Tetra Tech, Inc.
Q2 2013 Earnings Call Transcript

Published: 2 May 2013

[Operator:]

Good morning, and thank you for joining Tetra Tech's 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 [phone]. 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 we'll then open the call for questions. During the course of the conference call, Tetra Tech management may make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These include statements concerning future events and Tetra Tech's future financial performance. The statements are only predictions and may differ materially from actual future events or results. Tetra Tech's Form 10-K and 10-Q reports to the Securities and Exchange Commission identify certain risk factors that could cause actual results to differ materially from the forward-looking statements. Tetra Tech undertakes no duty to update 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 Investor Relations section of Tetra Tech's website. [Operator Instructions] With that, I would now like to turn the call over to Dan Batrack. Please go ahead, Mr. Batrack.

[Dan L. Batrack:]

Great. Thank you very much, Carrie, and good morning and welcome to our Fiscal Year 2013 Second Quarter Earnings Release Conference Call. Well, as in past, Steve Burdick, our CFO, will present the specifics of our financials for this past quarter. I'll start with a brief overview of some of our key financial metrics. I'd like to start off with noting that we performed, in aggregate, about as we expected and in line with our guidance for the quarter. Our revenue for the second quarter was at $642 million, with an associated net revenue of $521 million for the quarter, which is up 9% over the prior year. The net revenue, I'd like to note, is largely indicative of our headcount, which should be noted was up over 1,000 for the quarter, which resulted in the end of the second quarter, at our total staffing, at over 14,000 Tetra Tech employees. Our EBITDA was at $54 million for the quarter, up 10% year-over-year. Operating income was at $38 million, which resulted in a diluted earnings per share of $0.38, which was 9% up over the same quarter prior year. I'm also glad to say that we ended the quarter with our backlog up, again, over at $2 billion levels. That was really a nice way to finish the second quarter for the year. We saw our continued growth in our international, U.S. commercial, and state and local markets in the U.S. Our 22% year-over-year international growth was primarily driven by our operations in Western Canada and South America, and we expect these to continue to be big growth drivers for us in the coming quarters. In the United States, our commercial revenue grew by 16%, supported by growth primarily in the oil and gas midstream services area, and water related industrials sectors for our manufacturing clients. In the United States, U.S. commercial and international work now is at 59% of our net revenues, which means more of our work is in a higher-growth and higher-margin markets than ever before. As we expected, our federal net revenue was down. In fact, it was down 12% year-over-year due to the continued slowdown associated with the fiscal uncertainty and the impacts of sequestration across the United States. Our U.S. state and local work was 13% of our business this quarter. It was up year-over-year primarily due to a few larger projects that I've spoken about on previous calls, although we have seen a localized pickup in some of our municipal orders and we've seen that market, in general, strengthening for us. On the next page on the webcast, performance by mix in our segments. We did see weaker funding from our federal clients and a downturn in mining that impacted our 2 front end units, and that was primarily the ECS or Engineering Consulting Services group, where the majority of our mining operations are based. It was both affected by a cyclical downturn in the mining market, which I'll speak a bit more to later in this presentation, and delays in authorization of funding for discretionary work we're doing for the U.S. federal work. Our TSS group was essentially flat with some reductions in federal related revenue, mostly in the energy efficiency area, but that was offset by strong commercial and industrial revenues in the United States. Our RCM, RCM was our best group in performance this past quarter, and it was up significantly, with a newly integrated commercial and oil and gas acquisitions contributing to significant revenue increase. And this has contributed to the continuing emergence of RCM as more of a private sector oriented group, which is actually driving faster revenue growth and higher margins. The 2 front end groups, Engineering Consulting Services and Technical Support Services, now represent about 75% of our business, which is very consistent with our targeted distribution for the 3 business groups. Our backlog. Backlog was actually very good this past quarter and one of the best performing areas. It was up 5% sequentially and ended the second quarter at $2.027 billion. This quarter, we received over $400 million in commercial related orders and they came from our mining clients, oil and gas, wind and just really a very broad base of our industrial customers. We also booked commercial remediation projects such as McClellan Park in Northern California, and we announced 2 major $100-million contract vehicles that we were just recently awarded, 1 with the U.S. State Department and a second with the U.S. Navy. And what was noteworthy on these is they are both new contracts for us, they're not just rebids. And we continue to receive task orders across our entire U.S. federal customer base, so we are still seeing some activity there. Overall, the backlog continues to rebalance towards a mix dominated by our commercial and industrial work, while we have been maintaining a strong stable U.S. federal base. I do expect our federal orders to pick up over the next 2 quarters as funds for fiscal year 2013 are released from the government because the work still does need to get done this fiscal year, and I believe the slowdown in the first half of the year will actually translate to an increase in orders that should contribute to the backlog. I'd now like to turn the presentation over to Steve Burdick, who will provide us a more detailed discussion of the financial results for the second quarter. Steve?

