Good day, and thank you for standing by. And welcome to the Telos Corporation 2Q21 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. Be advised that today's conference is being recorded.

[Operator Instructions] I would now like to hand the conference over the Brinlea Johnson with Blue Shore Group. Please, go ahead..

Good afternoon. Thank you for joining us to discuss Telos Corporation's second-quarter 2021 financial results. With me today is John Wood, CEO, and Chairman of Telos, and Mark Benza, CFO of Telos, Ed Williams, COO, will be joining us for the Q&A. Let me quickly review the format of today's presentation.

John will begin with some brief remarks on the second quarter 2021 results and tell us his strategic priorities, and Mark will cover the financials and guidance. Then we'll open up the line for the Q&A session. Earnings press release [Indiscernible] earlier today and is posted on the Telos website where this call is being simultaneously webcast.

Before we get started, 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 Security Laws. These statements are based on current expectations and assumptions that are subject to risks and uncertainties.

Actual results can materially differ for various reasons, including the factors described in today's earnings press release, in the comments made during this conference call, and our SEC filings. We do not undertake any duty to update any forward-looking statement.

In addition to 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 section of Teslos' website. The webcast replay of this call is available for the next year on our Company website under the Investor Relations link.

And with that, I'll turn it over to John..

the CIA awarded Telos a contract through June of 23, providing our Xacta solution in support of the CIA's new multi-cloud contract. A major intelligence community customer awarded Telos an option through May of 2022, providing our Xacta solution. The U.S. Department of State awarded Telos another contract through 2022 providing our Xacta Solution.

And the U.S. Space and Missile Command awarded Telos an expansion of their existing Xacta Solutions contract as well.

In addition, we continue to see increased commercial adoption of our Security Solutions with the new and renewed contracts from AT&T, Collins Aerospace, Accenture, Northrop Grumman, Vibrant Health, Iron Net Cybersecurity, and Comtech Telecommunications Corporation. I'd also like to provide an update on the TSA PreCheck contract.

On July 1st, TSA said and a public notice that they expect the additional TSA PreCheck enrollment providers to become available in 2021. While we do not control the decision-making timeline with TSA, we do control our readiness to move out once the authority to operators is issued. We remain confident in our service launch in 2021.

Now, next, I'd like to highlight recent updates within our Xacta, Telos Ghost, and ID Trust 360 solutions. On June 30th, we announced a new version of Xacta.io which expands our control mapping capability which is really needed by regulated industries to address audit fatigue.

We followed on August 11th with the release of a new version Xacta 360 which offers multiple data exchange protocols to enable machine-to-machine interaction for more efficient collaboration, regulatory reporting, and reciprocity.

These new capabilities increase commercial and international opportunities for Xacta, where there is an increase in demand for automation. These capabilities also address FedRAMP acceleration requirements specified in the recent Presidential Cybersecurity Executive Order.

The heavily regulated financial services industry requires substantial automation to keep up with the multitude of disparate IT Security and privacy-related content. Xacta continues to provide significant value to this market, as evidenced by our recent renewal by a major insurance Company.

This Fortune 50 organization, uses Xacta.io to aggregate the extensive data needed to manage IP asset inventory and vulnerabilities while providing automated control mapping to multiple sets of standards. This ultimately reduces the burden and strain on their internal security operations and compliance teams.

In the second quarter, Telos Ghost, Telos' virtual obfuscation network, won the 2021 Fortress Cyber Security Award for network security. It's always an honor to be recognized alongside other companies advancing the cybersecurity agenda. Capabilities like Telos Ghost are critical to protecting privacy and identity in today's remote world.

And we're excited to see such strong traction, not only in the public sector but in the commercial market as well. Over the past year Telos has seen increased success and interest in Telos Ghost within the education, Internet of Things, banking, healthcare, and critical infrastructure markets.

With development including a strategic partnership with Johnson Controls to integrate Telos Ghost into their open blue cloud view gateway, which supports a worldwide cloud-based video network used for surveillance and physical security. The integration of this solution will be completed in Q3.

Telos also inked a partnership with Omnilert to integrate Telos Ghost into Omnilert Gun Detect, the industry's first AI-powered visual gun detection solution. The integration of this solution will also be completed in Q3. The Johnson Controls and Omnilert integrations will drive revenues for 2022.

