Tetra Tech, Inc. (TTEK) Q2 2014 Earnings Report, Transcript and Summary

Good morning and thank you for joining Tetra Tech’s earnings call. (Operator Instructions). 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 then open the call up for questions. During the course of the conference call, Tetra Tech management may make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These include statements concerning future events and Tetra Tech's future financial performance. The statements are only predictions and may differ materially from actual future events or results. Tetra Tech's Form 10-K and 10-Q reports to the Securities and Exchange Commission identify certain risk factors that could cause actual results to differ materially from forward-looking statements. Tetra Tech undertakes no duty to update 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 Investor Relations section of Tetra Tech's website. (Operator Instructions). With that, I would now like to turn the call over to Dan Batrack. Please go ahead, Mr. Batrack.

Thank you very much. Good morning and welcome our fiscal year 2014 Second Quarter Earnings Conference Call. While Steve Burdick, our Chief Financial Officer, will present the specifics of our financials, I'll start this morning’s call with a brief overview of some of our key financial metrics. Overall the quarter came in just about as we expected. The revenue was at the lower end of the guidance which was directly attributable to the weather related impacts on our business this past quarter. The operating income in within our guidance range if you backed out the earn out related gain that we had and Steve Burdick our Chief Financial Officer will talk about this a bit more in the conference call this morning. As we expected backlog dropped as we worked toward completing some of the large fixed price contracts that are in the non-core businesses that we’re existing and I will speak a bit more detail on this during the call this morning. In the second quarter our revenue was $586 million with an associated net revenue of 456 million for the quarter. Our operating income was 46 million which is up 24% from the prior year and the EBITDA was 59 million or up 12% from the last year. As a result of this operating income and EBITDA we delivered an earnings per share of $0.48 which was up 29% year-over-year and I’m glad to announce that based on our consistent performance we have initiated a quarterly dividend for the first time in Tetra Tech’s history, feel quite good about that here. I would now like to review our performance by customer. Taking into account the foreign exchange translation, our total revenue for international work it's actually up 1% from last year. We did subcontract more of the work that we performed this last quarter so our net revenue was down 8% year-over-year that was mostly due to the difficult comparisons we had with the second quarter of last year or 2013 when our mining work in Eastern Canadian activities were still extremely strong. In the United States, we work for a commercial clients was essentially equal to last year which I actually feel pretty good about considering the impact of weather on our operations this past quarter. Our federal work was down 17% primarily due to two factors. The first is we’re completing and not replacing a number of fixed price construction projects that are in our core business and example of this would be fixed price construction projects that we have in Afghanistan. We’re not bidding and we’re not replacing this work. So as we do complete these activities, it is affecting our year-on-year comparisons on the revenue in the federal sector. The second area is we have continued to see slow release of task orders from the federal government including and a little bit unusual for us, the U.S. State Department and USAID who typically are our most consistent clients in funding the task orders that we have under contract vehicles that they have issued. And finally our U.S. state and local work with 13% of our business this quarter which was down due to the substantial completion of a couple of large transportation projects we have on the East Coast. All three of our business groups felt the effects of winter weather this past quarter. The ECS business group was down 8% primarily due to it's comparison to stronger manning in Eastern Canadian revenues last year, that I spoke of a moment ago but that was also exacerbated by the weather related impact in the Eastern and Central regions of both United States and Canada. So it did have an impact. The TSS, or Technical Support Services group which has the highest percentage of our U.S. Federal Work was down 6% year-on-year. In addition to their revenue being impacted by weather and the revenue is also being impacted by the slow federal contracting environment that we’re seeing in all of the USAID work we have is actually contained in this group. So this is where we saw the impact. However I will note that the TSS business group is increasingly being influenced by the higher margin commercial work they have and that’s primarily the U.S. oil and gas activities. I will also give them credit for excellent operational management and the TSS business group delivered the highest operating income of all three of our business segments this past quarter at almost 15% that was helped by some favorable project close outs but I do give them credit both for increasing the commercial business mix and excellent operational performance. Finally our RCM, our construction management group was down 17% due to the completion of some of the large U.S. transportation projects and fixed price projects in Afghanistan. They were also impacted this quarter by the unusually cold and persistent winter conditions that were present in many of our project construction sites across both the U.S. and Canada. Our backlog finished this last quarter at just over $1.8 billion and was impacted by a couple of factors. The first, the strengthen U.S. dollar resulted in a lower reported backlog from our international operations and that was associated with the foreign exchange translation. If we added back the impact of the foreign exchange translation our backlog would have been closer to $1.9 billion for the quarter. But the second item affecting our backlog is that we do continue to burn out backlog from select fixed price contracts such as projects in Afghanistan, Iraq and the U.S. transportation construction projects. It's these projects or markets that we’re continuing to exit and based on the low margins and high risk that contained in these types of projects. We’re looking not to replace this type of work and put it back into our backlog but we’re actually putting into our backlog is work of much higher value and much lower risk. So during the second quarter we received a significant number of commercial orders including oil and gas industrial water projects. We also received a significant number of awards from our long term federal customers like the U.S. Navy, U.S. State Department, USAID and the National Guard and I would like to note one item here on this backlog slide if you’re following along on the webcast. We did add a $1 billion in new contract capacity since this last conference call including $700 million contract with USAID, a $243 million contract with the National Guard and many others which collectively exceeded more than a $1 billion this past 90 days. These new contract vehicles demonstrate the strength of our relationships and the contract capacity that we have with the U.S. government and this will continue to be a very strong contributor of the company. And I would now like to turn the presentation over to Steve Burdick who will provide a more detailed discussion of the financial results for the second quarter. Steve?

