Tetra Tech, Inc.
Q3 2018 Earnings Call Transcript

Published: 2 Aug 2018

[Operator:]

Good morning, and thank you for joining the Tetra Tech Earnings Call. By now, you should have received a copy of the press release. If you have not, please contact the company's corporate office at 626-351-4664. As a reminder, Tetra Tech is also simulcasting this presentation with slides in the Investors section of its website at tetratech.com. This call is being recorded at the request of Tetra Tech, and this broadcast is the copyrighted property of Tetra Tech. Any rebroadcast of this information in whole or part without the prior written permission of Tetra Tech is prohibited. With us today from management are Dan Batrack, Chairman and Chief Executive Officer; and Steve Burdick, Chief Financial Officer. They will provide a brief overview of the results and will then open up the call for questions. I would like to direct your attention to the Safe Harbor statement on page 1 of today's presentation. Today's discussion contains forward-looking statements about future growth and financial expectations. Actual results may differ significantly from those projected in today's forward-looking statements due to various risks and uncertainties, including the risks described in Tetra Tech's periodic reports filed with the SEC. Except as required by law, Tetra Tech takes no obligation to update its forward-looking statements. In addition, since management will be presenting some non-GAAP financial measures as references, the appropriate GAAP financial reconciliations are posted in the Investors section of Tetra Tech's website. At this time, I would like to inform you that all participants are in a listen-only mode. At the request of the company, we will open the conference up for questions-and-answers after the presentation. With that, I would now like to turn the call over to Dan Batrack. Please go ahead, Mr. Batrack.

[Dan L. Batrack:]

Great. Thanks, Jennifer, and good morning, and welcome to our fiscal year 2018 third quarter earnings conference call. Overall, we had a very good quarter. Our third quarter generated record revenue, and earnings per share for the company. We had strong double-digit growth in all four of our market sectors. And consistent with our strategic focus on high-end services and margin expansion, we increased our EBIT margins by 100 basis points over last year. We continued to focus our business on high-end services primarily by expanding and investing in our consulting services. We're also reshaping our portfolio slightly with this plan. At the end of the quarter, we completed the sale (02

[Steven M. Burdick:]

Yeah. Thank you, Dan. So, I want to point out that in the appendix of this earnings presentation, you can find a full reconciliation of our GAAP results, which are presented on this slide to our ongoing results, which Dan just addressed. So, now turning to our financial [Technical Difficulty] (08

[Dan L. Batrack:]

Great. Thank you very much, Steve. I'd now like to give you an update on the three key markets that we expect to drive our growth in the fourth quarter and well into fiscal year 2019. First, our U.S. Federal business is very strong with further expansion expected as we win new work funded by the budget increases that were put into place by the government earlier this year. For the U.S. Department of Defense, we're seeing bidding activities picking up as the various departments we work with begin to award their 2018 funds before the end of the fiscal year. We're also seeing more clarity on the priorities of the Department of Defense's spending as they work on strengthening the workforce and the preparedness of the military. Increasingly, we're seeing an emphasis on resilience, in infrastructure, water supplies and even power generation. In this long-term trend with the Department of Defense, is directly in line with our focus on sustainable infrastructure and water services. In addition, the Department of Defense is turning their attention to assessing and implementing solutions for newly emerging contaminants associated with military activities. Tetra Tech here provides both the high-end evaluation services as well as the water treatment solutions to [Technical Difficulty] (14

[Operator:]

The question-and-answer session will begin now. The first question comes from Sean Eastman with KeyBanc Capital.

[Sean D. Eastman:]

Hi. Thanks, team. So first off, just congratulations on another really great quarter. Congratulations on your success. I guess I just wanted to start out here. We're getting to the point in the year where we're all looking out to fiscal 2019. And one interesting dynamic here is that clearly really broad-based momentum in the top line, but it's not necessarily being matched in the backlog we're seeing in the quarter. So, I was just hoping to get a little bit more color on the line of sight you have on new awards and backlog momentum, and just on the sustainability of some of these growth rates we've seen in the last couple quarters.

