Good day, ladies and gentlemen, and welcome to Telos Corporation third quarter 2021 earnings conference call. At this time, all participant lines are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will be given at that time. To ask a question, you will need to press star, then one on your telephone. As a reminder, this call is being recorded. If anyone should require operator assistance, please press star then zero. I would now like to hand the conference over to Christina Mouzavires. Please go ahead.
Thank you for joining us to discuss Telos Corporation's third quarter 2021 financial results. With me today is John Wood, Chairman and CEO of Telos, and Mark Bendza, CFO of Telos. Let me quickly review the format of today's presentation. John will begin with brief remarks on the third quarter results and Telos' strategic priorities, and Mark will cover the financials and guidance. We'll open the line for Q&A, where Ed Williams, Executive Vice President and COO of Telos, and 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 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 statement. 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 page of the Telos website. 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.
Well, thank you, Christina. Welcome to our third quarter 2021 financial results conference call. Let's begin today on slide three. I'm pleased with our performance this quarter. We delivered 48% reported sales growth, 80% adjusted sales growth. We increased our gross profit 57% to a record $26.1 million. We expanded our gross margin by 229 basis points to 37%. We generated $12.5 million of positive cash flow from operations, and we continue to win meaningful contracts. Let's turn to slide four. We are nearing the end of our first year operating as a publicly traded company. It's been a busy year with an exciting new energy and pace. While we welcome many new people to the team this year, we have others who are nearing the end of their careers.
One such retirement is that of Ed Williams, who has served as our Chief Operating Officer since 2003. Ed joined Telos in 1993, and throughout his tenure has provided nearly three decades of leadership and dedicated service to the company. Effective today, November 15th, Ed's responsibilities will transition to two of my senior staff members, Mark Griffin and Brendan Malloy, who will report directly to me. Mark Griffin will step in as the Executive Vice President of Security Solutions, where he will oversee all the operations and business development efforts surrounding our Security Solutions business, which includes Xacta, Telos Ghost, the Automated Message Handling System, and IDTrust360. Mark's been with Telos since 1984, and in 2007, he became the General Manager of our Identity business, and he was instrumental in navigating and ultimately winning the TSA PreCheck expansion contract.
Brendan Malloy will become the Executive Vice President of Secure Networks, overseeing all operations and business development surrounding the Secure Networks business. Brendan's been with Telos since 1996, and throughout his tenure, he's provided leadership in support of Secure Networks opportunities in the DoD, intelligence community, and federal agencies. In 2012, Brendan became the General Manager responsible for the business development, implementation, and operations of the Secure Network Solutions area. To ensure a smooth transition, Ed Williams will stay on as a senior executive until the end of January of 2022. I'm confident we have the deep leadership bench needed to take us to the next phase of our growth.
Now let's turn to slide five to discuss our recent highlights and updates. Over the last four quarters, we've been on a journey to ramp up our sales force and channel partner program, which lays the groundwork needed for the expansion of our commercial business in the coming years. Since the beginning of 2021, we've achieved our objective, tripled our sales, marketing, and channel team, and continued to attract top talent. The build-out of the Telos CyberProtect Partner Program is progressing. We're actively pursuing partner recruitment and have 20 partners in our partner ecosystem. Most of our channel partners have both a government and a commercial enterprise practice. This gives Telos solutions more opportunity to expand into new markets.
While we didn't expect the channel to begin driving revenue until 2022, we've seen a few deals go through the channel from the Department of Housing and Urban Development and the Alabama Medicaid Agency, which allowed us to pressure test the channel program. In the third quarter, we also announced a partnership with AWS, Splunk, and StackArmor with an initiative called FASTR, which stands for FASTR ATO, and ATO stands for Authority to Operate. FASTR ATO was Splunk, Telos, and ThreatAlert for regulated markets. FASTR benefits independent software providers and regulated defense contractors required to comply with complex federal, state, and local government security regulations. Since our launch, Red Hat and Wickr have been added as customers of the FASTR program. This partnership is a great example of how organizations can embed and leverage our technology into a partner-driven solution that expands our market reach.
Another example of expanding our reach of our solutions is in the state and local government and education markets, or what we call SLED. A critical component of any SLED go-to-market strategy is to have contract and procurement vehicles. In our third quarter, we successfully added Xacta and Telos Ghost solutions to 11 SLED purchasing contracts, both regional and state specific. We are very pleased with the performance in our Security Solutions Group, where we have nurtured strong relationships with new and existing customers. We continue to see accelerated growth. For example, a customer since 1995, the Defense Manpower Data Center, or DMDC, awarded Telos option year three through mid-September of 2022. Our IDTrust360 solution supports the Department of Defense within its security and common access programs. As a part of the DMDC award, we received over $22 million in orders in Q3.
We continue to bring on new airlines within our designated aviation channel business, adding three additional airlines in Q3 and receiving option year extensions from current airport customers, including Chicago O'Hare, Chicago Midway, and Phoenix Sky Harbor International. The most notable expansion within the practice is with the United Parcel Service or UPS, where they announced its full use of our solution for cargo security, threat assessments, and criminal history record checking beginning later this year. We continue to work closely with cloud service providers AWS and Microsoft around our Xacta solution. We recently added a third cloud service provider, Oracle, to our roster of cloud customers, and we continue to engage with Google and IBM. The commercial cloud enterprise contract with the CIA that was awarded to AWS, Microsoft, Google, Oracle, and IBM continues to be a catalyst for our expanded cloud provider footprint.