Thank you Dan. Like Dan said I will begin the fiscal 2014 second quarter financial results and I will look at those in a bit more detail with you. So overall our second quarter results met the guidance ranges that we provided for both net revenue and EPS as I will explain later in this presentation. Comparing the second quarter results this year to last year, revenue decreased by about $56 million or 9% to 586.3 million primarily as result of a slowdown in operations focused on Eastern Canada, global mining and the U.S. government market as Dan had previously discussed. In addition we were negatively impacted by extreme weather conditions both in North America that were beyond our seasonal expectations. And the year-over-year comparisons were also negatively impacted by the foreign exchange rates due to the strengthening of the U.S. dollar. Now these decreases were partially offset by increases in our North America commercial markets which focused primarily on oil and gas activities. Similar to revenue our net revenue also decreased to $456 million or about 12%. The net revenue results were consistent with our expectations and towards the lower end of the guidance range provided due to the lower revenues both in Canada and for the weather factors as I noted in the U.S. Our operating income was up $8.5 million or about 23% to $46.2 million. This represents a margin about 10.1%. The higher operating income was primarily driven by project execution and favorable close outs, a reduction in overhead cost due in part to the right sizing actions that we took in the second half of fiscal 2013 and non-operating net gains on revaluing acquisition related earn out liabilities that were partially offset by a project charge related to a relatively new business acquisition. We did achieve a 9% increase in our EBITDA, now our EBITDA increase for the same reason is our operating income but at a lower percentage due to the intangible amortization and depreciation which was about $3.2 million in the current year compared to last year. Now in order to provide a bit more clarity to our operating income and earnings per share we have provided a reconciliation on this next slide for those following on the webcast. As Dan mentioned earlier in this presentation without the adjustments a pro forma operations posted operating income of about $39 million or EPS of $0.38. This EPS is within our estimated range albeit at the lower end of our guidance of weather and is consistent with the lower end of our net revenue results. As previously noted we have one RCM project in Canada in which the results deferred from our expectations. These changes were caused by different site conditions and scope of effort plus schedule and cost impacts and as a result and as the accounting rules require we wrote down the project margin to zero and our income was negatively impacted by about $40 million versus our previous expectations. I do want to point out that we’re currently negotiating changes to the contract whereby we expect to recoup this lost amount in the very near term. This project was performed by a recently acquired company in Canada that has an earn out provision as part of the purchase. Now because of the lower operating income we have calculated a lower earn out potential and thus reduce this liability. Virtually all of the earn out gain resulted from the single operating units and as such we recognized a $21 million gain that was included in this operating income. So in aggregate our gap based financial results totaled about $46 million of operating income or about $0.48 per share. Now our SG&A was about $44.2 million for the quarter, this is a decrease from the prior year quarter was up 9%. The net decrease was due to lower intangible amortization which was down about $2.3 million from last year. In addition we realized reduction and overhead expenses as a result of the actions taken in fiscal 2013 in response to our decreased revenues in certain weaker markets. The tax provision resulted in a net expense of about a $11.8 million. The effective tax rate is 27% for the quarter and the lower rate is due to the non-taxable nature of our earn our charges or changes in earn outs. The expected rate was about 33.5% without these earn outs but this could decrease even further if the U.S. Congress extends our new credits during our fiscal year. Earnings per share was about $0.48 which exceeded guidance but also as I have discussed earlier without the aforementioned non-operating net gains from revaluing the acquisition related earn out contingencies plus this one project charge we would have recognized EPS of about $0.38 and this resulting pro forma EPS of $0.38 is within the guidance that we had previously given $0.37 to $0.42 per share. Now I would like to point out I guess a few more of the significant balance sheet items, as a result of our lower revenue we experienced a decrease in our net accounts receivable balances. Also the accounts payable balances increased due to higher subcontracting activities when comparing the current year to the prior year. We did experience a decrease in our net