[Dan L. Batrack:]

Great. Well, thank you for your comment, Sean, and thank you for your question. I'll start with the question that the backlog hasn't actually matched revenue growth in this particular quarter. I think if you take a look over the past eight quarters, you'd see in the graph that we provided that our backlog actually has increased quite significantly and consistently over the past couple years, past eight quarters. I will note this quarter we were down slightly and in fact while the mathematic calculation, arithmetic calculation would show that we're 4% down year-over-year. And some of that was attributed to FX. Since our international activities have been so successful, the strong dollar actually did contribute to a re-evaluating of the backlog a bit so that accounted for a portion of it. The other was the reduction was the divestiture of the field utility services business also caused a portion that we actually took out of our backlog. So with those two, actually, it moves our number to be a little bit closer to flat to minus just 1% or 2%. Now what I would say is there's really two items that account for that. Number one, when we have a number that is far higher than even our own guidance range and that we have a revenue quarter that is at such a extremely high level and in fact, as I'd commented, at a record level, that does naturally put a bit more pressure on your backlog because you're burning it at a quite high level. But I would say even with that, our backlog held quite well. And this is at a time where the U.S. Federal Government is only 90 days. This is essentially at the beginning of the quarter, the budget was passed and authorizations put in place for the U.S. federal government, and we did begin to see that actually flow through contracts which we've seen a number of announcements from us and we've actually begun now to see the task orders come through. So this is quite expected from us, for us given the timing of the federal government. So backlog at this quarter, actually felt quite good about and don't feel that that represents an area of concern at this time. Now with respect to – is the growth rates sustainable? We do believe that the broad-based nature of this is probably the strongest overall footing that we've had in the past. Our growth while it was [Technical Difficulty] (23

[Sean D. Eastman:]

That's great answer. Secondly, I just wanted to move to the margins. GSG smashes out of the park, was quite a bit stronger than I thought on the operating margin. So, I'm wondering exactly what's driving this continued expansion. I assume that there's a utilization benefit in there but perhaps some more color on the mix in there. And then also if you could just comment on sort of margin upside drivers into next year and what we need to see to see more expansion over the next 12 months, say?

[Dan L. Batrack:]

Oh, good question, Sean. We certainly give recognition to our GSG operating leaders. They did a exceptional job, but I wouldn't say smashed it out of the park. 14.7% is good; in fact, is quite good, but we were at 15.1% in the fourth quarter last year. So it's not a high watermark for us, and we can do better. And we are not hitting on all cylinders. And we can actually do a bit better. And in the case of GSG, two items drove that to increase margin in the third quarter. First was a volume. So increased utilization; as we've spoken before and if you're familiar with this business that increased utilization actually drops an awful lot of it to the bottom line, and that's why you saw a significant increase in the margin. And the second was actually performance on projects. Our folks actually did an excellent job of performance and deliverables. We did do well with respect to receipt of award fees. We did do well with respect to close out of projects that we completed during the quarter at the upper end of the booking ranges of the margins. So I would say the increase was a combination and roughly equally from both volume, which is utilization, and the second is outright good technical performance on behalf of our clients projects. I do think and we have talked about this that we can do better on an annual basis. Our Q3 and Q4 are seasonal high points for our businesses in general, because we have more folks out in the field doing biological surveys, field surveys, civil work, monitoring both for environmental programs and sustainable infrastructure design activities. So we have more folks actually out in the field in addition to the office. So while we are looking for equal or even better performance in the fourth quarter and if you certainly take the midpoints of our ranges, you would see that while we had a very good third quarter, we have embedded margins that are even higher in our fourth quarter. So with respect to is it sustainable, we've put that into our guidance.

[Sean D. Eastman:]

Excellent. Thanks for taking my questions and congratulations again.

[Dan L. Batrack:]

Great. Thank you, Sean.