Since last we spoke, Telos has advanced our ability to serve the education market. Of note, we finalized the integration of Telos Ghost in the Chromebooks. Nearly 60% of computers purchased by K-12 schools in 2018 were Chromebooks.

And it's safe to say that number has increased significantly due to the rapid switch to remote learning in response to the global pandemic. Telos ' Ghost-enabled Chromebooks are easy for K-12 institutions to deploy and manage. And we're glad to add that capability to protect student's privacy with the integration of Telos Ghost.

Beginning this month, a large Virginia school district will pilot the Telos Ghost student privacy solution. This solution will be formally announced later in Q3. On July 30th, Telos acquire the assets and patents of Diamond Fortress Technologies and will integrate the ONYX touchless fingerprint software with our ID Trust 360 platform.

You see, Onyx eliminates much of the friction involved in biometric data gathering by leveraging a mobile device's camera to capture the user's unique fingerprint.

This technology enables the fast and easy collection of fingerprint biometrics and will allow Telos to better serve our growing customer base at both the enterprise and consumer levels in verticals such as transportation, healthcare, financial services, and other industries.

This acquisition solidifies Telos's position in an expanding market with contactless biometrics technology expected to grow from approximately 7 billion in 2019, at a compound annual growth rate of 20% from 2020 to 2027. Put simply, ONYX allows people to get their fingerprints taken in the comfort of their own home, versus having to go somewhere.

Over the last few months, we've won nearly a dozen recompetes from existing designated aviation channeling airport customers, including Chicago O'Hare, Minneapolis-St Paul, and Sacramento International Airport. Now, let me turn to some comments on the industry landscape and growing market opportunity.

As extensively reported in the media, a number of cyber-attacks targeting various sectors in the U.S. have pushed President Biden to put cybersecurity at the center of his agenda.

This includes, not only the president's recent executive order on cybersecurity and subsequent actions such as new requirements for pipeline security, but also includes some legislative initiatives in Congress which could have significance for Telos. Here are some examples.

The bipartisan infrastructure package supported by the White House and recently approved by the Senate, calls for increased funding and other incentives to address the cybersecurity needs of U.S. critical infrastructure. The package also provides funding for cybersecurity grants to state and local governments.

Additionally, the pending Senate version of the FY 2022 defense authorization bill not only incorporates President Biden's full requested level of cybersecurity funding for the Defense Department but it goes further to add funding above the requested level.

And an FY 2022 appropriations bill approved by Committee in the House would boost funding for DHS's cybersecurity and Infrastructure Security Agency, or CISA, by nearly 20% over last year's appropriation level. This includes increases above the President's request for infrastructure, cybersecurity, and risk management operations.

These government actions haven't changed anything for Telos in the near term, however, in the long term, they will provide the Company with far more opportunities and will grow our pipeline.

The National Institute of Standards and Technology, known as NIST is also developing a ransomware profile for the cybersecurity framework to help organizations manage security best practices required for ransomware attacks.

Telos has actively engaged in this effort by participating in the NIST-sponsored workshops, which will help shape the final version of the standard. The NIST CSF ransomware profile once finalized, is something that we plan to operationalize via our Xacta solution.

In conclusion, we had a strong quarter, and our Company's exceptional results continue to be driven by increasing demand for our advanced Security Solutions and our growing sales channel. We are well-positioned to continue to execute as a leading world-class organization in the cyber cloud and enterprise security market.

I'd also now like to pass it over to our CFO, Mark Benza, who will discuss the financials and guidance in more detail. Mark, over to you, bud..

Thank you, John, and thank you, everyone, for joining us today. First and foremost, I'd like to begin by saying how thrilled I am about the opportunity to join Telos. I'm excited about the numerous opportunities ahead to execute for our customers, partners, and shareholders, and to work with this team.

I'm pleased with our second-quarter results underpinned by strong revenue growth, gross margin expansion, and positive cash flow. Let's start with revenues. Year-over-year reported second-quarter revenues grew 8%, from $48.6 million in 2020 to $52.6 million in 2021. Excluding our contracts with the U.S.

Census Bureau, which is ramped down as planned since the same period last year, total second-quarter revenues grew 48%.

Sequentially, total second-quarter revenues declined 6%, from $55.8 million in the first quarter due to a large delivery and our Secure Networks business that was originally planned for the second quarter but was delivered in the first quarter per our customer's request.

