Earnings Call Transcript - TTEK Q1 2024

Operator, Operator

Good morning, and thank you for joining the Tetra Tech Earnings Call. 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 a 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; Steve Burdick, Chief Financial Officer; Jill Hudkins President; and Leslie Shoemaker, Chief Sustainability Officer. They will provide a brief overview of the results and then we'll open the call for questions. I would like to direct your attention to the safe harbor statement in today's presentation. Today's discussion contains forward-looking statements about future business 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 undertakes 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 all that 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 now like to turn the call over to Dan Batrack. Please go ahead Mr. Batrack.

Dan Batrack, CEO

Thank you very much, Paul, and good morning. Welcome to our first quarter earnings conference call for fiscal year 2024. We’re excited to share Tetra Tech's first quarter results and discuss how we're building on our record-breaking 2023 performance. We recently celebrated one year since the RPS group joined us, and their transition into Tetra Tech has been very successful. As a global leader in high-end water and environmental consulting, we have a strong future outlook. This success reflects our strategy focused on the full water cycle, which you'll hear more about today from Jill Hudkins and Leslie Shoemaker. Our science-led approach is supported by our skilled workforce of scientists, data analysts, and engineers who use our Tetra Tech Delta digital tools in their everyday work. Our Delta technologies encompass analytic tools that set us apart, along with software and applications that our clients are subscribing to. Given our strong first quarter performance and our optimistic outlook for the remaining fiscal year, we have raised our full-year guidance for net revenue and increased our earnings per share guidance to indicate a 20% growth rate year-over-year. While we report our financials based on US GAAP, we've included some IFR metrics for our international investors' reference. I’ll start with an overview of the quarter. Steve Burdick, our Chief Financial Officer, will discuss our financial performance and capital allocation strategy. Jill Hudkins and Dr. Leslie Shoemaker will provide an overview of our distinct water services. Our first quarter results continue to build on last year’s record performance. In the first quarter of fiscal year 2024, our net revenue rose 38% to $1.02 billion, reflecting a double-digit organic growth rate. Our EBITDA increased 32% to $131 million, leading to an earnings per share record of $1.40 for this quarter. Additionally, we achieved strong new orders totaling $1.2 billion, resulting in our largest first quarter backlog of $4.74 billion, up 24% from last year. The integration of RPS with Tetra Tech is proceeding very well, and I'm pleased to report that in less than a year, RPS's EBITDA margin has exceeded 10%, rising more than 600 basis points since they joined us on January 23 of last year. Now, I’d like to give you an overview of our performance by end customers. In the first quarter, revenue grew by double digits across all four sectors. Revenue from our US Federal clients increased 49% year-over-year, driven largely by the Department of Defense and USAID Resiliency Consulting. Our state and local revenue grew organically by approximately 16%, primarily due to our work in water supply and treatment, which Jill and Leslie will elaborate on later. The US Commercial sector saw a revenue increase of around 10%, driven by infrastructure decarbonization, environmental permitting, and energy transition services. Meanwhile, our international revenue surged by 74%. The international operations, along with RPS, are expanding our water and clean energy services, particularly in the United Kingdom and Australia. Moving on to our performance by segment, in the first quarter, the Government Services Group, or GSG segment, grew 25% from last year to $443 million, achieving a strong 14.3% margin. Key growth drivers included inland waterways, coastal flood protection programs, and ongoing support for USA Energy programs. It's worth noting that last year's first quarter was exceptionally busy due to responses to Hurricane Ian, which resulted in margins exceeding 17%. In our Commercial and International Group, or CIG segment, we grew our net revenue by 49%, yielding a 12.5% margin for the quarter. While RPS significantly contributed to revenue growth, we achieved about a 10% organic growth in the CIG segment. Next, I’d like to discuss our backlog, which is our key forward-looking indicator. As I have mentioned in previous quarterly calls, we report backlog based on signed contracts, funded projects, and authorization received from clients—all of which must be in place before we include any dollars in our backlog. We do not include future order estimates in backlog despite having over $25 billion in contract capacity. Significant contract wins this quarter included the $125 million United Utilities program, an $800 million US Army Corp of Engineers PFAS remediation contract, and a $450 million Great Lakes environmental restoration project. Overall, we booked approximately $1.2 billion in orders in the first quarter of 2024, resulting in a backlog of $4.74 billion, a 24% increase from last year, marking a new first quarter high. Now, I will hand it over to Steve Burdick, our Chief Financial Officer, to discuss more details regarding our financials from the first quarter.

