Participants

Allison Phillipp; Director of Corporate Communications; Telos Corp

Mark Bendza; Chief Financial Officer, Executive Vice President; Telos Corp

John Wood; Chairman of the Board, President, Chief Executive Officer; Telos Corp

Mark Griffin; Executive Vice President - Security Solutions and President, General Manager - Telos Identity Management Solutions, LLC; Telos Corp

Bradley Clark; Analyst; BMO Capital Markets

Zach Cummins; Analyst; B. Riley Securities

Rudy Kessinger; Analyst; D A Davidson

Nehal Chokshi; Analyst; Northland Capital Markets

Presentation

Operator

Good day. And thank you for standing by. Welcome to the Telos Corporation third quarter, 2024 earnings call. (Operator Instructions)
Please be advised that today's session is being recorded. I would now like to hand the conference over to your first speaker today, Alison Phillips. Allison, you have the floor.

Allison Phillipp

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 Bendza, Executive Vice President and CFO of Telos. 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 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 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.

Mark Bendza

Thank you Allison and good morning, everyone. Let's begin today on slide 3.
I'm pleased to report that Telos has delivered revenue near the top end of the guidance range and the adjusted 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 the Defense Manpower Data Center or DMDC begins to ramp.
DMDC 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 have 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 assess 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 the $1.4 million restructuring charge including $400,000 in cost of sales.
In total, 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 and 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 with a $7.1 million outflow and free cash flow with a $9.9 million outflow.
I will now turn the call over to John for an overview of recent business highlights. John?

John Wood

Thanks Mark and good morning everyone. Let's turn to slide 4. 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 Telos 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 US 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. Within the United States Department of Defense and it 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 Xact 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?

Mark Bendza

Thanks John. Let's turn to slide 5. 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 10% to low 20% sequentially driven by the accelerating ramp of TSA PreCheck enrollment 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.
GAAP 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 D&A 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.
Lastly, 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 PreCheck 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 per out of 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.

John Wood

Thanks Mark. Let's turn to slide 6. In summary, we delivered revenues near the top end of the guidance range and exceeded guidance on adjusted EBITDA.
Additionally, we are thrilled to protest from the DMDC program was resolved in our favor, we are now generating revenues on this program as we ramp operations. I look forward to working with our partner to provide exceptional support to our customer for years to come.
We 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.

Mark Bendza

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

Question and Answer Session

Operator

(Operator instructions)
Bradley Clark, BMO.

Bradley Clark

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, what ultimately determines how much that contract can be given that the $485 million feeling like what are the factors that determine where you land below that feeling?

Mark Bendza

Yeah, so Brad, it's Mark back in here. So on that program, there is -- there are a couple of different revenue streams there. There's a base services revenue stream, which is 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 million to $85 million a year. But in any given year, you can be over $100 million in total. But our best estimate at this point on a low year would be about $60 million. Now, in those numbers, I tend to lump together the DMDC, and DHS is a small piece of that, of the $60 million to $85 million that I quote. We're only including about [$2 million to $8 million] in that range for DHS which is the smaller program of the two.

Bradley Clark

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?

Mark Bendza

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 think 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 diluted to margins. Overall in 2025, I'd say we're probably going to be a couple 100 basis points lower on cash grows margins so slightly lower on cash flow margin, but of course, on a significantly higher revenue base.

Bradley Clark

Okay. Thank you.

John Wood

Sure.

Operator

Zach Cummins, B. Riley.

Zach Cummins

Thanks. Good morning, Mark and John, thanks for taking my question.
I really wanted to focus on the restructuring actions that you decided to take here, 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 and maybe more of a margin uplift when we look at the revenue ramp next year?

John Wood

Sure. Hey Zack, 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.

Mark Bendza

Yeah and Zach, what I'll add to that is, current revenues in those two solutions are effectively, I'd say the minimis at this point. So there will be no a 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 those ramp -- as 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.

Zach Cummins

Understood. And if my one follow up question is just, around the pipeline going into the key buying season, especially for secure networks. Can you give us a sense of 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.

Mark Bendza

Yeah. So maybe I'll start and then Mark Griffin and John can supplement. So, we have a pretty meaningful portfolio of opportunities that were that are either already submitted or that we're currently working on.
You could think of it as somewhere around 20 opportunities or so, about a third of those are already submitted, the balance are in process. In total, you're looking at, nine figures of total contract value to Telos.
And next year, of course, depending on win rates and when these programs start -- there's potential for a couple of 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.