[Steven M. Burdick:]

Well, thank you, Dan. I'll begin with the fiscal 2013 second quarter financial overview in a bit more detail. Overall, our second quarter results met our previous guidance that we had provided. Comparing the second quarter results, this year to last year, revenue increased by about $18 million or 3% to $642 million, primarily as a result of an increase related to our oil and gas, and our commercial markets, both in the U.S. and abroad. The increase was partially offset by a slowdown in our federal government discretionary projects. Also, net revenue increased more significantly by about 9%, to $521 million. The net revenue results were within our guidance range that we had previously given also. I do want to point out that our net revenue is growing faster than our revenue because we're involved in more self-performance work, especially in our commercial and international client base, and the self-performance activity has benefited our bottom line. In fact, income from operations increased by about 6%, to $38 million, on a year-over-year basis. We did experience a strong growth rate in operating income, and as previously mentioned, our top line growth is coming from these U.S. and international commercial activities, led by oil and gas work, and these activities do have higher margins; thus, our operating income is increasing at a pretty good rate. Our second quarter income is higher in spite of increased severance cost and decreased utilization in our ECS group as Dan had mentioned a little bit earlier. EBITDA also increased by about 10% to $54 million. This improvement resulted in EBITDA margin increasing to about 10.4%. This is better than the prior year for both the quarter and year-to-date. Our EBITDA increased at a higher rate compared to our operating income due to intangible amortization expense of about $2 million in the current quarter compared to last year. The SG&A was about $47.5 million for the quarter. This is a decrease from the prior year second quarter of about 9%. The majority of this decrease resulted from our efforts to control costs relative to discretionary G&A spending. In particular, we took actions to decrease our overhead cost where we saw weakness in the second half of the year and this includes Eastern Canada, mining, federal and even at corporate. Our tax expense was about $1 million lower at $10.7 million compared to last year. The effective tax rate, therefore, is about 30% for the second quarter, and this compares to about 34.5% for last year. The primary reason for the decrease was the fact that our foreign entities that we operate in, have lower tax jurisdictions and, thus, we're benefiting from a lower tax expense, and we're also benefiting from certain R&E credits that came in the second quarter. Our EPS of $0.38 met our previous guidance range and we hit our guidance range as a result of solid project performance and our lower SG&A costs. I would like to point out a few of the more significant balance sheet items. As a result of our revenue growth that we had experienced, we thus have higher accounts receivable balances and higher accounts payable balances based on that growth in our business. We did experience an increase in our net debt, and the primary driver for this was our recent acquisitions of both AEG and Parkland in the second quarter. Our net debt position was positively impacted by some very good cash flows in the quarter. It says we've got -- speaking of the good cash flows on the -- if you're following on the webcast, you'll see that we generated $44.3 million of cash from operations in the quarter. This is about 34% more than the prior year quarter, and these improved results came from an increase in our EBITDA and better working capital. We expect that our operating cash flow for the year will still be about $150 million to $170 million for fiscal 2013, and this translates to cash generated, on a per-share basis, of about $2.31 to $2.62, which is quite a bit more than our EPS guidance. CapEx is higher than the prior year but in line with our previous guidance. We expect our CapEx to be in the range of about $25 million to $30 million for fiscal 2013. This was a plus up for our second quarter acquisitions, and our CapEx does continue to represent a ratio of less than 1% of our annual revenue. Our day sales outstanding at 83 days are slightly higher when compared to last year at this point. Even with the higher DSO, we had a very good operating cash from operations in the quarter. The higher DSO does relate back to our revenue mix, which is weighted more towards our international and commercial work. The payment terms that we have on these projects are less optimal when we compare it to our federal government projects, but offsetting this is the higher prop rates on those international commercial projects. In addition, we do see slower payments from our customers across a broad range of all of our markets, due to economic pressures that are still persisting out there. So, even with these headwinds, we are working across all of our operations to focus on decreasing the DSO to -- back to a range of about 75 to 80 days by the end of this fiscal year. Also, for those following on the webcast, the next graphic shows the impact of our positive operating cash generated and also the cash used in our acquisition investments. As you can see on the graphic, our previous net cash position has transitioned to about a net debt position due to the borrowings for our recent acquisitions in the quarter, for both AEG and Parkland. In the second quarter, we now have a net debt balance of about $106 million, and we do expect to bring this back to a net cash position by the fall of 2013. With that said, this management team will continue to leverage our balance sheet to invest in growth opportunities, to provide higher profit margins, access new markets and, ultimately, further enhance our shareholder value. That concludes the second quarter financial review in a bit more detail and I'll hand it over back to Dan.

