secure networks revenues to decline sequentially in the fourth quarter due to the steady decline in backlog in advance of new business wins that would typically be awarded in the fourth quarter of 2024, and the first quarter of 2025. As previously mentioned, Secure Networks has gained access to new contract vehicles in recent quarters and has cultivated a large pipeline of new business opportunities that we are pursuing to replenish the backlog for 2025 and beyond. As a result of forecasted strong sequential growth in security solutions in the fourth quarter, combined with a sequential decline in Secure Networks, We expect security solutions to contribute over 80% of total company revenues in the fourth quarter. Gap gross margin is expected to expand by 170 basis points to 330 basis points year over year, primarily due to the favorable mix shift from our lower margin secure networks business to our higher margin security solutions business. Cash gross margin is expected to expand by 465 basis points to 580 basis points year-over-year for the same reason. Cash below-the-line expenses, which adjust for capitalized software development costs, stock-based compensation, restructuring costs, and DNA, are forecast to be approximately $4 million lower year-over-year due to lower incentive compensation expense and the benefits of cost actions taken in the third quarter. We will provide further detail about our 2025 outlook on our fourth quarter earnings call in March. But in the meantime, the 2025 revenue drivers that we outlined on prior earnings calls have not changed. We forecast a return to year-over-year revenue growth in 2025. Revenues in 2025 will be comprised of several key components. First, we expect our existing business excluding TSA PreCheck and the DMDC and DHS programs that we won in the first quarter of 2024 to generate approximately $60 million to $65 million of revenue in 2025. Assuming the DHS protest is resolved in our favor, the DMDC and DHS programs could generate over $100 million of revenue in some years. But for modeling purposes, we're assuming a more modest $60 million to $85 million in a typical year at full run rate. We believe we have potential to achieve the typical year run rate in 2025. Third, we are targeting a pro rata market share of the TSA pre-check market after we complete the rollout of our 500 enrollment locations and those locations mature into productive sites for a full calendar year. We expect to complete the rollout of our 500 enrollment locations by the end of 2025, and we believe the TSA PreCheck market is approximately a $200 million market based on our current pricing structure. Although we do not expect to achieve our pro rata market share in 2025, we expect TSA PreCheck revenues to ramp as we continue to roll out our enrollment locations over the course of next year. And lastly, we have a large pipeline of new business opportunities, especially in secure networks, and we'll be submitting proposals during the fourth quarter government buying season. Any new business wins during the fourth quarter of 2024 or the first quarter of 2025 will have the potential to contribute revenue next year. And with that, I'll turn it back to John.

Thanks, Mark. Let's turn to slide six. In summary, we delivered revenues near the top end of the guidance range and exceeded guidance on adjusted EBITDA. Additionally, we are thrilled the protest on the DMDC program was resolved in our favor. We are now generating revenues on this program as we ramp operations and look forward to working with our partner to provide exceptional support to our customer for years to come. We've continued rapid expansion of our network of TSA PreCheck enrollment locations to 173, more than doubling our footprint since the last earnings call. We continue to expect we'll reach 500 locations in 2025. Finally, with this recent positive news, we expect to achieve sequential revenue growth in the fourth quarter. And with that, we're happy to take questions.

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

Thank you. At this time, we will conduct a question and answer session. As a reminder, to ask a question, you will need to press star 11 on your telephone and wait for your name to be announced. To withdraw your question, please press star 11 again.

Please stand by while we compile the question and answer roster. Our first question comes from Bradley Clark with BMO.

Bradley, please go ahead with your question.

Yeah, hi. Thanks for taking my question. And congrats on the protest resolution. Can you just review the DMDC contract with up to $485 million? What are some of the puts and takes around, you know, what ultimately determines how much that contract costs? can be given the 485 ceiling? Like, what are the factors that determine where you land below that ceiling?

