Tetra Tech Inc Q4 FY2021 Earnings Call

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 www.tetratech.com. This call is being recorded at the request of Tetra Tech and this broadcast is the copyright 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 we’ll open up the call for questions. I’d like to direct your attention to the Safe Harbor statement in 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 up the conference for questions-and-answers after the presentation. With that, I would like to turn the call over to Dan Batrack. Please go ahead, Mr. Batrack.

Thank you very much, Laura, and good morning. And welcome to our Fourth Quarter and Fiscal Year 2021 Earnings Conference Call. We had an excellent fourth quarter completing an exceptionally strong 2021 fiscal year. And as we enter fiscal year 2022, we’ve never been in better alignment with our clients' priorities than we are today. Globally and here in the United States, the priorities of water, environment, sustainable infrastructure and renewable energy are creating new projects and additional funding commitments from our clients. Climate change is driving our communities to invest in resiliency and governments to make longer term commitments for the reduction of carbon emissions. In areas impacted by climate change, we’re seeing increased emphasis on adaptation, while we also are supporting those affected by unprecedented disasters. These global and local trends are directly aligned with our Leading with Science approach that resulted in strong growth across all of our client sectors and generated new orders that resulted in an all-time high backlog for us. As shown on our webcast, if you’re following along, are the results of our fourth quarter and fiscal year 2021. We hit all time highs across the board, with full year revenue of $3.21 billion and operating income of $275 million, up 13% from last year. We delivered $3.79 in adjusted EPS, up 16% from last year and $4.26 of earnings per share on a GAAP basis, which is up 35% from last year. And we also generated $304 million in cash or more than $5.50 of cash per share in fiscal year 2021. The strong performance of our company across our global operations is a demonstration of the strength of our business and the capability of our 21,000 associates who are technically differentiated, highly client focused and physically disciplined. I’ll now begin with an overview of our performance and end customers, followed by Steve Burdick, our Chief Financial Officer, who will provide more detailed review of our financials and capital allocation. I’ll then address our customer outlook and our earnings guidance for fiscal year 2022. We had a strong fourth quarter ending the year with record net revenue, operating income and earnings per share. Our net revenue increased 20% year-over-year to $709 million for the quarter. Our fourth quarter operating income of $79 million generated an earnings per share of $1.05, up 15% from last year. This represents the highest quarterly EPS in the company’s history and the first time we’ve exceeded $1 EPS in any quarter in the company’s history. And our backlog, our best forward-looking indicator was also the highest in the history of the company growing to $3.48 billion, up 7% both year-on-year and sequentially. I would now like to provide an overview of our performance by our end customer. In the fourth quarter revenue for all of our client sectors increased compared to last year. We saw continued strength in our state and local revenues, which were up organically 30% from the fourth quarter of last year. Even excluding the extraordinary contributions of our disaster response work, this is the sixth consecutive year of double-digit growth for our state and local business. Work for our U.S. Federal clients was 28% of our revenue in the quarter. It was up 11% from the same quarter last year. This growth was driven by an increase in climate change-related services and advanced analytics for our clients. Our U.S. Commercial revenue was 22% of our business, up 8% from last year. Our environmental permitting, regulatory-driven programs and renewable energy services all contributed to our growth in the sector. And finally, our fastest growing client sector was International, where our revenue was up 35% from last year. Our International revenues did benefit from the addition of our new high performance buildings group in the United Kingdom, Hoare Lea, who joined us in the fourth quarter of fiscal year 2021. The rest of our International work grew at a strong 24% year-on-year pace with the expansion of broad-based sustainable infrastructure programs in Canada, Australia, and the United Kingdom. Now I’d like to present our performance by segment. In the fourth quarter both of our segments grew at double-digit rates year-over-year. The Government Services Group, or GSG, segment was up 13% compared to last year to $372 million, while maintaining a strong 14% margin on operating income. This performance was driven by our high-end data analytics and design services for water and environmental programs, augmented fire disaster response and recovery work all across the country. The Commercial International Group, or CIG, grew by 30% year-over-year and delivered a 12.4% margin, up 50 basis points from last year. CIG’s fourth quarter results were driven by growth in our International operations and the strengthening Commercial market here in the United States. Our backlog was up 7% both year-on-year and sequentially on strong broad-based orders resulting in a new all-time high of $3.48 billion of contracted, funded and authorized work from our clients. In the fourth quarter, we won new programs and task orders for differentiated water, environmental and renewable energy services building momentum for us in fiscal year 2022 both in the U.S. and the International market. We also expanded our contract capacity by over $1 billion per key USAID, U.S. Army Corps of Engineers and NOAA programs that provide the contract vehicles for us to support the U.S. Government’s climate change priorities. We won task orders with both the United States and International government agencies for water, environment and climate change adaptation programs. In the fourth quarter, we had strong Commercial orders of over $400 million to provide renewable energy, environmental restoration and sustainable infrastructure services. This was an extraordinarily well-balanced quarter for orders from both our government and from our Commercial clients. And at this point, I’d now like to turn the presentation over to Steve Burdick to present the details of our financials from the quarter and where we finished the year. So, Steve?

