Telos - Earnings Call - Q4 2024

Executive Summary

• Revenue of $26.4M came in near the top end of company guidance, with GAAP gross margin at 40.3% and cash gross margin at 47.0%—the highest quarterly cash gross margin since the 2020 IPO; adjusted EBITDA improved to a $0.2M loss, above the top end of guidance. Security Solutions grew to 83% of revenue, driving margin expansion. Positive cash flow is guided for Q1 2025, with sequential revenue growth of 7%–15%.
• Mix shift to higher‑margin Security Solutions and cost actions taken in Q3 (restructuring, portfolio pruning) drove sequential improvement in profitability; TSA PreCheck became the largest program and the DMDC program transitioned and began generating revenue.
• Near‑term headwind: year-over-year revenue declined versus Q4 2023 due to Secure Networks runoff, though margins expanded YoY from 34.3% to 40.3%. Working capital build and one‑time IT capex drove negative operating and free cash flow in Q4, but management expects reversal and positive cash generation in Q1.
• 2025 framework updated: “core” business raised to ~$70M (from $60–$65M), DMDC/DHS revised to ~$50–$75M (from $60–$85M) on first‑year revenue recognition mix; TSA PreCheck still targeting ~500 locations around year‑end. Management notes delays in some single‑award government decisions amid administration transition, prioritizing task orders in the interim.

What Went Well and What Went Wrong

What Went Well

• Security Solutions strength and mix shift: Security Solutions grew 19.6% sequentially in Q4 to $21.9M and reached 83% of revenue, driving YoY GAAP gross margin expansion to 40.3% and cash gross margin to 47.0%.
• TSA PreCheck execution and scaling: “TSA PreCheck grew quickly into our single largest program by revenue during 2024,” with enrollment centers expanded from 26 at the start of 2024 to 218 by the call; targeting ~500 locations around YE25.
• Cost discipline delivered P&L leverage: Adjusted OpEx declined by ~$2.4M sequentially, improving adjusted EBITDA from a $4.2M loss in Q3 to a $0.2M loss in Q4; Q4 margins landed at/above guidance ranges.

What Went Wrong

• Year-over-year revenue decline: Q4 revenue fell to $26.4M from $41.1M YoY, reflecting Secure Networks runoff despite stronger mix and margins.
• Cash outflows in Q4: Cash from operations (-$10.5M) and free cash flow (-$14.8M) were negative due to working capital build and one-time IT infrastructure capex; management expects reversal in Q1.
• Timing of awards: Management cited delays in single-award government decisions due to administration transition, shifting focus toward task orders; Secure Networks revenue was guided to be comparable to Q4 in Q1.

Transcript

Operator (participant)

Good day, and thank you for standing by. Welcome to the Telos Corporation Fourth Quarter 2024 Financial Results Conference 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'll need to press star one-one on your telephone. You will then hear an automated message advising your hand is raised. To withdraw your question, please press star one-one again. Please be advised that today's conference is being recorded. I would now like to hand the conference over to Allison Phillipp, Director of Corporate Communications. Please go ahead.

Allison Phillipp (Director of Corporate Communications)

Good morning. Thank you for joining us to discuss Telos Corporation's fourth quarter and full year 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 2024 year-end results. Next, John will discuss business highlights from the quarter. Mark will follow up with first 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 fourth quarter and year-end 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, including all of those relating to 2025 company performance, plans, and operations, 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, in the comments made during this conference call, and in our SEC filings. We do not undertake any duty to update any forward-looking statements. In addition, during today's call, we will discuss non-GAAP financial measures, which we believe are useful as supplemental and clarifying measures to help investors understand Telos's financial performance. These non-GAAP financial measures should be considered in addition to, and not as a substitute for, or in isolation from GAAP results.

You can find additional disclosures regarding these non-GAAP measures, including reconciliations with comparable GAAP results in our fourth quarter and year-end financial results summary 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 Mark.

Mark Bendza (EVP and CFO)

Thank you, Allison, and good morning, everyone. Let's begin today on slide three. I'm pleased to report that Telos has delivered fourth quarter revenue near the top end of the guidance range and adjusted EBITDA above the top end of the guidance range. Total company revenue grew 11% sequentially to $26.4 million in the quarter, compared to guidance of $24.5 million-$26.5 million. Security Solutions revenue grew 20% sequentially to $21.9 million, or 83% of total company revenue, which was near the top end of our guidance range. During the fourth quarter, our large program with the Defense Manpower Data Center, or DMDC, successfully transitioned from the incumbent contractor and began to generate significant revenue for Security Solutions. In addition, revenue from TSA PreCheck enrollments grew over 30% sequentially.