Steve Burdick, CFO

Thank you, Dan. So, I'd like to now provide an update on our working capital and cash flow for the first quarter. So, cash flows generated from operations for the first quarter were positive for the trailing 12 months totaled $353 million, which is up 26% year-over-year. Now, over the same 12 months cash flows exceeded net income by more than 152% and as I further thought about this key metric, I actually researched our historical financial results and found that our cash flow from operations has exceeded our net income every year for the last two decades. And I got to say I'm not aware of many other companies who have that same track record. So, I'm really proud of what Tetra Tech has been able to do. Our focus on working capital and cash flows has resulted in our DSO, reflecting an industry-leading standard of 55 days versus the industry average at over 80 days. This first quarter results are an improvement of six days over last year. And we consider this high watermark for working capital to be sustainable over the long-term as we continue to make cash flows from operations a priority. The lower DSO metric also provides significant insight into our core business as it reflects the outstanding work that our project managers perform relative to high-quality projects and highly satisfied clients in our broad portfolio across all of our end markets and all of our geographies. Our net debt amounted to $746 million and the net debt on EBITDA was a leverage of 1.5 times, well within our target and much lower than when we acquired RPS a year ago. In addition we have total cash positions of about $199 million at the end of the quarter. So, as we present here today, we continue to execute on high-quality operating results with strong cash flows, industry-leading metrics just mentioned. For those following along in the presentation, I'd like to now present our capital allocation overview for 2024. We have a significant amount in liquidity available to invest in organic and acquisitive priorities and we have a well-balanced mix to both fixed and floating rate debt to mitigate interest rate risk as we look to invest in key strategic priorities. We have a strong pipeline of acquisitions, which are aligned towards technical leaders, especially in the water and environmental spaces where we have led the market for the last 20 years. And regarding our dividend program, I want to announce that our Board of Directors approved a $0.26 dividend, which is a 13% increase year-over-year to be paid in the second quarter and this is our 35th consecutive quarterly dividend with double-digit increases in the amount paid. As we revise our capital structure in the last year to take advantage of the credit market to really support our financing means, I want to remind our shareholders that we do still have available a significant portion of the $400 million buyback plan that was approved by our Board back in 2022, for future consideration as part of our capital allocation strategy going forward. I'm really pleased to share these results for the quarter with you all. And I want to thank you for your support. I will now hand the call over to Leslie Shoemaker, to discuss Tetra Tech's differentiated leadership in the Water and Environmental sector.

Leslie Shoemaker, Chief Sustainability Officer

Thank you, Steve. Hello. My name is Leslie Shoemaker. And I've spent over 30 years with Tetra Tech in the research and development of Watershed Simulation, Watershed Protection studies and the advancement of our Tetra Tech Delta offerings across the company. Tetra Tech's pure-play focus on water and environment has differentiated us from the very beginning. Since our founding in 1966, we have developed first-of-a-kind solutions for the entire water cycle and then provided our clients with practical implementation at scale. Tetra Tech has set the standard for water analytics from the earliest simulation of flood protection structures to our industry-leading models of watershed behavior that have protected over 100,000 critical water bodies worldwide. It is this work, leading with science and scaling solutions across government and commercial clients that has led to our rapid growth and the number one ranking that Tetra Tech has held in water for 20 consecutive years as well as number one rankings in water treatment, hydro and environment. So Tetra Tech works across the full water cycle, in four major phases. We think of it as Research and Development, followed by Climate and Watershed work, Water Treatment and then Flood Protection and Navigation. Our water work represents approximately 85% of our annual revenue or approximately $4.25 billion of revenue distributed across our four distinct water cycle phases. In the Research and Development phase the smallest in revenue but the most important in the work that we do working side-by-side with our clients to investigate new contaminants unlock the impact of climate on water quality and even decipher the root causes of degradation of essential water bodies. It's this research that actually helps drive us to new opportunities and new research that can provide the Climate and Watershed phase with the new ideas. In the Climate and Watershed phase at $2 billion in revenue a year by far the largest base of our services, we scale these ideas into practical solutions. Applying our Analytical and Software Solutions on large regional programs like, The Chesapeake Bay, The Great Lakes and, The Gulf of Mexico as well as essential water bodies worldwide. Now increasing variability in climate has also further increased the demand for our risk-based analysis of watershed behavior and the science underpinning specific design solutions to adapt to these changes. Our leading with science approach has also built our Tetra Tech Delta solutions that differentiate us. It's the ability to leverage new technology and apply it at scale that has been the hallmark of Tetra Tech's success. Today we are scaling water solutions by providing new data platforms that make the application of Artificial Intelligence practical and useful in managing water-related risks. The Research and Development we do and the Scalable Solutions we provide are the flywheel of our success in the water market. I'll now turn it over to Jill to speak to the other phases of the water cycle.

