Telos Corporation’s (NASDAQ:TLS) Q3 2022 Earnings Conference Call November 9, 2022 8:30 AM ET
Company Participants
Christina Mouzavires – Investor Relations
John Wood – Chairman & Chief Executive Officer
Mark Bendza – Executive Vice President & Chief Financial Officer
Mark Griffin – Executive Vice President, Security Solutions
Conference Call Participants
Dan Ives – Wedbush
Zach Cummins – B. Riley
Rudy Kessinger – D.A. Davidson
Operator
Ladies and gentlemen, thank you for standing by, and welcome to Telos Corporation Third Quarter 2022 Financial Results Conference Call. [Operator Instructions] Please be advised that today’s conference may be recorded.
I would now like to hand the conference over to your speaker host for today, Christina Mouzavires. Please go ahead.
Christina Mouzavires
Good morning. Thank you for joining us to discuss Telos Corporation’s third quarter 2022 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 begin with brief remarks on our 2022 third quarter results and Telos’ strategic priorities, and Mark will cover the financials and guidance for the fourth quarter and full year 2022. Then we’ll open the line for Q&A, where Mark Griffin, Executive Vice President of Security Solutions, will also join us. The earnings press release was issued earlier today and is posted on the Telos Investor Relations website, where this call is being simultaneously webcast. Additionally, we have provided presentation slides on our Investor Relations website.
Before we begin, we want to emphasize that some of our statements on this call are forward-looking statements and are made under the safe harbor provisions of the federal securities laws. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could materially differ for various reasons, including the factors described in today’s earnings press release and the comments made during this conference call and in our SEC filings. We do not undertake any duty to update any forward-looking statements. In addition, during today’s call, we will discuss non-GAAP financial measures, which we believe are useful as supplemental and clarifying measures to help investors understand 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 Wood
Thank you, Christina, and good morning, everyone. Let’s begin today on Slide 3. We executed well in the third quarter and exceeded quarterly expectations for our fourth consecutive reporting period.
Mark will discuss our financial performance later on this call, but at a high level, we delivered $63.6 million of revenue in the third quarter, above our guidance range of $58 million to $62 million, up 14% sequentially and down 8% year-over-year. Gross margin was 32.9%, above the guidance range of 31% to 32.5%. We delivered $8.6 million of adjusted EBITDA, above the high end of our guidance range of $3.5 million to $5 million and a 13.5% adjusted EBITDA margin. Lastly, we delivered $0.10 of adjusted EPS.
Now let’s turn to Slide 4, where I’ll provide an update on the TSA PreCheck expansion program. On October 18, the Transportation Security Administration issued an authority to operate for Telos’ PreCheck system, marking an important milestone for another long-term program for our company. In the near term, we will be providing TSA PreCheck enrollment services for a soft launch trial period to a limited population of applicants in order to validate systems and processes in advance of full implementation. Once the trial period has been successfully completed to the satisfaction of TSA, Telos will launch enrollment services to the public more widely. We are pleased to have finally reached this long-awaited milestone.
If you turn to Slide 5, you can see additional business highlights and successes achieved this quarter. Turning to Xacta, we received renewals with several key customers, including the National Security Agency, the Federal Bureau of Investigation, the Central Intelligence Agency, the Defense Intelligence Agency, the Office of Naval Intelligence, the National Archives, the Social Security Administration and Orcale. We are also continuing to build on our partnership with IBM. This relationship will enable us to broaden our reach into the global marketplace for sales of our Xacta solution to drive future growth for Telos. The value in Xacta’s native OSCAL format, inheritance and adaptive mapping across regulations will drive IBM and Telos’ success and customer perceived value in the combined IBM, AGS, Telos solution.
We were also awarded key contracts with large cloud service providers and data-as-a-service providers to expedite the ATO or the authority to operate process. And our automated message handling service and designated aviation channeling services continue to perform well. Near term, our focus and strategy for the Ghost product line will be as an embedded security element of customer and Telos solutions. All development, product enhancement and expansion efforts are aligned with this evolutionary product strategy driven by customer mission requirements. We are confident in this direction as evidenced by the JCI Ghost product positioning.