Mark Griffin

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

John Wood

That's good. I agree, that.

Zach Cummins

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

John Wood

Thank you, Zach.

Operator

Rudy Kessinger, D A Davidson.

Rudy Kessinger

Hey, thanks for taking my questions guys. Mark, so if I go back a year ago your Q3 call last year. At that point in time you guys said you believe you had a total 2024 potential revenue opportunity that exceeded 200 $million and obviously, you guys 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, ball park $150 million 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 million to $85 million. How are you getting to that $60 million to 85 million? And what's the risk that, you know, a year from now, those contracts are only doing $30 million to $40 million next year.

Mark Bendza

Yeah. Really 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 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 in the fourth quarter, we're just starting to generate revenues on this program.
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 protest. 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 million to $85 million I would describe it in this way, of the $60 million to $85 million there's $2 million to $8 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's $2 million 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 million to $8 million. For the balance of the revenue of $60 million to $85 million, 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 streams to use that as a basis for the $60 million to $85 million. But a relative to the $100 million that it could be in any given year, we think $60 million to $85 million is a pretty prudent haircut on the total potential. Thanks for the question.

Rudy Kessinger

It does. That's very helpful color, breaking 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 you're not going to have full one third market share for the full year. But I guess I'm curious 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 million, $23 million of annualized PreCheck revenue today.
I'm curious, are you getting one third market share at those existing 170 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?

Mark Bendza

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. At the same level of productivity and 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.

Rudy Kessinger

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

Mark Bendza

Yeah.

Operator

Nehal Chokshi, Northland Capital Markets.

Nehal Chokshi

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 the timing of subcontracted revenue.

Mark Bendza

So of the $485 million, $125 million is the base services revenue that I described as having a high level of visibility. The difference between the $125 million and the $485 million 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 approximately $100 million in some peak years.

Nehal Chokshi

Got it.

Mark Bendza

It's really going to be driven by the needs and the demands of the program.

Nehal Chokshi

Okay. (multiple speaker)

John Wood

So what I would say is that, unlike other contract vehicles that we have, this is a single award contract for what is essentially the 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. It's very important to the mission. So in general, if they have the requirement to spend the money they're going to.
And we've had a relationship with this customer since 1995. This 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 (inaudible) and just by way of color and we have something like 14, 18 wheelers of equipment coming our way. So there's all kinds of different things that we're doing for this customer.

Nehal Chokshi

Got it. 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 ID, IQ 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.

Mark Bendza

So now that -- 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.

John Wood

And the reason for that in the hall is that each of -- in this particular case, this contract based in infrastructure modernization was 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.

Nehal Chokshi

Yeah. And just to be clear, has there been any material task orders from this new contract vehicle issued yet?

John Wood

Mark Griffin will answer.

Mark Griffin

Hello, it's Mark Griffin. The task orders are just coming out now, the government's released, I believe three and we're bidding on one of them right now. Task order two. We'll 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 program awards.

Nehal Chokshi

Okay. And then for calendar '25 what you're basically talking about is, you have a bunch of contracts in hand, but you're not expecting them to be matured in 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?

John Wood

So, I'm not going to comment directly on free cash flow. But what I will say is this about, like 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.

Mark Bendza

Yeah, and the Nehal, I guess what I'll add to that is in the past we've talked about as a rule of thumb, approximately $200 million of revenue being free cash flow break even and $155 million of revenue being adjusted EBITDA per even.
Some of these revenue streams that we have ramping in particular, a PreCheck is a very favorable working capital profile. So the free capital break even point is probably lower than 200 now. And we think we are on a good path to get there.

Nehal Chokshi

What would you expect the incremental operating profit for incremental revenue above that $200 million or breakeven rate which might be too high to be?

Mark Bendza

Yeah. No, I don't want to get on a slippery slope to guiding '25 on this call. But we feel -- my earlier comments around the restructuring and the movement of resources that I talked about.

John Wood

I thought my point about growth and free cash flow.

Mark Bendza

All are very good. 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, you know why I said here.

Nehal Chokshi

Got it. Thank you for taking all my questions.

John Wood

You're welcome.

Operator

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

John Wood

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. Telos is a strong foundation for the future.
Thank you everybody.

Operator

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