Earnings Call Transcript - TTEK Q3 2022

Operator, Operator

Good morning and thank you for joining the Tetra Tech Earnings Call. By now, you should have received a copy of the press release. If you have not, please contact the company's corporate office at 626-351-4664. As a reminder, Tetra Tech is also simulcasting this presentation with slides in the Investors section of its website at 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. With that, I would like to turn the call over to Dan Batrack. Please go ahead, Mr. Batrack.

Dan Batrack, CEO

Thank you very much, Laura, and good morning, and welcome to our fiscal year 2022 third quarter earnings conference call. I'd like to start this call today with the recognition of the executive appointments announced just this week here at Tetra Tech of Jill Hudkins to Tetra Tech President; and Dr. Leslie Shoemaker to Chief Sustainability and Leadership Development Officer. Both Jill and Leslie represent some of the most exceptional talent that we have in the entire company. In the case of Jill Hudkins, she's been with the company for over 20 years, in fact, 24 years to be precise, and has personally led our digital water growth strategy that I'll be discussing later on in this call. As for Leslie, Leslie has been with the company for over 30 years and has successfully led our growth initiative strategies and operations of the entire company. And in her new role, she'll further advance Tetra Tech's industry-leading sustainability program and leadership mentoring and development of our staff. I'd like you to join me in congratulating both of them in their new roles. Now I'd like to turn to our third quarter performance. We had a very strong third quarter with record third quarter revenue, net revenue, operating income and earnings per share. Operating income was $84 million in the quarter, up 20% year-over-year, which reflected a 70 basis point increase in our operating margin over last year. Our backlog on a constant currency basis increased to an all-time high of $3.65 billion, which is up 12% from last year. This collective performance is really a direct result of our successful long-term strategy to provide high-end Leading with Science services in the water and environmental markets. Our strategy has put us at the forefront of our client's critical programs to address climate change, increase resiliency, provide essential water supplies and protect the environment. Given the strength of our performance, we're increasing our guidance for both the net revenue and earnings per share for the entirety of fiscal year 2022, and I'll provide more details of that guidance toward the end of this call. Now I'll begin with an overview of our performance and our customers, followed by Steve Burdick, our Chief Financial Officer, who will provide a more detailed review of our financials and capital allocation. I'll then follow Steve with addressing our customer outlook and our earnings guidance for fiscal year 2022 and for the fourth quarter. In the quarter, we hit new all-time third quarter highs for revenue, net revenue, operating income and earnings per share. Our net revenue increased 13% year-over-year from $638 million to $720 million, which represents an all-time high for any quarter in the company's history. Our operating income increased at an even faster rate, up 20% from last year, reaching a third quarter record of $84 million and increasing our operating margin by 70 basis points from the same quarter last year. And finally, we delivered $1.09 in earnings per share, which is up 15% from the $0.95 that we produced last year and is a new all-time high of $1.09 for the third quarter and the second highest earnings per share of any quarter in the history of the company. I'd now like to provide an overview of our performance by our end customer. In the third quarter, we saw growth across all four of our customer sectors. International, from clients and projects that were contracted for outside the United States represented 35% of our revenue and was up 18% from last year, and it was actually up 26% if you evaluate it on a constant currency basis. This strong performance was driven by rapid growth in our high-performance buildings practice and our resilient infrastructure design work across the United Kingdom, Australia and all across Canada. We saw continued strength in our state and local revenues, which were up 10% compared to last year. This is the seventh consecutive quarter of double-digit state and local growth. And our underlying municipal water services work was up 15% year-over-year led by the rapid growth of our digital water practice, while our episodic disaster response services were flat in comparison to last year. Our U.S. commercial net revenue was 22% of our business, up 19% from last year. Our services and sustainability which include environmental permitting, high-performance buildings design and renewable energy, all contributed to strong growth in the sector. And finally, our work for our U.S. federal clients represented 27% of our net revenues in the quarter and was up 8% year-over-year if we exclude the one-time impact of our Afghanistan wind-down that took place almost a year ago now. Our federal work was driven by growth in all three of our main federal client sectors, and that includes the civilian agencies, international development and all of the defense agencies that we work for. All three of them grew during the quarter. I'd now like to present our performance by segment. The Commercial International Group or CIG segment grew by 19% year-over-year. Higher utilization and strong project performance resulted in a 13.8% margin in the quarter, up 230 basis points from the prior year. Now while 13.8% was a very strong quarter, about 50 basis points of that increase were associated with pickups due to excellent project execution during the quarter. I expect CIG to continue to perform at the high end or even exceed the range that we've identified earlier for the CIG segment, which was an 11.5% to 12.5% margin range. And that particularly will be the case as we have higher margins in typically the third and even more especially in the fourth quarter of the fiscal years due to seasonality. CIG did have a strong broad-based growth from international work in the United Kingdom, Australia and Canada as well as work for commercial clients here in the United States. Our Government Services Group or the GSG segment grew by 6% and delivered a 13.4% margin. The GSG segment's government work grew for municipal clients and federal clients during the quarter, while the episodic disaster work was a smaller portion of the GSG segment's revenue this quarter. GSG's 13.4% margin is right in the middle of the expected range that we have for this group of a 13% to 14% margin range. Typically, GSG's fourth quarter, which we're entering, will be at the high end of this range, which we expect as utilization increases due to summer field programs and other federal projects that close out and are timed at the end of the fiscal year. Our backlog during the quarter was up 12% year-over-year on a constant currency basis. And even in a quarter with an all-time record revenue, our strong orders resulted in a book-to-bill of greater than 1 for the quarter. In the third quarter, we won new programs and task orders across all of our global operations that leveraged our more than $20 billion in federal contract capacity and also add additional work through our long-term client relationships that we have globally. Commercial orders added $396 million to backlog in the quarter. U.S. federal orders from long-term clients, such as the Department of Defense, USAID, USEPA and the Department of Energy, all contributed to backlog in the quarter. We continue to receive significant orders for climate change-related international development work from both Australia and the United Kingdom's aid agencies. At this point, I'd like to turn the presentation over to Steve Burdick, our Chief Financial Officer, to present the details of our financials.