Yeah, so, Brad, it's Mark Meza here. So, on that program, there is, you know, there are a couple of different revenue streams there. There's a base services revenue stream, which is a recurring revenue stream that we have a high level of visibility into. That's approximately $25 million. The remainder of the revenues are a combination of third-party hardware, software, technology that we integrate into the overall solution for our customer. That revenue stream can fluctuate quarter to quarter and year to year. So overall, for modeling purposes, we're calling it $60 to $85 million a year. But in any given year, you can be over $100 million in total. Our best estimate at this point on a low year would be about $60 million. Now, in those numbers, I tend to lump together DMDC and DHS. DHS is a small piece of that. Of the 60 to 85 that I quote, we're only including about two to eight in that range for DHS, which is the smaller program of the two.

Okay, thank you. And then can you remind us of the margin profile of this work compared to the remainder of your security solution business?

Yeah, so the margin profile varies quite a bit depending on which revenue stream. I don't want to get into the details of the margin profile for each revenue stream, but overall on a blended basis, I'd say those two programs combined, I describe it as being dilutive to cash gross margins. Now, in my prepared remarks, I talked about buckets of revenue for 2025. Some of those are accretive to margins. Some of those are dilutive to margins. Overall, in 2025, I'd say we're probably going to be a couple hundred basis points lower on cash gross margin so slightly lower on cash gross margin but of course on a significantly higher revenue base okay thank you sure stand by for our next question our next question comes from zach cummins with b riley zach go ahead with your question thanks good morning uh mark and john uh thanks for taking my question uh

I really wanted to focus on the restructuring actions that you decided to take here in late Q3, early Q4. Can you give us a little more detail on maybe some of the business lines that are going away and potentially how this could result in maybe more of a margin uplift when we look at the revenue ramp next year?

Sure. Hey, Zach, it's John. So the two solutions that we ended up deciding not to continue selling are advanced cyber analytics and our ghost solution. Basically, we just weren't seeing the uptick in sales that we wanted to, and as a result, we just decided let's fail quickly and move on.

Yeah, and Zach, what I'll add to that is current revenues in those two solutions are effectively, I'd say, de minimis at this point. So there will be no revenue headwind as a result of that decision. And really as we looked at the portfolio and we have these very substantial programs in hand that we are ramping quickly, we wanted to maximize the benefit of operating leverage, incremental margins and cash flows heading into 2025 as a result of the ramp of those programs that we have in hand. So we took a hard look at the overall portfolio to identify where we could be shifting resources from higher risk, lower return opportunities to the lower risk, higher return opportunities that we have in hand.

Understood. And my one follow-up question is just around the pipeline going into key buying season, especially for secure networks. Can you give us a sense of maybe maybe the size of some of these opportunities that you're bidding on and confidence in securing some of this business as you go through the award process here in the next couple of quarters?

Yeah, so maybe I'll start and then Mark Griffin and John can supplement. So, you know, we have a pretty meaningful portfolio of opportunities that are either already submitted or that we're currently working on. You can think of it as you know somewhere around 20 opportunities or so About a third of those are already submitted the balance are in process You know in total you're looking at you know nine figures of total contract value to tell us and Next year of course depending on win rates and when these programs start is there's potential for a couple tens of millions or more of revenue in 2025. But again, there's a lot of contingencies around that. It's what proportion do we win? Are they protested? When do they start? So on and so forth. So a little early to try to give direction on what that number is for next year or to guide it. We'll do that in March. But it's a pretty solid portfolio of opportunities that are actively in process. Let me see if Mark Griffin or John have anything to add.

This is Mark Griffin. I don't have anything to add other than the total portfolio right now of the pipeline is around $4.1 billion, and it represents about 245 opportunities, of which what Mark indicated was a subset of that.

That's good. I agree with that.

Yep. Understood. Well, thanks for taking my questions and best of luck with the rest of the quarter. Thank you, Zach.

Stand by for our next question. Our next question comes from Rudy Kessinger with DA Davidson. Rudy, go ahead with your question.

Hey, thanks for taking my questions, guys. Mark, so, you know, if I go back a year ago, you know, in your Q3 call last year, at that point in time, you guys said you believed you had a total 2024 potential revenue opportunity that exceeded $200 million. And obviously, you know, EIS fell well short of that this year. You're kind of painting a picture. I know you're not giving a number, but with the pieces you gave, you're kind of painting a picture of, you know, ballpark $150 million issue of revenue for next year. I guess I'm just curious what risk lies within that kind of number, and in particular on the two large programs, the $60 to $85 million. How are you getting to that $60 to $85 million, and what's the risk that a year from now those contracts are only doing $30 to $40 million next year?