And our advanced cyber analytics, or ACA solution, launched earlier this year, continues to evolve, including strengthening its cyber and analytic capabilities, enabling an enhancement of our market position via the growing value of intellectual property in the platform. We continue to enhance ACA through new features and by integration with other technologies. We are confident that ACA will continue to gain sales momentum due to its unique capabilities to scale seamlessly and deliver to customers near real-time cyber situational awareness by harnessing the power of integrated cloud, data science and actionable threat intelligence insights. We are proud of the meaningful progress we’ve made across these business segments this quarter.
In other parts of our portfolio, we are experiencing challenges that are weighing on our near-term outlook. Revenues on some large programs in security solutions will likely begin to step down in the fourth quarter, and our Secure Networks segment has not generated sufficient new business wins so far in the second half to backfill revenues from large programs that have been winding down and coming to successful completion over the course of 2022. The combination of these factors will result in lower than previously expected revenues in the fourth quarter of ’22 and potentially lower revenues year-over-year in 2023.
Mark will provide additional details on the fourth quarter and 2023 outlook later on this call. Needless to say, I’m not satisfied with our near-term outlook. We have significant room for improvement. The Board and I are laser-focused on taking the necessary actions to improve our performance by optimizing and streamlining how we serve our customers and pursue new business opportunities for long-term sustainable growth and success.
While we are clear eyed about our near-term outlook, we are confident in the foundation and long-term potential of our business. The core fundamentals of our company remain strong. Our robust and recession-resistant end markets, well-funded customers and decades-long track record of serving the world’s most security-conscious organizations provide a solid foundation for the future. And our strong balance sheet ensures significant financial and strategic flexibility.
Finally, we have a leadership change to announce. Brendan Malloy, Executive Vice President of Secure Networks, has notified me of his intention to retire at the end of 2022. For over 26 years, Brendan has provided exceptional service and commitment to Telos and our customers. I want to extend my sincere thanks for his dedicated service and wish him a happy and healthy retirement.
I will now turn the call over to Mark, who will discuss third quarter 2022 financial results, guidance for the fourth quarter and some high-level direction on 2023. Mark?
Mark Bendza
Thank you, John, and thank you, everyone, for joining us today. Let’s turn to Slide 6. As John mentioned, we executed well in the third quarter, delivering results that exceeded the high end of our guidance range on all financial metrics. We reported revenue, gross margin and adjusted EBITDA above the high end of our third quarter guidance range.
Total revenue was $63.6 million, up 14% sequentially and down 8% year-over-year. Performance above the high end of the guidance range of $58 million to $62 million was primarily driven by favorable timing variances on pre-existing higher-margin programs in Security Solutions. Secure Networks revenues performed in line with our guided expectations. Security Solutions sales were $32.4 million, up 5% sequentially and down 6% year-over-year due to the completion of the U.S. census program in 2021 and quarterly variability of perpetual license sales. Secure Networks sales were $31.2 million, up 25% sequentially and down 10% year-over-year due to the ongoing wind down of large programs coming to a successful completion as expected. Our program management teams within Secure Networks continue to successfully navigate a complex supply chain environment to deliver major programs on time and as forecasted in our guidance.
Turning to profitability and cash flow. Third quarter gross margin contracted 313 basis points to 32.9%. Performance above the high end of our guidance range of 31% to 32.5% was primarily due to better-than-expected sales contribution from our higher margin Security Solutions segment as well as margin outperformance within Secure Networks. Security Solutions gross margin contracted approximately 850 basis points to 48%, primarily due to higher investment in a single large program as well as the previously mentioned variability of perpetual license sales. Secure Networks gross margin expanded approximately 170 basis points due to performance on major programs and favorable mix across the portfolio.