If the delivery had shipped during the second quarter as originally scheduled, second-quarter revenues would've been approximately $57.4 million, sequential growth would've been 13% instead of negative 6%. and year-over-year growth would have been 18% instead of 8%. But in either case, first-half results are the same, with reported revenues up 24%.

Now let's turn to our individual businesses. Total second-quarter revenues for our Security Solutions business declined 9% from $34.2 million in 2020 to $31.2 million in 2021. This decrease was driven by nearly $13 million of lower sales in Telos ID on the contract with the U.S. Census Bureau as mentioned previously.

This contract recognized peak revenues in the second quarter of 2020 and largely ramped down according to plan through the second quarter of 2021. New contracts in Telos ID, our Xacta solution, and Telos Ghost are quickly backfilling the ramp-down on the contract with the U.S. Census Bureau.

In fact, excluding this contract, second-quarter revenues in Security Solutions grew 48%. In part as a result of the new pilot program awarded by a confidential customer to Telos ID in the second quarter, which we mentioned on our last earnings call, as well as 18% growth in our Xacta solution and 12% growth in Telos Ghost. Ghost.

Growth in our Xacta solution and Telos Ghost reflects both the expansion of relationships with pre-existing customers, as well as new wins and increased commercial adoption of our offerings as John explained earlier.

Total second-quarter revenues for our Secure Networks business also grew approximately 48%, from $14.4 million in 2020 to $21.4 million in 2021. This significant increase was mostly driven by two large programs issued under the U.S. Air Force Net Cents contract vehicle.

The rollout began for a $66.4 million contract to provide security modules and kits to support the upgrade of the Theatre Deployable Communications Black Core Architecture. And site work began on a five-year $45 million U.S.

Army contract to support the migration and modernization of telephone communication systems throughout the entire Pacific region. Secure Networks continues to win related business as a result of these programs and expects work on these programs to continue into 2022.

Before turning to our profitability metrics, I'd like to provide some color on our stock compensation expense, which will be mentioned throughout my remaining comments about the quarter.

As a newly public Company, stock compensation is an effective tool to retain existing staff post-IPO, attract seasoned professionals, and enhance incentive compensation. As a private Company, we recognized a minimize amount of stock compensation expense in 2020.

But starting in the first quarter of 2021, we began amortizing stock compensation expense through our income statement as a result of an initial round of post-IPO grants made in the first quarter.

Because this expense is new for 2021 and because it is non-cash, we believe it is appropriate to provide adjusted metrics, excluding the impact of stock compensation expense where relevant. This year, we recorded $13.7 million of total stock compensation expense in the first quarter and $21.3 million in the second quarter.

We expect stock compensation expense to step down to approximately $13 million to $14 million in each of the third and fourth quarters of this year. With that backdrop, let's turn to profitability and cash flow. The second-quarter gross profit increased 17% from $17.6 million in 2020 to $20.6 million in 2021.

The cost of sales included $795,000 of stock compensation expense, which did not exist here. Second-quarter gross margin increased 290 basis points from 36.2% in 2020 to 39.1% in 2021 due to gross margin expansion in both Security Solutions, as well as Secure Networks.

Excluding the impact of stock compensation expense during the quarter, gross profit was $21.4 million and gross margin increased 440 basis points to 40.6%. SG&A and R&D expenses increased by $26.6 million to $39.1 million in the second quarter.

Of the $26.6 million increase, $20.5 million was attributable to stock compensation expense that we did not have in the prior-year period.

The balance of the increase was driven by previously discussed investments in our sales force, marketing, and channel staff, which will drive ongoing high-margin revenue growth and rapid expansion into commercial, international, state, and local markets.

We're also making investments in GSA functions to support our post-IPO business model, and investments in R&D to ensure our customers have the world's most sophisticated cyber, cloud, and enterprise Security Solutions. And that the solutions continue to address new and evolving threats for years to come.

Operating income before stock compensation expense was $2.8 million compared to $5.1 million in the prior-year period. Operating income benefited from higher gross profit driven by sales growth and gross margin expansion, offset by investments in R&D and SG&A, all of which I've outlined previously.

Adjusted net income increased from $262,000 in 2020 to $2.6 million in 2021.

The increase in adjusted net income was primarily driven by the same factors as operating income discussed previously but also benefited from the elimination of $1.8 million of interest expense and the elimination of $2.8 million of minority interest compared to the same period last year as a result of the actions we took to deleverage our balance sheet and simplify our capital structure post-IPO.