Yeah. Yeah, Rudy, good question. The big difference between last year and this year, last year our comments – and we were clear about this on the call, but last year our comments – were based on the 625 million dollars of proposals that we had submitted and we won a good chunk of those proposals in march and then they were protested and they slid to the right for the lion's share of this year and now uh in the fourth quarter we're just starting to generate revenues on those programs so that was a big driver of that delta but a really good outcome on the new business wins relative to what we had submitted at the time of that call. And then, of course, the risk for revenue recognition in 2024 ended up being around the protests. Now, fast forward to today, the revenue growth that we're talking about for next year, these are programs that are, one, in hand, that we're currently generating revenues on and ramping. As we talk about the 60 to 85, I would describe it in this way. Of the 60 to 85, there's two to eight million in the DHS program, which is still under protest. I think we said on the last call, and on this one as well, that we're expecting that to be resolved in the fourth quarter based on feedback that we've received. So that $2 to $8 million, the protest needs to be resolved. And then, of course, there's a range there depending on how much share of that program we get from quarter to quarter, year to year. But we think that can range from $2 to $8. For the balance of the revenue of $60 to $85, we have high degree of visibility into $25 million of it. And then the balance is the third party hardware and software that I referred to earlier that we integrate into the overall solution for the customer, that portion is variable and can fluctuate quarter to quarter, year to year. We think we have a pretty good understanding of what that revenue stream would look like in a typical year, given that 2025 would be the first full year of execution on that program. We don't have multiple years of history on this overall scope of work. Of course, we have decades of history on this program on a smaller scope of work. This is a significantly bigger scope of work on this program. So we don't have the history of years and decades of revenue strains to use as a basis for the 60 to 85, but relative to the hundred million that it could be in any given year, we think 60 to 85 is a pretty prudent haircut on the total potential.

Does that answer the question? That's very helpful. It does. That's very helpful color, bringing it out there. I appreciate that. I also wanted to ask on pre-check, the ramp has certainly picked up in locations. I know you're saying get to the 500 locations. That's your not going to have full one-third market share for the full year. But I guess I'm curious, you know, with the locations you have now, we assumed you were getting one-third market share with your currently live locations. That would indicate about $22, $23 million of annualized pre-check revenue today. I'm curious, are you getting one-third market share at those existing 170-ish locations? And if not, like how quickly – Are you seeing yourselves get to one-third market share with some of the locations you rolled out earlier this year?

Yeah, we don't have data on the catchment area around each of those locations, but I can answer it a different way. Based on the average locations that we have open currently, and when you extrapolate that out to 500 locations, we are currently capturing the portion of overall market share that we would expect based on the locations we have open today. And if the same level of productivity on the locations we have open today holds as we roll out to 500, we should be on track to capture a pro rata market share of enrollments.

Okay, that's helpful. Thank you, Mark.

Yep.

Stand by for our next question. Our next question comes from Nahal Chotsky with Northland Capital Markets. Nahal, go ahead with your question.

Thank you, and congrats on the solid bottom line results and guidance here. It's good to see that. Of this DMDC $485 million total contract value, is there any portion of that $485 million that may not be realized over the course of that five years? Or is that $60 million low point simply a reflection of timing of contracted revenue?

So of the 485, 125 is the base services revenue that I described as having a high level of visibility. The difference between the 125 and the 485 is the third party hardware and software that we integrate into the overall solution. The amount of that over the five years, we'll have to see, but our best estimate is that the two combined shouldn't be less than $60 million in a typical year, and could be over, it could be, you know, approximately 100 million in some peak years. Got it. It's really going to be driven by the needs and the demands of the program.

Okay.