Jill Hudkins, President

Thank you, Leslie. Although you may primarily know me as Tetra Tech's President, I have spent most of my 25 years with Tetra Tech, designing advanced water treatment facilities. I've led the design of 15 desalination programs and developed a deep passion for our digital water services using data and digital technologies to create value for our clients. Tetra Tech is the market leader with $1 billion in water supply and treatment revenue for municipal, commercial and federal clients. We provide high-end engineering and consulting services for advanced treatment for drinking water, optimization of sewer networks and water reuse. Tetra Tech designs first-of-the-kind water treatment programs for PFAS removal, desalination and potable reuse including our award-winning Orange County Water District PFAS program, which includes the largest PFAS treatment facility of its kind in the US. Continuing with the water cycle, Tetra Tech is the industry leader with $1 billion in flood protection and navigation revenue for state, local and federal clients. This phase of our water work includes planning, permitting and design for dams, levees and locks including Tetra Tech's design of the largest search barrier ever constructed by the Army Corps of Engineers. We are also a market leader for designing solutions that help communities adapt to the increased frequency of flood events. Tetra Tech is the leader in all four phases of the water cycle, while many of our competitors perform work that is limited to only one or two parts of the water cycle. When we discuss market drivers for the water cycle, a lot of airtime has been given to new federal infrastructure funding from the IIJA, IRA and the CHIPS and Science Act. Clients across all of our end markets are benefiting from multiple state, local and commercial funding opportunities, sometimes augmented by federal government funding like the IIJA. Leslie spoke to Tetra Tech's early water cycle position in client-funded research and development. Our federal clients such as the Department of Defense, NASA and NOAA distribute more than $100 billion in annual funding for research and development. Market drivers for Tetra Tech watershed protection and restoration projects include an estimated $380 billion spend for emerging contaminant removal from global watersheds, as well as site-specific environmental restoration programs such as the estimated $1.8 billion cleanup program for the Passaic River. Tetra Tech's water utility clients fund their programs through a combination of established sources. These include user fee revenues, debt financing and tax receipts. These are sometimes supplemented by federal funding or loan programs. For example, the £96 billion U.K. water AMP 8 program will be funded through user fee revenues and debt financing. While the $1 billion Texas Water Fund has been funded 100% through state appropriation. Climate change and multiple $1 billion extreme storm events continue to drive demand for Tetra Tech's high-end flood protection and navigation services. The state of Florida estimates a $4 billion spend to protect Florida's coast from sea level rise and the state of California is investing $1.5 billion for modernizing the ports of Los Angeles and Long Beach. And now I'd like to turn the presentation back to Dan.

Dan Batrack, CEO

Thank you, Jill and Leslie, for discussing our position and differentiation in the water market, particularly regarding the entire water cycle. As we approach the election cycle in the United States, we have received several questions about how Tetra Tech may be affected by the upcoming presidential election in November. Tetra Tech's federal clients account for about 30% of our total revenue, distributed evenly across the Department of Defense, civilian agencies, and the US State Department. I want to briefly outline each of these components and how we anticipate they may be influenced by the election outcome. First, roughly 10% of our revenue from defense is expected to see stable growth under the current administration or an increase if a Republican administration takes office, as this area typically holds high priority for both political parties due to its importance in national security. The second 10% comes from our civilian agency programs, which are essential services—like those we provide to the Federal Aviation Administration. These services require consistent funding and have bipartisan support, leading us to believe there will be no adverse impact on growth in our civilian programs. USAID or the US State Department may experience some impact from an administrative shift, but historically, the timing of such impact has been mitigated by the long-term nature of our contracts, which typically last five to ten years and align with national security interests, making them less discretionary. As for the remaining 70% of our revenue not tied to the federal government, it comprises commercial, state and local, and international work, which we believe will remain largely unaffected by the election outcome. Therefore, regardless of the elected administration, we project that Tetra Tech’s federal revenue will rise collectively, either through continued funding increases under a Democratic administration or from heightened outsourcing of government services if a Republican administration comes to power. Now, I would like to present our guidance for the second quarter and the updated guidance for fiscal year 2024. For the second quarter of fiscal year 2024, we project net revenue in the range of $990 million to $1.04 billion, with diluted earnings per share between $1.25 to $1.35. For the entire year, our revised net revenue guidance is $4.15 billion to $4.3 billion, with associated diluted earnings per share between $5.90 to $6.20. At the midpoint, this represents a net revenue increase of 13% compared to the record high of fiscal year 2023 and a 19% increase over our GAAP earnings from 2023. We have provided assumptions regarding intangible amortization and a breakdown of charges in our presentation, estimating a total of $44 million or $0.59 per share for the entire year, a 27% effective tax rate, and approximately 54 million diluted shares outstanding. In conclusion, as we begin fiscal year 2024, we see strong demand for our science-driven services in both the water and environmental markets. Our first quarter results have set new records in terms of revenue and profitability, and our strategic focus on the pure-play water and environmental services markets continues to yield strong margins and long-term growth. I am pleased to share that we have raised our entire fiscal year 2024 guidance for both net revenue and earnings per share. Now, I would like to open the call for questions.