The corresponding adjusted earnings per share increased from $0.01 per share to $0.04 per share. EBITDA adjusted for the impact of stock compensation expense was $4.2 million compared to $6.4 million in the second quarter of 2020.

The decrease is attributable to the previously mentioned investments in SG&A and R&D, partially offset by the increase in gross profit. We generated $3.5 million of positive cash flow from operations during the quarter compared to a cash outflow of $904,000 in the second quarter of 2020 and a cash outflow of $9.3 million in the first quarter of 2021.

The improved cash flow was primarily the result of higher adjusted net income and favorably working capital dynamics during the quarter. Now, I will turn to our financial outlook for the year.

We are reaffirming our guidance for the full year, including total revenue in the range of $283 million to $295 million and adjusted EBITDA in the range of $33 million to $36 million. Our guidance implies year-over-year revenue growth in the range of 89% to 102% for the second half of the year, and 57% to 64% for the full year.

We're forecasting approximately 40% to 50% sequential revenue growth from the second quarter to the third quarter, with additional sequential revenue growth from the third quarter to the fourth quarter, primarily driven by TSA PreCheck. Our overall guidance remains unchanged. However, the composition of our sales growth in the second half has evolved.

We previously forecasted approximately $8 million of TSA PreCheck revenues in the third quarter and $30 million in the fourth quarter. We're now assuming no revenues from that program in the third quarter and approximately $25 million in the fourth quarter due to short-term program delays, as discussed earlier by John.

Similarly, we previously assumed approximately $8 million of revenues from the centers for Medicare and Medicaid services in each of the third and fourth quarters, but we're now assuming no revenues from that program this year.

So overall, we're assuming approximately $30 million of revenues from those two programs will be recognized in 2022 instead of during the second half of 2021. Keep in mind, these are short-term, customer-driven delays that impact the initial timing of revenue at the beginning of these programs during the second half of 2021.

The value of these programs and our out-year expectations have not changed. These remain multibillion-dollar, profitable, long-term programs. We have a solid base of business that supports our full-year guidance, notwithstanding the short-term delays in CMS and TSA PreCheck.

The revenue that has been pushed into 2022 has been replaced by new customer wins and expansion of existing customer relationships across all of our businesses as John discussed earlier. These successes are further supported by our rapidly expanding new business pipeline.

In closing, we're very pleased with our performance this quarter, which was underscored by 48% adjusted revenue growth, 290 basis points of gross margin expansion, and $3.5 million of cash flow from operations.

And we are well-positioned for 2022 with multiple large programs launching and a fully resourced sales and marketing team building our channel program and cultivating a strong pipeline of opportunities and commercial, international, state, and local markets. With that, John, Ed, and I are available to take your questions.

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

And thank you, ladies and gentlemen. As a reminder, [Operator Instructions]. Please stand by while we compile the Q&A roster. And our first question comes from Alex Henderson from Needham. Your line is now open..

Thanks. Boy, I'm breathing a sigh of relief. I thought you guys were going to have to lower the guide for the year. This is a pretty good outcome considering the degree to which TSA Pre was late and the risks to Medicare and Medicaid. So, I was wondering if you could talk a little bit about what it is that is [Indiscernible].

Ghost is replacing it? Is it Network Solutions that are replacing I? Where are the revenue streams coming from? And given you had expected to get to double-digit operating margins in the back half of the year, is that something that you still expect to be able to attain without the TSA and Medicare, Medicaid programs?.

Hey Alex, this is John. Thanks for your question. Thank you for your comment.

The way to think about it, in general, is that our mix, our revenue mix will be about the same as we projected from an IPO point of view, which means that Security Solutions should be around 60% of the revenue going forward, which is going to be a result of a mix of those 3 areas, plus that confidential customer that we talked about before doing more work with us because we've done well with them.

So, across the board, you'll see growth, really, within our Secure Networks group as well so I believe that we'll have a good solid second half of the year..

Is it Ghost? Is it Xacta? Any color on what it is that's, obviously, running well ahead of forecast to offset the loss of, I think, if I do the math right, five -- something like $30 million in the third quarter, going into the fourth quarter?.

Basically, what it is all of the Security Solutions components are doing better than the plan from a pipeline point of view. And then, the second part is with Secure Networks as well, we're seeing good growth across the board..

Okay.

And then the margin comments, any reason to believe the margins aren't going to be at least as good then?.