debt compared to the prior year. The primary driven for higher debt last year was the borrowings used for our fiscal 2013 acquisitions. Now we have taken down our net debt over the last 12 months as we have generated about a $132 million in cash from operations. Offsetting this we implemented a stock repurchase program in fiscal 2013 which so far has utilized about $27 million of cash. Our net debt cash position was also impacted by CapEx purchases of about $26 million over the last four quarters. So, as noted in our balance sheet or the discussion of our balance sheet we have had solid cash flows from operations. Although the second quarter was less than the prior year, on a year-to-date basis we’re on plan in similar to last year at this time. We do still anticipate our fiscal 2014 cash from operations to be in the range of a 150 million to about a 170 million and so the midpoint for our 2014 results on a cash EPS basis is about $2.50. CapEx is less than prior year been in-line with our previous guidance that we had given for 2014. We continue to remain disciplined in our spending and as a result we have decreased the top end of our CapEx estimate so we’re now in the range of about $25 million to $30 million for 2014. This amount continues to represent about 1% of our annual revenue. Day sales outstanding of 88.6 days are higher when compared to last year at this point. Our DSO is higher due to the lower revenue in the second quarter, we used to calculate the DSO as well as timing of collections on a few large receivables that slipped from March into the third quarter. The DSO result is not in-line with our expectations but we have already taken corrective actions and put those in place to improve that the rest of this year and so our expectations for fiscal 2014 continues to be a range of about 75 to 80 days with an ultimate goal to get back below 75 days. Now for those following on the webcast this next graphic shows how our net debt has changed over the last five years. As you can see on the graphic our previous net cash position in part of last year has transitioned to a net debt position due to the borrowings for acquisitions in the second quarter of fiscal 2013 but it also shows what I mentioned earlier that we have reduced our debt by a substantial amount. Our operating cash flow in the first half of fiscal 2014 has allowed us to decrease our net debt by almost $60 million since the end of last fiscal year. In fact our experience has been that we’re generating cash at a faster and more consistent pace compared to our net income and so as I look back over the last five years we have historically outperformed our loan estimates on cash generation. As a result of that performance we have enhanced our capital allocation program for which I would like to give you all an update. Today and as Dan had previously mentioned I would like to announce that our further commitment to provide value to our shareholders going forward. So the Board of Directors has approved the declaration of Tetra Tech’s first ever quarterly dividend. The initial quarterly dividend is $0.07 per share. This amount on an annualized basis represents about 15% of our estimated annual free cash flow. This now further equates to about a $1 yield of our current market value. The dividend will be paid on June 4th of this year to shareholders of record as of May 16th. An important aspect to understand is that this cash dividend will not impact our growth strategy from either an organic or acquisitive standpoint. Now due to the many changes over the last year I would like to summarize for you all our capital allocation strategy and the decisions we have implemented to further provide for long term shareholder value. The goals we have established are two fold, first our strategy is to maximize our shareholder return and second we have instrumented the optimal leverage to be about one to two times net debt compared to our EBITDA. So we address these goals in three ways or these goals and our strategy in three ways. First, return to shareholders, these are delivered through the mix of both buybacks and dividends and we’re targeting about 33% of our free cash flow to be returned to the shareholders. We have in place a $100 million stock buyback program of which we have incurred about $27 million through the second quarter of fiscal 2014 and as I mentioned we have instituted a quarterly dividend of $0.07 per share. Relative to organic growth we will continue to invest in growth opportunities with long term markets. Throughout the organization there is a financial discipline to increase utilization and project margins and we will not lose sight of our focus in managing both our CapEx and reducing our day sales outstanding on our receivables. And finally acquisition, we must pursue a disciplined pricing in order to realize accretive acquisitions on a GAAP basis and we will push our whole efforts to expand geographic and service offerings in water, environment and energy. So with that said I will now hand the presentation back over to Dan to discuss our outlook and business strategy in a bit more detail.