Adjusted EBITDA was $8.6 million. Performance above the high end of our adjusted EBITDA guidance range of $3.5 million to $5 million was primarily the result of gross profit outperformance and lower below-the-line expenses resulting from cost reduction actions. Adjusted EBITDA was approximately flat year-over-year, notwithstanding year-over-year declines in gross profit, primarily due to lower below-the-line expenses. Adjusted EBITDA margin expanded 80 basis points to 13.5%. Free cash flow improved significantly from $1.3 million during the first 9 months of 2021 to $10.7 million during the first 9 months of 2022 as a result of favorable working capital dynamics. We continue to return free cash flow to shareholders through share repurchases.
During the third quarter, we deployed $4.7 million to repurchase nearly 500,000 shares. And since announcing our share repurchase program 6 months ago, we have deployed $7.7 million to repurchase nearly 860,000 shares.
Now let’s turn to Slide 7 to discuss our outlook for the fourth quarter. For the fourth quarter, we forecast sales in a range of $43 million to $47 million, representing a sequential decline from the third quarter. The midpoint of the fourth quarter revenue guide implies approximately a $19 million sequential decline, including approximately $4 million from Security Solutions and $15 million from Secure Networks.
The $4 million sequential decline in Security Solutions includes nearly $2 million of revenue on a pre-existing program that pulled forward into the third quarter and drove the guidance to be above the high end of the third quarter guidance range. The other $2 million represents a short-term slowdown on a different pre-existing program. The $15 million sequential decline in Secure Networks is primarily the result of a single program, which ended in the third quarter and will not recognize revenue in the fourth quarter.
Lastly, as John described earlier, Secure Networks has not won sufficient new business so far in the second half of 2022 to backfill declining revenues on pre-existing programs in the fourth quarter. To be clear, Secure Networks has won approximately $37 million of new business so far in the second half of 2022. But those programs will either convert to revenue over a multiyear period of performance or in the case of some quick churn programs, the speed of revenue recognition will be constrained by supply chain limitations.
There are still some large opportunities in the new business pipeline that could be awarded in 2022, but those opportunities if captured, will benefit 2023 and beyond. We expect gross margin to be down approximately 300 to 450 basis points year-over-year primarily due to Security Solutions mixing lower, partially offset by higher margin Security Solutions contributing a greater proportion of total company revenues. We expect Secure Networks’ gross margin to be approximately flat year-over-year. Adjusted EBITDA is expected to be approximately breakeven to $2 million.
Now let’s turn to Slide 8 to discuss the resulting outlook for 2022. For the full year, we now expect total revenues in a range of $213 million to $217 million and adjusted EBITDA in a range of $14 million to $16 million. The midpoint of the revenue guidance range implies a top line reduction of approximately $19 million from our prior guidance to our updated guidance. $14 million of the $19 million is primarily due to lower-than-expected new business wins in Secure Networks and also partially the impact of supply chain constraints on delivery of that new business. The other $5 million is in Security Solutions and is spread across software sales, a step down in large programs and TSA PreCheck.
In the aggregate, Security Solutions is still expected to deliver full year revenues within the original guidance range that we communicated at the beginning of the year. The entirety of the reduction below the bottom end of the original guidance range is due to a shortfall in Secure Networks’ new business wins.
And lastly, with respect to 2023, it is far too early to provide much specificity at this point, but we can offer some high-level color on headwinds and tailwinds. Within Security Solutions, we have large programs that will potentially slow down and/or turn off sometime around the end of this year or the first quarter of next year. Those programs will be partially offset by the ramp of TSA PreCheck over the course of next year and potentially by at least one new long-term business opportunity that we will compete for in the second half of next year that is larger on a run rate basis than the programs that will potentially turn off. We have strong past performance qualifications that position us well to compete for this new opportunity.
Within Secure Networks, the wind down of large programs in 2022 will create a year-over-year headwind into 2023, but there are opportunities remaining in the pipeline for 2022 that have the potential to offset that headwind, if awarded. We believe these opportunities are lower probability.
So as you can see, there are a number of moving pieces that will become more visible before we provide 2023 guidance on our fourth quarter earnings call in March. In the meantime, the range of potential outcomes is quite wide. But from where we sit today, it’s possible revenues could be down approximately mid-teens year-over-year in 2023. But again, I will emphasize that even a single large win in the next few months could meaningfully improve that outlook. We will provide 2023 guidance on our fourth quarter earnings call in March.