Operator, Operator

The question-and-answer session will now begin. Our first question is from Tim Mulrooney with William Blair. Please proceed with your question.

Tim Mulrooney, Analyst

Yeah. Good morning, everybody. Thank you for taking my questions. I have two this morning on the guide. The first one, it looks like you raised the midpoint of your full year guidance range for net revenue by about $75 million. We noticed you beat the first quarter by about $40 million. So you raised the full year by more than you beat the first quarter. Can you just talk about what's driving that confidence? What businesses are seeing strong demand or that you're excited about as you head into 2024?

Dan Batrack, CEO

Great question, Tim, and thank you for noticing that our raise was much more than our beat in the first quarter. I would like to point out that, a few of the examples, I gave in our backlog commentary that had added to our contract capacity of $25 billion. I commented on our new win with the Army Corps of Engineers of this $800 million, I commented on our UK single award at over $100 million. And in fact, we included on our backlog sheet in the presentation, a full tabulation of new awards. And what I would comment on those based on the way that Tetra Tech tracks and reports its backlog, these are new contract wins that have gone into our contract capacity and yet don't even show up in our backlog or revenue. And the first quarter, while we did book $1.2 billion in new orders that were added to our backlog, I'll tell you, it's not nearly representative of how much new work we won in the quarter. And so a number of these new very large programs we won really across the United States, with many programs with the federal government, state, local and others, both in the UK and Australia being the primary large awards, are going to begin contributing to revenue as we move through the rest of the year. So, I think that with the new records of our backlog hitting new all-time high is pretty clear to us, particularly with single awards that are going to be executed solely by Tetra Tech for these clients and the new synergies that we're seeing with RPS. We see that things are going to continue to build based on actual awards, not just a feeling or some insight that things are getting better. We've got tangible awards, new clients and new programs starting up that all begin to contribute as we move through the year. So, it's really those items that have come together to cause us to raise the outlook for the year even more than we had in the first quarter. And by the way, you see the growth rates in the upper 30%. Just adding those numbers, we felt it was even better than that.

Tim Mulrooney, Analyst

Thank you for the clarity, Dan. Regarding the guidance, it seems you've increased the full year EPS guidance by approximately $0.15 at the midpoint, which exceeds our expectations based on the revenue guidance increase. This suggests that you anticipate stronger margins this year. Could you elaborate on the types of higher-margin projects you are undertaking that may be contributing to this guidance?

Dan Batrack, CEO

That's a great question. If you've been following Tetra Tech for several years, you've likely noticed our ongoing efforts to enhance our business by focusing more on the initial stages of the services we offer to clients. While we often mention our work in consulting and engineering, I would emphasize the significant consulting aspect, as our work is increasingly led by our scientists, technical professionals, and engineers. This is not just general engineering support; it is more about consulting and being thought leaders, which enables us to command higher billing rates for the unique expertise we possess in various markets. Our average charge-out rates are rising as we shift towards these earlier stages, and it's important to note that this does not mean we're becoming more expensive; rather, we're delivering greater value to clients in their approaches, evaluations, and program outcomes. Consequently, our average billing rate is increasing, and we are providing more differentiated services that come with slightly higher margins. Regarding our internal digital tools used in the water cycle, as mentioned by Leslie and Jill, our ability to work more efficiently on a fixed-price basis is translating into improved margins, which is beneficial and contributing significantly. Lastly, I received some good news recently about our subscription services, which have seen an increase. Although we haven't actively marketed these, clients are subscribing to our services through our website for various software packages related to watershed management and water treatment system optimization. While still in the early stages, this growth in subscription revenues is contributing to the margin expansion reflected in our EPS increase for this year.

Tim Mulrooney, Analyst

That's interesting. I know that you're excited to see that gain some traction, because it's harder at first to gain traction but then it builds on itself. I'll let others ask questions now, but I'll get back in the queue later. Thank you for your time.

Dan Batrack, CEO

Thank you very much, Tim.

Operator, Operator

Thank you. Our next question is from Sangita Jain with KeyBanc Capital Markets. Please proceed with your question.