As for overall direct sales performance, we received the following notable wins and renewals. VMware, a leading cloud computing and virtualization technology company, selected Xacta to support its FedRAMP compliance efforts. A Fortune 50 insurance company renewed an annual license of Xacta in supporting its auto-automation of security controls validation. Salesforce, a leading CRM SaaS provider, renewed an annual license of Xacta in support of its FedRAMP requirements. New federal Xacta customers include Idaho National Laboratory and the U.S. Department of Housing and Urban Development. The latter is already moving towards expansion. New Xacta clients were also added in the construction and financial services sectors, and a special customer utilizing Telos Ghost for an intelligence support solution executed an option year and increased the contract value by 63%. These wins continue to demonstrate the viability of Telos solutions in a wide variety of markets.
In addition, we had a solid quarter of Xacta renewals for added backlog with existing government customers. Those customers include the National Security Agency, the National Geospatial-Intelligence Agency, the Federal Bureau of Investigation, and the Social Security Administration, among others. In our Secure Networks business, we're pleased to see solid revenue growth associated with recurring large programs that offer solutions to the Department of Defense. These large programs continue to provide a solid foundation of business now and into the future for the company. Next, I'd like to provide an update on the TSA PreCheck expansion contract. In July, and then again on September 29th, TSA confirmed in public notices that they anticipate the additional TSA PreCheck enrollment providers to come online in 2021. Our team is in near daily communication with TSA program officials, and we stand ready to support TSA's authorization timeline.
The short-term delay in granting the new enrollment providers with the authority to operate is related to TSA's own efforts to ensure superior security of the enrollment provider ecosystem and superior quality of the customer experience. We're encouraged by the commitment TSA has demonstrated to ensure the security of its systems and operating environment. That's a good thing for all of us. We want this program to be on a solid footing from the day it launches so that customers within the program can feel confident that they can transact securely while benefiting from the expedited screening experience. I'd also like to reiterate that TSA PreCheck is a multi-year contract with multiple option year extensions. Let me now turn to some comments on the industry.
Congress has been working on an enormous infrastructure package and President Biden's Build Back Better legislation, both of which have potential implications for cybersecurity and specifically for Telos. The infrastructure bill recently given final approval by Congress will provide $1.9 billion in new cybersecurity money, including $1 billion dedicated to a new state, local, tribal, and territorial cyber grant program. The latest version of the Build Back Better bill would provide $400 million for cybersecurity initiatives by DHS's Cybersecurity and Infrastructure Security Agency, or CISA, and $100 million for FEMA to directly support state cybersecurity efforts. This new federal funding is above and beyond the money provided for cybersecurity via the annual congressional appropriations process. We believe many of these initiatives could ultimately result in an increased need for solutions and services supplied by Telos.
While the government is currently operating under a continuing resolution, individual appropriations bills awaiting final negotiations between the House and the Senate would also boost cybersecurity funding in several areas, including for the Department of Defense, infrastructure cybersecurity, and risk management operations. As part of the administration's focus on addressing cyber vulnerabilities in our nation's critical infrastructure, TSA recently announced that it would require higher-risk rail transit companies and critical U.S. airport and aircraft operators to take certain actions to protect themselves in cyberspace. This action follows TSA's directive in July to require owners and operators of critical pipelines to implement mitigation measures against known threats to IT and operational technology systems and establish plans to recover from a cyberattack.
These actions by TSA are significant because they represent the first real efforts by the federal government to impose mandatory cybersecurity requirements for some of the 16 designated critical infrastructure sectors. We believe that all these initiatives, once finalized, will provide Telos with a number of additional long-term business opportunities. More importantly, these initiatives, once enacted, will provide organizations and individuals with a higher level of security. I'll now pass it to our CFO, Mark Bendza, who will discuss the third quarter financials. Mark?
Thank you, John, and thank you everyone for joining us today. Let's turn to slide six. I'm pleased with our results this quarter, highlighted by 48% reported sales growth, 80% adjusted sales growth, 229 basis points of gross margin expansion, including gross margin expansion across every line of business, record gross profit of $26.1 million, $12.5 million of cash flow from operations, and $9.4 million of free cash flow, bringing year-to-date free cash flow to positive $1.3 million. Now let's get into the details, starting with revenues. Reported third quarter revenues grew 48% from $47.4 million in 2020 to $70.1 million in 2021.
Excluding our contract with the U.S. Census Bureau, which is ramped down as planned since the same period last year, total third quarter revenues grew 80%. In future quarters, comparisons with prior year periods will not be meaningfully impacted by our contract with the U.S. Census Bureau. Total third quarter revenues for Security Solutions grew 14% from $31.2 million in 2020 to $35.7 million in 2021, notwithstanding $7.8 million of lower sales in Telos ID on the contract with the U.S. Census Bureau, as previously mentioned. Continued strength in Security Solutions was driven by Telos ID, Xacta Solutions, and our confidential healthcare program with the federal government. Excluding the contract with the U.S. Census Bureau, third quarter revenues in Security Solutions grew 56%.