With that, I’ll pass it back to John, who will wrap up on Slide 9.
John Wood
Thank you, Mark. To summarize, we exceeded quarterly expectations for our fourth consecutive reporting period and delivered results above the high end of our guidance range on all financial metrics.
Lower expenses and favorable working capital performance have driven strong free cash flows that we’re returning to shareholders through share repurchases. We are pleased to have received the ATO from the TSA for the Telos PreCheck system, marking an important milestone for another long-term valuable program for Telos. That said, I am not satisfied with our near-term outlook and I recognize we have much work to do to improve our performance.
The Board and I are focused on taking the necessary steps to maximize the strong foundation we already have in place to create value for our shareholders. As one of Telos’ largest shareholders for more than 30 years, I’m clearly disappointed with our recent new business conversion and wish we had greater visibility into the timing of critical program awards. We have and are continuing to take immediate action to improve our performance.
Having said that, I’ve never been more committed to driving long-term success for all Telos stakeholders and I’m heartened by the track record we’ve built over decades of service to the world’s most security-conscious organizations. Our solutions continue to resonate with new and existing customers. Our progress to date has not been linear, and there have been speed bumps over the past 3 decades as well. Yet Telos has consistently emerged stronger, and we expect this period to prove no different.
With that, we’re happy to take questions.
Mark Bendza
Operator, please open the line for Q&A. And we’d 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] And our first question coming from the line of Dan Ives with Wedbush.
Dan Ives
Yes. I mean my question, just being fully honest, what would give investors confidence that there’s just not more execution or some moves ahead? It just feels like the last 1.5 year, it continues to kind of be one disappointment after another. And I’m just — I mean, I’m just curious on that in terms of from your angle?
John Wood
First thing is I’d say that our solutions are widely adopted and they’re recognized by our customers, and those give us reasons to be optimistic for the future. The other thing I’ll say is that we are very clear eyed about the near-term outlook, but we’re confident in the foundation of our business. And that foundation provides a solid core for us despite some of the macro headwinds that we’ve discussed on this call.
Dan Ives
But is there something execution — I mean, in another words, like is there something fundamentally wrong with the business that we continue to just have the Groundhog Day?
John Wood
So I’d say 2 things to you, Dan, and to the rest of the people on the call here. The first thing we’ve learned as we’ve expanded commercially and into the channel is that it’s a longer sale cycle than we expected due to the need for additional training and education. And so one major change we’ve decided to make is to consolidate our business development and capture functions to go after the same kind of solutions that we discussed previously as it relates to the large confidential health care customer. There are a tremendous amount of opportunities in the federal government around cloud, cloud migration and cybersecurity, that, the combination of both sides of Telos bidding on, I think, provides a very big opportunity for the company going forward.
As it relates to the business expectation as to the fundamentals, they’re there. And sometimes things happen that just — it’s beyond our control. So what we’re trying to do here by giving the puts and takes as to what we see in front of us as of today, that will — we hope that will change by the time we give actual guidance out for 2023, Dan.
Operator
And our next question coming from the line of Zach Cummins with B. Riley.
Zach Cummins
Is there any way you can give more insight into the headwinds that you’re seeing in the Security Solutions business? Any sort of additional insight there would be helpful, especially considering some of the other positive things that could be contributing to growth in that segment in 2023?
John Wood
So Mark, he’s asking about headwinds in Security Solutions.
Mark Bendza
Sure. The headwinds in Security Solutions primarily have to deal with the Zero Trust architecture and the combination, as John mentioned, of taking our solutions, and instead of point sale solutions, looking at more of a centralized combined solution in positioning those on some of the larger contracts. So the headwinds primarily have to do with transition from point solution sales to enterprise solutions sales. And we’re seeing some slower adoption in those areas based on some of that activity.
Mark Griffin
And Zach, it’s Mark here. So just to clarify the question. Were you referring to the 2023 headwinds that I referred to, the few large programs that we might experience some headwinds year-over-year into ’23?