Thank you Steve. I would like to just add to Steve’s comments on our use of cash. As Steve just stated based on our track record of cash generation, I’m very pleased that we can initiate a shareholders dividend program and reiterate what Steve said while continuing to invest both in organic and acquisitive growth is going to benefit the company in the long term and strengthen and profitability for the company. Our growth investments where we’re going to put that cash to work, are focused on our core water, environment and energy related services in three major high growth areas that are highlighted on this slide if you’re following along the webcast and they are oil and gas, solid waste, and industrial water. Each of these three markets have higher profitability and will support our goal to deliver 13% margins for the entire company and provide a long term growth potential which is supported by very specific new regulatory and industry drivers and these markets are very large and we plan that on a collective basis, they will comprise over $2 billion of our business within the next 3 to 5 years. I would like to go into a bit of detail in each of three of these, explain a few of those specific drivers and our expectations for these markets. In oil and gas we’re primarily focused on supporting our clients in the rapidly expanding midstream markets across North America, that’s both the U.S. and Canada, 2/3rds of our oil and gas revenues are in the midstream market and it's growing quickly in Canada across the Western Regions, Alberta and British Columbia and throughout the oil gas producing areas of United States and those are very many different shale producing regions. Across the midstream area we’re currently providing early studies and permitting an increasingly we’re now providing design services to our clients. We also think that the future expansion opportunities for this if you’re following again along on the webcast you can see this especially in the United States include construction management and working for our clients as their owner’s engineer. We’re currently growing this market at a pace of over 20% and expect our oil and gas revenues to be over $400 million for the fiscal year of 2014. In solid waste and this includes primarily landfills and the manage of the solid waste but we’re advising our clients on cost effective solutions across North America and providing full service both to municipal, clients, as municipal landfills and private sector clients. For us the solid waste market has two emerging regulatory drivers that are creating this as a new market in a growing market. The first is for municipal landfill gas markets, and there are new federal and state programs that are incentivizing and in some instances regulating the reduction of greenhouse gas emissions and that’s essentially methane from landfills. So not only is there incentives and regulatory requirements to reduce the greenhouse gas capture of this greenhouse is allowing new market for waste to energy systems to be installed at these landfill gas systems and we see this as an opportunity both to reduce the greenhouse gas emissions and confer it to energy producing facilities at these landfills and so really we get two opportunities for one with respect to addressing greenhouse gas emissions. For waste generated by coal fired power plants, there are new regulations that are coming out. They are expected to be issued in December of this year by the United States Environmental Protection Agency and these setup is a couple of different possibilities of these regulations could go whether or not it would regulate this as either a hazardous or a non-hazardous waste but regardless of which decisions made, these new regulations will create more than a $1 billion a year new market to design and build specialties landfills to receive this waste and these are areas that we’re well positioned for, we’re experts and we expect to participate materially in this new market as it emerges. In Industrial Water, new regulatory requirements whether or not they were recently enacted or under development will drive demand for our specialty water services. Efficient and innovative water management services is what we do here at Tetra Tech both for the public and private sectors and increasingly we’re providing engineering solutions that are recycling and reusing this water, reducing the demand for this water, increasing the efficiency of this application and minimizing disposal requirements for water, all of which are growing