Secure Networks delivered $4.5 million of revenue, or 17% of total company revenue, representing the top end of the guidance range. Secure Networks' revenue declined sequentially as expected due to the ramp-down of existing programs. Turning to margins, GAAP gross margin expanded nearly 600 basis points year-over-year to 40.3%, and cash gross margin expanded nearly 900 basis points year-over-year to 47%. Fourth quarter cash gross margin of 47% was the company's highest quarter since the IPO in 2020, and full year 2024 cash gross margin of 43.7% was the company's highest since 2000. Gross margin expansion was primarily driven by the favorable mix shifts from our lower margin Secure Networks business to our higher margin Security Solutions business. Security Solutions revenue grew from 50% of total company revenue in the fourth quarter of 2023 to 83% in 2024, and from 53% for the full year 2023 to 71% in 2024.

As discussed on our last earnings call, during the third quarter of 2024, we discontinued the development and sale of selected solutions or parts of solutions that were not generating acceptable returns. These actions reduced our cost base and created new capacity for investment in our highest growth programs in order to maximize our operating leverage, incremental margins, and cash flow as we return to growth in 2025. Largely as a result of our third quarter cost actions, adjusted operating expenses, which include R&D and SG&A expense, excluding stock-based compensation, restructuring, and impairment expenses, declined sequentially by $2.4 million. When combined with higher cash gross profit, the reduction in operating expenses drove a sequential improvement in adjusted EBITDA from a $4.2 million loss in the third quarter to a $200,000 loss in the fourth quarter.

Lastly, cash flow from operations was a $10.5 million outflow, and free cash flow was a $14.8 million outflow, reflecting a short-term buildup of working capital associated with high-growth programs and one-time CapEx investments in IT infrastructure expansion. We expect these dynamics to reverse and drive positive cash flow from operations and positive free cash flow in the first quarter of 2025. I will now turn it over to John for an overview of recent business highlights. John?

John Wood (Chairman and CEO)

Thanks, Mark, and good morning, everyone. Let's turn to slide four. First, I'll provide an update on our TSA PreCheck program. We made significant progress expanding our nationwide network of enrollment centers, providing a convenient solution to travelers and gaining market share in this important national security program throughout 2024. We increased our enrollment centers from 26 locations at the beginning of 2024 to 218 locations in key markets across the United States today. As we said in the past, we do not expect a linear monthly pace of opening new enrollment centers. We will have phases when we open a larger number of locations, followed by quarters when we open fewer locations, and during which we, together with the TSA, will assess the operations of our enrollment centers before resuming a higher pace of rollouts.

We opened a total of 177 new locations in the second, third, and fourth quarters of 2024 before moderating the pace of openings with 15 new locations so far in 2025. We expect to resume a higher pace of rollouts in the coming weeks and months and continue to target 500 locations sometime around the end of the year. TSA PreCheck grew quickly into our single largest program by revenue during 2024, and we expect the program to deliver significant growth again this year. Next, I'll provide an update on the two key program wins that we have previously discussed over our last several earnings calls. We have successfully transitioned the Defense Manpower Data Center, or DMDC, program and are now generating revenue. This program, along with TSA PreCheck enrollments, was a key source of our sequential growth in the fourth quarter.

We look forward to a full year of successful operations on this program in 2025, as we expect it to be a major driver of revenue growth for the company. Additionally, we were pleased to report that the stop work order on the program with the Department of Homeland Security, or DHS, was lifted in January. We expect to begin generating revenue on this program later in 2025. We're thrilled with the positive outcomes on both these program awards and look forward to providing high-quality services to these critical customers over the next several years. Finally, I'll provide the latest news on other business outcomes since our last earnings call. Our executive business has achieved new orders with several customers, including the Office of Naval Intelligence, the U.S. Department of Energy, a U.S. federal government agency, as well as a key renewal with a U.S.

federal government customer in the intelligence community. We also received a new order for cyber services from a Fortune 100 company in the technology sector. The Automated Message Handling System, or AMHS business, achieved key renewals from a U.K. government department and a U.S. federal government customer in the intelligence community. Regarding our new business pipeline, on our previous call, we indicated we had submitted several bids and were working on additional opportunities that totaled nine figures of total contract value to Telos. As a result of the recent change in administration and uncertainty around near-term priorities and objectives, we're experiencing some delays in the timing of awards from the government on single awards. However, we are not seeing similar delays on task orders available via the various active contract vehicles we have won over the last couple of years.

Accordingly, we are reprioritizing task orders on our contract vehicles over single awards and are currently vetting and responding to task orders at a rapid pace. We remain optimistic of our positioning and competitiveness on our outstanding and upcoming bids. I'll now turn the call over to Mark, who will discuss first quarter guidance. Mark?

