Tetra Tech's business has bottomed and is set to recover after a tough last year. The company has returned to beat and raise mode, but sell side is still conservative after the negative surprises they have seen in the last year. Sell-side analysts are modelling the company's 2Q2014 EPS below the mid-point of its guidance range, but I believe Tetra Tech can easily do better than the top end of its guidance. In addition, the company's cash earnings is much better than its GAAP EPS, which is getting depressed by high intangible asset amortization.The stock is headed higher, with second quarter earnings beat serving as a catalyst.
Tetra Tech's (TTEK) stock has underperformed the broader markets over the last one year. The company suffered from numerous headwinds during the last year, including slowdown in Eastern Canadian business due to corruption probe (which affected the entire E&C sector), weakness in mining business, Federal budget uncertainty, and charges in four problem projects. This dented investor optimism about the company's prospects and they shifted to sidelines. However, most of these headwinds are fading in CY2014, and the company's business is set for a recovery as the year progress. Here's a look.
Comps getting easier, end markets recovering
In FY2013, the company saw a good first quarter (ending December 2012), as the mining industry and eastern Canadian business were still healthy. Things started to get slow in Q2 and saw a sharp decline in Q3. Since there were several factors like acquisition, charges, etc. impacting the company's revenue last year, one needs to adjust for these one-time items to get a sense of organic revenue trend. I have done the same in the table below.
Impact of Acquisition on Gross Revenues
Impact of Acquisition on Net Revenues*
Charges on 4 problem projects
Net Revenues (ex. Acquisition, Charges)
YoY Organic Growth(Decline)
Q1 was still flattish in terms of organic revenues
Decline Started from second quarter
And really worsened in the back half
Q1 saw difficult Organic Revenue comparisons
*assuming net revenue to be ~75% of gross revenues (the company didn't disclosed impact of acquisition on net revenue)
One can clearly see that the company's organic revenues settled at 9%-10% lower in the back half of FY13. The first quarter of fiscal 2014 also saw some incremental decline, but it was due to currency fluctuation as the US dollar strengthened against the Canadian dollar. Going forward, the company will lap somewhat easy comps in 2QFY2014 and then "bottom of the market" comps from Q3 onwards.
In addition to comps getting easier, the company's end markets are also set to recover as the year progresses. Last quarter, the company's business got adversely affected due to Government shutdown. Prior to that, uncertainty over the budget cuts was a big headwind. Usually the uncertainty over which expense items will be reduced leads to a bigger drop than the actual cut itself, as government agencies hold off appropriations for their projects across the board when things are not clear. From December onwards many of the companies providing E&C services to Federal government agencies have seen a pick-up in orders post removal of this uncertainty. For example, AECOM (ACM) reported that it received $730 mn federal order in December and another $700 mn in January post the budgetary gridlock in Washington DC was broken. Tetra Tech has received over $1 bn of orders from government agencies in the first two months of 2014. While Tetra Tech's management is expecting Federal revenues to be flat for rest of the year, I won't be surprised to see it increasing from the level it was at in fiscal Q1.
The other two pain points for Tetra Tech's business over the last couple of quarters were the decline in mining industry and corruption probe in Eastern Canada, which slowed procurements, awards, and project initiations in the entire geographic region. While the mining industry is not expected to recover anytime soon, the good news is that it is not declining anymore. On the other hand, orders slowed due to corruption probe in Canada are not lost forever and are expected to come back over the next couple of quarters.
The company is also seeing very a healthy trend in its Oil and Gas, Solid waste and Industrial end markets, which are growing at over 20% year-over-year. Increased regulations are the key driver of growth in these markets, and the company expects these businesses to ramp up substantially over the next few years. Further, in the third quarter last year, the company's business was affected by four problem projects which won't repeat this year. So, that will be an additional tailwind. To sum up, we have easy comps going forward, recovering end markets, and a strong demand from growth markets like oil and gas. This indicates that the company can post significant growth in the back half of this fiscal year, which can act as a catalyst for the stock and help it achieve a better valuation multiple.
Margins likely surprise on the upside
One thing which is quite surprising is that while sell-side is expecting revenues to sequentially increase (~2%) from fiscal Q1 to Q2, they are expecting EPS to decrease from $0.42 in Q1 to $0.39 in Q2. Even if we account for one-time items like revaluing the acquisition-related earn-out contingencies in Q1, the company's EPS was $0.40. With revenues increasing, there is no way the company can do worse. It appears like sell side is modeling a margin decrease from Q1 to Q2 this year in line with the last year, but missing the fact that dynamics this year are a lot different than the last.
Last year, the company's topline started weakening in Q2, while the cost-cutting started only in Q3. This led to margin compression in Q2 versus Q1. However, this year things are different. The company has taken $34 mn in restructuring charges (downsizing operations, consolidating long-term leased facilities) in the back half of the last year reducing costs. With volume uptick, this will begun to show in terms of operating leverage from current quarter onwards.