[Operator:]

Our next question comes from Andy Wittmann with Baird.

[Andrew John Wittmann:]

Okay. Hey, guys. Thanks for taking my question. I'd just pick up where we left off there on the fourth quarter guidance implications in the margins, but particularly, kind of looks like implicit in the fourth quarter guidance, here is maybe a growth rate slight deceleration. I was just wondering, Dan, is that comps, is that conservatism? Certainly, I think you gave us some color on that. You did mention the margin profile that's embedded in there. So, really maybe we focus more on the top line guidance?

[Dan L. Batrack:]

Yeah. So I think the – what you saw is that we increased our EPS guidance for the fourth quarter, but you did see that the revenue was a bit more muted. So, let me address that. I want to be very clear on this that we did divest in entity that was our utility field services. It was a lower margin business, but the revenue was originally included in our guidance for the year, but it was not anticipated that we would actually divest this. So, if you take just the component of our field services, a division that is now not going to be contributing on a topline revenue in the fourth quarter and pro forma or add that back in, you would find that we would be at a double-digit growth rate with respect to our revenue forecast for the fourth quarter. So, when you normalize that, we did bring down the growth rate just slightly due to taking that contribution out, but we did not adjust it down with respect to our EPS which is actually the reflection of our increased margin across the business.

[Andrew John Wittmann:]

Okay. Great. That helps clarify that. Thank you for that. Just, Steve, maybe one for you here. I'm curious on the tax rate here. You guys guided at 28%. It's been running year-to-date kind of lower than that. Is that 28% exclusive of the ASU changes that you (29

[Steven M. Burdick:]

Well, I think part of the reason for the year-to-date lower tax rate is that when the tax law went into effect, we had to revalue our deferred taxes at a lower rate, so that was quite a significant pickup. And so that was – that's really the cause for that lower tax rate. But on an ongoing basis, I think the stock option deductibility ends this year. So there may be some benefit for the rest of this year, but after that, it goes away. And so when we look at what our ongoing tax rate should be on a go-forward basis, it's probably in that range of 28%, similar to what we're looking at for the year.

[Andrew John Wittmann:]

Okay. All right. Thanks for that. And then, Dan, maybe just one final one, just on capital and return of capital. You guys slightly under your target here after the good cash flow this quarter, fourth quarter is usually even better cash flow, certainly to finish the year unless you do something in this quarter. Looks like you've been trending well beneath your targets. The buyback has been really programmatic at $25 million a quarter. Do you think that as you get into next year that there's an opportunity for change either in the buyback policy or more material uptake in the dividend?

[Dan L. Batrack:]

Those are both good questions. We are not to just leave our cash or leverage idle. We are active in identifying strategic partners to join us that will actually add new technical capabilities that actually increase both our standing and position and clients that we serve. We're not looking (31

[Andrew John Wittmann:]

Okay. Thank you very much.

[Dan L. Batrack:]

Right. Thank you, Andy.

[Operator:]

And our final question comes from the line of Noelle Dilts with Stifle.

[Noelle Christine Dilts:]

Hi. Good afternoon and – oh, for you, good morning and congratulations on the nice quarter.

[Dan L. Batrack:]

Thank you, Noelle.

[Noelle Christine Dilts:]

Dan, I thought you sounded a little bit more – incrementally more positive on federal, I think when we last spoke in June. You felt that maybe that was a little bit less predictable in terms of just the work release. What's giving you more confidence as we look forward?