Sangita Jain, Analyst

Thank you for taking my question. Dan, I wanted to ask you about the recent AMP 8 and PFAS awards this quarter. Can you provide some insights on how you see the pace of these awards developing? Are you still anticipating a gradual increase this year with a peak next year, or is it progressing a bit more quickly?

Dan Batrack, CEO

Well, I'll make a comment overall regarding a peak next year or late next year. We have spoken and I think both I've spoken and I know Jill did on a previous quarterly call that we expect the US stimulus programs particularly IIJA to see a peak probably in late 2025, so a little over a year from now. But AMP 8 is a United Kingdom or UK wide asset management program for their water utilities and it's really unrelated to a peak of next year. So we see that this is going to continue the contracting for their AMP 8 cycle, which is a five-year cycle. It's just beginning here shortly. And maybe I can just have Jill is tracking this quite closely both on IIJA, but more importantly I'm really pleased to share with you that in the presentation to the client for United Utilities, Jill, herself was over there all the way up until essentially Christmas Eve, the Friday before Christmas, participating in our presentation and making commitments to in this case our UK clients of United Utilities that will bring the best of all our RPS has and the more than 50 years of technical leadership we hold here in the US and bring all of those lessons learned to the UK. And certainly I think it's just the first of I would hope many different successes we have under the AMP program, but maybe I can have Jill say a few words to this.

Jill Hudkins, President

Yeah. Thanks Dan. And great question Sangita on AMP 8 UK water. Although the AMP 8 funding cycle officially starts in April 2025 what we're seeing is multiple UK water clients going out for procurement to be ready and start the planning for the AMP 8 water cycle. A lot of our existing contracts or frameworks as they call them in the UK are also being utilized to start the planning or acceleration for the historic AMP 8 UK water spend, which I mentioned in my remarks is £96 billion, which is two times, the spend from AMP 7. So we're very excited about bringing the resources and capabilities and client relationships of RPS along with Tetra Tech's water industry leadership in both wastewater overflow reductions and high-end water management services that Leslie and I talked about earlier on the call.

Sangita Jain, Analyst

Great. That's very helpful. Thank you. If I can ask one more. Dan, thank you for the breakdown on the elections and the possible outcomes. But if I can ask a more shorter term question. It looks like we've avoided a shutdown, but there is still not that much clarity on passing a full budget. So does this continuation of a short-term CR situation hurt your line of sight into funding opportunities? Like at what point do we start to worry over the next several months if we don't get a full budget? Thank you.

Dan Batrack, CEO

That's a great question. I've had to address this a few times in recent years due to some challenges in the funding process. At Tetra Tech, I think a continuing resolution is a favorable outcome. It essentially means we are agreeing to maintain funding at the level from the previous year, which was quite high. This allows the administration to push forward their priorities, particularly those focused on a clean environment, clean water, climate change mitigation, and other related areas that are beneficial for us. Ideally, I would prefer one continuing resolution until the end of the fiscal year, rather than multiple ones. I don't believe a CR has negative implications for us; in fact, it tends to be quite advantageous. Each continuation comes with its own challenges, but I don’t see it as an issue. Reflecting on past shutdowns, we’ve become much better at ensuring we have funding in place and can work remotely when necessary. Therefore, any short-term impact from a potential shutdown would likely be minimal on our ongoing activities. While I wouldn't advocate for a shutdown, we are prepared and knowledgeable about how such situations affect our operations.

Sangita Jain, Analyst

Great. Thanks so much. I'm going to turn it back over to others to ask questions.

Dan Batrack, CEO

Great. Thank you very much, Sangita.

Operator, Operator

Thank you. Our next question is from Sabahat Khan with RBC Capital Markets. Please proceed with your question.

Sabahat Khan, Analyst

Thank you, and good morning. You provided some insights earlier, as well as in the materials regarding the RPS integration and the margin improvement you've experienced. Can you discuss some of the key factors contributing to the 600 basis points of margin improvement? Additionally, what are some of the larger areas for potential growth that could enhance that margin profile over the next one to two years? Lastly, I would like to hear about the long-term opportunities, as it has been mentioned that RPS might achieve even higher margins than the legacy aspect. I'd like to understand the margin outlook for the acquired platform in both the near to medium term and the long term.