Steve Burdick, CFO

Thank you, Dan. So I would like to now review the GAAP financials for the third quarter of 2022. Overall, as Dan noted earlier, we had record high double-digit growth for revenue and earnings. The strong performance from our operations resulted in a top-line growth, with third quarter revenue of $890 million and net revenue amounted to $720 million, which was above the upper end of our guidance range of $665 million to $715 million. Our revenue and net revenue were both up at 11% and 13%, respectively, over last year, with strong growth from U.S. commercial, international, state and local end markets. Our operating income and earnings per share for the third quarter also improved over last year. Our reported operating income came in at $84 million this quarter, up 20% over last year. Our improved operating income for the third quarter was largely driven by our 19% growth in the CIG segment net revenue, coupled with a 44% growth in CIG's operating income. On a consolidated basis, these improvements resulted in our EBITDA margin increasing 70 basis points over the third quarter of last year. Now GAAP EPS came in at $1.09 in the third quarter, which was an increase of 15% over last year. Our EPS of $1.09 also came in better than the top end of our guidance range, which was $1 to $1.05. Furthermore, our effective tax rate last year was lower. So a more appropriate way to look at the year-over-year comparison would be to utilize a consistent tax rate basis with last year, and this would have resulted in an EPS being up 22% over last year. Cash flows generated from operations for the third quarter totaled $98 million, an increase of 42% over last year. Our focus on working capital and cash flows has resulted in our DSO improving once again to an all-time low of 58.8 days. This is an improvement of about 6 days from last year at this time. And this lower DSO trend continues to reflect the outstanding work our project managers lead relative to high-quality projects and highly satisfied clients in the broad portfolio across all of our end markets and geographies. Our net income amounts to $44 million, and our net debt to EBITDA was at a leverage of 0.1x, with a total cash position of more than $200 million. Our return on invested capital on a trailing 12-month basis exceeds 22%. And as a note, our ROIC has been over 20% for each quarter this fiscal year. So as we presented here today, the continued high-quality results with improved EBITDA margins, along with strong cash flows and lower working capital requirements, has shown that Tetra Tech is able to reinvest in the business and generate very strong returns. Now our long-term capital allocation strategy calls for a balance of investing in this growth in our business, managing the balance sheet, and as I will now present, providing return to our shareholders. Year-to-date, cash flow from operations generated $276 million. Our strong cash flow allowed us to successfully complete four acquisitions so far this year, all of which advance our digital strategy, which Dan will discuss later. And during the third quarter, we continued to provide significant returns for our shareholders through dividends and share buybacks. Now regarding our dividend program, year-to-date, we've paid out $34 million in dividends. And I want to announce that our Board of Directors approved our 33rd consecutive dividend, which is set at $0.23 per share and a 15% increase over last year. Furthermore, year-to-date, we utilized $150 million in our stock buyback program. We have a total of $398 million remaining in our approved stock buyback program. And all told, year-to-date, so we've returned $184 million to our shareholders through these dividend and share buyback programs. And our strong balance sheet and available liquidity of over $1 billion positions us to continue investing in technical capabilities and strategic growth areas. Now prior to handing the presentation back over to Dan, I want to remind everybody of three key items for reconciliation to our Q4 '21 results from the actual net revenue of $709 million. First, we had one extra week in Q4 of last year. Because of how our 52-, 53-week fiscal year works, we had an extra week in last year's Q4, which we do not have repeating this year that will result in a year-over-year impact of about $50 million or 8% of net revenue, which we highlighted on our previous earnings call. Second, the Afghanistan wind-down occurred