in importance and market requirements. Just few of the drivers that are going to continue to drive this market include the development of standards for chemicals and this is to address an ever increasing list of potential toxins that are either poorly understood or currently poorly regulated. There is an ongoing update to water quality criteria or standards that are going to increase the treatment requirements for our waste water or recycled water from the municipalities and public sectors and even new reporting requirements by the security exchange commissions is requiring that they recognize the significance of water and climate change related impacts to the financial health and viability of many of these businesses. Now our segment outlook for fiscal year 2014 shows an EBITDA margin of -- in a range of 11% to 13% for the year with a slightly lower range for the third quarter of 10% to 12%. Our ECS business segment is expected to be in the 9% to 11% range for both the third quarter and fourth quarter. Our TSS business segment which now represents over 1/3rd of our businesses at 34% of the company’s revenue and we expect to continue to have very strong margin performance in a range of 11% to 13% throughout the remainder of fiscal year 2014 and our RCM, our construction management business segment we expect to trend up to a 7% to 9% range for the third quarter and complete the year in the 8% to 10% range which would be the fourth quarter of this fiscal year. And with the larger percentage of overall revenues now coming from commercial clients and the improved performance in all three of our segments, I expect 2014 to keep us on track to a longer term goal of achieving a 13% EBITDA margin for the company. I would now like to present our guidance for the third quarter and for all of fiscal year 2014. As you will know we’re raising our earnings per share guidance range, we’re increasing the bottom by $0.10 and we’re increasing the top end of our range by $0.15, are primarily due to the earn out that we recognized this quarter that Steve Burdick spoke to and our year-to-date performance. We’re also adjusting our revenue range for the full year due to three primary reasons, the first and we spoke to this in a number of portions during this call, the foreign exchange translation which the international work of Tetra Tech now is 30% of our business and with the strengthening dollar we now see roughly a $50 million on the revenue side impact to our revenues for the year. We also expect about a $100 million reduction in the amount of renewable energy and wind related work that we expected to perform this year so we have incorporated that into our annual revenue guidance and we have also seen about a $50 million impact associated with delays in federal orders that we expected to receive prior to the second half of fiscal year 2014. So our updated guidance is as follows, for the third quarter our net revenue guidance is in a range of $475 million to $525 million with an associated diluted earnings per share of $0.39 to $0.44. For the entire fiscal year 2014, our net revenue guidance range is from $1.9 billion to $2 billion and with an associated diluted earnings per share of $1.75 to a $1.85. The one item that hasn’t changed at all is our cash earnings per share, that has remained unchanged at a range of $2.30 to $2.60. Some of the fundamentalist functions and these guidance that we have provided, we do anticipate an intangible amortization of $0.28 per share, we do expect roughly 65 million diluted shares outstanding for the company and excludes contributions from any acquisitions that would take place in the second half of this year. In summary we delivered a second quarter results in-line with the guidance and our EPS exceeded the high end of our forecast for the quarter. We initiated a quarterly dividend as part of the capital allocation strategy that emphasizes returning value to the shareholders while still supporting and not affecting the long term growth of the company and investment both in organic and acquisitive growth. We continue to invest in high growth markets while we’re existing some of the lower value, high risk fixed price construction projects as I have spoken earlier on this call and we continue to generate cash with our strong balance sheet positioning is very well for continued investment and the highest value opportunities in the markets both here in the United States and internationally all around the world. And with that I would like to open the call up to questions.

