TTEK - Tetra Tech: Remaining On The Sidelines

Summary

• TTEK’s sales should benefit from the healthy order backlog and the acquisitions of RMS Group and Amyx Group.
• In the medium to long term, the company should benefit from the Infrastructure Investment and Jobs Act, the CHIPS and Science Act, and the Inflation Reduction Act.
• Valuation is still expensive.

Investment Thesis

Tetra Tech Inc. (TTEK) is experiencing healthy demand across its end markets, which has resulted in healthy order backlog levels. This should benefit sales in 2023. Additionally, the sales should also benefit from the acquisitions of RMS Group and Amyx Group. Beyond 2023, TTEK should benefit from the different legislative actions passed in the United States, which include the Infrastructure Investment and Jobs Act (IIJA), the CHIPS and Science Act, and the Inflation Reduction Act (IRA). On the margin front, the RMS Group has a lower margin compared to TTEK. The company plans to bring the margins of RMS Group to TTEK's level through cost synergies by moving to a common ERP platform and aligning corporate systems. This should be done by the end of FY2025. The company has good revenue growth prospects. However, due to a higher valuation compared to its historical levels as well as immediate peer Aecom ( ACM ), I have a neutral rating on the stock.

TTEK's Q1 FY23 Earnings

TTEK recently reported better-than-expected first-quarter FY23 financial results. The revenue in the quarter was up 4% Y/Y to $895 mn (vs. the consensus estimate of $717.7 mn). The adjusted EPS increased 13% Y/Y to $1.34 (vs. the consensus estimate of $1.21). The revenue growth was due to the growth in its end markets, including the U.S. Commercial, international, federal government, and state and local government clients. The adjusted operating margin improved by 90 bps Y/Y to 13.1% due to the shift in mix to higher-margin services and improved labor utilization. The improvement in adjusted operating margin benefited the adjusted EPS in the quarter.

Revenue Outlook

In Q1 FY23, the net revenue (excluding sub-contractor costs) increased by 8% to $737 mn due to healthy demand from its end markets. The net revenue in the Government Services Group ((GSG)) increased 8% Y/Y due to the growth in water and environmental programs. The Commercial/International Services Group ((CIG)) segment's net revenue increased 9% Y/Y due to the healthy demand in environmental and renewable energy programs globally.

The company's backlog at the end of the first quarter of FY23 was up ~10.5% Y/Y to $3.81 bn as the company won new programs and task orders with both its commercial and government clients in the U.S. as well as international clients. TTEK leveraged its $25 billion contract capacity with the U.S. Federal government and its existing master service agreements to generate ~$1 billion in new orders in the quarter. The company was also awarded new programs, such as $42 mn in additional contract capacity by the U.S. for energy transformation services in Moldova and a $95 mn contract with the U.S. Navy to support their environmental restoration needs.

Looking forward, the company's revenue in 2023 should benefit from the healthy order backlog levels. The revenues should also benefit from the recent acquisitions of RPS Group and Amyx Group in January 2023. The RPS Group employs 5000 associates across Europe, APAC, the United Kingdom, and North America, delivering high-end solutions in energy transformation, water, and program management for government and commercial clients. This acquisition advances TTEK's strategy to position itself as a global high-end consulting and engineering firm focused on water, the environment, sustainable infrastructure, and energy transformation. The RPS Group will double TTEK's staff in the U.K. and Australia and provide a first-time presence in European countries such as Norway, the Netherlands, and the Republic of Ireland. The addition of RPS expands TTEK's addressable market by providing access to a GBP 10 billion per year U.K. water market and a GBP 15 billion per year wind market in the U.K. and Europe. Management expects RPS Group to contribute $400 mn to net revenue in 2023.

Another acquisition, the Amyx Group, is a technology service, cybersecurity, and management consulting firm. The addition of Amyx enables TTEK to expand the use of advanced data analytics, cyber security, and digital transformation solutions for its government and commercial customers.

In the medium to long term, the company should benefit from the three major legislative actions passed by the U.S. government over the last few years. This includes the Infrastructure Investment and Jobs Act (IIJA), the CHIPS and Science Act, and the Inflation Reduction Act (IRA). The IIJA focuses on water, sustainable infrastructure, the environment, and renewable energy markets. TTEK's exposure in these end markets should support order book growth in the coming years. The $280 bn CHIPS and Science Act focuses on the expansion and development of semiconductor facilities in the U.S. TTEK's sustainable infrastructure design services position it well to take advantage of this opportunity. The $369 bn IRA includes investments in energy security and climate change over the next 10 years. TTEK's presence in sustainable and renewable energy should benefit its revenue growth.

So, I am optimistic about the company's near as well as longer-term growth prospects.

Margin Outlook

In Q1 FY23, the Government Services Group segment's adjusted operating margin was up 240 bps Y/Y to 17.1% due to the shift in the mix of business to high-margin services, favorable project closeouts, and higher labor utilization. The company had strong utilization for U.S. federal work and disaster recovery services due to the impact of Hurricane Ian in Florida in October and the related work extending into November and December. Without the extraordinary margin contributions from the favorable project closeouts and disaster recovery work, the margins would have been ~15% in the quarter.

The adjusted operating margin in the Commercial/International Services Group segment increased 60 bps Y/Y to 13.1%, driven by strong utilization in high-performance buildings, environmental programs, and renewable energy services.

The EBITDA margin of the RPS Group is below TTEK's adjusted EBITDA margin. TTEK plans to increase the EBITDA margin of RPS from 4% in 2022 to 13%, in line with the company's margins over the next three years. This should be accomplished in a similar manner as it had done with its previous two public company acquisitions, Coffey (in 2016) and WYG (in 2019). TTEK focused on integrating the business into its ERP program and corporate systems for cost synergies.

Management's target is to double RPS Group's EBITDA margin in 2023 and achieve 11% in 2024, and 13% plus by the end of 2025. While these targets are certainly not easy, management's past execution gives me some confidence in their ability to achieve this target. Initially, this acquisition should be margin dilutive but in the longer run TTEK's margins should benefit as the benefit of cost synergies start flowing through. In the medium to long run, the company's margins should also benefit from the mix shift towards the higher-margin services business in the long term.

Valuation & Conclusion

The stock is currently trading at 31.20x FY23 consensus EPS estimate of $5.04, which is higher than its five-year average forward P/E of 29.05x. The stock is also pricey compared to its peer Aecom which is available at 23.07x FY23 P/E.

While I like the company's execution and its growth prospects, its steep valuations leave little room for upside. I previously covered the stock in November and then also I gave it a neutral rating based on valuation. The stock has remained flattish since then underperforming the recent rally in S&P500 ( SPY ). I still prefer to be on the sidelines and wait for the valuation to correct before becoming more optimistic about the stock. Hence I reiterate my neutral rating.

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