That's why we have held our guidance. We wanted to make sure that the market understands that we believe the mix will hold, and as a result, the margins will hold..

Okay. And so to the extent that TSA, Pre, and Medicare, Medicaid starting bound -- if you think about it as a physics boundary value problem, it started a little later, does that change the expectations for '22 or alternatively, the fact that it started later has no impact because you'd expected the volume in '22 either -- in either case.

How do you talk to the magnitude of '22 based on the difference in timing?.

Yes. So one part of that, Alex, is going to be, obviously, CMS and PreCheck, some components of that pushing, but the other component keeping the back your mind's eye is, I think we assumed 600 and some odd -- 625,000 transactions, I think it was, for 2022 and I think that's going to prove to be conservative..

So, it sounds like you think that you'll still hit the original expectations for TSA premium Medicare, Medicaid in 22 based on better transaction volumes and whatever share, despite the delay in the start time; is that right?.

Correct..

Perfect.

And then one last question, then I'll see the floor, as I'm looking at this delay, does that help you at all or hurt you at all relative to the competitive balance between your offering in that arena and your competitors in that arena? Does it give you more of an opportunity because of the Xacta tie-in or does it have any impact at all or is it -- is that not impacted?.

From our standpoint it allows us to hit the ground running. So, it allows us to prepare ourselves, we'll have several hundred sites up and ready. So as a result of that, I think it gives us a better chance of much faster success..

All right. I'll see the floor. Thanks..

Yes..

Thank you. And our next question comes from Dan Ives from Wedbush Securities. Your line is now open..

Hi, this is Sam Brandeis on for Dan. My question is, can you speak on the surge of federal spending that we're seeing on cyber towards year-end? And how does this environment compare to the last few years in terms of spending? Thanks..

You are welcome. So, I would say from a standpoint of our year and this year, I would say it's going to have a little impact this year. However, it will have an impact over the next year and two years.

Even though the government has put money to work, you still have to go through what's called the contracting process, and that inevitably tends to slow things down. So, from a standpoint of planning, we're not planning on additional revenue out of that plus up, if you will, from the government. If it happens, great, but we're not planning on it.

We are, however, all over it, and we're making sure that we mine all the opportunities that we see out there, which there are many, but we have to all realize that there is a contracting process that goes behind when they push dollars into these big programs.

So, the pipe, the way to think about it, for all of you on the line here, is our pipeline is getting a lot bigger in general as a Company..

Great. Thank you..

Thank you..

Thank you. And our next question comes from Zach Cummins from B. Riley Security..

Hi, John and Mark, thanks for taking my questions. I appreciate the time here.

John, just given that the business remains on track here and reaffirming your full-year outlook, can you just give us a little bit more insight into why we've been seeing this string of insider selling of late?.

Sure. As I've pointed out to certain investors that have called me about it and spoken to some of the people in research as well, one of the great assets we have here is we have longevity here. And so, a lot of people here with a lot of tenures and they've never sold a share.

So, we expected there to be some selling, and these plans, the so-called 10b5-1 plans were put in place months ago. So, when they start their process of selling, it's out of their control at that time. So, I think that's where it really comes from.

It's not a question about the Company or its condition, it's more really getting liquidity for my own employees who have an opportunity to diversify most of their wealth out of the Company and put it prudently into other investments as well. Understood.

That's helpful and also encouraging to hear the progress we've seen with the expansion on the sales and marketing and the channel team.

I mean, can you give us some updates on the early progress that you've seen there and expectations from that expanded group as we go into the second half of the year?.

Yes. So just to remind everybody, we started with 16, I think we're up about 66 now, something like that, plus 50 or something. [Indiscernible].

Of about 50 people. We're seeing. I think the partner ecosystem is going to be much broader than we were expecting. We are -- we think that'll pull in some opportunities into the early part of '22, maybe the late part of '21. And we're seeing that it's also translated commercially which is very important to us, as you all know.

So, I'd say that, again, this is a reflection of a much faster growing pipeline for us as a Company. And remember every time when we get into an account, the whole idea, once you get in, is to expand it over time, so we're continuing that process as well, which I think is helpful for the company, obviously..

Understood. And it sounds like, with the ramp in revenue, we should see the margin expansion as well in the second half of this year.

So, Mark, should we expect the Company to continue to be free cash flow positive as we see this ramp in the back half of the year?.

