Ladies and gentlemen, thank you for standing by, and welcome to Telos Corporation First Quarter 2022 Earnings Conference Call. At this time all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session.

[Operator instructions] I would now like to turn the conference over to your speaker for today, Christina Mouzavires. You may begin..

Good morning. Thank you for joining us to discuss Telos Corporation's first quarter 2022 financial results. With me today is John Wood, Chairman and CEO of Telos; and Mark Bendza, Executive Vice President and CFO of Telos. Let me quickly review the format of today's presentation.

John will begin with brief remarks on our 2022 first quarter results and Telos' strategic priorities, and Mark will cover the financials and guidance for second quarter and full year 2022. Then we'll open the line for questions and answers where Mark Griffin, Executive Vice President of Security Solutions, will also join us.

The earnings press release was issued earlier today and is posted on the Telos Investor Relations website, where this call is being simultaneously webcast. Additionally, we have provided presentation slides on our Investor Relations website.

Before we begin, we want to emphasize that some of our statements on this call are forward-looking statements and are made under the safe harbor provisions of the federal securities laws. These statements are based on current expectations and assumptions that are subject to risks and uncertainties.

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

In addition, during today's call, we will discuss non-GAAP financial measures, which we believe are useful as supplemental and clarifying measures to help investors understand Telos' financial performance. These non-GAAP financial measures should be considered in addition to and not as a substitute for or in isolation from GAAP results.

You can find additional disclosures regarding these non-GAAP measures, including reconciliations and comparable GAAP results in our earnings press release and on the Investor Relations website. Please also note that financial comparisons are year-over-year unless otherwise specified.

The webcast replay of this call will be available for the next year on our company website under the Investor Relations link. With that, I'll turn the call over to John..

Thank you, Christina, and good morning everyone. Let's begin today on Slide 3. I'm pleased to report that Telos is off to a sound start for 2022. Mark will discuss our financial performance later on this call, but at a high level we delivered $50.2 million of revenue in the first quarter above the high-end of our guidance range.

Security Solutions grew 18% year-over-year, while Secure Networks was down 29% as expected due to a large program that is coming to a successful completion this year. Both segments perform slightly better than our first quarter guidance. Gross margin was also slightly above our guidance range at 37.6% due to margin outperformance in both businesses.

Finally, we delivered $1 million in adjusted EBITDA above the midpoint of our guidance range and a modest $0.01 adjusted EPS loss. Now let's turn to Slide 4 to discuss our recent business highlights and updates. This quarter we announced a new product offering that Telos Advanced Cyber Analytics Solution or Telos ACA.

We believe this solution offers unique capabilities and will address critical unmet needs within today's cybersecurity environment.

More specifically with Telos ACA customers can in near real-time detect malicious activity, uncover and identify previously unknown attacks and new malicious behavior, enhance network protections and over the near-term attribute and geolocate malicious cyber activities and assist in the attribution of events of concern with actionable information.

We are offering Telos ACA as a service with sophisticated capabilities and comprehensive analytics with minimal financial and technical barriers to adoption. We are very excited about this new offering, which we believe will create value for our customers and shareholders alike.

Beyond the Telos ACA launch, we have continued to maintain momentum with key wins and renewals for Xacta sales and services, including Ernst & Young, Amazon Web Services, the National Security Agency, as well as the new foreign government customer.

We continue to focus on the government and commercial space and in particular prioritizing regulated industries. Within our channel partner program, recent developments in the first quarter include the establishment of a partnership with Carahsoft to further expand the reach of all of Telos Security Solutions.

The secure communications business continues to perform at a high level of quality and customer satisfaction achieving a 100% renewal rate for our Automated Message Handling System.

Secure Networks is having success with new contract wins including a recent award with The United States Air Force Academy to upgrade and expand their network infrastructure. Now, let me turn to some comments on the industry landscape and the number of recent initiatives in Washington, D.C. that present opportunities for Telos.

The Biden Administration has now submitted its proposed FY 2023 budget to Congress, which calls for a nearly 11% increase in non-defense cybersecurity funding next year, much of this is to help agencies meet the priorities outlined in last year's cyber security executive order.

As noted on our previous earnings call, last year's cybersecurity executive order directed federal agencies to accelerate migration to the cloud and make greater use of Zero Trust architecture, both of which are complemented by Telos Solutions.

The President's budget specifically emphasizes this continued push for Zero Trust as well as boosting supply chain security.

The proposed budget also calls for roughly a 4% increase in defense spending although the Department of Defense notes this did not include funding to help Ukraine or to address the potential Russia-Ukraine war impacts here at home, nor DoD acknowledged did the proposed budget fully account for the impacts of inflation.