[Dan L. Batrack:]

Great. Thank you, Steve. I'd like to present an overview of one of our fastest-growing market sectors, and that's the oil and gas industry. For us, oil and gas equals water environment. The services that we're well known, have over 5 decades of experience, and I think we're the best in class. The demand for energy and the transformation in this sector in North America demands exactly the services that we here at Tetra Tech provide. From the earliest studies, to design and construction management, their needs for water sourcing, water management, environmental permitting and restoration, water treatment and remediation. All things that Tetra Tech are best in class in. Through a combination of strategic acquisitions, you saw one this last quarter with Parkland, and investment in our operations for organic growth, we're expanding from Tetra Tech's strong positions in the study areas to the entire project life cycle, which includes design and construction management. Acquisitions over the past few years, that have included Fransen, Rooney and most recently, Parkland, have provided us with an excellent position in the midstream design and construction management in the oil sands, and also in the midstream shale basins in the United States that are just beginning to grow. We're going to continue to expand our services in oil and gas through a combination of organic and inquisitive investments in the pipelines and opportunities for acquisitions to round out -- both geography and services are stronger than ever before for us. This sector is growing very rapidly for us and I expect our oil and gas revenues to double from 2012. And by the end of 2013, our annual revenues for this year should exceed $300 million, and this is at a scale that'll be significant -- that'll be a significant contributor to Tetra Tech's overall growth. And we're not stopping there. I expect our oil and gas revenues will triple again in the next 3 to 5 years, and our projection here at Tetra Tech is that we'll achieve oil and gas related annual revenues of more than $1 billion in this timeframe. Although our oil and gas and commercial and industrial sectors are growing very strongly for us, mining in the regional markets in Eastern Canada are experiencing some significant challenges that have resulted in impacts on our operations and their financial performance, primarily in the ECS business segment. In Eastern Canada, recent investigations are affecting the entire construction and engineering community. And as a result, we've seen a significant slowdown in procurements, awards and project initiations across that entire geographic region. This has also been compounded by a weakening economy in Eastern Canada. Mining, especially in North America and Australia, is also showing a significantly reduced slowing as a result of less capital investment, lower commodity prices and just generally lower demand. We're moving quickly to address these challenges and I'd like to summarize the financial impacts of these headwinds on our operations. If you're following on the webcast, on the next page, this table summarizes the estimated revenue reductions and associated one-time cost to rightsizing our operations in the second half of 2013. More specifically, we anticipate a reduction of approximate $100 million in revenue, split relatively evenly between mining and Eastern Canadian revenues. So about $50 million each, with an approximate $10 million of associated margin or operating impact production, so about 10% reduction. One-time cost from rightsizing that includes severance, office-space reductions and all of the associated cost with adjustments in our operations are actually more significant. These costs are anticipated to have an impact of about $10 million to $20 million on our operating income in the second half of the year. Let me actually give you a few details of where that's broken down into. So over the next 2 quarters, Q2 and Q3, we anticipate somewhere between $3 million to $6 million of severance; a similar number, $3 million to $6 million of expense in office closures; with the remainder of the amount associated with lower utilization and back-office reductions. Now, we did begin to initiate these actions at the end of Q2. They did have $1 million to $2 million impact at the very end of Q2 or the end of March, but most of these costs I expect to fall in the third quarter. As we expect, these actions will be taken very quickly and they should put us in a very good position as we finish this year to go forward. I'd now like to turn to our customer outlook, the next page in our webcast. Over the next 6 months, we expect our U.S. commercial and international revenues to increase to 65% of our business, from 59% where they are today. International will be up -- will be overall flat to slightly up, with strength in Western Canada and South America being offset by weakness in Eastern Canada, at least for the near term. U.S. commercial, we expect to grow and continue to grow at double-digit rates. While the U.S. federal revenues and work we have, I expect to continue to decline slightly as the market adjusts to sequestration and declining federal budgets. At the state and local level, if we exclude the impact of a few large state transportation projects, our state and local business will be flat to slightly up at about 10% of our business, and it's actually been quite solid and growing slowly but very steadily. Of the 3 business groups, ECS, Engineering Consulting Services group, will be the most impacted by the mining and Eastern Canadian issues that I discussed. As a result, I expect ECS margins in the second half, Q3 and Q4, to be between 7% to 10%, which is a bit below their historical averages, and then they should return to their historical levels that you've seen before. Both TSS, Technical Support Services, and RCM groups, I expect will maintain their margins and, in fact, be at the high end of the ranges that we've shown and distributed in the past. Based on our performance in this past quarter, and evaluation of the current business trends and prospects, I've set our fiscal year 2013 Q3 and updated our full year guidance as follows