Total third quarter revenues for our Secure Networks business grew 112% from $16.2 million in 2020 to $34.4 million in 2021. This significant increase was mostly driven by the same two large programs mentioned on our last earnings call. The rollout continued for a contract to provide security modules and kits to support the upgrade of theater deployable communications for the U.S. Air Force. Site work continued on a five-year U.S. Army contract to support the migration and modernization of telephone communication systems throughout the Pacific region. We expect work on these programs to continue into 2022. Now, let's discuss profitability and cash flow. Third quarter gross profit increased 57% from $16.6 million in 2020 to a record $26.1 million in 2021.
Third quarter gross margin increased 229 basis points from 34.9% in 2020 to 37.2% in 2021. Cost of sales included $442,000 of stock compensation expense, which did not exist in the same period last year. Excluding the impact of stock compensation expense, gross margins increased 292 basis points to 37.8%. Security Solutions and Secure Networks both drove gross margin expansion, including gross margin expansion across every line of business. In fact, Security Solutions gross margins expanded over 12 percentage points from approximately 45% in 2020 to a record 57% in 2021, driven by program performance and favorable sales mix within Xacta Solutions and Telos ID.
SG&A and R&D expenses increased by $19.3 million from $12 million in 2020 to $31.3 million in 2021. Of the $19.3 million increase, approximately $12 million was attributable to stock compensation expense that we did not have in the prior year period. We incorporate restricted stock grants into our compensation strategy as a retention tool and to ensure direct alignment of interests between our employees and shareholders. The remaining increase in R&D and SG&A expense was primarily driven by planned and previously discussed investments in our sales force, marketing, and channel staff, investments in G&A functions to support our post-IPO business model, and investments in the development of next-generation security capabilities for our customers.
Operating income before stock compensation expense increased 54% from $4.5 million in 2020 to $6.9 million in 2021. Operating income benefited from higher gross profit driven by both sales growth and gross margin expansion, partially offset by the previously mentioned investments in R&D and SG&A. Adjusted net income increased from a loss of $198,000 in 2020 to a profit of $6.8 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 $2.7 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 quarterly earnings per share increased from a loss of $0.01 per share in 2020 to a profit of $0.10 per share in 2021. EBITDA adjusted for the impact of stock compensation expense increased 45% from $5.8 million in 2020 to $8.4 million in 2021, primarily due to the record gross profit generated this quarter. We generated $12.5 million of cash flow from operations and $9.4 million of free cash flow during the quarter. Year-to-date, free cash flow is now positive $1.3 million. Before turning to our outlook for the year, I'd like to provide insights regarding our sequential performance from the second quarter to the third quarter.
During our second quarter earnings call, we indicated that we expected roughly 40%-50% sequential sales growth from the second quarter to the third quarter. Based on $52.6 million of sales in the second quarter, that would imply roughly $73 million-$79 million of sales forecasted for the third quarter compared to our actual third quarter sales of $70.1 million. Our sequential sales growth forecast included a multi-million dollar AMHS software license sale to an international government customer within our secure communications business. Although that program is still scheduled to begin in 2021, our customer has decided to move the software license portion of the program out of the current year.
If the software sale had occurred in the third quarter as originally expected, our third quarter sales would have been within the $73 million-$79 million range that we had originally forecasted, and our gross margins would have been over 40%. Turning to slide seven, we'll discuss our financial outlook for the remainder of the year and provide a high-level preview of 2022. As John previously mentioned, the TSA has reconfirmed in public notices in July and again on September 29th that it expects the additional PreCheck enrollment providers will be made available to travelers before the end of 2021. While we are encouraged by the TSA's public confirmations, at this stage in the fourth quarter, we are not expecting this program to deliver meaningful sales this year.
Accordingly, we are updating our 2021 guidance to reflect our third quarter results, as well as our latest view on the PreCheck expansion program and our Secure Communications and Secure Networks businesses. Our original 2021 guidance reflected sales of $283 million-$295 million, year-over-year growth of 57%-64%, and adjusted EBITDA of $33 million-$36 million. We are updating our 2021 guidance with sales of $240 million-$245 million, year-over-year growth of 33%-36%, and adjusted EBITDA of $18 million-$19 million.
Our updated guidance implies fourth quarter sales of $61.6 million-$66.6 million, year-over-year growth of 37%-48%, and adjusted EBITDA of $3.9 million-$4.9 million. Now let's recap the buildup to our updated guidance. On our second quarter earnings call, we lowered our modeling assumptions on two programs due to customer delays beyond our control. First, we eliminated the provider enrollment and oversight program with the Centers for Medicare & Medicaid Services, including $16 million of sales and $6 million of adjusted EBITDA. Second, for the TSA PreCheck expansion program, we eliminated $13 million of sales and $5 million of adjusted EBITDA, while maintaining a forecast of $25 million of sales and $10 million of adjusted EBITDA in the fourth quarter.