In recognition of these items, most observers anticipate that Congress will significantly boost defense spending in real dollar terms well above the levels proposed in the President's budget. The Russia-Ukraine war has resulted in increasingly elevated warnings of potential cyber attacks against U.S. interests, including against U.S.

critical infrastructure. This continues to highlight the need for the public and private sectors to adopt cybersecurity best practices and ensure their cybersecurity posture is ready and able to meet these new and evolving threats.

I will now turn the call over to Mark Bendza, who will discuss first quarter 2022 financial results and our guidance for the second quarter and full year 2022.

Mark?.

Thank you, John. And thank you everyone for joining us today. Let's turn to Slide 5. As John mentioned, we're off to a sound start to the year with results that met or exceeded our guidance for the first quarter.

We reported sales and gross margin above the high end of our guidance range over 1,100 basis points of gross margin expansion, a 30% increase in gross profit and adjusted EBITDA above the midpoint of our guidance range. We also delivered a $6.4 million increase in free cash flow, turning free cash flow positive for the trailing 12 months period.

Now let's get into a bit more detail starting with sales. Total sales were $50.2 million. Security solutions contributed $26.9 million or 54% of total sales and secured networks contributed $23.2 million or 46% of total sales.

The 54% contribution from security solutions compares favorably to the 41% contribution for the comparable quarter last year, when a large order from a secure networks customer pulled forward from the second quarter to the first quarter of 2021.

Year-over-year, total sales contracted 10% as expected due to the previously mentioned pull forward of the large order last year, as well as the ongoing wind down of that same program this year. Excluding that program, total sales grew 19%, including 18% growth within security solutions and 20% growth within secured networks.

Turning to profitability and cash flow. First quarter gross profit increased to 30% as a result of more than 1,100 basis points of gross margin expansion. The gross margin expansion was driven by a more favorable sales mix between security solutions and secured networks, as well as gross margin expansion within both reporting segments.

Security solutions gross margin expanded over 1,500 basis points to 55.9% and secured networks gross margin expanded over 80 basis points to 16.4%. As a side note, much of this gross margin expansion will reverse in the second quarter as expected, but net-net, we expect to deliver gross margin expansion for the first half of the year overall.

Adjusted EBITDA and adjusted EPS declined slightly due to the ramp in investments in R&D and SG&A over the course of 2021. Free cash flow improved by $6.4 million, turning free cash flow positive for the trailing 12 months period.

The improvement in free cash flow was the result of more favorable working capital dynamics compared to the same period last year. Let's turn to Slide 6, to recap on our gross margin expansion and free cash flow trajectory over the past several quarters.

Since our IPO, we have made steady and significant progress on gross margin expansion and free cash flow generation. On a trailing 12-month basis, gross margins and free cash flows have improved every quarter for the past four quarters.

Gross margins expanded 530 basis points between the trailing 12-month period ending March 31, 2021 and the equivalent period ending March 31, 2022 due to gross margin expansion within both security solutions, as well as secured networks.

Similarly free cash flows improved by $19.6 million as a result of improved profitability and working capital dynamics. I expect these metrics to have short-term ups and downs over time, but the overall upward trajectory illustrates our focus on balancing investments in our future with margin and cash flow performance today.

In particular, our positive free cash flow for the trailing 12 months is an important milestone. As we become a consistent free cash flow generator over time, we will consider various options to deploy our capital that remain consistent with our strategy, including a share repurchase program.

Now let's turn to Slide 7 to discuss our outlook for the second quarter. For the second quarter, we forecast sales in a range of $50 million to $54 million and adjusted EBITDA of negative $2 million to positive $2 million.

We forecast security solutions revenues to be down low to high teens, primarily due to the completion of the 2020 Census program in 2021, lumpiness and perpetual license sales and lower revenues on a single program in secured communications. We expect no TSA precheck revenues in the second quarter.

We expect secured networks revenues to be up mid single digits to mid-teens primarily due to lower revenues in the comparable period last year, as a result of the previously mentioned pull forward of a large order into the first quarter from the second quarter of 2021.

Gross margin is expected to be down between seven percentage points and nine percentage points as expected primarily due to the year-over-year change in revenue mix between security solutions and secured networks. In addition revenues within each of security solutions and especially secure networks will mix lower in the second quarter.

But overall for the first half of the year, we expect gross margins to be higher year-over-year. Below the line expenses, excluding stock-compensation expense, are expected to be approximately $3.5 million higher due to the ramp of sales, marketing, and G&A investment during 2021.

And lastly on Slide 8, we're making no changes to our full year guidance. So far, the year is progressing as we expected when we originally set our full year guidance in March. With that, I'll pass back to John who will wrap up on Slide 9..