Dan Batrack, CEO

Sure. I'll discuss the near, medium, and long-term phases. Phase 1, which encompasses the last year, focused on reorganizing their cost structure to achieve cost synergies. This mainly involved transitioning back-office operations to more efficient ERP systems, particularly moving to Tetra Tech. As a result, we saw an improvement of 600 basis points in their margin, increasing from around 2% to 4% up to 10% at the start of this year. This phase primarily involved about two-thirds of their operations, mainly in the U.K. and a small portion in the U.S., being integrated into our ERP systems. We're almost done with this phase on the cost side. Phase 2 involves having them operate on our systems, which will allow them to align their programs more closely with Tetra Tech's practices and refine their portfolio of contracts. I've previously mentioned that we can gain from shedding less profitable contracts that also carry higher risks. Since acquiring them, RPS's revenue has been relatively stable, and in some areas, it has declined. However, the EBITDA contributions and margins have significantly increased, reflecting our strategy. We aim to focus on high-end differentiated services that will generate higher margins. While we haven't yet seen revenue growth, we have experienced new contract wins that have boosted our guidance for both revenue and profit. This year, we anticipate enhancing their operations to further increase margins from 10% to 12% by year-end, and we are already seeing promising progress in the first quarter. Moving on to Phase 3, this is where we will collaborate with RPS as a unified company. We plan to advance toward higher-end services. RPS is well-positioned as they typically don't engage in lower-margin, cost-plus work with the federal government, which has affected our margins. They focus more on consulting, and I believe this segment will grow, especially in their advisory business in Australia, led by Meegan Sullivan, who is a top industry leader in that region. I expect this will result in margins significantly exceeding 15%, providing substantial support to Tetra Tech's overall margins in Phase 3. This expectation also includes advancements from Tetra Tech's Delta technologies and subscription services. Ultimately, I believe that by 2025, RPS will make substantial contributions to the company.

Sabahat Khan, Analyst

Thanks for that. Could you provide some insight into how utilization is trending for the combined business? Are there opportunities to improve utilization at RPS? I’d like to understand how this is progressing for the combined platform and whether you are on track with your initial plans for the combined business.

Dan Batrack, CEO

I want to emphasize that operationally, we do not separate operations from the overall activity at legacy Tetra Tech. When we refer to the 70% target, it reflects the entire company's payroll and the systems we have established. In RPS, those who have transitioned to Tetra Tech's ERP system, which we call Tetra links, have experienced an increase in utilization, nearing Tetra Tech's level. However, there's still about a third of the transition left to complete. Currently, their utilization remains lower because their systems are not as advanced as Tetra Tech's and they are not on a unified common system. This results in numerous integration activities that hinder utilization. We've observed RPS's utilization rising towards Tetra Tech's level throughout fiscal year 2024 as we continue to move the remainder of the company onto our platforms. Tetra Tech's utilization remains high, around 70% of what we consider legacy Tetra Tech. Notably, the two-thirds of RPS that has transitioned to our systems typically reflects a 13% to 14% EBITDA margin on a GAAP basis. I want to make it clear that if you are considering international standards, using IFRS and NSR would generally adjust our figures by about 600 basis points. I don't expect RPS to reach full utilization until the end of this year when the final 30% of their business is fully migrated to our ERP systems. This outlines our timeline and the transition regarding utilization.

Sabahat Khan, Analyst

Okay. Great. And if I could sneak in one more here. You alluded to some of the progress you're making with the digital subscription model and that tracking better than expected. Can you maybe just share some thoughts on sort of your outlook or strategy for that business. How big or meaningful, could that be over the next two three years? And maybe what are you doing to support its growth? You indicated you're not doing much marketing now, but maybe just a plan for the next few years if you can.

Dan Batrack, CEO

I've talked to some investors, and they mentioned that we're clearly not a software company, which is true. However, the work we do for our clients involves developing software applications that Leslie Shoemaker discussed regarding funding for research, development, and client-funded software applications. We typically retain the intellectual property, patents, trademarks, and the technology itself. The growth has become organic, progressing even without our active efforts. It’s crucial for us to further develop our software products and establish a number of anchor clients that we can use as reference points while we expand our offerings to additional clients. Interestingly, some of our anchor clients have recommended us to others in the industry, including state and local clients, which has boosted subscriptions without us actively marketing. It feels as though we're catching up with our own growth. In terms of recurring subscriptions and related metrics, I expect this segment to contribute about 5% to 10% of our overall earnings or EBITDA, translating to roughly $50 million to $100 million in revenue, with around a 50% margin. Selling the first 1,000 subscriptions can be more challenging than selling the subsequent 100,000, and we're currently navigating this initial phase. I anticipate we’ll need one to two years before we can fully disclose and track all metrics related to this part of the business. Ideally, I would like it to be a distinct segment with transparent financial performance metrics or key performance indicators in the industry. While I don't expect full disclosure in 2024, I hope we can achieve that by late 2025, and if we do it sooner, it will be due to the organic growth we're experiencing.