[Dan L. Batrack:]

Well, when we spoke and I had the opportunity to be with you and had the materials distributed to our collective shareholders. I was a bit more cautious on federal partially because of the international development and state department. The U.S. was in a position where we had an excellent Secretary of State, but was a little bit less familiar with the workings of the government in the timing and the release of task orders and contracts and the facilitation of the government business. The current Secretary of State is much more versed in that. It's been a couple of months now, and it's actually part of the – if you wanted to call it a little bit of apprehension was a lack of clarity on that particular area. And the U.S. State Department and its U.S. international aid division does represent about a third, about a third of the federal work we have. And so, having a lack of full clarity on that particular area gave just a moment of hesitation to not have full clarity where that piece was going. And we're quite clear on defense and our civil agencies, which represent the other two, roughly 32 pieces. But if you say that we sound a bit more confident, I think that's directly associated with clarity that we're seeing on that particular area that may not have existed a few months ago.

[Noelle Christine Dilts:]

Perfect. That's really helpful. And then, as we think about the divestiture of the utility business, how do we think about what that kind of means for margins longer term? And in the past, you've kind of talked about longer term margin goals toward the higher end of the – toward the 13% to 15% range for GSG and even into the mid-teens for CIG. How are we thinking about that at this point?

[Steven M. Burdick:]

Well, making this slight shaping of the portfolio actually will help move that direction. I think the – there's two different drivers for margin expansion between the two different segments. They're slightly different. The performance on the margin basis for our government work is primarily driven by volume and utilization. So as utilization goes up, and I will say, certainly performance on the projects, but because much of the work we have with the government is cost plus, our time and materials or has other definitions with respect to margin, we perform well, and we have sufficient volume to keep our staff fully utilized. That will drive us to the upper range of 15%, whereas the CIG or the commercial work, or the commercial and international work is primarily driven by the mix of work. It's actually different. And so, I think as things pick up, we need to move out of anything that's become commoditized. And certainly have been asked, so how is it utility field services was core and it's not core? We do look at our businesses. At one time, that business actually was more design work, upfront work, and then we were doing it on a turnkey. And over the past several years, it's migrated more and more to the field services or the field implementation, which actually caused margins to drop precipitously. It caused the overall use of CapEx to increase, because as we do more work in the field, we needed more trucks and other CapEx in PPE equipment. And it also included increasing our risk profile with insurance, because if you drive over a mailbox or break someone's curb, (36

[Noelle Christine Dilts:]

Thanks. That's extremely helpful.

[Dan L. Batrack:]

Thank you, Noelle.

[Operator:]

We also have another question from the line of Ryan Connors with Boenning & Scatter.

[Ryan Michael Connors:]

Great. Thanks for taking my question, and I apologize if I make you run over any ground, because I've been hopping back and forth here, but you briefly mentioned utilization on that last response there. And I wondered if you could update us on the utilization picture across the company on a consolidated basis, kind of where we stand, any metrics you can provide us, and whether we're any closer to the point where we start to generate that real margin leverage that you've talked about in the past.

[Steven M. Burdick:]

Yeah. Actually, I think you're seeing the margin leverage show up now in the 14.7% in GSG, but across the company, we're probably just around the 70% level. But I think that's a bit of a miss – would be a number that would maybe not be as valuable as to taking a look at one level below, because we actually see the GSG utilization is higher. And so, it's in the low 70s and the CIG is actually in the upper 60s. And so, you can see that when we take a look at it, when we would have to add additional staff or begin to incur additional incremental cost, we still have some more room for expansion in the GSG market, but we're closer to that point, whereas CIG, I think we have plenty of capacity to increase both utilization and so the synergistic effect of the return or implication of increasing margins is twofold in CIG. It's both the business mix at a higher margin and the increase in utilization. So, it does have the ability to swing much quicker and we do have more capacity there. But on an aggregate basis, we're right around 70%, we [Technical Difficulty] (39

[Ryan Michael Connors:]

Got it. And then, while we're on the topic of human capital, just from a big picture standpoint, job market has been very good. There's a lot of talk about wage growth and benefits improving and things like that. I mean given that you are a people business, I mean what's your outlook for any related cost pressures you could face or is that not a factor? Just give us your view on that side.