With our updated guidance this quarter, we are now eliminating the remaining $25 million of sales and $10 million of adjusted EBITDA from the TSA PreCheck expansion program in the fourth quarter. In total, we have lowered our sales assumptions on these two programs by $54 million and our adjusted EBITDA assumptions by $21 million. The guidance reductions attributable to the CMS and TSA programs are partially offset by better than expected performance elsewhere in our portfolio, for example, due to a confidential healthcare program with the federal government, as well as lower than expected G&A expense. On our second quarter earnings call, we forecasted $29 million of sales outperformance and $11 million of adjusted EBITDA outperformance. We are now forecasting $4 million-$11 million of sales outperformance and $4 million-$6 million of adjusted EBITDA outperformance.
The changes since our second quarter earnings call reflect the previously mentioned lower than expected sales from our secure communications business and lower G&A expense in the second half. The changes also reflect supply chain disruptions at one of our subcontractors that will delay several large fourth quarter shipments on a major program within our Secure Networks business. Lastly, we are very pleased with our free cash flow performance in the third quarter and our positive cumulative free cash flow for the first nine months of the year. However, as a result of our revised guidance, we do not expect to generate positive free cash flow in the fourth quarter or the full year 2021. Now let's discuss our preview for 2022.
Although we will not provide specific guidance for 2022 today, we can provide some high-level direction on the year-over-year sales growth dynamics for our Security Solutions and Secure Networks businesses. Let's start with Security Solutions. We're expecting Security Solutions to have another year of strong growth in 2022, primarily driven by the expected ramp of TSA PreCheck throughout the course of the year, on top of a solid base of recurring revenue, as well as potential for higher commercial software sales later in the year. We believe Security Solutions has the potential to continue growing approximately in line with the growth rate that we are forecasting for Security Solutions in 2021, excluding the 2021 year-over-year headwind from the contract with the U.S. Census Bureau. Next, we're expecting Secure Networks sales to be flat to down in 2022 due to the completion of a large program.
Keep in mind, we're forecasting Secure Networks to grow over 85% in 2021. The year-over-year growth comparison is a very high hurdle. Nonetheless, with large multi-year programs in process, we believe Secure Networks will hold sales at a high level in 2022. Our 2022 outlook is based on several key assumptions as follows. TSA grants the authority to operate in 2021, and sales on that program ramp throughout the course of 2022. The provider enrollment and oversight program with the Centers for Medicare & Medicaid Services continues to be delayed, thereby generating no sales in 2022. We start to see the initial benefits from our investments in commercial software sales and marketing late in 2022.
The executive order on vaccine mandates does not cause any meaningful disruptions to our ability to recruit and retain employees or to our subcontractor relationships, and our supply chain normalizes. To summarize, our growth drivers remain intact and our end markets are strong. We are well-positioned for continued growth, and our long-term outlook remains unchanged. Our 2022 preview does reflect some customer delays, which will push a portion of our growth profile to the right. With that, I'll pass it back to John, who will wrap up on slide eight.
Thanks, Mark. We're confident the seasoned leadership team we have in place will usher the company into this next phase of growth. We're moving forward on our strategic priorities to increase commercial adoption of our solutions, build a robust and productive sales team, nurture a strong partner ecosystem, and drive continued adoption of our solutions through existing customer expansion. We're very pleased with our performance this quarter, which was underscored by substantial revenue growth, record gross profit, and excellent cash generation. We look forward to another year of strong growth in 2022. With that, Mark Bendza, Ed Williams, Mark Griffin, and I are available to take your questions. Operator, please open the line for Q&A.
Thank you. To ask a question, you will need to press star then one on your telephone. To withdraw your question, please press the pound key. Please stand by while we compile the Q&A roster. Our first question comes from the line of Zach Cummins with B. Riley Securities. Your line is now open.
Hey, good morning, John and Mark. I think thanks for all the incremental color, and especially kind of around the outlook here going forward. Mark, just really dialing down into that, when I'm looking at the full year guidance here for FY 2021, I mean, can you give me a little more sense of, I guess the other areas of the business outside of TSA and CMS that really didn't outperform to expectations that you were thinking they would when you gave that guidance in Q2?
Yeah. Listen, in terms of the outperformance, really, the change in the outperformance is really driven by two things. First, it's the perpetual license that we were expecting in the third quarter on AMHS within our secure comms business. That program will still launch this year as we had expected, but the perpetual license portion of it has pushed out of 2021. The other piece is you know the supply chain disruptions that we're experiencing on one program within Secure Networks. It's a sizable program. So that is having a meaningful impact on that outperformance line.
Now, what I'll say is, you know, even at the low end of our guidance for the fourth quarter, there is still meaningful supply chain risk, you know, at the low end. We have about $3 million of assumed shipments in December, even at the bottom end of the guidance range. So please keep that in mind. And there's also another $6.5 million of shipments that we thought would have gone out by now this quarter, which have not yet gone out. But we feel like we have more comfort around that $6.5 million. And then elsewhere within the portfolio, you know, the business is performing as expected.
We feel, you know, really good about the other programs within Secure Networks, as well as broad-based performance across Security Solutions and all other aspects of Security Solutions outside of the AMHS reference that I made earlier. Strong broad-based performance, I should say, in line with our expectations within Security Solutions, and then elsewhere within Secure Networks outside of that one large program.
Understood. That's helpful. Looking at your 2022 preview, I really appreciate just some high-level insight into this. Maybe I didn't fully understand. In terms of Security Solutions, expecting that growth rate to be in line with what you're going to post this year, could you just clarify the expectations for Security Solutions growth rate this year? I'm assuming that's excluding the contribution from the Census contract.