late in September 2021 where the U.S. and other countries departed from the country, and as a result, our projects were wound down swiftly which we expect to have about a $10 million impact in the fourth quarter. And third, we had a $15 million of episodic disaster recovery work in the fourth quarter last year that we do not expect to have in the current year. In addition to these three issues, I want to note that the FX rate impact on our fourth quarter with the recent strengthening of the U.S. dollar. So as a reminder, our primary non-U.S. operations are represented by Canada, Australia and the U.K., which have all been performing well in their local currencies. And I have to say, across the board are exceeding expectations on both the top line and the bottom line. And so the recent strengthening of the U.S. dollar versus the currencies in these countries is expected to create an FX translation impact of about $20 million or just about 3% of our net revenue. So in total, the net revenue amounting to $614 million should be utilized as a baseline for the year-over-year comparison to the fourth quarter and fiscal 2022 guidance that Dan will provide in the next few slides. I am very pleased to share these great results with you all for the third quarter and fiscal year-to-date. Thanks for your support, and I'll hand the call back over to Dan.

Dan Batrack, CEO

Thank you, Steve. One of Tetra Tech's key growth initiatives that advances our strategy is digital water. We launched our digital water practice in 2019, and over the past three years, it has grown to $150 million in annual revenue, with expectations to double in the next three years. We have expanded our digital water practice by bringing in skilled professionals in automation, systems integration, and data analytics. There is increasing demand from our municipal clients for innovative and scalable technology solutions. This market is driven by new and proposed regulations for water utilities focusing on cybersecurity and remote monitoring, as well as digital twin technologies that enhance facility optimization. Funding for these initiatives is included in the Bipartisan Infrastructure Investment and Jobs Act, also known as the infrastructure stimulus program. Our goal is to deliver Tetra Tech's suite of delta technologies to the more than 500 municipal agencies we currently serve. In the past two years, we have acquired three firms that enrich our digital water practice with new technologies and expertise. The latest addition is The Integration Group of the Americas, or TIGA, who joined us just 30 days ago. TIGA enhances our digital water practice with top-notch software engineers and digital transformation consultants experienced in addressing the complex challenges utilities face. They provide our customers with customized analytics software and platform-as-a-service applications that seamlessly integrate into our range of delta technologies. I would now like to share our guidance for the fourth quarter and all of fiscal year 2022. For the fourth quarter, we expect net revenue in the range of $676 million to $726 million, with earnings per share of $1.13 to $1.18. As noted in my initial remarks, we are raising our full-year guidance for both net revenue and earnings per share. Our new guidance for fiscal year 2022 estimates net revenue of $2.78 billion to $2.83 billion. This indicates an expected net revenue growth of 14% for the fourth quarter at the midpoint of this guidance. Our revised earnings per share forecast for fiscal year 2022 is $4.38 to $4.43. This fourth quarter and full-year guidance includes intangible amortization of $3.4 million, approximately $0.05 per share, with an effective tax rate of 26% for the fourth quarter. It assumes we have 54 million diluted shares outstanding and does not account for any revenue or income from acquisitions made during the fourth quarter or the rest of the year. In summary, we had a strong quarter with record high Q3 results. This performance is a direct outcome of our successful long-term strategy to deliver high-end differentiated services in the water and environmental markets. We advanced our digital water growth strategy with TIGA's addition in the quarter, and due to the strength of our end markets and our increased backlog, we are pleased to raise our guidance for both net revenue and earnings per share for the full fiscal year of 2022. With that, I would like to open the call for questions.