Mark Bendza (EVP and CFO)

Thanks, John. Let's turn to slide five. For the first quarter, we expect revenue to grow 7%-15% sequentially to a range of $28.2 million-$30.2 million. We forecast an adjusted EBITDA loss of $1.8 million-$800,000. Sequential revenue growth will be driven by Security Solutions. We forecast Security Solutions to grow high single-digit % to mid-teens % sequentially, driven by our new program with the Defense Manpower Data Center and the ongoing ramp of TSA PreCheck enrollments. Security Solutions is forecasted to contribute approximately 84% of total company revenue. We anticipate Secure Networks revenue to be comparable to the fourth quarter. GAAP gross margin is expected to expand by 150 basis points to 215 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 forecasted to expand by 260 basis points to 285 basis points year-over-year for the same reason. Cash operating expenses, which include R&D and SG&A, adjusted for stock-based compensation, restructuring expenses, depreciation and amortization, impairment, and capitalized software development costs, are forecasted to be approximately $1 million lower year-over-year due to lower spending as a result of the restructuring plan that we implemented during the third quarter of 2024, partially offset by investments in our highest growth programs. We're pleased to report that we expect to generate positive cash flow during the first quarter. Turning to the full year 2025, the structure of the revenue framework that we outlined on prior earnings calls has not changed. We forecast a return to year-over-year revenue growth. Revenue for the full year 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 $70 million in 2025, representing an increase from the previously estimated $60 million-$65 million. This increase in estimates reflects higher expected revenues on various contracts across the portfolio due to a combination of scope expansion and contract extensions. Second, we estimate the DMDC and DHS programs could recognize approximately $50 million-$75 million of revenue, representing a decrease from the previously estimated $60 million-$85 million. The change in estimates reflects the time phasing of revenue recognition during the first year of the program.

Time phasing in the first year will be driven by the ultimate mix of third-party solutions that are recognized as revenue when orders are filled versus solutions that are recognized as revenue over a period of performance. The mix of gross revenue recognition and net revenue recognition will impact the range as well. Third, we are targeting a pro rata share of the TSA PreCheck enrollment market after we complete the rollout of our 500 locations at full capacity for a full calendar year. We believe the entire TSA PreCheck market is approximately a $200 million market on a net revenue basis in a typical year 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 along with our enrollment centers during the year.

Enrollment revenue represented approximately 70% of the total $200 million TSA PreCheck market in 2024. Renewal revenue comprised the other 30%. John discussed our new business pipeline and business development activities. Any new business wins during 2025 will have the potential to contribute additional revenue during the year. With that, I'll turn it back to John.

John Wood (Chairman and CEO)

Thanks, Mark. Let's turn to slide six. In summary, revenue grew 11% sequentially to $26.4 million, and adjusted EBITDA improved sequentially by $4 million to a $200,000 loss. Additionally, we achieved our highest full-year cash gross margin since 2020. We successfully assumed full operational control of our scope on the DMDC program and look forward to a full year of operations and the accompanying revenue growth in 2025. We continue to ramp our network of TSA PreCheck enrollment locations and are targeting 500 locations sometime around the end of the year. We expect 7%-15% sequential revenue growth and positive cash flow in the first quarter of 2025. We are forecasting significant improvements in revenue, profit, and cash flow for the full year. With that, we're happy to take questions.

Mark Bendza (EVP and CFO)

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

Operator (participant)

As a reminder, if you'd like to ask a question at this time, please press star 11 on your telephone and wait for your name to be announced. To withdraw your question, please press star 11 again. Our first question comes from Zach Cummins with B. Riley Securities.

Zach Cummins (Equity Research Analyst)

Hi, good morning, Mark and John. Congrats on the solid results in Q4. John, I just wanted to ask, with the change in administration, it sounds like you've had some impact on single award type of programs. Just curious of maybe what you've heard from some of your partners and just how you're framing the year, just given all the moving parts here in early 2025.

John Wood (Chairman and CEO)

In general, Zach, and thank you for your question. In general, the company really is focused on delivering solutions that help optimize performance for our customers in terms of automation and so forth. I would say the new administration in general is positive for Telos. Having said that, at the customer level, we are seeing single awards being held back while the administration sort of reviews those opportunities. That is why we are focused on the task orders that we have from existing contract vehicles.

Zach Cummins (Equity Research Analyst)

Understood. My follow-up question here towards Mark, helpful to get a little bit more detail in terms of the 2025 framework. Just in terms of the new awards that you outlined with DMDC and DHS, is it largely just accounting issues as we think about that ramping up in the first year, or can you just go a little bit more into the nuances of that for revenue recognition in the first years of those awards?