[Operator:]

[Operator Instructions] Your first question will come from Noelle Dilts with Stifel.

[Steven Folse:]

This is actually Steven on for Noelle. My first question is surrounding Park -- a little bit more detail around the Parkland business. If you can give us some update on how that business is performing and if you guys are making any traction towards bidding on some of those larger $100-million-plus EPC-type pipeline jobs that you guys had said that maybe that acquisition would open up the opportunity for?

[Dan L. Batrack:]

Well, Parkland's been with us for -- in the second quarter for 2 months and now 1 month into the third quarter. So, let's call it 90 days they've been with us, and they have been one of the best contributors, both financially and from a collaboration standpoint, that we've ever seen. Now, we do see that their primary size is generally small to mid-diameter. So sort of 12 to 24, could maybe go to 36, but 12 to 24 inch is their primary focus on the midstream for the piping systems. But that certainly includes $100 million EPC contracts. We have seen those opportunities. We've had some success, and as that takes place, we'll actually press release that. So I won't -- but they've met and, in fact, exceeded our expectations so far. They are leveraging and working with the rest of the company already, and in their first 60 days with the company, have had joint presentations to some of the largest midstream clients across Canada and, really, which represents some of the largest in the world, on turnkey projects that wouldn't have happened, either without Tetra Tech -- and Tetra Tech could have never considered doing this without Parkland. So, really, it's gone very, very well and I'm hoping to present both press releases on new wins and financial results that support that here in the coming quarters.

[Steven Folse:]

And then, I guess, just one more question here on the targeted ECS margins. You mentioned in the commentary, you kind of expect that to return to the targeted 9 to 12 range. Is that something that we could expect for fiscal 2014? Is that a goal or -- with kind of some of the kind of material CapEx mining cuts that we've seen, is that going to be a stretch in 2014?