Hey. Thank you, Dan. So, now I’d like to review the GAAP financial results for the fourth quarter, as well as our financial condition for fiscal year 2021. Overall, as Dan noted earlier, we had record results in Q4 and record fiscal year results — revenue, operating income, EPS and backlog. For fiscal 2021 fourth quarter revenue was $892 million. The net revenue amounted to $709 million, which exceeded the upper end of our guidance range of $650 million to $750 million. Our revenue was up 18% over last year and net revenue was up 20% over last year, with double-digit growth across International, Federal, state and local end markets. Similarly, our operating profit and earnings per share improved. GAAP EPS came in at $1.52 in the fourth quarter, which was an increase of 85% over last year. In addition, adjusted earnings per share of $1.05 came in better than the top end of our Q4 guidance range of $0.95 to $1. This is an improvement over the fourth quarter of last year by 15%. The higher EPS was due to improvement in operating income, which came in at $82 million for the quarter, up 23% over last year, and adjusted income was $79 million, up 15% over last year. As Dan noted earlier, the improved operating margin in the fourth quarter was really driven by a 30% growth in CIG and the resulting CIG margin of 12.4% was an improvement of 50 basis points over the last year. The difference between our GAAP EPS of $1.52 and adjusted EPS of $1.05 was primarily due to a non-recurring tax benefit. A reconciliation is available in the release, but to point out, the tax benefit results from a release of the tax net operating loss reserve from the WYG acquisition in the fourth quarter of 2018. And because we turned the company around from perennial losses with tax losses to double-digit profitability, there’s no longer an accounting requirement to not recognize that future tax benefits. And that future tax benefit as such will provide future positive cash flows for the company. We also remain focused on generating positive operating cash flows in excess of our net income. Cash flows generated from operations for the fourth quarter totaled $78 million. For fiscal 2021, we have generated $304 million in cash flow from operations, which is ahead of last year by 16%. Our focus on working capital and cash flows has resulted in our DSO decreasing to 63 days as of the fourth quarter. This is an improvement of five days from last year at this time. Our net debt amounts to $46 million and our net debt on EBITDA was at a leverage of 0.2 times. This is with a cash position of more than $167 million, an improvement in net debt of $88 million compared to last year. Our long-term capital allocation strategy calls for a balance of investing in the growth of our business, managing the balance sheet and providing returns to our shareholders. For the year, cash from operations generated $304 million, which is equal to about $5.57 per share. This has allowed us to invest in five acquisitions over that time to advance our long-term strategy. And during the fourth quarter, we continue to provide significant returns for shareholders through dividends and share buybacks. So regarding our dividend program, during the past quarter we paid out $10.8 million in dividends and I want to announce that our Board of Directors approved our 30th consecutive dividend, which will be paid in the month of December at a rate of $0.20 per share, which is an 18% increase over the last year. Furthermore, we utilized $15 million in the fourth quarter on our stock buyback program. With the addition of the recently announced $400 million program, we had a total of $548 million remaining in our approved stock buyback programs. All told, for fiscal 2021, we returned more than $100 million to our shareholders through dividends and share buybacks. And in fiscal 2021, our strong cash flow allowed us to successfully complete these strategic acquisitions, continue to return capital to our shareholders, while still deleveraging to 0.2 times. And our strong balance sheet and available liquidity of over $900 million positions us to continue to invest in these technical capabilities and strategic growth areas, both organically and through acquisitions. I’m really pleased to share these financial results for the fourth quarter and the fiscal year with you all. Thank you for your support and I’ll turn the call back over to Dan.