Operator, Operator

Our first question comes from Sean Eastman with KeyBanc.

Sean Eastman, Analyst

It was a strong quarter, and I want to commend the team for their efforts. While it might be early to discuss fiscal '23, I know you anticipated this conversation. We're certainly focused on where the growth rate will land in the upcoming years. Your insights on the strong exit growth velocity reflected in our fiscal fourth quarter guidance were very helpful. We are considering the momentum from the IIJA, which hasn't yet impacted our model. On the flip side, we also need to account for the foreign exchange drag expected to continue into next year. Additionally, the disaster response efforts might present a more challenging comparison for state and local entities. Can you clarify any of these aspects? Are there other factors you believe we should keep in mind as we approach fiscal '23 revenue?

Dan Batrack, CEO

Thank you for joining the call and for your question. We are very focused here at Tetra Tech and have had a strong finish to fiscal year 2022. In the fourth quarter, we provided guidance with a 14% midpoint for revenue growth. Looking ahead to 2023, we see mostly positive trends but are paying close attention to a few specifics where we had notable strength in 2022. I will give detailed guidance in our next call for fiscal year 2023 but I do want to highlight a few macro trends and areas where our clients are currently providing new funds and projects. The IIJA, which was passed earlier this fiscal year, is expected to start contributing to our results in early 2023, and we see it as a significant program that will last 5 to 10 years. The CHIPS Act, with its $53 billion allocation, also presents considerable opportunities for us as it necessitates new manufacturing facilities that will all require permitting and environmental evaluations. These projects will also need ultrapure water for chip manufacturing, which is an area we are involved in. Additionally, our focus on high-performance buildings that are energy-efficient and self-sufficient will benefit us. The Inflation Reduction Act is another key topic, generating approximately $700 million in funding and reallocation, with around $400 million earmarked for climate change and renewable energy, which is advantageous for us as it expands tax benefits beyond just wind and solar to include clean energy initiatives. These federal government measures, including the CHIPS Act and IIJA, together amount to significant funding opportunities totaling over $1 trillion. However, we must also consider the impact of extraordinary contributions we made to disaster response earlier in 2022, which produced strong numbers that may not be repeatable in the next year. We will be monitoring this closely and will provide updates in our next quarterly guidance. Additionally, foreign exchange fluctuations are noteworthy, as we’ve seen a significant drop in the euro and British pound recently, impacting our revenues derived from our operations in Australia, Canada, and the UK, which account for 35% of our total revenue. We will compile all these elements for a more detailed forecast in the future. I hope this gives you a clearer picture of our outlook as we approach 2023.

Sean Eastman, Analyst

Yes. That information is very helpful and exciting. I appreciate it. Additionally, I have one more question regarding possible offsets. We have been hearing from many government contractors about a slowdown in new award activity due to sluggish federal spending, which seems to stem from productivity issues within government agencies. I am curious if Tetra Tech is experiencing this as well, and if you view personnel challenges at the client level as a potential risk to Tetra Tech's growth prospects over the next year?