Sabahat Khan, Analyst

Okay. Thanks very much for all the color.

Dan Batrack, CEO

Thanks very much Sabahat.

Operator, Operator

Thank you. Our next question is from Tate Sullivan with Maxim Group. Please proceed with your question.

Tate Sullivan, Analyst

Great. Thanks for your comments, Dan. I have a question for Jill about the PFAS treatment facility in the US. Was it the Orange County facility, and can you elaborate on the PFAS opportunity in terms of how many of your orders have started to receive funding?

Jill Hudkins, President

Sure. Addressing my comments, the Orange County Water District program encompasses various water treatment programs and facilities, including the largest facility in the U.S. This positions us at the forefront of municipal water opportunities, showcasing our thought leadership and expertise. Regarding our PFAS revenues, we have historically generated between $50 million and $60 million annually from PFAS projects, primarily with the Department of Defense, focusing on the characterization and remediation of water bodies. As we anticipate finalizing federal regulations, we expect to see increasing opportunities for state and local facilities, similar to the Orange County Water District program.

Tate Sullivan, Analyst

Is the US PFAS market still estimated at about $200 billion, and does that contribute to the watershed management opportunity of $380 billion?

Jill Hudkins, President

Yes. Well, in the $380 billion refers to multiple emerging compounds. Tetra Tech is not just a leader on PFAS, but also in microplastics and pharmaceuticals and other emerging contaminants. So, the $380 billion was the combination of multiple emerging compounds and the market that we see the you're correct the $200 billion referred to what we see as the PFAS market not just for watershed protection and enhancement but also for future treatment opportunities on the municipal side.

Tate Sullivan, Analyst

Is this opportunity moving faster than you expected or sort of as you expected? Or any delays in getting PFAS work, if you could summarize it?

Jill Hudkins, President

I would say as expected as Dan's commented on prior calls, as well as myself which is having spent my whole career in the water treatment arena, when our clients move forward on programs once there is a final regulation. And so until there is a final US EPA regulation for PFAS, there's going to be continued conversation about the levels that utilities will be requested or required to treat to. And so I think it's as expected. It's going to mostly be on the watershed side for characterization until the final US EPA regulations are established. And there will also be another at that point another 24 months typically for compliance.

Tate Sullivan, Analyst

Okay. Great. Thank you. And just one more question, either Dan or Steve. You mentioned in the press release about the repurchase capacity. How are you thinking about repurchases compared to acquisitions at this point, a year after RPS?

Steve Burdick, CFO

Yes. No, I think as many people noted and as we explained a little over 1.5 years ago as we were preparing for and figuring out the financing to do or to complete RPS, we put our share repurchases on hold. And as we've brought our leverage down to kind of the midpoint between our range, we're starting to once again think about, does that make sense from a capital allocation a long-term value for our shareholders. So that is something that we are starting to think about, now that we've paid that down quite a bit. And so that's why that's there.

Tate Sullivan, Analyst

Okay. Great. Thank you all.

Steve Burdick, CFO

Thank you, Tate.

Operator, Operator

Thank you. Our next question is from Andy Wittmann with Robert W. Baird. Please proceed with your question.

Andy Wittmann, Analyst

Great. Thanks. Good morning. Thank you for taking our question. I guess I'll just build on that last one. And Dan, you mentioned that the M&A pipeline is strong. I'm just curious, as you look at the opportunities that are in that pipeline, are there larger deals in there that you would consider doing? I guess I asked that because, I guess it's an implication if RPS is far enough along now that you're willing to do something else bigger that would take management time the way larger deals can typically do.

Dan Batrack, CEO

That's a great question. We've built a strong history of acquiring companies with employee counts ranging from 100 to 1,000. Typically, we aim for one to three acquisitions a year within that size range. We have also made a few larger acquisitions over the years, such as the coffee company in Australia and another in the UK, both with several thousand employees. These larger acquisitions have occurred roughly every two to three years. There are additional companies that fit this profile. I believe that the amount of management time required for RPS has been minimal in relation to overall operations. The integration process has progressed smoothly, and those involved are collaborating well, almost as if they have been part of the organization for a long time. If a company of RPS's size or larger, generating around $1 billion in annual revenue, becomes available, we are prepared to proceed, and I assure you there would be no hesitation from management in handling the integration and boosting its success compared to when it operated independently. However, for any potential acquisition, three criteria must be met: first, it has to align with our strategic direction, meaning we won’t venture into unrelated fields like shoe manufacturing or competing with SpaceX. We intend to maintain our leadership in water, environment, and sustainable infrastructure while enhancing our top rank. The second criterion is cultural alignment; we seek companies with teams that are focused on being the best scientists and engineers, delivering superior technical solutions for clients. Lastly, as Steve consistently reminds me, any acquisition must make financial sense, must be beneficial to our shareholders, and add value to our financial structure. We are aware that there are companies that meet these criteria, and while we remain busy with RPS, if the right opportunities arise, we will act on them. However, it's important to note that we do not plan to reduce our leverage to below one unless we find suitable acquisitions. If we do not identify the right opportunities, we will return capital to our shareholders through dividends or buybacks instead of pursuing M&A. Our focus will be on ensuring that our capital allocation serves the interests of our shareholders.