Great. Thank you very much, Steve. I’d like to spend a few minutes discussing our outlook and the three major market drivers that we see today. First, the U.S. Biden administration is increasingly focusing Federal agencies on programs that are directly aligned with what we do. Second, the U.S. Congress passed with bipartisan support the landmark $1.2 trillion Infrastructure Investment and Jobs Act that was signed by the President just three days ago. And third, internationally, there’s an increase in climate change awareness that is resulting in new programs and budget commitments in the economies that we’re working in. These three market drivers are all directly in line with the work that we do for our clients. Since January 2021, the Biden administration set the priorities of the Federal Government across the multiple Federal agencies that are our clients. Their prioritization of climate change, water and environment and international development is increasingly focusing resources on the type of work that we do. U.S. Federal work for us is distributed across three primary sectors: first civilian agencies; second the Department of Defense; and third is international development. For these agencies, we are their high-end consultants. We currently have over $20 billion in contract capacity with the U.S. Federal Government that we use to support over 100 different Federal agencies and departments with their highest priority programs. We work with the United States Environmental Protection Agency to assess climate change impacts on water quality all across the United States. We support the Department of Defense in analyzing and mitigating the impacts of emerging contaminants such as PFOS and provide resilient design for their facilities. And for USAID, we work on some of their highest profile programs in ocean and coral reef protection, sustainability and forest management and clean energy development. On November 15, 2021, President Biden signed into law the Infrastructure Investment and Jobs Act, or IIJA, committing an investment of $1.2 trillion here in the United States. The act includes $550 billion in new commitments and sets out clear funding designated to the administration’s priorities of water, renewable energy, environmental restoration, and ports and waterways. These priorities are directly aligned with what we do and the funding will flow through Federal, state and local programs, and the contracts that we’re working on now. For example, we’re a leading consultant for the Army Corps of Engineers in dam design and waterway restoration. We provide our state and local clients with our number one ranked services in watershed management, water supply and desalination design. And we provide permitting, design and high voltage engineering for renewable energy programs that include hydropower, wind and solar. This landmark infrastructure act will provide new opportunities for us to work with our clients to advance the science in resilient design across the markets we serve. As we enter fiscal year 2022, there’s also an increase in climate change commitments in the major countries that we’re working in. This increased awareness is resulting in additional funding for climate adaptation, including coastal protection, water supply and clean energy. Across Canada, the United Kingdom and Australia, we’re seeing an increase in project activity, investments in resilient infrastructure and the demand for high-end solutions. By leveraging our Leading with Science approach, we provide our clients with the high-end expertise to address their programs anywhere in the world. I’d now like to present our outlook for fiscal year 2022 across all four of our client sectors and I’ll start with the U.S. Federal sector. U.S. Federal should continue to grow in the high-single digits with alignment to the administration’s priorities. We assume, however, that material increases associated with the new infrastructure act will not begin or actually hit our contracts until late fiscal year 2022 or early fiscal year 2023, and therefore, we have not included any contribution from this bill in our guidance. State and local should continue to grow at a double-digit pace for us between 10% and 15%, with expected continued strong growth in the sector, as additional projects are initiated by our clients with their increased budgets and the remaining stimulus funding that came from fiscal year 2021. This growth rate does exclude $50 million in 2021 revenues associated with extraordinary disaster response activities that we performed. U.S. Commercial is expected to be about 20% of our business and grow at a 5% to 10% rate. Growth will be supported by a continued focus on environmental restoration, much of which is driven by regulatory requirements or directives, as well as our rapidly growing renewable energy consulting and engineering practice. And for International, our International work is expected to be about a third of our business, evenly split between Government and Commercial work. Our International work is expected to grow at a 10% to 15% rate as we increase our support for sustainable infrastructure and climate change services in the key geographies of the United Kingdom, Australia and Canada. Now while I just covered the growth rates on revenue from our key client sectors, we’re also going to see in fiscal year 2022 our operating margins continue to expand. As you can see on our webcast, since 2017 we’ve expanded our operating margins by 180 basis points and 40 basis points just from fiscal year 2020 to 2021. We do anticipate an additional 40 basis points expansion to result in an 11.2% operating margin for the year of fiscal year 2022. I will say that this is going to be contributed both from a margin expansion relatively evenly between our GSG segment and our CIG segments. So it’s not just one of them that we’ll be promoting and expanding the margin within the company. We see it relatively contributed evenly from a continued margin expansion from both segments. I’d now like to present our guidance for the first quarter and for all of fiscal year 2022. Our guidance is as follows and I will start with the first quarter for 2022. Our net revenue guidance range is $630 million to $680 million, with an associated diluted earnings per share of $0.98 to $1.03. For the entire year, our net revenue guidance is for a range of $2.6 billion to $2.8 billion, with an associated earnings per share of $4.00 to $4.20. As has been our practice in the past, these guidance do include the intangible amortization; we expect that to be about $0.14 per share during fiscal year 2022. Effective tax rate in the first quarter, which is a bit different than the remainder of the year, is 17% with the remaining three quarters at 25%. We do have 54.5 million shares outstanding and this, as it’s been our practice in the past, does not include contributions from acquisitions that may take place during the year. In summary, we had an excellent fourth quarter and entirety of fiscal year 2021 setting new records across the board for Tetra Tech’s performance. As we enter fiscal year 2022, our high-end water, environment, renewable energy services are directly aligned with global priorities of all of our clients. Our all-time high backlog of $3.48 billion provides us with both excellent visibility and momentum as we’re moving into this new fiscal year. And Laura, with that, I’d like to open up the call for questions.