Well, thank you, Mark. In summary, we reported substantial gross margin expansion and gross profit growth in the first quarter. We generated significant free cash flow improvement in the quarter and free cash flow turn positive for the trailing 12-month period.

We continue to develop our portfolio of new growth vectors, including the launch of our Telos Advanced Cyber Analytics offering. And we remain focused on striking the right balance between investing in our future and managing costs, margins and cash flows today. And with that, we're happy to take questions..

Operator, please open the line for Q&A, and we ask the call participants to please be mindful of others in the queue by asking only one question. Thank you..

Thank you. [Operator Instructions] Our first question comes from the line of Alex Henderson with Needham. Your line is open..

Thanks. I was hoping you could give us some granularity on the performance of Xacta goes to AMHS and IDTrust with particular focus on Xacta and Ghost scaling it on growth rates.

And what's the impact has been of the sales hiring that you did last year as well as the resale opportunity and whether that's kicked in with the key cloud companies Microsoft and Amazon, that's kind of all wrapped up into that same question..

Hello, Alex. This is Mark Griffin. I'll take your question, a couple parts. So we had expected or we had forecasted that the Xacta end Ghost sales would be starting to see results from the expansion of sales and marketing efforts in the second half of this year. And so that is still tracking.

We did report that we received a foreign government award for Xacta and that resulted in Q2. So things are tracking right now based on the forecast that we presented as it relates to Xacta end Ghost in the second half of the year.

IDTrust is progressing now with the confidential health program and our efforts within our Defense Manpower Data Center as well as other programs. So right now the progress that we're making in the Q1 and we're projecting in Q2 are playing out as we expected in the timing of those..

Could you just give us some sense of what the rate of growth is in those product areas that we have lose the baseline?.

Yes. Alex, we're not giving granularity down to the level below our reporting segments. Security Solutions was up 18%. I'd say that was primarily driven by our ID business.

Comms was a little – secure communications, which includes AMHS and Ghost, was a lower year-over-year due to a single program that renewed at a slightly lower level last year, so we'll see the impacts there. And then on the IA side, what I'll say is that software revenues were lower, although orders were higher.

The reason for the difference is that the orders this year were more weighted to subscriptions than to perpetual licenses..

Thank you..

Thank you. Our next question comes from the line of Zach Cummins with B. Riley Securities. Your line is open..

Yes. Good morning. Thanks for taking my questions and congrats on the solid results here.

Just following up a little bit on Alex's question, just for the Q2 guidance, Mark, can you give some more insight into what are some of the moving parts and the impacts that we're seeing for Security Solutions to see this down kind of low to high teens, I still believe is the guidance here in Q2?.

Yes. So it's a couple of items. I'd say on the information assurance side where I'd say we're flattish year-over-year. Secure comms will be lower year-over-year due to lower volume on that single program that I just mentioned to Alex.

And then on the ID side, we did have although Census ramped down significantly from 20 to 21, there was still Census revenue running through 2021 is running at about $1.5 million or more a quarter. And so when you look at that just on a quarterly basis and ascribe that only to Security Solutions, you're going to see a year-over-year impact there.

So those were the main items. So Census overall for total company isn't that big of an impact, but what would you start looking at it just for Security Solutions or in particular just for the ID business year-over-year, it's more meaningful..

Got it. That's helpful. Thanks for taking my question..

Sure..

Thank you. Our next question comes from the line of Keith Bachman with BMO. Your line is open..

Hi. This is Brad Clark on for Keith. Thank you very much for taking my question. Just wanted to touch in on the TSA program seemingly still waiting for the authority to hop away, but it seems like guidance for the programmer meant [ph] the same from three months ago.

So I just wanted to check broadly, if there is any sort of update that can be helpful for how we should be thinking about the puts and take of the program throughout the year and then even going forward? And then another follow up is the Johnson Controls program for Ghost in the second half of 2022.

How should we be thinking about that still tracking and potential for maybe some appetite later in the year? Thank you..

Good morning. This is Mark Griffin. The – yes, we are still engaging daily with TSA and making progress towards an ATO. Positive progress and achievement of these security protocols is happening and we look forward to becoming a TSA PreCheck provider. Our focus still is achievement of that this calendar year. And so, we are making progress on that.

We – every day we meet with them. We escalated our concerns up to the highest levels within TSA. But every day we are making progress towards that and we are very excited about becoming a TSA PreCheck provider. On the Johnson Controls, we've reached out obviously as a partner of them on the solution and that's the Ghost solution within that program.

And we’re confident based on their forecast and their executive leadership that ghost will become a mainstay in their product later in the second half of the year. So we’re still very positive that could be upside for the year based on that growth in that area. So we look forward to seeing sales on that side as well..