Yeah. When you back out the headwind from the U.S. Census contract, you know, Security Solutions, I think, embedded in our guide is gonna grow kind of in the high 30% range. High 30%. Probably short of 40%, but in the high 30%.
Got it. That's including the headwind from the Census contract? I'm just trying to make sure I'm fully clear on that.
Yeah, that is excluding the impact.
Got it.
Excluding the headwind from Census. If you calculated it on a reported basis, it would be lower than that.
Understood. That was helpful. And just finally on the CMS contract, it seems like you're already assuming there's not gonna be any contribution from that in 2022. I mean, can you give us some more insight into what's going on with that program and potentially what could be pushing that further to the right?
Yeah. First, let me just give you kind of a perspective on how I'm thinking about guidance in general. You know, I've only taken over the forecasting and guidance process in recent weeks here, as I've transitioned to the role. What you're starting to see in part with the changes we're making today to our guidance and our outlook is a little bit around, you know, kind of my philosophy on guidance. You know, we're currently working through our 2022 planning process, so of course, you know, we're not gonna provide 2022 guidance today. We'll do that on the Q4 earnings call. You know, we're accepting a range of scenarios for 2022 as we work through our planning process.
You know, as we've discussed today and throughout the course of 2021, you know, a couple of our, you know, more meaningful short-term growth drivers that we originally expected in 2021, you know, they've pushed into 2022 or maybe even beyond in the case of CMS. In addition to that, as I mentioned, you know, Secure Networks, you know, will have a sizable year-over-year headwind to backfill due to the expected completion of a large program early in 2022.
You know, the way I think about guidance is I like to guide based on what I have a high degree of visibility into at a point in time, and then we can pull additional opportunities into our guidance as the year progresses and opportunities become, you know, more visible and certain, especially with respect to timing. I'll look to Mark Griffin here to comment briefly on CMS and how we're feeling about that. I think based on what we're seeing right now, at this stage, we're not putting, you know, CMS into our 2022 outlook. I'll pass it to Mark for more color there.
Hello, Zach. The way we see CMS is that government agencies have not been reverting back to full in-person fingerprinting, and the population that this program was anticipated was the lower risk health providers that needed to undergo background checks based on that population. The anticipated fingerprint volume until that population comes back into the mix due to both COVID and the vaccine that has come up, that expansion and increased opportunity this contract was afforded has been delayed. That's the guidance that Mark and John are both talking about, is that specific lower risk health providers have not come into the population yet.
Understood. Just final question for me. In terms of the Q4 guidance, I mean, can you give us a rough assumption of the mix between Security Solutions and Secure Networks in Q4?
Yeah. Give me one second here. You know, at the lower, it's gonna be a little better than the 50/50 that we saw this quarter.
Understood. Appreciate you guys taking my questions. Looking forward to your progress next year.
Our next question comes from the line of Dan Ives with Wedbush. Your line is now open.
Yeah. So my question I think a lot of people are asking is, how could management be so off in terms of miscalculating the timing of deals as well as just the complexity? That's my first question, just given, you know, what we're seeing in terms of just the massive guidance cut.
Yeah. Let me take a first shot at that, Dan . Listen, you know, I think one of the strengths of our equity story here is that, you know, we have some very large needle-moving growth opportunities in our portfolio that we're very excited about and we think our shareholders are excited about. Now, you know, the double-edged sword there is that when some of those meaningful growth opportunities shift even a little bit in some cases, in terms of timing, it can have a meaningful impact on, you know, what we're forecasting versus actual results. We saw that in the third quarter of this year with the movement of that one software license out of the quarter.
We saw it to the upside in the first quarter of this year when we had a large customer order pull forward into the first quarter, and we ended up better than we expected. You know, that's the way I think about it. As I said, you know, earlier going forward, and I think what you're starting to see in the guide this quarter is that, you know, my philosophy on guidance is, you know, that I will guide based on if I have a high degree of visibility into at a point in time. You know, you're gonna see that in how we guide going forward, and you're seeing that for the fourth quarter here, as well as our preliminary look on 2022.
I'll pause there and see if John or anyone else wants to counter.
Dan, it's John. The other thing I'd say just in general is that, when we guided on TSA, our perspective was based on the program office that we could deliver, but the security office was not able to get to the point where they could get to an ATO. As a result, you know, as of today, at least, we don't have that ATO. We, you know, like Mark says, these are large programs, they're multiyear programs. Unfortunately, you know, it just didn't happen this particular quarter on the TSA.
Yeah, isn't there a $40+ million cut and only $25 million of it's TSA?
There's $25 million from TSA. There's a large-
How much is the guidance cut?
Yeah. Let's take each of those in turn.
No, I just wanted to know just clear numbers. How much is the guidance cut?
Top line $43 million-$50 million. Now there's three components-
Okay. How much is TSA?
Well, no. There's three components there. Of the $43 million-$50 million, $25 million is TSA, and the balance is primarily between two other factors. First, supply chain disruptions that we're getting that are impacting a large program within Secure Networks. There are several large shipments on a Secure Networks program that are forecasted to go out at the end of this quarter. Those supply chain disruptions are impacting one of our subcontractors, and that's gonna push those shipments out of the end of the fourth quarter into the first quarter. The other piece is within our secure communications business, a large multi-million-dollar software license, perpetual license that the customer is pushing out of this year. None of these shifts, and this is an important point. I think this is an important point.