Our first question comes from the line of Sam England with Berenberg. You may proceed with your question.

Hi, guys. Thanks for taking the questions. The first one I had, could you talk a bit about what you’re seeing in terms of wage inflation at the moment and also staff attrition? It’s obviously a common topic in most of the professional services space at the moment and doesn’t seem to be impacting your margins at all?

Those are good questions, Sam. Today, we’ve really seen little to no impact on wage inflation. We do recognize that it has impacted portions of the economy and that issue is with respect to finding workers and increasing salaries has been an issue in some sectors, but it’s really not affected our business. Generally, we find our individuals are paid well and the decisions that they come to join Tetra Tech with respect to wage inflation, we do pay what I would consider market wages. Much of the individuals who may be more focused on salary increases are the people who’ve just entered the market. Quite often they’re associated with our early projects that are cost plus or time and materials. So in the event we do see it in the future, which I will reiterate we’ve not seen it today, we would be able to pass it on through our rates or our cost reimbursable contract vehicles that we have. With respect to attrition or turnover, we’ve also not seen that at this point. I think I’ve shared on previous calls the overall turnover rate for Tetra Tech on an annual basis actually dropped a little bit since the advent of the pandemic, roughly in March of 2020. We’ve seen it go down. We were sort of in the high 9%s collectively as a company. We’ve seen that drop to about 9%. And we’ve not seen that increase as mobility has increased with the reopening of economies and other restrictions. So we’ve really not seen that be an issue for us at this time. But we are, for sure, watching it carefully. And the one thing that we have here at Tetra Tech that we think makes employees find Tetra Tech a great destination for a lifelong career is the most interesting work that we have, that allows them to work not in a matrix or not just be a number, but actually make a difference with the type of work that they perform for our clients and that have impact on the environment in the world, particularly with climate change becoming such a prevalent topic. So we’ve actually not had much turnover, and in fact, have attracted some of the best talent in the industry who have joined us.