That's certainly our expectation for the full year, is that based on our guidance even at the low end, we're expecting to be cashflow positive. In the absence of an unusual end-of-year ramping and working capital, we would -- which we're not expecting, we would expect to be cashflow positive for the year..

Understood. Well, thanks again for taking my questions, and congrats, again, on the third quarter..

Thank you..

Thank you, Zach..

Thank you..

Thank you. And our next question comes from Nehal Chokshi from Northern Capital. Your line is now open..

Thank you.

Can you guys hear me?.

We can. Yes, sir..

Great. Great. Okay. So, yes. I echo my sentiments of a great quarter, and great to see the reiterated guidance given the TSA pushout timing of that.

The work with the confidential customer, this is the same customer that was announced during the 4Q call that was a contract that was worth up to 45 million, correct?.

That was worth up to 45 million, that's correct, Nehal. It was $35 million, Nehal..

I'm sorry, it was 35 million..

And the award, right?.

Yes. Okay. And so, what this confidential customer, the composition of their work, it sounds like it's heavily weighted towards ID Trust 360 but there is a bit of Xacta goes there as well. And therefore, that's why you're maintaining your margin profile as well..

Yeah, the way to think about it's, I think it's -- Ed's here, is it 75-25 in terms of the mix, roughly? So Secure Networks is roughly 25% of it and the rest of the work is Security Solutions with about 25 million of that 34.5 million or 35 million being recurring..

Okay..

And then, you made another interesting comment, the same comment that you made from the prior call, wider V-shape funnel. Two questions with that.

One is that is it even wider than the wider V-shape funnel that you referred to in the prior call? And then, can you just define what you mean by wider? Do you mean more diverse customers or something else?.

It's really a combination of depth, breadth, and size. So, the size of the opportunities is getting bigger. The duration of the opportunities is getting longer. The type and flavor of opportunity, meaning, Security Solutions versus Secure Networks is broadening.

So, it's happening across-the-board, and it's not really -- it's not in one group or another, it's happening across the board.

And Ed, I think that's correct, do you?.

Yeah. And the channel and the fact that we've got a lot more people out there..

Yeah..

Doing their jobs as well as we are enlisting channel partners who also bring a portfolio of customers on their end, so that helps to broaden the pipeline even more..

Yeah. And just to put a fine point on that, we talked about DLT, but there are others -- other large distributor types who have hundreds and hundreds of contract vehicles of their own. And basically, from our point of view, we're dealing with one buyer, meaning the distributor.

But then they have hundreds of contracts of their own that they would as orders come in and administer on our behalf, but from our point of view, we're dealing with one entity. So again, it's another flavor of the channel strategy that we've been discussing with everybody since the IPO..

Okay, great. And then, just to be clear, the winding is a trend that has happened from the first -- end of the fourth quarter to end of the first quarter to end of the second quarter, it's not just we had one [Indiscernible] step..

That's right. That's right, Nehal..

Great.

And then finally, you have I think, a very important line in the press release where you announced a lot of new and renewed contracts, a bunch of impressive commercial names such as AT&T, Accenture, Arnett (ph.), Cybersecurity, Comtech, was -- which of these were actually new?.

I think those are all new. Yeah, those are all new in the hall. They're all new..

So, and is that generated through the channel programs or is that direct?.

It was all direct, Nehal, but in each case, they start out as internal use kind of things, and then they plan on expanding channel. Remember what we want our partners to do like as an example, in Accenture -- excuse me.

We want them to build out their own capabilities of many Xacta so that as we sell, we're selling more software as a service versus solutions as a service..

Great.

Well, do you sound like these would be important beachhead customers within each commercial vertical that should help the channel program, is that an incorrect assessment?.

That's not incorrect. That's correct..

Okay. Great. Thank you..

You're welcome. Thank you..

Thank you. And our next question comes from Keith Bachman from the Bank of Montreal. Your line is now open. Hello, Keith? If you have phones on mute, could you please unmute them? Next question. Keith Bachman from Bank of Montreal..

Can you guys hear me?.

Hey, Keith. We can hear you now..

All right. Yes, sorry. I have a little bit of technical difficulty. I had a little trouble getting into the call too, so I may have to do a little bit of repeat, but I want to start on TSA. And could you revisit -- I had a few questions about this.

