Summary
Telos Corporation (NASDAQ:TLS) offers information technology services. The company provides cyber security, secure mobility, cloud computing, risk management, and other information technology solutions to government agencies and commercial enterprises. I am recommending a sell rating for TLS as I don’t see any positive catalyst in the near term that will drive the stock up. It is going to take more than 1 or 2 quarters for investors to be convinced that TLS is on track for growth. While the update on TSA Pre is good, I don’t think it is enough to drive positive sentiment in the stock as the expected contribution is too low.
2Q23 key financials
Revenue for TLS fell by 41% to $32.9 million. This result exceeded both analyst and management forecasts, but I should point out that it was driven by a single, very large, perpetual contract win in the Security Solutions business that was not factored into projections.
Revenues for our security solutions business declined 44% to $17.2 million and were above the top end of our second quarter guidance range due to the sale of a large perpetual software license that was not included in our forecast and drove the entirety of the revenue guidance beat for the company overall. Source: 2Q23 earnings
Similarly, I believe this large contract is a major contributor to the increase in adjusted EBITDA and the decrease in net income loss from -$2.5 million in 1Q23 to -$1.9 million in 2Q23.
Gross margin for our security solutions business expanded to 55.5% primarily due to higher software sales, lower indirect costs from ongoing expense management actions, and lower stock-based compensation and cost of sales, and significantly exceeded the high-end of our guidance range primarily due to the previously mentioned sale of a large perpetual software license, a more favorable mix of labor and materials on select programs, and expense management on fixed price contracts. Source: 2Q23 earnings
Comments
Based on my assessment, TLS stock collapsed due to the significant delays in both the TSA Pre and the CMS programs, which basically destroyed investors’ confidence in management. The share price action (the stock dropped from $10 to $2 over 1 year) shows that the market essentially gave up on the stock. Until the company shows actual results (reported P&L), I agree with investors that the stock is unlikely to work in the near future.
In my view, the only positive news for the 2Q23 results is that TSA Pre is now available in four states via their website and seven store sites. Management believes this company will bring in between $2 and $4 million in 2CH23 and between $10 and $15 million in CY24. Profitability won’t arrive until CY25, which is a problem because investment is still increasing. On a long-term run rate basis, revenue from TSA Pre could reach $35 million if it hits 33% share over time. With an expected gross margin of 50% and an adjusted EBITDA margin in the 30% range for the TSA business, its growth should have a positive effect on overall margins.
However, as I mentioned before, investors are likely to focus on the performance of existing businesses until all these (TSA PRE performance) become tangible results on the financial statements. Management now expects a decline in Security Solutions segment revenues of 30-40% due to lower revenue on two ongoing programs and the loss of a program. This translates to a decline of $25 million (assuming 40% decline), which is much larger than the expected positive contribution from the initial ramp of TSA Pre. Management is also anticipating a revenue decline of 30% to 40% in the Security Networks division. This drop is attributable to the conclusion of major projects in 2022 and 2023, as well as lower revenues on some ongoing projects.
Considered as a whole, management is effectively warning the market to prepare for a very difficult period of poor performance in 2H23. For the Security Network segment in particular, management expectation is that 2H23 new business wins won’t start generating revenue until 2024. Bulls, on the other hand, might take heart from the fact that R&D and S&M costs have been cut in half as a result of management’s efforts to cut costs. However, the fact that G&A remained at such a high percentage of revenue (>30%) was surprising. This leads me to believe that TLS either has management that is unwilling to cut costs or that has a cost structure that is too complex to cut (in which case, a major restructuring is required, further impeding growth). In either case, I believe this is a red flag that shareholders should not dismiss.
I don’t see any reason for the market to be interested in this stock, despite the fact that it is dirt cheap relative to its market cap (around 70% of which is in cash). Due to executional hiccups, the unraveling of large deals, and a lack of exciting growth prospects outside of TSA, I believe the stock price will remain low. Even with Pre-Check ramping, the potential revenue ~$35 million run rate is not enough to offset the decline in Security and Networks segment (completion of large programs). Overall, I’m staying on the sidelines because of the company’s lackluster growth, negative profitability, unsustainable cost structure, and questionable management credibility (for execution).
Conclusion
In conclusion, TLS faces significant challenges that make a sell rating appropriate. Despite the positive news regarding TSA Pre, the recent collapse in stock value reflects investors’ diminished confidence in management. The 2Q23 results, driven by a large contract win, should not be overestimated for future quarters. Management’s warnings of upcoming revenue declines in Security Solutions and Security Networks segments, alongside delayed business wins, point to a difficult period ahead. While efforts to cut costs are notable, high G&A expenses raise concerns. Despite a cheap valuation relative to cash holdings, the execution issues, unraveling deals, and lack of substantial growth prospects suggest the stock’s low price is justified.
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