Andy Wittmann, Analyst

That was a comprehensive response. Thank you. I'd like to approach this from a different angle since I haven't in a while. There's been a movement of private equity into the consulting and environmental consulting sector. Currently, as we've seen recently, some highly respected companies are emerging. I'm curious, as these firms look to make transactions, although you've never been an auction buyer or a banker buyer, do you view these companies as potential candidates? Could they be a good fit for Tetra Tech? I'm interested in your thoughts on this, especially now that your company has expanded in size.

Dan Batrack, CEO

Yes, that's a great question. I've been fortunate to be in this industry for quite some time. I remember when the term PE was only associated with a professional engineering license, not private equity. That has certainly changed. Nowadays, most people only recognize PE as private equity. Over the past few years, I've noticed a significant shift. Prior to the rise in interest rates, there was essentially no cost of capital, allowing leverage of eight to ten times, with some private equities requiring management teams to reinvest 40%, effectively buying companies with little to no cash outlay. However, in the last two to three years, this has changed dramatically. Rollover amounts have decreased, and leverage has dropped, potentially down to six times or even lower. Some private equity firms that may not be as experienced in our industry appear to have overpaid significantly. You will see this reflected in various metrics within the industry; I could provide more details offline. I believe they may need to divest and seek more reasonable valuations, which could be beneficial for us. They might attempt auctions, but I've noticed management teams expressing a reluctance to pursue certain options. Management teams are starting to engage with private equity to influence their direction. When companies have a say in their future, Tetra Tech stands out as the top choice. This scenario could create a win-win opportunity for shareholders, helping private equity monetize parts of their overvalued investments while benefiting Tetra Tech. A straightforward auction where a higher price is paid simply to flip the asset for a quick return may not be as feasible now that interest rates have risen above 1%. This might be more detail than you were expecting, but it captures our perspective at Tetra Tech.

Andy Wittmann, Analyst

I appreciate the context and thanks for indulging on that one. Just a technical question maybe Steve for you to wrap up for me. Can you quantify the amount of Ukraine net revenue in the quarter as well as any contribution that you expected from Ukraine in the second quarter guidance? Thank you.

Steve Burdick, CFO

Yes. In the last quarter it was probably right around $75 million is what came in from Ukraine. And that was about $35 million more than what we had expected going into the quarter just because there was quite a few contracts that were won late after we released earnings.

Andy Wittmann, Analyst

Got it. And then is there any expectation for second quarter revenue contribution from Ukraine?

Steve Burdick, CFO

Yes. There are contracts that are continuing and that's included in our guidance. Right around there $20 million to $40 million-ish is our estimate.

Andy Wittmann, Analyst

Great. Thank you very much. Have a nice day, guys.

Steve Burdick, CFO

Thank you very much, Andy.

Operator, Operator

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

Dan Batrack, CEO

Well, thank you very much, Paul. Thanks for introducing us this morning and for turning it back to us as a team. I really appreciate all of your questions. I appreciate you being on the call today. And for all of the current shareholders and those interested in following Tetra Tech, I really appreciate your being on the call and following in getting a little bit of insight into Tetra Tech's entire water cycle. I know there's been some confusion that individuals that may do treatment of one water treatment plant or one other aspect or somehow analogous to Tetra Tech and that they're magically up here. I hope that today's details presented by Dr. Leslie Shoemaker and Jill and I assure you we have thousands and thousands of others professionals that dedicate their entire careers just to the water cycle all the way from Research and Development, to Coastal Flooding and Navigation Systems that we are the pure-play water and environmental leader. And we expect to remain in that. And we are going to continue to evolve the entire thought process and technology application to this industry to transform it to new heights to for value for our clients across the board. And I look forward to sharing more details on exactly which programs we have. And sharing with you how they translate into higher growth and higher margins for our collective business and for our shareholders. And with that, I look forward to talking to you on our next quarterly call. And hope you have a great rest of the day and week. Thank you.