Telos Corporation: Growth Outlook Turns Positive (NASDAQ:TLS)

Summary

Readers may find my previous coverage via this link. My previous rating was a sell, as I did not see any catalyst that could drive the share price of Telos Corporation (NASDAQ:TLS) upwards. My thoughts were that TLS needed to show a couple more quarters of growth before the market would be convinced that the business had recovered. Now that TLS has shown a very strong sign of growth recovery in 4Q23, I am revising my rating from sell to buy.

That said, I must clearly note that this buy rating is to advocate a small position as there are still some uncertainties with the growth outlook (i.e., the protest). However, if the protest gets resolved as expected and TLS continues to ramp up its penetration across the other live enrollment sites, I expect TLS to continue seeing growth acceleration in FY24/25. Also, note that I am not modeling FY25 today because I want to get more certainty about the result of the protest before looking further ahead.

Financials and Valuation

In 4Q23, TLS saw its revenue decline by 13% to $41.1 million, way better than what the street was expecting ($32.1 million). This performance also outperformed the high end of management’s guidance range of $30-$34 million. Although this was attributed to the accelerated delivery of a customer contract worth $7.8 million (originally for 1Q24), the point to note is that the supply chain has improved.

By segment, Security Solutions revenue declined 32% to $20.7 million, and Secure Networks revenue grew 20% to $20.4 million. Adj EBITDA performance also came in as a surprise, beating the high end of management’s guided range of -$3.2 million vs. a range of -$4.5 to -$6.5 million. As a result, adj. EPS came in at -$0.09, beating the consensus estimate of -$0.11.

For FY24, while revenue guidance was not provided, management expected $100 million from existing programs; new programs that are already won could potentially add up to $100 million in revenue, but management is conservatively expecting $60-$85 million due to protests. Using this guidance to get a sense of how much TLS is worth in the near term, I assumed TLS would generate $173 million in revenue in FY24 (recovery to positive growth in FY24).

Assuming TLS were to trade at the same multiple today at 1.5x forward revenue, the potential upside is 16%. There could be a potential upside from here, as management did not incorporate any revenue contribution from new business deals throughout the year, and there was also an earlier-than-expected resolution of the protest. If TLS outperforms, it could see multiples re-rate higher, which the market seems to be willing to re-rate higher based on how the valuation and share price has trended over the past few months.

Comments

I think the worst is over for TLS, and it seems to be a matter of time before TLS starts to grow positively. There are a couple of reasons that led me to believe this is the case going forward. Firstly, TLS has multiple new contracts worth $525 million over the next 5 years (from FY25 to FY30, with $85 million of the $610 contract potentially recognized in FY24). This is very positive news, as it means that TLS is able to translate deals that were in the pipeline into actual revenue-generating contracts.

Recall that management had previously noted a strong pipeline of $610 million of potential deals. The problem with realizing this revenue today is that TLS needs to resolve the delays from protest (customary for competitors post-award) resolution. Although nobody knows how this protest will turn out, my opinion is that TLS will get past this eventually. Historically, only 5% of such protests have been sustained (out of ~10,000 protests). Suppose TLS gets past this, the business should see a material acceleration in revenue growth in FY25, as I expect TLS to realize ~$100 million (average of $525 million over 5 years) between FY25 and FY30, vs. the expected revenue contribution of $60 to $85 million in FY24 (management conservative expectation).

Although, we are not able to opine on the merits of any specific protest, for context and as an example, according to data from the Government Accountability Office, or the GAO, over the past five fiscal years, nearly 10,000 protests have been filed with the GAO and approximately only 5% of those protests were ultimately sustained. Source: 4Q23 earnings

Secondly, TLS and TSA PreCheck transaction volumes have ramped up for three straight quarters, which clearly shows the underlying “demand profile.” Although TLS live enrollment center sites remained flattish sequentially at 26, the underlying transaction volume trends make me believe that TLS could further penetrate the 500 sites that are identified as potential targets.

The potential financial impact is huge, as management mentioned that these sites are worth tens of millions of dollars in revenue. The expected timeline for full penetration is by the end of 2025, and based on how TLS is executing on this (management stated that throughput at existing sites is meeting expectations), it seems likely they can hit this target.

Scaling up is important because it would drive a huge incremental margin for TLS (management noted that TSA margins are currently near the corporate average). So while the impact on topline might be limited (tens of millions vs. TLS 100+ millions of revenue), the impact on EBIT is going to be huge because of the small base.

We believe a fully ramped network of new enrollment locations will ultimately generate several tens of millions of dollars of revenue. Source: 4Q23 earnings

Risk

Telos has high exposure to the U.S. government, creating a reliance on spending cycles, competitive bidding, and long sales and implementation cycles. Also, if the protest is sustained, the $610 million contract might not flow through TLS’s P&L, putting a big dent in the business’s growth prospects.

Conclusion

I am upgrading TLS to buy. TLS revenue growth has trended upwards significantly from down -40+% to down 10+%, and with the newly secured contracts that are worth $525 million over the next five years, I believe growth will track back towards positive growth. TSA PreCheck transaction volume growth also suggests further penetration of target enrollment sites is achievable. As for FY24, I do see upside potential if the protest is resolved earlier than expected and TLS manages to further penetrate the live enrollment center sites.