[Dan L. Batrack:]

Well, I'm not intending, on this call, to actually provide guidance for 2014, but I will talk in general with respect to a period outside of the next 2 quarters. I do expect the margin is going to go back to those levels and, in fact, I expect it to be at the upper end of those levels. That the full amount of work that they do at the front end is the highest margin, is the highest barrier to entry and, actually in some instances, has the highest value in the company because it provides leveraged opportunities for design and construction work down. I do expect it'll go back up, whether or not mining slowdown continues, and as we rightsize Eastern Canada for the temporary slowdowns, total revenue growth in ECS could, and I do expect, will come down. But as soon as we complete these rightsizing activities here this quarter, the third quarter, I expect the margins to come right back up. You'll see the first move in Q4, and then I should expect it to be back into historical levels thereafter. And that does equate to 2014, yes.

[Operator:]

Your next question will come from Alex Rygiel with FBR.

[Alexander J. Rygiel:]

So just one question, I think. You sort of have a shadow backlog of federal awards that have a contract ceiling but you haven't yet received task orders for. Can you attempt to quantify that and/or kind of comment on the size of that today versus maybe 1 year or 2 ago?

[Dan L. Batrack:]

Well, I understand what you're referring to as a shadow backlog. We don't use that here. We use it as -- we have a huge amount of contract capacity with the federal government. In fact, it's -- rivals the highest that we've ever had in the past with contract capacity. What we have seen -- and I'll give one short anecdote and then you can expand it across the federal work we have. EPA has been very slow to issue task orders and, in fact, I have personal commitments from very senior individuals within Tetra Tech that the EPA task orders would come out each Friday for about the past 4 weeks saying, they're converting it from contract capacity to individual task orders and it's actually quite sizable numbers. And you can imagine, Friday at 2

[Alexander J. Rygiel:]

And can you give us a sense for contract capacity? You referenced it's the highest ever. How much higher is it today versus maybe a year ago?

[Dan L. Batrack:]

I would say, it's up by probably $400 million to $500 million and is probably between $10 billion to $11 billion just on the federal side.

[Operator:]

Your next question will come from David Rose.

[David L. Rose:]

A couple of questions on -- one is in terms of your sense on the range. You talk a lot about what it depends on to execute your rightsizing actions. Can you walk us through a little bit of the risk scenario on the top line in terms of net revenues? And then maybe provide a little bit of color on what you're seeing in Latin America, specifically with the new acquisitions or the recent acquisitions?

[Dan L. Batrack:]

Yes. The threat, so to speak, of achieving our net revenue guidance for the second half anticipates about a 15% reduction in our mining revenues in the second half. If, for some reason, that became steeper, there would be some risk there, although I think we've been reasonably conservative in that estimate and intend to provide both our revenue and our income guidance to encompass a relatively worse case scenario. The same is true with Eastern Canada, so I think the likelihood of it going below is relatively small.

[David L. Rose:]

And on the federal side?

[Dan L. Batrack:]

Federal, we've already forecasted. We've gone through this internally, a fair amount. We've already anticipated, roughly, a 15% to 17% reduction in our federal revenues that represent sort of 1/2 half of the discretionary work that we have. We've gone through this presentation and calculation in the past. It's actually been right about what we've anticipated, in fact, amazingly so. I actually think the second half should be incrementally better than what we saw in the first 2 quarters. So we don't see softness beyond what we've reported these past 2 quarters, on the federal side.

[David L. Rose:]

Okay. And then on Latin America, there are 2 parts to the Latin America. Metalica, you've got all the mining business there as well. I mean, that's how that business really started, right? So your commentary was that Latin America was relatively strong. I guess you're referring to Brazil versus Chile. Maybe you can provide a little bit of color of what you're seeing in both of those markets?