[Dan L. Batrack:]

Yeah. I actually look at it from two different buckets. And I just spent briefly what the two are. Number one is the staff retaining and holding [Technical Difficulty] (40

[Ryan Michael Connors:]

Got it. Okay. Well, that's very helpful. And thanks for your time today.

[Dan L. Batrack:]

Great. Thank you very much, Ryan.

[Operator:]

We also have a question from Sean Eastman with KeyBanc Capital.

[Sean D. Eastman:]

Hi, gentlemen. Just a quick follow up from me. Just in light of the strong cash flow this quarter, some cash coming in the door from the divestment, just wanted to get an update on the M&A pipeline, what you guys are looking at, maybe just the big focus in terms of filling out the gaps in the operations.

[Dan L. Batrack:]

Yeah, it's a good question, Sean. We are continued to put a priority on identifying the best and brightest entities to come join us. We've actually had a nice steady process of entities joining Tetra Tech. I will say that for the larger firms and for the larger entities, so I'll start both with what's available, what the pressures are and then what we're looking for. But as you move up in scale, I will say that there is a scarcity premium for some of the larger firms, which typically hasn't been the target of Tetra Tech. So, looking for something that's transformative or particularly large, that particular dynamic hasn't played into our calculation, because that hasn't been the primary area of our focus. Our area has been looking for entities that range from 50 people to 1,000 people. And in fact, we've had two entities that joined us this year that were best in class, one was 300, 350 engineers here in the U.S. at the high-end buildings, sustainable design practice, and one that was over 700 engineers. So, these are direct negotiated deals. These are accretive for ourselves and valuable for those that are joining us. So, we do think that in the sort of, make it round numbers, from 100 people to 1,000 people. There's actually a good number of opportunities out there that are direct negotiation, that are looking to join Tetra Tech to actually fulfill their career, and take it to new higher level that is not achievable on their own. I will say that the public deals that are run by investment bankers are quite heady. We do follow those. It is interesting that those that are looking to go through a banker or through an auction process have fared quite well in valuation. I'm not sure how they fell, how they fared subsequent to the acquisition. I'll allow that discussion to take place, transaction by transaction, but with respect to what we're looking for the type of firms, we actually think the evaluations are still appropriate and accretive to the company. Where we're looking to go? We'd like to go to Europe. We have a number of clients that we're servicing, and we're servicing them through a limited presence we have both in the UK and the Continent, so we would like to round out to further expand the work with the clientele we have and add new subs. We would also like to expand a bit with respect to our municipal and water work in Australia and the Asia Pacific region. It's a priority for us. We think it's an area that we can move to be a top tier competitor and service provider. So, take a look for Australia and New Zealand and the surrounding area for municipal area, where we are – we would like to turn Australia and New Zealand into a service area that looks just like what we're doing in Canada and the United States. And so that's an area that we're quite interested in, and we're actually looking to expand at the very high end of the consulting, and top-end engineering work with respect to work that we can do for the oil and gas clients that would be quite differentiated and perhaps less tied to the cyclicality of just the price, something that would be more in demand through the different market cycles. So, those are actually areas that we are specifically looking for. And then, I just addressed some of the evaluations out there.

[Sean D. Eastman:]

Thanks so much. I really appreciate it.

[Dan L. Batrack:]

Great. Thank you very much.

[Operator:]

This will conclude the Q&A session. And I will now turn the conference back over to Dan Batrack to conclude.

[Dan L. Batrack:]

Thank you very much, Jennifer. And I'd like to thank all of you for your insight, for your questions and your interest in Tetra Tech, certainly for those associates that I work with that have contributed to an excellent quarter, and in fact, a record quarter. I'd like to thank all of you personally for having had an excellent performance during the quarter. And I'm looking for us to even eclipse these high marks. And so, I look forward to speaking with all of the investors and analysts, and our shareholders again next quarter. Hope you have a good rest of the week. And thank you and goodbye.

[Operator:]

Ladies and gentlemen, this concludes our conference for today. Thank you, all, for participating, and have a nice day. All parties may disconnect now.