Okay. Great. Thanks. Then the next one I had, I was just wondering if there was anything arising from COP26 this month that you think could be a benefit to you in the longer term, particularly thinking about the International side of the business?

Well, I do think there is opportunity there. We’re going to look to see how the commitment of increased funding develops. I did have one slide that was one of the drivers for us. We have seen Canada, as I noted in the webcast presentation, increase by over $5 billion commitment to climate change finances, United Kingdom had double that number at more than $11 billion and Australia actually committed just over $20 billion, and that funding is focused on mobilizing private investments that are anticipated at an additional $80 billion. So we have seen these commitments. We do believe, similar to the Infrastructure Bill here in the United States, it’s not a light switch. The commitment doesn’t turn those dollars and projects into immediate actions within a day, a week, or a month. But we do think we’re going to see continued build and prioritization. And we’re really encouraged— it was not just the United States and the largest economies committing to this, it was a global commitment, so we think this portends very well for our future and the work that we can contribute to our clients in the future.

Okay. Great. Thanks. And maybe just one more, I was just wondering on the margin side, another strong improvement we have seen? Are you sort of rethinking the longer term margin opportunity for the business, given the way in which technology is improving the margin profile of the business or are you still sort of set on the targets you talked about in the past?

Well, I think that’s a great question. I hope that as we progress through the year, we’ll actually identify new targets that will establish out two years or three years from now. We have targeted a 13% operating income margin. If you add back some of the items that are typical for many reporting, which is adding back stock-based comp and adding back amortization, you’ll see that we’re very close to the 13% now, and in fact we are reevaluating that. There’s no question that as we build a little bit more scale, with some of the data analytics work we have, some of the subscription programs and some of the software that we’ve deployed to our clients, we do think that number will go up and I do look forward to sharing that with our shareholders in the coming quarters. We do think there’s higher ground and more margin expansion available for us and I’d like to quantify that for you here as we move through the year.

Great. Thanks very much. I’ll hand it over there.

Our next question comes from the line of Marc Riddick with Sidoti. You may proceed with your question.

Good morning. I was wondering if we could start a bit on one of the callouts that you made — mention of performing well was around high performance building and I know we’ve talked in the past about that opportunity, particularly in the U.K. I just wanted to touch a little bit on maybe what your initial views are there as far as what you’ve seen so far and what that opportunity may provide going forward?

Well, this is an interesting area and one of the areas that is high performance buildings practice now with the addition of Hoare Lea in the U.K., which adds just under 1,000 staff. We have a larger number in the United States primarily focused on the East and West Coast and a similar number in Australia. So we think we have a great geographic presence to support our clients globally, wherever they are. We noted that in 2021 and even late 2020, because of the pandemic and reevaluation of office space, we saw a slowdown in that business. It was impacted by a pullback in investment in buildings. Internally, we saw the growth rates really go up in the second half of this year, year-on-year, but it was primarily because of very depressed comparables from the prior year with the pullback. So we did see numbers that are in the mid-teens in growth. I’m much more interested to see how that will progress as we move into early 2022 where the comparables are more pre-pandemic representative. I do think the growth rates can be in the double-digit range. A lot of it is moving from just new construction to renovation and reconfiguration of buildings to allow more distancing, to allow improved industrial hygiene, to allow wellness-focused buildings and to move to net zero, both for existing buildings and new construction. I will say that collectively the margins are higher than our average Commercial activity. So I think it’s going to be one of the strongest contributors that we have. These items have been driven by our Commercial clients as priorities for their tenants and for the buildings they own. But we’ve seen an additional tailwind emerge with regulatory drivers. As part of moving to lower emissions from buildings, approximately 30% of greenhouse gas emissions are associated with physical building structures globally. This is a cornerstone area that needs to be addressed to combat increased global warming and greenhouse gas emissions. So we are seeing growth and with regulatory drivers now contributing to what was driven by client preferences, we think this is going to be a big driver. And with respect to the U.K., some of the regulatory mandates that are emerging may put it at the forefront of regional jurisdiction requirements in the world. So I think it was great timing for Hoare Lea to join us. They are a forefront, gold-standard consulting engineer that fits very well with Tetra Tech and I expect great things from them to contribute to Tetra Tech and help elevate our leading position with high performance building design.