[Dan L. Batrack:]

Yes, I can. Let's start with Chile, which is Metalica, that joined us a couple of years ago. They're primarily copper, Codelco, a little bit of other work. I would call that a stable market, work looks good, it's stable. We've seen them actually hit and exceed the forecast, as we've entered this year. So they're slightly up, beyond what we anticipated coming in, and we have pretty good visibility, but I wouldn't call it a high-growth area. But we've seen Chile do well for us. And, again, primarily driven by mining and within mining, primarily driven by copper. And these have been long-term projects, so I don't expect any short-term -- much of a short-term variability there. Brazil. Brazil has actually been much stronger for us, and we have 2 activities in Brazil currently. We have a mining activity, which is the dominant practice that we have, and it's primarily associated with an iron ore project. It's really one of the world's largest iron mines that is going to come on. It's known as the Minas-Rios which gives -- it's not just ourselves. There's many, many -- in fact, all of the top mining engineers, consultants and others are working on this. It's expected to go online in the next year or 2 and so we do have a great amount of visibility with this project. And in fact, the demands in order to accelerate the completion of the project, is driving growth there. And I expect that for the next couple of years. It's not a month or quarterly backlog that we have here. In fact, some of the biggest orders that we've had in the company have come out of there. We do have a very small operation, doing coastal engineering and marine work to support the oil and gas industry. It's really quite small. It's only been with us, here, just over a quarter and it's doing well. It's growing -- I won't even use the percentage because the math of small numbers make it really not meaningful, but if you're doing $2 million, $3 million and you get another $1 million of growth, it's 30%, 40%, but it's $1 million. So it's hitting all of our expectations, but it's still quite small as far as scale goes and so we -- I'd really like to hold material contribution details until we get some more scale on that. But it's doing quite well.

[David L. Rose:]

And I assume we'll see more acquisitions in that market as well as North America and oil and gas.

[Dan L. Batrack:]

I think you will, yes.

[Operator:]

Your next question to come Will Gabrielski with Lazard.

[Jonathan Evans:]

This is Jonathan Evans for Will. So I was wondering, you laid out the goal to triple your oil and gas revenue over the next 3 to 5 years. Can you help us strip that out, maybe into organic versus acquired growth?

[Dan L. Batrack:]

I think organic will be about 20%. So I think the organic -- we're growing at about 20%, the balance will be acquisitive.

[Jonathan Evans:]

Okay. And then maybe just expanding on that a little bit. Can you give us a sense of where you expect to grow, whether that's in midstream or actually at the well site itself?

[Dan L. Batrack:]

Well, I expect -- let me go up even before that. Tetra Tech is known as leading with science and, really, at the very earliest stages of the project initiation, and that's with reservoir analysis and the other work that starts with even regulatory reporting of the overall reserves. And so I would expect us to start there. So expect us to continue to lead with science which gives us, really, the best unique position. You're not -- there's really very little or no competition. You don't have multiple people guessing what your reserves are. You have one doing a scientific calculation and support for legal opinions for that. So expect that we'll expand there. We're doing some of that work now, and we'll grow both organic and acquisitively there. Once you move down I expect more midstream, and midstream being what you see in Parkland, with respect to both design build and Rooney, which is in the Bakken. So you take a look at Alberta, I expect to do more work to support both the oil sands movement of oil, whether or not it's to the American border and across, or whether or not it's to the Pacific Ocean for sending. We have a very good position with Parkland located, not only in Calgary, but also to the West in British Columbia. We'd look to augment that on the midstream, and we'd look to add similar resources in the United States. And we have a design capability in the Bakken, so sort of the Dakotas, and we'd like to add this in the Permian, which is in West Texas. We have offices in Midland. We're doing upfront environmental work, siting work, permitting work and we'd actually like to add the capability to do the design and construction management. So look for growth in West Texas, additional expansion in the Bakken, where we already have a good presence, and then adding to the capability that we have in both Alberta and British Columbia, both for natural gas movement to the LNG terminals, which are just in their very infancy, and for additional movement of oil sands oil.

[Operator:]

Your next question will come from Tahira Afzal with KeyBanc.

[Tahira Afzal:]

Yes, my first question is in regards to the pipeline side. These are larger opportunities, around $100 million, that you're seeing on the Bakken side. We seem to be getting the same feedback about the market, that it's very strong. But could you talk about the contractual terms you're seeing, in general, for these larger ones? Are they fixed-price? And then sort of asking question in regards to your expansion plans. Could you talk a bit about what's making you look at Bakken a little more closely? That's where it seems that there's a lot of surplus right now and the questions around the economics of rail versus pipeline. So what are you seeing there that makes you more comfortable on investing a little more there?

