If you watched financial infotainment TV this morning (I would recommend a walk outside instead), you probably heard that investors were relieved by a weak jobs report, allaying fears of a near-term rate hike, and that bad news is good news, and GOOOOO BULL MARKET! Something like that, anyway.
As a fundamental, value-oriented investor, I don't trade around broad market themes like Fed easing and tightening. It matters, but I just have zero edge, so I don't even try. Where I do have a potential edge, if I've been diligent and thoughtful, is in the realm of individual securities and the businesses underlying them. If I understand a business fairly well, and there's a piece of news that looks pretty bad on the surface but is fixable, I may be able to capitalize on other investors/traders/algorithms overreacting to the superficial bit of bad news. I've written about this at some length.
In the case of environmental engineering and consulting services firm Tetra Tech (NASDAQ:TTEK), I believe that the bad news announced this week is not only fixable, but fixing it will make the company better than it was before. If I'm right, the bad news is actually good news, as it has prompted management to make important and immediate corrections to the way they're running the business.
Tetra Tech bills itself as a full-service company whose "solutions may span the entire life cycle of consulting and engineering projects and include applied science, research and technology, engineering, design, construction management, construction, operations and maintenance, and information technology." The company recently ranked no. 1 in areas including water services, water treatment and supply, environmental management, consulting studies, solid waste and wind power. The company's reputation in these areas, established over 50 years of working for public and private sector clients, provides a rather potent incumbency when it comes to winning new contracts. It also allows the firm to attract additional talent - engineers and scientists looking to solve challenging problems - further compounding the competitive advantages provided by the firm's strong institutional knowledge.
Tetra Tech has three reportable segments: Engineering and Consulting Services (ECS), Technical Support Services (TSS), and Remediation and Construction Management (RCM). ECS and TSS address the front-end of the project life cycle, performing highly specialized study, planning and design work, while RCM picks up the more commoditized construction/construction management piece. Unsurprisingly, the latter segment posts much lower margins, when it turns a profit at all:
|Segment||FY2011||FY2012||FY2013||FY2014 (9-Mo. Trailing)|
So why does Tetra Tech bother with the back-end segment? I believe this has largely been driven by client demand for a single point of accountability across the project life cycle. Tetra Tech obviously wants to both win bids and keep its clients happy, so it complies. The ability to leverage front-end relationships to capture follow-on work, a model mastered by the likes of Accenture (NYSE:ACN), is also pretty attractive, at least in theory. Some of this activity, such as remediation work for the DoD, is quite reliable and profitable. The problem is that Tetra Tech has taken on work that's both non-core (building management, constructing force protection structures in Iraq) and unattractively priced for the risks involved (i.e. fixed-price contracts subject to cost overruns). As a consequence of this mission drift, RCM has reported a loss in three of the past five quarters, including the just-reported fiscal third quarter.
I have been following Tetra Tech since 2012, and one of the things I appreciate about this management team is that they move quickly to address problems. CEO Dan Batrack had the following to say on yesterday's conference call:
"it's due to this performance of these projects in these specific areas within the RCM segment that I've initiated a strategic and operational evaluation of this business. So our intent (is) to complete this evaluation prior to the end of the fourth quarter, and that's the quarter we're in right now. We'll be reviewing all aspects of this segment, including acceleration of exiting non-core activities, which we've already initiated... I expect prior to the end of the fourth quarter, we'll evaluate alternatives, select a course of action, develop a schedule and define the financial impacts associated with these actions that we'll be initiating. Our evaluation will result in specific actions with an implementation plan to eliminate activities that are high-risk or low-margin or non-core to our business. They don't have to be all 3, they just have to be any one of those. My objective is to provide the maximum ability for the company to deliver high margins, reliable performance and drive the company's growth into new markets and geographies as we go forward."
You could argue that a better management team would have avoided these issues in the first place. That's fair, but then there would be no opportunity. These pending corrective actions by management should put the business on better footing for the long term. I do not believe that likelihood is reflected in the stock price, which dropped 9.3% yesterday on the earnings miss (it has recovered a portion of the loss today).
Tetra Tech has maintained its long-term target of delivering 15% top- and bottom-line growth, half driven organically and the balance through M&A. For some time, my thinking has been that based on its growth outlook and cash earnings power (FY2014 guidance is for $137.5M in free cash flow at the mid-point), Tetra Tech is worth somewhere in the $31 to $34 range. This new effort to pare or even entirely discontinue the lowest-quality segment biases me to the higher end of that fair value range. On that basis, I took a position yesterday morning at $23, or roughly 2/3 of my fair value estimate.
Meanwhile, management has committed to completing its $100 million buyback authorization (there's $53 million remaining) in the current quarter, which combined with the recently initiated quarterly dividend will result in a return of roughly 2/3 of FY2014 free cash flow to shareholders. None of this will impede the company's M&A efforts, as the balance sheet is close to zero net debt vs. management's target leverage of 1-2x net debt/EBITDA.
This company has its flaws, and Tetra Tech's total shareholder returns have badly lagged the broader market over the past decade. I do believe management is focused on the right things, however, and that the combination of improving business quality through "self-help" measures, a strong balance sheet, and low price relative to cash earnings power tilt the odds in favor of a satisfactory outcome from today's (and particularly yesterday's) prices.
Disclosure: The author is long TTEK. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.