John Wood (Chairman and CEO)

Yeah, it's a good question, Zach. Yes, there is no change in our expectations around the total value of third-party content that we would integrate into that program. The difference is the mix of that third-party content. As we're getting deeper into the program, what we're seeing is that the mix is more weighted to software than it is to hardware. Now, hardware content is pretty straightforward in terms of revenue recognition. You recognize essentially the full value of the order at the time the order is filled. You recognize as revenue the full value of the order at the time the order is filled. With software, it's a mix. Some software will be recognized full value at the time the order is filled.

Other types of software would be recognized over a period of performance, say over a one-year period of performance or a one-year license or maintenance contract. In the first year, on some of these orders, we'll see a partial year of revenue recognition rather than a full year. In 2026, you'll see the full year of revenue recognition. The other important point is that it looks like from a cash perspective, for the most part, we'll see the full benefit, the full cash flow benefit at the time the order is filled. That's one of the reasons why we're bullish on cash in the quarter and the year. Cash flow should outperform the P&L, so to speak, in 2025.

Zach Cummins (Equity Research Analyst)

Understood. That's helpful. Thanks for taking my questions and best of luck with the rest of the quarter.

John Wood (Chairman and CEO)

Thanks, Zach.

Operator (participant)

As a reminder to ask a question, that is star 11. Our next question comes from Rudy Kessinger with D.A. Davidson.

Rudy Kessinger (Managing Director and Senior Equity Research Analyst)

Hey, guys, thanks for taking my questions. Mark, if I think about TSA PreCheck, $200 million market opportunity, 70% coming from enrollments, you have 218 locations, or I guess you're at about 45% of the rollout if we just do the numbers there. That would imply if you're getting that one-third share at those 218 locations, you should be running about $21 million in annual revenue from enrollments plus some from renewals, understanding it's going to take longer to get the one-third share on the renewal side. Is that the right way to think ballpark about where TSA revenue is running currently?

John Wood (Chairman and CEO)

The framework you've laid out, yes, is the right way to think about it. Of course, over the course of 2024, on an average basis, we have far fewer locations open than we do now. Over the course of this year, those locations will ramp.

Rudy Kessinger (Managing Director and Senior Equity Research Analyst)

Okay. I am curious on cash flow. I know it says in slides here you guys mentioned it should be positive in Q1. Just how much of that is maybe just driven by strong Q1 collections? For the full year, you just made a comment there, cash should outpace, I guess, P&L. How should we think about free cash flow potential for the full year?

John Wood (Chairman and CEO)

Yeah. In the first quarter, there is a benefit in terms of the fourth quarter working capital buildup that will be liquidating in the first quarter. In terms of the overall year, here's the way I would think about it. Adjusted EBITDA break-even for the year is probably somewhere around, say, $155 million-$160 million of revenue, somewhere around there, depending on mix. At break-even adjusted EBITDA, at a break-even adjusted EBITDA this year, I would expect us to be positive free cash flow at a break-even adjusted EBITDA level. What that means is you're going to have, let's say you have break-even adjusted EBITDA, you're going to subtract from that about $10 million of capitalized software, then you're going to add about $2 million of interest income. That would imply roughly $8 million of negative free cash flow before changes in working capital.

I would say the change in working capital should be enough in 2025 to get us to positive free cash flow. The change in working capital should be better than $8 million at that hypothetical break-even adjusted EBITDA level. Does that make sense?

Rudy Kessinger (Managing Director and Senior Equity Research Analyst)

That is a very, very helpful breakdown. I appreciate that. Thank you.

John Wood (Chairman and CEO)

Yeah. By the way, that's just another way of saying our break-even level of revenues for the level of revenues required for break-even free cash flow should be lower than the level of revenues required to break even on an adjusted EBITDA basis.

Rudy Kessinger (Managing Director and Senior Equity Research Analyst)

Got it. Thank you.

Operator (participant)

This will conclude today's question and answer session. I'll now turn the call back to John Wood for closing remarks.

John Wood (Chairman and CEO)

Our shareholders for your ongoing support. With the encouraging news on our DMDC and our TSA PreCheck programs, we look forward to significant improvements in revenue growth, profit, and cash flow in 2025. I look forward to 2025, and I remain excited about the long-term outlook for the company. With robust and recession-resistant markets, well-funded customers, and a decades-long track record of serving the world's most security-conscious organizations, Telos has a strong foundation for the future. Thank you.

Operator (participant)

This concludes today's conference call. Thank you for participating. You may now disconnect.