None of these changes in any way represents a loss of business. All of this is timing. Actually, in all cases, this is timing, you know, timing outside of our control, unfortunately.
Okay. I guess just to follow up, like what would give investors any confidence that we're not back here three, six months from now, and it just keeps getting pushed, but like, in terms of your ability to forecast this? Thanks.
Well, Dan, the way I again, this is, you know, I've only recently taken over the forecasting guidance process here. How I'm thinking about guidance going forward, again, is that we will guide based on what we have a high degree of visibility into at a point in time. Then as things become more imminent, as things materialize, we'll pull them into the guidance over the course of the year. There is gonna be a shift in terms of the philosophy of guidance here, at least from my perspective.
Thanks.
Our next question comes from the line of Keith Bachman with Bank of Montreal. Your line is open.
Yeah. I have a couple similar to the last line of questioning. I wanna go back to CMS for a second. I think previously, we had thought that might be kind of a $60 million tailwind associated with 2022. Now it's zero. Pretty big variance there. You know, what are the conditions that might allow for some of that to flow into 2022 and/or is there a risk that that's a perpetual zero, right? I mean, you're saying it's zero in 2022. Is that a zero in perpetuity, you know, in that maybe hybrid workforce stays or things along those lines? Put some context around CMS 'cause I think most people were expecting the TSA to get pushed into next year. This is a pretty big change on CMS as well.
You know, Keith, before I ask Mark to answer that question, you might recall in the last discussion we had, people were asking me about CMS, and I said that until we had more data, I wasn't about to talk about it for 2022. We still are down the path of going down the vaccination program process, where HHS has basically said, "That's our, you know, that's where we're pushing a majority of our dollars." When the vaccination process is over, we'll get back to sort of business as usual, where we move from doing manual intervention to using automation like ours at Telos.
Mark Griffin, I'd like you to add any additional points here, 'cause for those of you on the call here, Mark, running our identity business also helped win us the CMS as well as the TSA business. Today, you know, Mark takes over Security Solutions. Mark.
Hello, Keith. The CMS program is a multifaceted program. The targeted revenue that we had previously given you was on roughly 1.5 million fingerprints annually on that program. As I explained earlier, that was primarily an expansion of the lower risk health providers coming into that ecosystem. It's a multifaceted program, there are other opportunities that Telos will be looking at, both from a security point of view and enhancement of that. We will also be targeting the acquisition that we had earlier in the year, which is the Diamond Fortress acquisition, the touchless fingerprinting application, to basically bring in other capabilities and modalities to collect that population. We're confident that the program will expand. Right now, we moved the guidance out from 2022 on specifically just that 1.5 million fingerprints.
There are other security elements that come into that program that we as a corporate security corporation will be bidding on, and we hope to bring those into the mix. I'm just not able to expand on those at this time. As the program expands, there are other opportunities within that 10-year, $2 billion program that we'll be bidding on.
Okay. My second question is on the commercial impact being laid in 2022. While I appreciate, given the very inconsistent performance of the collective firm, you've been hiring for a while now commercial sales reps, and throughout the course of certainly 2021. To say the impact doesn't come till late 2022 means, you know, it's concerning. Most enterprise sales reps are kind of six to 12 months. If you've been hiring through the course of 2021, even if you took a weighted average, you should see some impact in, you know, March or June quarter. It leads kind of begs the question, why not a greater impact?
Yeah. Why don't I start with that, Keith. Listen, it's not to say that there won't be impact earlier. It's, you know, what I was more signaling in my script is, you know, degree of impact. You know, maybe we'll see something more meaningful earlier than what I'm indicating in the script. As I said earlier, you know, I think about guidance and forecasting, you know, more based on, you know, the level of visibility that I have at a point in time. We'll see over the course of next year what the ramp curve, you know, looks like.
The other thing I'd point out, Keith, is that we'll give actual 2022 guidance on the heels of Q4 earnings.
Right. Okay.
There are still more things for us to be doing here between now and then. What Mark's trying to do is give a, if you will, a heads-up block ahead of time and trying to make sure that everybody understands sort of what we're having to deal with with these large programs.
Okay. Well, my last one is just philosophically, is there any I'm not expecting specific numbers, but any directional barometers that you wanna provide based on at least kind of the top-line cadence on how we should be at least philosophically thinking about margins in 2022? You know, flat down, up, you know, any kind of just directional barometer, so folks can at least try to set their models up to be in the neighborhood perhaps.
Yeah. You know, I think there are a couple of puts and takes there. First, as PreCheck phases into the P&L, I would describe PreCheck in the early days as being dilutive to gross margins. Over time, as that program scales, and in particular, scales against the fixed costs running through cost of sales on that program, you're gonna see gross margins expand. Then also over time, as ancillary revenues get pulled into that program, those are gonna be at a higher margin, so you're going to mix higher. In the short term, you know, initially in that program, I would consider that program to be dilutive to gross margins. I think on the Secure Networks side, I think there's opportunity for Secure Networks to mix slightly higher next year.