Dan Batrack, CEO

We've noticed a slight slowdown in contract activity that isn't confined to any single area. Our revenue sources are evenly split among the Department of Defense, civilian agencies, and international development, each accounting for about one-third. All these sectors have experienced a slowdown recently. Feedback from our project managers suggests that the impacts of COVID have resulted in many employees working remotely, and this hasn't been as efficient for the federal government compared to some private companies. Additionally, the great resignation has affected the U.S. government's contracting officers. Despite expectations for a surge of work following the approval of the 2022 federal budget in late March, we didn't observe that. Instead, we're seeing steady growth, with our federal revenue growth this quarter being double that of the second quarter. While it's increasing, it's more of a gradual ramp-up due to ongoing personnel challenges from remote work and staff turnover. We had predicted a growth range of 5% to 10% in federal government contracting, and if we exclude the impact from Afghanistan, our year-on-year growth is at 8%, which falls right in our expected range. Although I hoped for stronger growth, it's important to recognize that this is more of a ramp-up rather than a sharp increase. Historically, the growth has been slower, and I've shared a few reasons for that. However, the slowdown has been fairly uniform across all segments of the federal government.

Operator, Operator

Our next question comes from the line of Noelle Dilts with Stifel.

Noelle Dilts, Analyst

So you discussed some of these elements in your comments. But I think last quarter, I asked about this idea that we should see convergence in the GSG and CIG margins. It certainly happened in the quarter, maybe a little bit faster than I was anticipating. Understanding you're not giving '23 guidance, maybe you could speak directionally to how we should think about the GSG and CIG margins and if we should expect some further convergence next year, again, understanding that you're not going to be guiding to the emergency work repeating?

Dan Batrack, CEO

Yes, that's a good question. I have mentioned in previous quarters that I expected CIG to improve and align with GSG. The goal is for CIG to catch up to GSG without any decrease in GSG. I noticed that CIG performed particularly well this quarter. Usually, the third quarter is strong, and I pointed out a 50 basis point benefit from extraordinary contributions. If I adjust the 13.8% by subtracting the 50 basis points, we arrive at a low 13%, around 13.3%. I believe they are currently in that range. The work we have in CIG in Canada enhances its strength in Q3 and Q4. Sequentially, I anticipate CIG will surpass its previous performance, possibly reaching or exceeding the 13.8% we observed. GSG is also expected to be slightly stronger, estimated between 13% and 14%. It will be a close competition for the highest margins in Q4. Regarding annual conversions, I think our government margins may be about 50 basis points higher. We'll have more clarity as we approach 2023. The gap between GSG and CIG is narrowing, and I expect it may completely close in 2023 without GSG decreasing. I plan to provide an update on our next call regarding GSG's margin increase. While I can't specify for '23, I hope this gives you some direction.

Noelle Dilts, Analyst

Yes, that definitely helps. I was hoping you could provide an update on your federal advanced analytics and software offerings, as well as your Software-as-a-Service, and how those are progressing and how you view that opportunity today.

Dan Batrack, CEO

Software-as-a-Service is a significant focus for us, but we're increasingly recognizing that Platform-as-a-Service may surpass it in importance. We provide our clients with a consolidation product that leverages analytics for aspects such as water flow distribution, flow rates, and contaminant loading, all represented on a Platform-as-a-Service model. This subscription-based platform aggregates various marketplace elements such as air, water, soil, and asset management. It's important to note that managing these inputs requires domain expertise, not just programming skills. Our growth in this area is bolstered by recent acquisitions, including Axiom and TIGA, as well as EA Consulting, all of which contribute to our subscription revenues in both SaaS and Platform-as-a-Service. While I am hopeful that by 2023 we can provide a quantitative measurement of our recurring subscription-based revenue, for now, I can confirm that we're making solid progress. As we continue to grow and track our metrics, we will eventually disclose specific growth rates and margins. The acquisitions we've made this year are actively contributing to our subscription revenue stream.

Operator, Operator

Our next question comes from Tate Sullivan with Maxim Group. At this point, I'll say we're making good progress. We're getting really hesitant to provide a quantified number, as that would then lead to questions about our growth rate, CAGR, and gross margin. All of that information will be available when we open this up for tracking. But we are making progress. It is growing, and it's being supported by the most recent acquisitions. In fact, the acquisitions Steve presented that we've made this year all contribute subscription revenues to the company.