Thank you..

Thank you. Our next question comes from the line of Nehal Chokshi with Northland Capital Markets. Your line is open..

Yes, thank you. Just Advanced Cyber Analytics program looks really interesting.

How long have you been building pipeline for this and how long – how big do you think this can be over time say relative to Xacta?.

Hey, Nehal. It’s John Wood. So we started doing Advanced Cyber Analytics in the government several years ago. And we really fine tune it for the commercial market over the last nine months roughly. I think what the use cases for Advanced Cyber Analytics is pretty significant in that.

Most times when people go in and try and figure out what happened, it’s after the fact.

What we’re trying to do is we’re trying to offer a service that’s approximately 98% automated that provides near real time information as to anomalies on your network with a very small portion of being service based, which means we’re able to then take that anomalous data.

And then we’re able to essentially put a fence around it and locate if you will, the bad actor from where they actually are operating. And so in this particular case, the use cases can range from, where we started was around things like terrorists and narcotics going after those kind of bad guys.

In this case, it’s going after bad guys that are involved in things like ransomware and other things. So I think the market is quite significant for us. The other thing I think is great about this particular offering is it’s not hard for someone to sign up for it.

And it’s basically an annual agreement with a monthly pricing based on the scale of service, then the kind of an analysis that’s required. So we’re very excited about it, as it relates to the size compared to Xacta, I’d say it’s too early to say exactly right now Nehal.

But in terms of the excitement in the marketplace, I think it’s people are quite excited about it..

Great. Thank you..

You’re welcome..

Thank you. Our next question comes from the line of Rudy Kessinger with D.A. Davidson. Your line is open..

Great. Thanks for taking my questions.

I guess following up a bit on that last question, just can you give an update on, where this commercial stand right now, either as a percentage of revenue or the pipeline or growth rate, and where do you see getting to over the next six to 12 months? And then, with $120 million in cash, getting the positive free cash on trailing 12-month basis, just how do you think going forward, how do you prioritize between buybacks? You mentioned that, but buyback, strategic M&A reinvesting into the business for accelerated growth.

How do you kind of prioritize between those three?.

Okay. So first on the pipeline. A great deal of our pipeline, we feel is going to come through the channel going forward. We do see direct sales opportunities, obviously as a result of us selling as we have been selling all along. But I think the vast majority of the growth from our point of view is going to come from large channel partners.

And so we – in terms of percentages, I’m not sure I can provide that level of detail for you. Maybe I’m going to turn over to Mark a little bit here and think what he….

I mean, I’d say on a revenue basis, commercial is still very modest, as we would’ve expected at this point. I’d say on a pipeline basis, it’s more weighted to commercial on a pipeline basis than it is on a revenue basis..

Yes. Agree. And then I think the other thing, Rudy, and the rest of the analysts on the call here, just to remind you the vast majority of the commercial sales opportunity is going to be in the form of a SaaS model or a subscription model.

So you’ll see a higher level of order, but we’ll be reflecting that revenue over a period of time versus the way we’ve traditionally done it as a perpetual model in the government in the past where you take it upfront with 20% of the licenses over – or 20% of the maintenance over time.

I don’t know if that answers that question, Rudy does it?.

Yes, it does..

Okay.

And this, what – I apologize, what was the second part of your question again?.

Yes, just, capital allocation..

Buyback?.

[Indiscernible] how do you think about capital allocation?.

Got it. Got it. I’m going to turn it over to Mark to answer that for me..

Yes. Rudy, I’d say in terms of prioritization first and foremost, our priority is to invest in the business, invest in our future and the growth of the company. So that’s our first priority.

For free cash flow generation going forward, where I would like to get to is to a place where we are a consistent free cash flow generator, so that we can start to at some point here, put in place potentially a buyback program where we are consistently buying back stock. And then I would say a third would be opportunistic M&A.

And the reason why I put it third is that I think that will be a bit more opportunistic and episodic, whereas on the buyback side, again, like to get to a place where we are consistently generating free cash flow and then can similarly consistently be buying back our stock, especially at these prices..

Great. Thanks, guys..

Thank you. There are no any further questions in the queue. I would now like to turn the call back over to Mr. John Wood for closing remarks..

Thank you, operator. First and foremost, I just want to thank our shareholders for your ongoing support, in these markets we are progressing as expected, despite all the turbulence out there and we remain focused on delivering for our customers and our shareholders in 2022 and beyond.

And so I just want to say thank you very much for your support and thank you for listening. And I’ll talk to you soon. Bye-Bye..

Ladies and gentlemen, this concludes today’s conference call. Thank you for your participation. You may now disconnect..