Then in terms of the mix between Solutions and Networks, I would expect Solutions to outgrow Networks next year. You're gonna see, you know, you should see a tailwind there. Headwind in the form of PreCheck. Tailwind in the form of potentially higher margins within Secure Networks, and then tailwind in terms of better mix between Solutions and Networks.
Okay. Last one that I'm. I'll cede the floor. Excuse me. It's now November 15th. Is there any, you know, what's the status in your mind on the ramp of TSA? You know, I'm reluctant to even ask since this has been kind of perpetually pushed off, but is there any chance of revs in the March quarter, or should we be thinking, you know, let's just start with June?
Mark?
I'm gonna have Mark Griffin answer that question, Keith, directly, okay?
Okay.
Hello, Keith. I want to first just touch on a point that, you know, the TSA Modernization Act of 2018 is law that mandated that TSA expand PreCheck providers. I just wanted to remind everyone on the phone that there isn't a question of if or when this program, it's mandated by law that it has to expand. Our goal all along was to improve the passenger experience at checkpoint. Where we're at right now is, as we indicated earlier, both by Mark and John, the TSA is still indicating that it was working with us daily, and they were here at our facility last week working through. We fully expect still to get our authority to operate this year and revenue to start ramping as early as January.
Now, it probably won't be significant in the first quarter, but we do start seeing revenue in the first quarter, not June.
Okay. I will cede the floor. Thank you.
Our next question comes from the line of Alex Henderson with Needham. Your line is now open.
Thanks. Since we were just talking about the TSA, can you give us a concise and clear explanation of why TSA has slipped as much as it has? Is it just simply because of, you know, the hacks that happened in the first half? What is the mechanics that's causing the slippage?
Alex, I'll ask Mark Griffin to answer that again directly for you guys.
Hello, Alex. Yes, I believe the increased security, heightened policy and procedure has added to some of that delay. As you know, as a government contractor, we have to follow the process and procedures that the government mandates us for the authority to operate. Part of the PreCheck expansion process, security is a heavy component of that, and TSA is very protective of their brand, and so they wanna make sure that all expansion providers come out of the gate strong with a secure solution that has gone through all the vetting components within their organization.
Including their own.
Right, including their own organization. We are seeing progress. I'm very confident we are moving forward in the right direction. Unfortunately, we are a government contractor, and we have to follow their process for the authority to operate.
Well, going back to the calibration of the timing, is there anything different in the challenges of estimating the timing of when they're going to launch this now than there was, say, three months ago when we got the third quarter guidance for the fourth quarter? I mean, I guess what I really don't understand is with only a month and a half left, what gives you confidence this is actually gonna close this year other than the press release, which we, you know, cannot be relied upon since we've already seen press releases.
Sure
suggesting timing that hasn't been materialized.
Sure. I can appreciate that. We're seeing steps in the process as a security provider within the government. There are steps in the approval process that the government takes. They review your security documentation. So there's various steps that they take in that process. Although we were confident that those processes were gonna begin on the last earnings call, they were delayed, and so now we have seen progress in the right move forward steps. So those security processes and those steps in the process are being taken now by TSA, and obviously, we're following suit in the process under their guidance.
Relative to the TSA, is there any change in the competitive dynamics as associated with the timing of these ATOs that would either help you or hurt you as we ramp in 2022?
As you're aware, eligibility in the TSA PreCheck, you know, is expanding market due to population growth. The population continues to grow. TSA awarded expansion contracts to three providers. As such, the implied competition will always exist on this contract and hasn't changed based on the delay in the launch in.
The question really goes to the question of how fast can those other companies comparatively get the approvals? Do they have the same timeline, or will you be able to, because of the inclusion of Xacta and some of the other software advantages you have, be able to get to market sooner than them? Are you at risk of them getting compliance ATO before you?
Government does not give us insight into the status of the other providers. However, we feel as though we're leading the approval process in making headway as a first out of gate solution provider. I don't currently feel as though we'll not be first out of the gate from an expansion provider.
All right. Let me go to a second subject, here. The commentary around the software growth being primarily in the second half of CY 2022 really makes little or no sense to me in the context of the fact that you've already said that the salespeople that you've hired and the distribution expansions that you've hired have already resulted in significant benefits to your numbers and to your growth. That in fact you felt that there was, you know, they were running ahead of budget. I don't understand why there would be a sudden lull for six months in the first half of 2022 against the already improved performance of those participants.
Alex, this is John. What I've seen, what we've seen is an expansion in the pipeline. That's why I said earlier as it relates to 2022 actual guidance. You know, we will give that on, you know, Q4 earnings, and then we will, you know, we'll go from there. I think Mark Bendza is trying to set expectations in a very conservative way, and my hope is that we'll be able to, you know, do better than what we're talking about as it relates to our Q4 earnings for 2022. Now, Mark, do you think I said that correctly from your point of view?
Yeah, I think that's fair. That's a fair way of
While that might be fair with the stock down at $18.50, down from $24.50, the mechanics of why the revenue contribution from sales and distribution are going to be less in the first half than they were in the back half of this year is hard to understand. You've said in the past that you're already getting contribution from them.
Yeah, I don't.
at that point.