Got a couple more questions here. So what I would say is that, you know, unlike other contract vehicles that we have, this is a single award contract for what is essentially one of the largest biometric applications in the government. It's really the program that drives the common access card, among other things, which gets you access to all the military bases and all the military networks around the world. So this particular contract is very important to the customer, and it's very important to the mission. So in general, if they have a requirement to spend the money, they're going to. And we've had a relationship with this customer since 1995. That's one that we know very, very well. I think it's actually our longest serving customer that we have as a company. So this customer understands emissions. And just by way of color, we have something like 40 18-wheelers of equipment coming our way. So there's all kinds of different things that we're doing for this customer.

Thanks for that color, John. And then you also announced being named one of 20 vendors of, I think, like a $13 billion base infrastructure management IDIQ contract for Air Force. Is that revenue from that award expected in calendar 25? Is that part of your calendar 25 buildup that you talked about, Mark?

So Nahal, any future task orders and revenues that would come from that vehicle, that would be included in the bucket of new business wins that I referred to that I did not quantify. But it's not included in any of the quantified buckets that I listed.

And the reason for that, Nahal, is that in this particular case, this contract based infrastructure modernization, which is an Air Force contract. This contract is competed at the task order level by those 23 or four bidders of which we are one. So we compete on a task order level on this contract. We would expect to get our fair share of this work over time, given that we've done a tremendous amount of work with the Air Force previously on another contract we had called NetSense, where we were able to deliver something like $1.6 billion worth of value to the Air Force doing essentially the same kind of stuff.

Yeah, and just to be clear, has there been any material task orders from this new contract vehicle been issued yet? Mark, what can you say?

Hello, Nahal. Mark Griffin. The task orders are just coming out now. The government's released, I believe, and we're bidding on one of them right now. Task order two will also bid on others as they come out. So it's just started once the protest was resolved and the playing field was announced. So we're in the process now of bidding on those and we expect some resolution shortly on hopefully awards.

Okay. And then for counter 25, you know, what's your, basically talking about is you have a bunch of contracts in hand, but you're not expecting them to be matured within calendar 25. At some point in time, calendar 26, calendar 27, they would be matured though. Once these contracts reach their mature state, what's your confidence level that you will be a material positive free cash flow and what kind of free cash flow do you think that could be?

So I'm not going to comment directly on free cash flow, but what I will say is this, Nahal. Me and my management team are compensated on two things. One is on revenue growth, and the other is on being free cash flow positive.

Yeah, Nahal, I guess what I'll add to that is in the past we've talked about, just as a rule of thumb, approximately $200 million of revenue being free cash flow breakeven and $165 million of revenue being adjusted to EBITDA breakeven. Some of these revenue streams that we have ramping, in particular TSA PreCheck, is a very favorable working capital profile. So the free capital breakeven point is probably lower than $200 now, and we think we are on a good path to get there.

What would you expect the incremental operating profit for incremental revenue above that $200 million sort of break-even rate, which might be too high to be.

Yeah. Nahal, I don't want to get on a slippery slope to guiding 25 on this call, but we feel, you know, my earlier comments around the restructuring and the movement of resources that I talked about. And I thought my point about growth and free cash flow was pretty good. You know, those actions that we took were all towards moving resources towards these programs in a way that would allow us to maximize the benefit of that V-shaped recovery on revenue in 2025. So we'll say more on the March call in terms of P&L details beyond what I said here.

Got it. Thank you for taking all my questions. You're welcome. Sure.

This concludes the question and answer session. I would now like to turn it back to John Wood for closing remarks.

I want to thank our shareholders for your ongoing support, and I'm very pleased with the recent positive news on our program award with the Defense Manpower Data Center and the continued progress with the TSA PreCheck program. Both these programs are key components of our future growth plans. Furthermore, we are focused on replenishing secure networks backlog through the recently won new contract vehicles and a large cultivated pipeline of new business opportunities. Finally, the team continues to prioritize the expansion of our pipeline and driving new business capture to enable additional growth for the company. Based on all of this, I look forward to 2025 and I remain excited about the long-term outlook for the company. With robust and recession resistant end markets, well-funded customers, and decades long track record of serving the world's most security-conscious organizations tell us there's a strong foundation for the future. Thank you, everybody.

Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.