Is the delay a supply or a demand-driven delay? What I mean by that was there something on the technical side or rolling out the program from the TSA side or was it demand-driven delay in that there are fewer business travelers sort of speak who was a primary driver of the TSA program, if you could just clarify?.

Sure. Keith, I'm glad you asked me that question. Thank you.

What I'd say is that it's driven by virtue of the fact that we've had, as everybody is well aware of, a bunch of different cybersecurity hacks and that has caused the TSA to take a step back to make sure that their own systems fundamentally won't have a problem by any third-parties coming after them. So that's --.

More supply..

That's the main reason why this is all being pushed out..

Okay..

So, it's programmatic. It really has zero to do with demand..

Right. Right..

The demand is actually there still and hopefully it will hold, but the demand is definitely there still..

Okay. And I want to stick with it because right now if I go on -- and this is a competitive landscape question, how does this a follow-up? If I go on the TSA site, it takes me to UE Universal Enroll Program.

How does the TSA to the government deal with the distribution of work as the program rolls out more in earnest? In other words, is, is it going to be a redirect to competitors or do you get a fair shake at it? How does the distribution of opportunities occur, so to speak, as the program unfolds more and earnest?.

First and foremost, they've said there's going to be equity between and amongst the different players. But Keith, we've never really expected that. We expect that we're going to have to compete on the merits so it's going to have to be -- that's how we're planning on this, is competing on the merits..

But how do you generate -- how do think you win the business then, from the 3 other participants, excuse me, 2 other participants in the market?.

So, you were -- were you going to say something?.

Keith, this is Ed. So, for my -- on the new customer side of it, there's a direct marketing play here, where we'll be marketing and there's also points of presence where we'll be establishing, John mentioned earlier, a couple 100 expanding to eventually thousands of sites for people to get into to apply.

So that right there is a distinction between competition, where we're at and where they're not, and so forth. And also, from a marketing perspective. We feel very comfortable with that program and what we're going to be doing there. On the re-compete side,.

there are some nuances as well as terms of benefits that potentially come to one -- using one enrolling Company versus another.

And as John mentioned, we're not quite sure how it's going to play out on the site, but we still anticipate between our marketing ventures where will be also marketing through distributors to customers that are both renewals as well as new customers. So, we'll be able to do direct impact there as well.

So, we -- that's the way these things we see it playing out at this point..

And then just to remind you, the universal enrollment contract is very different than the expansion contract, Keith. In that, the provider of that program, which is Idemia, pays the government directly the full amount of the cost of PreCheck.

And the government then issues a check back to them per government terms over -- usually, the government pays within 60 to 90 days. In our case, we're taking at the point-of-sale, which allows us to do things like do discounting that you really can't do on Universal Enrollment.

They have to pay the government a certain amount of money with every transaction.

In our case, we pay the government a smaller fee, but we take the entirety of the $85 and are able to use it in a way where we, A, get paid up front, but, B, we're also able to do things like providing no costs incentives, which include things that I've referred to in the past, like discounts on various websites for purchasing merchandise, etc., and then those merchandisers pay us on the backend which becomes another source of revenue for the Company.

There is a ton of additional activity behind that that we just don't get into because this is a public forum. So, it's very, if you will, highly -- we hold it very close. All the various initiatives we have internally, but we do think that out of the shoot, we'll be very well prepared to execute from Q4 and beyond.

As I mentioned earlier, we'll have a couple of hundred or a few hundred actually, up to a few hundred sites by the fourth quarter anyway, which puts us into a running start mode, got it?.

Got it.

Okay, question number 2 relates to the previous question, which was asked by somebody else, but on the commercial side, could you just give us an update on either the percent of commercial bookings or pipeline or revenues? How did you see that today? How did you see that unfolding at year-end?.

Okay..

And let's just keeps TSA out of commercial definition..

Yeah. No, I get your point. I get your point. I think at the end of the day, we'll probably be somewhere around 90/10 by the end of '21. I think by the end of '22, we're going to be around 80/20 if you don't count TSA PreCheck..

Yeah..

And that could change very rapidly based on the channel and based on the distribution models. So, remember the numbers that we have are based on channel and the commercial pipeline not having any impact on 2022 until the second half of the year of 2022..

Got it..

So, my -- our assessment will be refreshed once we go through our end-of-year planning for purposes of full-year 2022 and then come out with our guidance for full-year '22 at some point in not too distant future..