Amortization of intangibles depressing earnings
If we look at the current consensus earnings of $1.78 for FY2014, Tetra Tech is trading at a PE multiple of 16x in line with S&P 500. However, one thing which is depressing Tetra Tech's earnings is the amortization of intangible assets worth $78.69 mn (as of the last quarter) on its balance sheet. Last quarter, the company incurred $8.2 mn of expense from amortization of intangible assets, and for the full fiscal year 2014, the company expects to incur $27 mn, or $0.28 per share in amortization expense. This is a significant amount compared to the current sell-side consensus of $1.78 in EPS for FY2014. If we adjust $0.28 non-cash charge from intangible asset amortization, the company's adjusted EPS will be ~$2.06 per share.
There are other items like improvement in working capital, etc., which will drive further upside to cash EPS. However, since they won't be recurring in the long term, I haven't accounted for them in adjusted EPS. Adjusted for intangible amortization charge, the company is trading at 13.8x FY2014e EPS, which appears cheap given the low teen topline growth and high teen cash EPS growth Tetra Tech has seen since over the last several years (FY07-13 Net Revenue CAGR 12%, Cash EPS CAGR 18%). The good news is that going forward, magnitude of intangible asset amortization is likely to decrease as the intangible asset base reduces. I expect average intangible asset amortization rate for the next three quarter to be $1.6 mn lower than that in the first quarter (i.e. $6.6 mn on an average for the next three quarters versus $8.2 mn in Q1).
If we start with Q1 and assume that Q2 will not see any sequential recovery (to be conservative) except for the fact that there will be no negative impact of government shutdown (+0.02), no positive impact of revaluing the acquisition-related earn-out contingencies (-0.02), and $1.6 mn less in amortization (+0.01), we will have $0.43 in EPS versus $0.42 in EPS in Q1.
The company's organic revenues bottomed in the back half of the last fiscal. So, if we assume no year-over-year deterioration due to mining, federal and eastern Canadian business, US commercial growing at 15% (in line with Q1), and rest of the business remaining flat in the back half of this fiscal year; we will have 4.5% year-over-year growth for Q3 and Q4. But in Q3 of the last fiscal, the company also incurred $29.4 mn in one-time charges, adjusting for which gives $527 mn in revenues for Q3 and $555 mn in revenues for Q4. Assuming no operating leverage versus Q1 (despite seasonal increase in revenues - being conservative here), and $1.6 mn less in amortization expense versus Q1, we have $46.91 and $49.45 in profit before tax for Q3 and Q4, respectively. This equals $0.48 and $0.50 in EPS for Q3 and Q4, respectively and $1.83 in EPS for FY2014. Of course, there is further upside from operating leverage (second half of any fiscal is much better than first half, as in Q1 and Q2 work is adversely affected by cold winter), mix change towards higher-margin commercial work, recovery in federal end market (given the significant new orders which company has won YTD), and slowdown due to eastern Canadian probe ending. So, my estimates may prove conservative.
Sell-Side estimates versus my forecast
Even though my EPS estimates are conservative, they are still higher than sell-side consensus. After beating or meeting the upper end of its initial guidance range in FY2011 and FY2012, the company disappointed analysts in FY2013. I believe it will likely take a couple of quarters of beat and raise for the analyst community to become comfortable with the fact that Tetra Tech has returned to its historical trend of beating guidance. The company did a lot of cost-cutting in the back half of the last fiscal, which didn't quite show up in the first quarter of fiscal 2014 due to increased amortization of intangibles (up $3.3 mn year-over-year). As the year progresses, the impact of this cost-cutting will become clearer, which will likely result in analysts raising their estimates.
Also, there were a lot of one-time items which impacted the company's earnings last year. So, if one is trying to model earnings starting with a year-ago quarter, the chances of making errors are a bit high. Instead, if one starts with Q1 margins and looks sequentially (as I did), he/she will get much closer to the real picture. For example, sell side is expecting a decline in EPS in Q2 versus Q1 despite modeling higher revenue in Q2. They are estimating an EPS of $0.39 for Q2 versus $0.42 EPS in Q1, which doesn't make sense as Q2 won't see any negative impact of Federal shutdowns and intangible amortization will be lower in Q2 than Q1. I believe they will re-examine their estimates post the Q2 beat.
Tetra Tech is a secular growth story in the water space, which has seen a double-digit CAGR from FY2007 to FY2013. Things have slowed a bit last year, but this doesn't change the company's longer-term growth story. Increased regulations and commercial activity in the company's key end market will help drive the company's growth in the longer term, while mix shift towards commercial clients (i.e. non-government clients) will help its margins. From the near-term perspective, resumption of its growth in the second half and a better understanding of the company's margin potential among investors/analysts will act as a catalyst for the stock. I believe the stock should trade at a slight premium to market on its adjusted EPS (ex-intangible asset amortization). Applying a 16x multiple to my adjusted EPS estimate of $2.11 ($1.83+$0.28), we get a target price of $33.76 - an 18.33% upside from the current levels.
- EPS beat in fiscal Q2 (ending March), which will lead to an upward revision in sell-side estimates
- Return of growth in the back half of FY2014 and more signs of recovery in the company's end market
The Company derives 30% of its revenues from international markets. Hence, if the US dollar continues to strengthen against other currencies, it will have a negative impact on the company's EPS. However, most of the company's foreign expenses are also incurred in local currency, which means it will be more of a translation impact rather than transaction risk.