John Wood
I think he is probably on mute. But why don’t you give him a little bit of color on the small cluster of large programs that I referenced.
Mark Bendza
So Zach, one other point. On several of our contracts, the volumes on those contracts go up and we get more revenue. In some cases, the volumes go down, and that’s the headwinds that we’re talking about. So it’s seasonality on several of the contracts and the volumes on those contracts that are creating headwinds into ’23. If the volumes between now and then obviously increase, then the headwinds will be mitigated. But right now, we’re looking as if those headwinds will be lower volumes, and that’s what we’re projecting.
Operator
And our next question coming from the line of Rudy Kessinger with D.A. Davidson.
Rudy Kessinger
Mark, I want to be clear on Q4 in Secure Networks. You had previously talked about these onetime programs that were high 60s in millions revenue in 2021. We’re going to be low 40s millions in revenue in 2022. Is that still the expectation? Or is that number fallen for 2022? I’m trying to figure out how much in Q4 the shortfall in Secure Networks is from maybe a faster wind down than expected in those onetime programs versus just business underperformance on the new business front.
And then secondly, on Security Solutions, I won’t belabor the point on the revenue side. But the gross margins on Security Solutions, it looks like you’re guiding to about 43%, 44%. That’s over a 10% decline from late last year and just Q1 of this year. It’s pretty abysmal. What has driven such a substantial decline in the gross margins of the Security Solutions as well?
Mark Bendza
Yes. Sure, Rudy. So a couple of things. First, on Secure Networks. I think you’re referencing the beginning of the year. When we gave our original guidance, we talked about a few large programs within Secure Networks winding down over the course of this year and coming to completion. That is roughly a $25 million headwind in ’22. Those programs did about $70 million of revenue last year, about $45 million this year. So a $25 million headwind this year. And then next year, that $45 million of revenue will further wind down to about $10 million. So that’s another $35 million headwind year-over-year into 2023.
With respect to the fourth quarter, the difference on Secure Networks is entirely related to new business wins. And it’s a combination of — a combination of lower volume and new business wins here in the government buying season since our last earnings call, combined with the nature of those wins, those wins being wins that will convert to revenue over a multiyear period of performance. And for the portion of the wins that are quicker churn, revenue recognition on those are going to be constrained by supply chain.
And then with respect to Security Solutions, in the fourth quarter, it’s really a couple of things. The primary driver is a single large program within ID that is — the good news is it’s converting from more of a pilot program to more of a long-term permanent program, which is requiring some investment in the short-term here. And so we’re seeing a pretty meaningful step down in margins here over the short term, which is driving ID margins lower, and therefore, Solutions lower.
John Wood
But should not have long-term impact, I believe.
Mark Bendza
Yes. We think…
Rudy Kessinger
Just…
Mark Bendza
Go ahead, Rudy.
Rudy Kessinger
Okay. Well, I guess I’m clear on the gross margin. But I guess — as a follow-up to that, if I could, I mean on Secured Networks, I mean, you’re basically saying you’re missing your mark in Q4 by $15 million to $20 million on Secured Networks due to not hitting your new business targets. That’s a pretty massive miss relative to the size of your business in one quarter. And so I would — I may just reiterate the question that was asked earlier. I just — how could anybody get any sort of [Technical Difficulty] whatsoever in your ability to execute against your target longer term given that massive of a miss?
Mark Bendza
Yes, Rudy. It’s actually — so it’s a $14 million miss in the fourth quarter on new business. The lion’s share of Secure Networks’ new business comes in around this time of year. And that was the case this year as well, about 70% of all the new business that they’ve won this year came in since our last earnings call. And that’s pretty typical. It’s just that this year both the composition of those new business wins didn’t support a fourth quarter revenue recognition very well. It’s more of a multiyear revenue recognition. And then for the other shorter-term quicker churn piece, there’s supply chain constraints there. But let me see if John has anything he’d like to add.
John Wood
No, I think that’s — those are hitting on the head.
Operator
Ladies and gentlemen, that does conclude our conference for today. Thank you for your participation. You may now disconnect. Good day.
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