Okay. Okay. My final question is just stress. And what I mean by that is, it's understandable that if TSA and Medicaid Medicare push that there could be some downward pressure on previous guidance, you're maintaining your guidance, which sounds like the pipeline is robust enough to maintain that, but I think investors may come away.

Did they leave a tall hill to climb?.

That is to say good management, we have a tall hill to climb to even make those -- the current guidance and see why '21 given that two of the largest programs are being pushed into '22.

And so, I think a different way to ask that question just on overall, maybe you could just characterize how the pipeline has evolved from, say, December 31, to June 15th, to today, is it up 15%? Is it up 20%? Is there any way to think about that because just, again, if 2 of your larger programs are pushed, yet you're maintaining guidance, I think the natural question is going to be, what stress did you thereby leave with on this side [Indiscernible]?.

No. I get it's a great question, Keith. And another one I am glad you asked upfront. One of the things that Mark did in his presentation as he gave you a sense of what we think Q3 looks like. And that's without CMS, that's without PreCheck.

That gives you some sense of the way that we've been able to fill in that whole, if you will, with existing and or new customers or expansion of existing customers.

And if I were to estimate what that would be for Q3, it's probably 20,15, 20 revenue?.

Percent?.

Million..

New customers?.

No, no. I'm saying the amount we're covering from CMS and PreCheck is rough, I think, 15 million bucks, roughly.

Isn't that right?.

Yeah, for Q3, yeah..

Yeah. So, we're covering a $15 million whole with other business, which has the same or better margin profile than those programs on their own..

Yeah. The margin profile I get. That's interesting. And then, just say it a different way, comfortable with Q3 and Q4 then..

We are, we're comfortable, as of today, with Q3 and Q4. And yes, so that's why we reaffirmed guidance. Otherwise, we wouldn't have. Now, I'll say it a different way, had we been up and running with both programs, we would've guided up..

Yeah..

At the end of the day. But in an overabundance of being cautious, we basically just said we're going to stick with what we're -- what our guidance is..

Yeah. Makes sense. Okay. I will see the floor and many thanks..

Thank you..

And thank you. And our final question comes from Catharine Trebnick from Colliers. Your line is now open..

Thanks for taking my question. Can we then get into the gross margins, I might have missed it when you talked about them and I'm specifically trying to understand better the solutions versus the network gross margin..

Sure, Catherine. Catherine, I'd like you to meet Mark Bendza who is our CFO, and great to hear from you again. So, Mark please dive into the gross margin for Catherine..

Hi Catherine, thank you for the question. I don't think we've been giving out precision around gross margins at that level. But what I can say is that Security Solutions, gross margins are tens of -- nearly double, let's say, between Security Solutions and Secure Networks.

We also saw pretty significant gross margin expansion from the first quarter to the second quarter in both Security Solutions and Secure Networks. And then in addition to that, we also saw some mixed benefit from 1Q to 2Q with Security Solutions going from 40% of total revenues in the first quarter to 60% in the second quarter.

That 1,300 basis points of gross margin expansion that you saw sequentially from 1Q to 2Q, was both mixed between Security Solutions and Secure Networks as well as gross margin expansion within each of those two businesses..

And put a fine point on it, just so everyone is aware, Q1, everybody will recall our Secure Networks business is more like 59% of revenue and our Security Solutions business is more like 41%. And there was concern that the model was wrong, it was off. And we said, no, it's really just a point in time.

If you look where we are today in terms of revenue mix, it's where we were thinking it should be, which is much more like around 59% Security Solutions and 40%, 41% is Secure Networks. So that is going to have the impact of obviously affecting gross margins, not just on a dollar basis but as a percentage of sales..

All right. And that helps because I remember the Secure Networks was significantly depressed last quarter, so thank you very much..

You're welcome, Catherine. Thank you for your question..

And thank you. And I'm showing no further questions. I would now like to go ahead and turn the call back to management for closing remarks..

Thank you very much, operator. I just want to say how much we appreciate everybody and their beliefs in the Company and what we're up to as an organization. I try to avoid watching the stock price, but of course, occasionally, I'd do it and just it's a crazy world out there as all I can say.

I'm hopeful that we'll just continue to hit numbers and perform, and over time, people will begin to trust that the information that we get people and the growth that we perceive is out there, is going to actually happen.

And therefore, I like people to remember that we have very long-term contracts and 2022 is going to be a bang-up year, in my opinion. So have a great night, everybody and we'll talk soon..

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