Thank you. That’s great. And then, the last thing for me before I turn it over, I wanted to just touch a little bit on the utilization opportunities going forward. You’ve mentioned in the past the ability to use some staff across borders or certain areas of service. I would imagine that’s something that is also a draw for folks to join and stay with the company. I was wondering if you could talk a little bit about what those opportunities look like, especially now that there’s maybe a little more visibility following the signing of the act?

That’s a great question, Marc. One thing I’ve been very pleased with is our use of the virtual and electronic platforms that we put in place over the past decade. So when the pandemic came, we got the opportunity to test how well it was going to work. The ability to move individuals working from home instead of the office was an extension of what we’ve been able to do internationally. For instance, the high performance buildings example: each of our geographic centers have different specialties. Some are the best at fire protection in the world. Some are the best at lighting and low voltage. Some are the best at communication systems. Others for mechanical systems. To take these expertise across locations and allow them to work electronically regardless of where they are in the world on a project to provide our clients the best world-class outcome has been very helpful not just for quality but when things got slow in the Commercial sector, we were able to move these individuals and work on our Federal work, which picked up, or state and local. So the fungibility of many of the technical disciplines we have has given us great flexibility to respond to surges in work. For instance, Federal Government work picked up significantly while we saw a slower recovery in Commercial, and we can move those individuals across. You can see it in our margin — we don’t have stranded technical assets or labor base. We’re running at about a 70% utilization, which is an all-in calculation that counts myself, Steve Burdick, our CFO, and every individual in the company. Some refer to whether you include SG&A; we include SG&A and everything else in between — it’s around 70%. We have about a 10% to 15% surge capacity with respect to utilization that we could take to address increased revenue with the existing workforce that we have today. So if the Infrastructure Bill accelerates and hits the market quicker, we really don’t have any issue responding and taking on this work without a problem adding additional staff. We don’t need it immediately. It’s a combination of increased utilization and the use of technology that we’ve employed in our business that can handle a 10% to 15% surge and that’s without adding any additional overhead. Much of that would drop to the bottom line or be margin expansion. So that’s how we see both the utilization opportunity and how we could handle additional opportunities in the market.

That’s really helpful. Thank you.

Our next question comes from the line of Noelle Dilts with Stifel. You may proceed with your question.

Hi, guys, and congrats on the quarter.

Hi, Noelle.

I was hoping to just dig in a little bit more on the margin profile of GSG and CIG as we look forward. Dan, I know you mentioned that you anticipate pretty even improvement across those sectors and yes, that surprised me maybe a little bit just because CIG seems to have been somewhat more impacted by the pandemic. Could you dig in a little bit more into how you’re looking at the kind of margin profile looking forward for each segment? And then you touched on this a little bit with utilization, but are there any costs that we should be aware of that you see coming back into the business, like travel, et cetera, with the pandemic kind of beginning to ease a bit? Thanks.