I don't think that's gonna happen, Alex. I think we're gonna see good contribution from our sales and distribution channel partnerships. We're just, again, without providing full guidance for 2022, we're just giving you know, sort of a heads up as we are where we are today.
All right, let's shift gears again, go over to the Secure Networks side. I get it that it was up 85% this year. Obviously, that is a much lower product gross margin product. Clearly, as that mix shifts away from that, if that's going to be flat to down sequentially for 2022, then I would assume that that mix quite significantly improves the gross margin outlook for next year. Is there any reason why that would not be the case?
Yeah. There's a few puts and takes there. Within Solutions itself, you're going to see a gross margin headwind as PreCheck phases into the P&L. In the early days of PreCheck, I would expect PreCheck to be dilutive to gross margins. Over time, as that program grows, you're gonna see positive operating leverage against some fixed costs that's running through cost of sales on that program. You'll also see benefit over time from favorable mix shift as some additional ancillary higher margin revenues get attached to that program. You're gonna have a favorable mix shift between Solutions and Networks next year as Solutions should outgrow Networks. Within Networks, we think there's potential for slightly higher margins there as well.
Those are kind of the puts and takes. The headwind from PreCheck and then tailwinds from mix shift between Solutions and Networks, as well as possibly some slightly higher margins within Networks.
Okay. The TSA delay of $25 million, is that a reasonable baseline for quarterly revenues for 2022, given you had expected to do that in the fourth quarter? I think you had expected to at least ramp that from fourth quarter forward. Ignoring that point, assuming it kicks in by the end of the year, is it reasonable to think that that $100 million worth of revenue, at least, from the TSA PreCheck?
I would love to be more specific on that as we actually get a couple months of experience in that program under our belt. But you could see a scenario where perhaps in the second half you could potentially see a run rate around those levels.
All right. Thank you. I'll cede the floor.
Our next question comes from the line of Nehal Chokshi with Northland Capital Markets. Your line is open.
Hi, Nehal. Nehal, are you on mute?
Yes, I'm here now. Thanks. Sorry about that. Mark, when you say you're changing the way we guide to include only items that have high visibility into... when you use the word changing, does that mean that there are still more low visibility items that you wanna still scrub out here, that may have got into your initial calendar 2022 look through?
No, probably not in terms of 2022. In the interest of full transparency, the one thing I would like to highlight for the fourth quarter is around the supply chain constraints. Again, even at the bottom end of that guidance range, there's about $3 million of December shipments assumed in that guidance range. We believe those will go out, but again, these are supply chain constraints two levels down here. So these are suppliers to our subcontractor, in particular around electronics and electronic components and plastics. There is a solid, you know, $3 million of additional risk there at the bottom end of the guidance range.
There's also another $6.5 million of shipments that we thought would've gone out by now, which are, you know, which are delayed within the quarter. We feel a little better on those that those will go out this quarter. You know, there's still. I didn't scrub everything out. I left, you know, I left $3 million in there at the bottom end of the range. Then with respect to 2022, you know, I think at this stage, based on what we know, I think the high level, you know, year-over-year direction for solutions and networks that I provided at this stage reflects, you know, kind of our current thinking on 2022. Again, bear with us, we'll give guidance on the Q4 call.
We're working through our 2022 planning process and looking at different scenarios, right now.
Okay. Thank you. With respect to effectively a high 30% preliminary look and high 30% year-over-year growth for the preliminary look into calendar 2022 Security Solutions, is that gonna be even across the three sub-segments, or it sounds like it probably would be more weighted towards IDTrust360. Is that a correct interpretation?
Yeah, I think that's the right way of thinking about it. I would say within solutions, the single largest growth driver would be the ramp in PreCheck.
Okay. Got it. Within the 3Q 2021 performance, you did say you had 56% year-over-year growth in Security Solutions adjusting for the Census Bureau from the year ago period. Is that 56% year-over-year growth relatively even across the three sub-segments, or how's that parsed out there?
I would say the largest grower there is within Telos ID, followed by information assurance, which is primarily our Xacta Solutions capability.
Finally, John, as in your part of the script, you mentioned a lot of FedRAMP-related Xacta wins with industry bellwethers such as VMware and Salesforce. What percent of the FedRAMP-associated opportunity do you think Telos has now captured? For the other percent, what's the typical legacy solution being utilized?
I would say it's a very small percentage right now, Nehal. The way that people do it, generally speaking, is manually. I think there's a great opportunity in front of us to expand that significantly because we are using automation to reduce the time it takes to actually get to FedRAMP compliance.
Yep. Great. All right. Thank you.
Thank you. This will conclude today's question and answer session. I will now turn the call back over to John Wood for closing remarks.
Guys, I just wanna thank our shareholders for their ongoing support. You know, we've delivered, you know, strong results in the third quarter of 2021, and we're well-positioned to capitalize on the, you know, the increased emphasis on cybersecurity across commercial and government organizations. We've got really solid, outstanding people. We've got leading security solutions and tremendous potential. While we have had a couple of issues with regard to our larger programs, I've actually never been more excited about Telos' future than I am today. I just wanna say thank you all for listening. Remember, this is a long-term investment, one that I plan to be a part of for a long time, as long as you guys will have me. Thanks a lot. Bye-bye now.
Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.