[Dan L. Batrack:]

A couple of questions there. First is the pipeline work and how are we seeing the contracting environment for that. Most of the work we're doing is either direct negotiation or limited competition for clients that we've had in place for a number of years. They typically tend to be the oil majors, and we have pre-existing terms and conditions in place. And these, generally, are actually task orders within a very large contract. The types of payment terms are typically time and materials, in some instances, or a fixed unit rate. Not a single fixed-price for a very large project. So the risk is somewhat mitigated or lower than you might see in an open competitive fixed-price environment that are generally associated with a very large diameter, hundreds, multi-hundreds or billion-plus, single-project fixed-price projects. Those are generally large diameter projects, and that's not our focus nor our experience and really not what we're looking to expand. So I do think that there's sometimes confusion as to where we're going versus some of these much, much larger projects. With respect to the Bakken, we're already there. We're doing pipeline work and yes, the pipeline -- the reason -- I do understand that rail has appropriate economics. I understand, actually, with the reduction in coal inventory on the rail lines, it adds up a lot of capacity to move natural gas or LNG. We think that, that's in addition to, not in place of the piping work we're doing. And part of it is it can be moved quicker but it's not, ultimately, we believe, a replacement. In fact, maybe a stopgap between what can happen now. If I got to move it now, I'll put it on a truck or a rail; but if I need it on a continuous basis, I need it on a pipeline. And so we think that it's not a replacement, but it's a stopgap. Bakken -- and by the way, with that said, Bakken is very good for us on a design phase, but I would say that we'll look for additional opportunities. We do think that it's perhaps overstaffed and oversaturated, and that's why I did focus on -- actually the Permian or West Texas is actually a little bit -- appears to be more attractive from us from where our resources reside within the company.

[Tahira Afzal:]

The second question I have is in regards to your free cash flow outlook. You're hoping for DSOs to improve. Is that factored into the outlook you provided?

[Steven M. Burdick:]

Yes. The outlook that we have for the $150 million to $170 million of cash from operations does contemplate us being able to bring down our DSO down below the 83 days and get back into the 75- to 80-day range.

[Operator:]

Your final question will come from Andrew Wittmann with Robert W. Baird.

[Andrew J. Wittmann:]

So, Dan, I just wanted to kind of get a status update on the longer-term goal of the 13% EBITDA margin. With the setbacks that you had this spring, how should investors think about the attainment of that goal? One, how do you get there and is there enough organic growth in your end markets to support maybe some margin expansion, as well as maybe the timing that you think is realistic given the environment we're seeing today?

[Dan L. Batrack:]

Andy, I think if -- that's a great question. That we have seen a reduction, in fact, most notably, the ECS margin is the lowest we've seen in the past -- jeez, I don't know, 5, 6, 7, 8 years. We haven't seen a margin this low. I believe it's because of the onetime adjustments we've made in some of the cyclical businesses in mining and the initial actions we've taken in Eastern Canada. So I think if you take a look and chart the company's growth and it's still -- we'll see how this models out, but we've had many years of sequential growth over the EBITDA margin. And certainly this year, it's still possible depending on which points you pick in our margin expansion. I do think that this is a 1 to 2 quarter adjustment in our back office costs, to get our staffing right for the adjustments in the revenue streams in these 2 areas. But I think that you should see, as we get into the fourth quarter and certainly thereafter, the ECS to be right back. I think that organic growth, we are seeing most of it in the commercial sectors which carries the margins and also the acquisitions. So I think you really need to take a look at -- or we're looking at both the organic growth on the commercial side and I think -- I think I have to think for a moment, the past many acquisitions, certainly Parkland, 100% commercial oil and gas; AEG, essentially all commercial work. You go before that, Rooney, all commercial work. So really, we've been adding both acquisitively, on the sides that carry higher margins, just intrinsically by the nature of their work, and the growth internally. So I think -- when are we going to get there? I have said in the past that as we grow towards 70%, and that would be 40% international, which turns out to be mostly commercial, and 30% U.S. commercial. So as we drive the combined percentage of those to 2 towards 70%, we should achieve 13% EBITDA margin. Actually, if you go back to my previous presentations as to time frame, we're not in a position to actually change that. So I think we've said 2 to 3 years in the past. So I think we're about 2 years out from achieving that. Unless we accelerate both international and commercial, it could be sooner. And you see we're up to 59%, almost 60%. It's really quite a big move, mid-30s now on international. So we're getting there. And I think as we add more oil and gas, and other commercial and industrial work in the U.S., it will move the commercial work up to our goal too. So timing, I think about probably 2-ish years, something like this. What's it associated with? Movement of international to 40% and commercial to 30%. And does it have to be organic? Yes, it has to include organic but acquisitive will contribute to that meaningfully.