Okay. Great. I’ll address both of those. First on margin: there’s no doubt, I originally expected that the CIG margin was going to expand or grow disproportionately to the Government Services, and in fact that is what we’ve seen over the past couple years. But I would say that with the additional use of technology in our Government Services Group — that’s been for digital water for state and local customers looking to move to digital platforms, remote monitoring and operation of plants for municipal clients — that has allowed for margin expansion. Our Federal IT practice, which I’ve spoken of in past calls and we expect to grow from its current rate at about a $300 million a year run rate up to about $500 million over the next couple years, carries a much higher margin and just the use of technology. These software applications for solving some of the engineering and consulting challenges are allowing additional expansion. So whereas a year or two ago I thought Government Services would be a bit lower, it has moved because of data and technology to the 12.5% to 13.5% range and I expect that will approach 13% to 14%. I also expect CIG margins to continue to expand, part of that driven by mix; we have shed and closed down what I would call business that moved to more commodity rates. We have used technology across both segments. For this next year, I still think there will be spotty recovery; some Commercial work will lag the recovery compared to state and local and government clients, yet I still expect margins to expand from where I came into 2021 at 11% to 12% — I think we’ll add another 50 basis points to that to the 11.5% to 12.5% range. So those are the reasons — utilization and mix affecting CIG and the Government side benefiting from technology and advanced analytics. As far as costs go, I’m not so concerned about travel and entertainment; I think those items will be relatively de minimis. One item to note is Q1 may be one of the first quarters we see an impact with respect to additional vacation time. People have been restricted from traveling and we may see a bit more travel and holiday time through the season from Thanksgiving through New Years. It’s relatively temporal and we’ve planned for that and embedded it in our guidance. I don’t see a resurgence of an indirect cost that will affect our rates materially.

Okay. That makes a lot of sense. Second question: you saw nice acceleration in U.S. Commercial in the quarter. Could you expand a bit on industrial water and what you’re seeing there in terms of activity and how you’re thinking about consulting around PFAS at this point? Thanks.

It’s a good question. I’ll start with PFAS since it’s extremely topical. PFAS has become more prominent in the news. The current EPA has come out with a timeline to initiate all the steps necessary to create a drinking water standard or MCL for PFAS. We’ve seen our Commercial clients move to complete investigations and assessments of areas where there may have been discharges or products that contained PFOS. So we’re seeing an increase in investigation and assessment. We’ve seen evaluation of changing some product usage to remove components or derivatives of PFOS or PFOA or other related chemicals. So that portion is a precursor to regulatory enforcement or regulatory-driven requirements. As for industrial water more broadly, it has been relatively stable. Some discretionary work has picked up, but much of our industrial water work is regulatory-driven to meet discharge requirements or pretreatment thresholds, so it’s been stable through the pandemic. I do expect that as PFAS moves toward regulatory standards, which we expect perhaps by 2023 based on current EPA timelines, municipal water utilities will have to meet PFAS standards and the work to evaluate and design treatment will begin soon. We already installed one of the largest PFAS treatment systems in Orange County, California, in anticipation of future regulation. So we’re seeing it move from something coming in the future to something that’s here now.

Our next question comes from the line of Sean Eastman with KeyBanc Capital Markets. You may proceed with your question.

Hi, team. Thanks for taking my questions. I just wanted to come back to the IIJA. If you look at the core water funding line items that Tetra Tech plays in, what type of percentage increases are you seeing in this legislation? I’m curious if you can provide any context for this bill.

I can point you to a slide in our presentation, but to summarize some areas we see as directly addressable: water infrastructure resilience — there’s a significant increase, and much of this funding is new. For some categories the increase is from essentially zero to a new level, such as $47 billion for certain climate resilience programs. We outlined over $200 billion of what we think are directly addressable new funding items in our presentation today, including over $100 billion for water infrastructure resilience in various forms. Our power infrastructure funding is significant, much of it for grid and high-voltage engineering and interconnections for renewable energy, and we have more than 500 high-voltage electrical engineers within Tetra Tech. Environmental restoration, which includes Superfund-type activities, received an additional $20 billion. Ports and waterways contaminated sediments have well over $10 billion. These are areas we’re focused on and should keep us busy for an extended period. Importantly, this is multiyear funding that will be deployed over five to ten years, not an immediate one-year surge. So it provides extended tailwinds for work in our expertise areas.

Okay. Very helpful. Given your excitement there, it’s interesting your comments emphasize flexibility in current staffing rather than immediate ramping. What exactly do you want to see before you start hiring aggressively?

That’s a great question. Our practice at Tetra Tech is to staff to the work, not to staff in anticipation of work. We won’t add 10% staff in advance; rather we’ll commit staffing as projects come on. We can handle a significant increase today with existing staff. For example, through utilization improvements and technology, we believe we can handle roughly a 10% to 15% surge without adding significant overhead. On a base of roughly $3 billion, that could be $450 million—rounding to $500 million—in additional revenue capacity with the workforce and technologies we have today. Running at that higher level isn’t sustainable forever, so as new work converts to longer-term assignments we would then add staff to bring utilization back to long-term sustainable levels. That’s the practice we’ve used and expect to continue.