Tate Sullivan, Analyst

Thank you for your comments on digital water and the slides illustrating the 2025 target that you've already shared. I have a question regarding organic growth compared to acquisition-based growth, which I believe you've discussed in prior calls. Specifically, concerning potential targets for digital water, are there numerous incremental technologies that you can incorporate, or will the focus shift more towards organic growth?

Dan Batrack, CEO

Well, that's a really good question. For us, it's been about evenly split. So the firms that we brought on have brought technology to us but actually very little revenue. And so in the case of TIGA, EA, and Axiom as examples, I'd say, even Axiom Data Science, what they brought to us is technology and platforms that we can then use to offer and bring to solve solutions for our suite of clients. And here in the U.S., that's roughly 500 municipal clients. So what we've been acquiring is really the technologies and the expertise in automation, remote monitoring, remote operation and other aspects on the digital transformation sector, but the actual implementation has been organic with respect to our clients, our projects, our contracts. And it's been co-linked with the experts we have internally in my prepared remarks where we've been very proactive on recruiting and hiring individuals into the automation and data analytics, and other, and that's an organic portion. So I would say as far as furthering the technology and market penetration, acquisitions are very helpful for bringing in expertise and technology, but the actual execution of the work and those that we're targeting is really our client sector. And so I'd put that all into organic.

Tate Sullivan, Analyst

And then also just following up on the slide where you comment on the orders and you released details earlier this month on the $500 million order with the Army Corps of Engineers and international orders for the DoD. Is that $500 million order part of that included in backlog for fiscal 3Q '22? And also related to that, can you give more detail on that order? Was it a renewal from an amount 5 years ago? Was it a new contract? Or is it a new contract fee?

Dan Batrack, CEO

Yes. The contract with the U.S. Army Corps of Engineers is for environmental assessments, cleanup, and remediation. This is a new contract for us, not a renewal. We issued a press release this week to announce it, though the Corps had announced it earlier, so some may have seen our name associated with that. However, no funds have been added to our backlog yet; it is entirely contract capacity. This highlights how Tetra Tech reports its backlog differently from others in the industry. I recognize how our peers report their backlogs, often including contract capacity without funding to make their backlog appear stronger, as that aspect isn't governed by GAAP. At Tetra Tech, we only include figures in our backlog when there is a signed, funded, and authorized contract. Therefore, when you see others reporting rising backlog numbers, the funded portions are often minimal. Our reported backlog reflects only contracts that have been signed, funded, and authorized. With the federal government, we have over $20 billion in contract capacity. The $500 million you mentioned relates to the new contract capacity we have, which will enhance our available contract vehicles with the federal government. For that particular contract, we have received the initial task order, but it has not yet been funded. I anticipate this will occur in Q4. That’s the update on the contract we announced this week.

Tate Sullivan, Analyst

Can you provide an estimate of how much of the $119 million from the previous year was related to disaster remediation work in fiscal 1Q '22?

Dan Batrack, CEO

I don't have that information broken out for you today, but we think it was about $25 million if you wanted an approximation. I'll give you a rough number on the revenue side. So it was about $25 million contribution to the top line, which then drove utilization at higher margins. I could convert that as we get into guidance for next year. But on a revenue basis, it was about $25 million, maybe a bit more, but in that neighborhood for the first quarter.

Operator, Operator

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

Dan Batrack, CEO

Thank you very much, Laura. Appreciate it. And thank all of you for attending this call for your great questions. We here at Tetra Tech are excited about finishing fiscal year 2022 very strongly as we have had great momentum through the first three quarters. And I look forward to speaking with you in our next quarterly call, which will both give you the results of our fourth quarter of 2022, but of course, and probably even more importantly, what our guidance for 2023 is and our outlook for the first quarter. So I hope you all have a great rest of the day and a great rest of the summer. And I look forward to talking to you in the next call. Bye.

Operator, Operator

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