[Andrew J. Wittmann:]

And I'm just kind of curious, in Eastern Canada, Dan, when you look at what's happening there today, clearly, the contracting pace is set down as investigations are ongoing, but you guys did have an investment in with BPR there and, clearly, it's going to undergo some changes here. But who comes out the winner when it's all said and done? And what's that market look like long-term, now that it's had a pretty different way of doing business in the past that needs to change going forward?

[Dan L. Batrack:]

Well, I think it's -- everybody's gotten beat up. Nobody has been unimpacted by the slowdown and the contracting. I do think that there's going to be a bit of a build up like a reservoir of work behind a dam, a little bit. That if they don't contract, don't contract, don't contract, you still have to upgrade your water treatment plants, you still have to upgrade your transportation routes, you still have to upgrade your general infrastructure. This work isn't just going away, and the largest population centers are in Eastern Canada, sort of from Toronto, Ontario, East and in Quebec. It's the second biggest. So the work, at least, still has to be done. So I do think you'll see sort of an unleashing of this. I do think it's still a couple of quarters out before they get this all sorted out, but then I think there'll be a bit of a catch-up, a little bit like you're going to see on the federal this year, toward the end of the year. And then I think it will get back to a normal level, which will probably be slightly less than we saw a year ago or 2 years ago because things have slowed a little bit. But I think you're going to see a -- maybe several quarters if not a year or more of just general catch-up because of what they haven't embarked upon.

[Andrew J. Wittmann:]

But coming out of this, is the BPR-Tetra Tech franchise a net winner or a net loser, just given that it's a broad-base of people that were -- or of companies that were implicated here. Do you have a sense about who is going to come out competitively better positioned when this all settles?

[Dan L. Batrack:]

Well, it's our goal of course, for us to come out better. That's our objective. But I will say it's still quite early. These investigations and all of the new rules that are coming out for contracting are still very early. We're watching them quite closely, like all the others. But I will note one thing. Some say that because of difficulties with existing engineers and contractors in Québec, others will swoop in. Well, unless you speak French and not France French, Canadian French, it's very difficult to do work there. So the natural barriers that exist in the province are not going away. The work products need to be delivered in French. The work needs to be delivered in French. The community and all of the implementation have to be in that, and to have between 1,500 to 2,000 French engineers and technical staff in the province, I think we're very well-positioned with resources and contracts and capabilities. I do think that there's going to be some sorting out, but it's not just a vacuum that can be filled by anyone else, even including Canada, coming from the West. There are very large natural barriers, so I feel reasonable about how this is all going to sort out.

[Andrew J. Wittmann:]

Great, and then just one final question, bookkeeping question, maybe for Steve. When you look at the backlog, how much of the backlog was acquired during the quarter, Steve, just to get a better sense about kind of what the organic trends look like?

[Steven M. Burdick:]

Yes. It was -- about 1/2 of the increase was through the acquisitions.

[Andrew J. Wittmann:]

About 1/2 of the sequential increase?

[Steven M. Burdick:]

Yes.

[Dan L. Batrack:]

With that, I'd like to thank you very much for your questions and interest in Tetra Tech. And I do look forward to speaking with you, again, next quarter and giving you an update on our progress as we move toward the end of the year. And with that, good bye, have a great day and talk to you next quarter. Bye.

[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.