J - Tetra Tech: Good Growth At An Expensive Valuation

Summary

• A strong order backlog and healthy end markets should support near-term revenue growth.
• The funding from the IIJA, CHIPS Act, and the Inflation Reduction Act should support the long-term prospects of the company.
• Valuation is expensive.

Investment Thesis

Tetra Tech ( TTEK ) has a strong order backlog, which should support its near-term revenue growth. The medium to long-term prospects also look good as healthy end markets are helping the company win new orders and build its order book. Further, the funding from the Infrastructure Investments and Jobs Act is expected to begin in 2023, which should benefit the order backlog growth of the company. Additionally, the funding from the CHIPS Act and the Inflation Reduction Act should also support the order backlog growth. The company is also working towards its strategy to deliver its delta technology solutions to municipal centers through digital water work. Even though the company has good growth prospects, the valuations appear expensive, and the company is trading at a higher valuation with a P/E of ~28.21x compared to its peers, AECOM's ( ACM ) ~16.76x P/E and Jacob Solutions' ( J ) ~17.62x P/E.

TTEK Q3 FY22 Earnings

Last month, Tetra Tech reported better than expected third quarter FY22 financial results. The revenue in the quarter was up 11% Y/Y to $890 mn (vs. the consensus estimate of $703.7 mn). The EPS grew 15% Y/Y to $1.09 (vs. the consensus estimate of $1.05). The increase in revenue was due to the solid Y/Y growth across the U.S. commercial, international, state, and local end markets. The operating margin was up 70 bps Y/Y to 9.4% due to increased focus on high-end consulting services, project execution, and improved labor utilization across the Government Services Group ((GSG)) and Commercial/International Services Group ((CIG)) segments. The improvement in operating income benefited the Y/Y growth in EPS during the quarter.

Solid Revenue Growth Potential

In Q3 FY22, the net revenue (net of subcontractor costs) increased 13% Y/Y to $720 mn due to the strong growth across all of its four consumer sectors. This was above management's guidance range of $665 mn to $715 mn. The International business grew by 18% Y/Y or up 26% Y/Y on a constant currency basis. The strong performance was driven by rapid growth in high-performance building and resilient infrastructure design work in the U.K., Australia, and Canada. The net revenue from the U.S. Commercial clients grew 19% Y/Y due to the strong growth in environmental permitting, high-performance building design, and renewable energy. The revenue from the state and local clients grew by double-digits with the underlying municipal water services business up 15% Y/Y due to rapid growth in digital water practice. The net revenue from the U.S. federal clients grew 8% Y/Y excluding the one-time impact of wind-down of a project in Afghanistan in the previous year's third quarter. The growth was driven by the strength of its three business clients, including civilian agencies, international development, and defense agencies.

The net revenue of the GSG segment grew 6.5% Y/Y due to increased activity from municipal and federal clients. The CIG segment's net revenue grew 19% Y/Y due to the strong broad-based growth from international work in the U.K., Australia, and Canada as well as commercial clients in the U.S. The backlog in the quarter was up 12% Y/Y to $3.51 bn and $3.65 bn on a constant currency basis. The increase in backlog was a direct result of TTEK's long-term strategy to provide high-end "Leading with Science" services in the water and environmental markets. The book-to-bill ratio in the quarter was more than 1.0 due to the solid new program wins and task orders across all of its global operations. Commercial orders added $396 mn to the backlog. Orders from U.S. federal clients such as DoD (Department of Defense), USAID (United States Agency for International Development), USEPA (the United States Environmental Protection Agency), and DoE (Department of Energy) also contributed to the backlog. The company also received orders related to climate change international development work from both Australia and the U.K. Recently, the company won a contract for environmental remediation services for the DoD with a contract ceiling of $500 mn. The project was not included in the last quarter's backlog as its funding is yet to be authorized. Once the funding is authorized by Q4 FY22, the project should be included in the company's backlog.

Looking forward, Tetra Tech is using various strategies to drive growth. One such strategy is to deliver its suite of delta technologies to more than 500 municipal agencies. The strategy uses digital water initiatives to advance growth. The digital water practice was launched in 2019, and its revenue grew from $60 mn to $110 mn in 2021 and is expected to grow to $150 mn in 2022. The growth is driven by new and proposed regulations for water utilities to address cybersecurity, and other remote monitoring and operations, pandemic accelerated modernization, digital twin technologies that support facility optimization, and acquisitions. The company is also using an inorganic growth strategy to accelerate growth. Tetra Tech acquired IBRA-RMAC Automation Systems and Enterprise Automation in 2021, and The Integration Group of America (TIGA) in July 2022. TIGA brings customized analytics software and platform-as-a-service applications that will be integrated with TTEK's suite of delta technologies. The net debt to EBITDA ratio of the company was 0.1x in Q3 FY22, which is expected to support its acquisition spree for its digital strategy.

The company should also benefit from the ongoing macro trends related to new funds and new builds. TTEK should benefit from the funding from the Infrastructure Investment and Jobs Act (IIJA). The projects from this funding are expected to start flowing in from the calendar year 2023 and should continue over the medium to long term. Another thing that creates an opportunity for the company is the funding of $53 bn from the CHIPS Act. As this funding aims at increasing the production of semiconductor chips within the U.S., the new facilities that will be installed will need an environmental evaluation, ultrapure water supply, water treatment, water recycling and sourcing, and an increase in the efficiency at those plants. Further, the $737 bn Inflation Reduction Act is expected to reallocate approximately half of the funding, which is ~$369 bn to handle the climate and energy crisis. TTEK's expertise in high voltage engineering, environmental permitting, citing, and resource evaluation should position the company well. I believe the strong macro tailwinds should support the backlog growth of the company in the near as well as the long term. This in turn should benefit revenue growth.

Margins

In Q3 FY22, the adjusted operating margin of the CIG segment was up 230 bps Y/Y to 13.8% due to higher labor utilization and strong project performance. The GSG segment's adjusted operating margin was down 70 bps Y/Y to 13.4% but was within the company's guidance range of 13% to 14%.

The adjusted operating margin of both segments is expected to improve sequentially in the next quarter due to seasonality and a higher utilization rate. In the CIG segment, the company has high margin work in Canada, which should support the margin improvement along with seasonality. In the GSG segment, the utilization rate should increase due to the summer field programs and the closing of some federal projects, which should improve the margins.

Valuation & Conclusion

The stock is currently trading at 30.75x FY22 consensus EPS estimate of $4.39 and 28.54x FY23 consensus EPS estimate of $4.73, which is close to its five-year average forward P/E of 28.21x. The company's near-term revenue growth should be supported by a strong backlog and healthy end markets, whereas the strong macro tailwinds from the funding environment should support its long-term growth. The company has good growth prospects, but the valuation is expensive compared to its peers, AECOM (16.76x) and Jacob Solutions (17.62x). Further, despite a significant correction in the market, TTEK is not available at a discount to its historical levels. Hence, I believe the companies like AECOM and Jacobs offer better alternatives and hence have a neutral rating on TTEK.

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