Very helpful. One more: you called for 40 basis points of margin expansion in guidance. How much of that is utilization versus higher-margin mix? Looking out, as the IIJA and international programs deploy, do you see accelerated penetration of advanced analytics and digital solutions creating an opportunity to further shift mix and expand margins?

Yes. For the 40 basis points we guided, about half is from utilization or more work and the other half is from mix and use of technology. Utilization can only contribute so much, so structural margin improvement will come from technology and mix changes across both Commercial and Government businesses. I expect that as we deploy more analytics and digital solutions, that will be a larger driver of margin expansion in the future.

Our next question comes from the line of Andy Wittmann with Baird. You may proceed with your question.

Hey, Dan. Thanks for taking my question. I had a question on the USAID business.

Yeah.

You’ve previously talked about how this business when nobody was traveling did suffer some declines because of the pandemic. I was just wondering, how back to work are your people in this business in particular and how much of the revenue uplift is baked into the 2022 guidance from USAID?

That’s a really good question. If you go back to our last quarterly call, I expected USAID to be one of the biggest drivers for our Federal growth. In the quarter we actually saw International development work relatively flat. Our Federal growth was primarily driven by civilian and defense. Specifically, at the very end of our fourth quarter in August and early September we saw the U.S. exit from Afghanistan. Tetra Tech was one of the largest international development support contractors for USAID and other agencies in Afghanistan, supporting infrastructure development, water supply, flood protection, sanitation, reliable energy from renewable sources — we were working on all of those programs. That business went from roughly $50 million revenue contribution to the company in the prior 12 months down to nearly zero quickly as personnel and contractors left. We have continued some work supporting refugees and other ancillary items, but that single program caused us to revise our outlook for USAID. In our prior view we had expected stronger growth; now with that program gone, USAID revenue looks flattish in 2022. Excluding Afghanistan, the rest of Federal work is growing quite well at 10% to 15%. International development overall has also been affected by travel restrictions and local lockdowns related to variants, causing more of a fit-and-start recovery. So the single Afghanistan program materially impacted the guidance for USAID.

That’s really helpful context. Thank you. My second question is about the buyback. You are in the enviable position of having free cash flow yield of the stock likely below your marginal cost of debt, so EPS accretion isn’t the only objective. How is the Board thinking about buybacks given this, and what is the posture toward repurchases?

It is a high-class problem to generate sufficient cash to be essentially net debt-free and carry cash on the balance sheet. Steve outlined our approach: we’re committed to returning capital to shareholders through buybacks and dividends, and we’ve balanced that with investing in acquisitions that advance our strategy. We increased our buyback authorization with the Board in early October by $400 million, bringing available buyback capacity to a sizable level. The goal of buybacks is not solely EPS accretion; we want to offset dilution from acquisitions and have the balance sheet work as hard as our engineers and scientists to make the company successful. We will deploy buybacks, potentially more aggressively, but the top priority for cash deployment is strategic, best-in-class acquisitions that add technology and expertise to differentiate the company. We’re selective and focused on becoming better, not just bigger.

Great. Thanks a lot. Have a good day, guys.

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

Thank you very much, Laura. I really appreciate it. And thank you all for your insights and questions and interest in Tetra Tech and for joining us today. We’re really excited here at Tetra Tech and I think one comment was you heard the enthusiasm. I’ll tell you the enthusiasm has come from the employees and the project managers here at Tetra Tech based on the work that we’re working on today. And so I really look forward to speaking to you at the end of this first quarter and sharing with you how we started fiscal year 2022. So thanks for your support. Have a great, safe rest of your day and weekend. Thank you.

Ladies and gentlemen, this concludes our conference for today. Thank you for all your participation. Have a great rest of your day. All parties may disconnect now.