(Operator Instructions). The first question comes from Will Gabrielski from Stephens.

Can you touch on organic growth in your assumptions in the back half of the year? And what’s your conviction now that it sounds like you are exiting some select markets that organic growth is still a possibility for fiscal 2015?

Well I think that the organic growth for ’15 should actually be much easier threshold to achieve. I will say for all the fiscal year of 2014 the first half of the year on a year-on-year comparison for some of our markets is extremely difficult and in fact mining and I would say the second quarter is a very large headwind, a year ago it was really at the top both in revenue and margin so it's a difficult headwind for this quarter compared to last year. Next year’s quarter compared to this year will be much easier and I expect it to be more favorable. Same is true with Eastern Canada and two of the three large U.S. transportation projects substantially completed this past quarter. So year-on-year comparisons next year will be much easier with respect to organic growth. In addition to those having less of a headwind as we have seen here in 2014, the size and growth and now critical mass of some of the faster growing markets like and gas are actually making and difference. Now oil and gas had grown at 100% in some years from 45 million to 90 million, so we have doubled it, that was 90 million. It was a very small number for us. Now at 400 million it actually has a size and capacity to make a difference and it's growing not only at high growth margins at over 20% but the margins in that business are double what we have in our base business. So it really has sort of a fourfold factor on the earning side. So I feel very good about that. I do expect -- that’s why I have talked about the federal market being a little bit slower here in the second half. They have been slower but they are issuing more contracts, more contract capacity and they do expect that they are going to utilize it. So I think of federal, while I do see it as a growth market. I do see it as a very stable, flat, consistent market as we go forward. So I think ’15 is actually looking quite good for us. We knew coming into ’14 the first half would be challenging because of the year-over-year headwinds but I do believe that’s subsiding’s go forward.

Okay. Then a follow-up. The pipeline market. Can you talk about -- I mean oil and gas in general, but specific to pipeline. It is still a new customer base for you in a lot of ways. I am sure you've had some integration and execution issues that you alluded to so far. I am just wondering what is your confidence that you can enter that market successfully make good money, and you have got a good handle on the commercial terms and risks and the competitive landscape so that at that can be a profitable growth in returns accretive for you over the next two or three years.

I just want to clarify one thing on a project that we had an issue with us last quarter that Steve went into. We have not had performance issues on the projects with the new acquisitions that have come in, they have actually performed very well including the project that Steve has spoken to now. I know you and others on this call would appreciate the reason why we want to keep this non-identified as either the unit or the specific project or client because we’re entering into discussions in fact are ongoing right now. But we did not have a problem with the execution of the project. We did not have an issue with respect to successful completion or substantial completion of this and it was not multiple projects, I know that sometimes people use the word project and they mean plural and it's a small bucket of them. This is one singular project and it was only associated with a change in scope of services on it and in fact we did complete it. We do believe that terms and conditions on the base contract allow us to account for it differently, not as a fixed price but in fact when the scope changes so significantly it actually moves to a cost reimbursable, sometimes referred to as open book and as Steve had mentioned the accounting necessitates that you complete what the plus or the fee. You set the fee inside, which we did and until it's complete and then we would have that comeback into earnings. So now with respect to integration I think the actual integration of these new acquisitions especially on the oil and gas side has gone very, very well. They contributed to backlog, they have contributed to revenue as expected and they have actually been greater contributors to the company. And so I would actually say these have gone well as expected and I really haven't seen that as an issue.

Okay. You are comfortable, though. I guess the main question was are you comfortable with what you’re learning about your customers and their commercial preferences and the competitive landscape that this is a very viable market to continue to put capital via M&A and organic growth?

Yes, very much so.

Your next question is from Corey Greendale from First Analysis.

I just wanted to clarify the unnamed RCM project. Are you still sustaining some negative impacts in Q4 or is that resolved at this point?

It's resolved at this point. We’re roughly 90% complete with the project going through some final completion in early Q3 but we expect no additional financial impact on that project.

Okay. And then I appreciate the introduction of a dividend and the fact that you have kind of framed what the free cash flow use is going forward. Within that 33% returning to shareholders, can you give us some sense how the Board is thinking about that whether you think the expectation is raising the dividend annually or keeping the yield flat or how would you think about that?

First of all, I will speak in a more general sense and then I will give a little bit more of a specifics but I sort of see the dividend initiation somewhat similar to what we started with the stock buyback. We started with a grid, we started by, started slow and then we added to it and then we opened it up to specific commitment over a time frame. It seemed that dividend is a very specific long term commitment to return to the shareholders. We did link it as a Board to a percent of cash generation so that as the company grows and cash generation grows it will automatically increase as we have limit it to the cash increase and I will tell you, I would look at this dividend and the Board is looking at the dividend similar to the stock repurchase. Let’s get started and we evaluate it as we go forward. So we really do see both of these sort of a as a one way gate valve. You can’t go back down, so do not start too much too high at the beginning so we will get started and then we will, we evaluate it as we go. So that was really the thought process with the Board.

Okay and we love your thoughts on a high level topic. I think one could make the case that given how your mix has shifted that Tetra Tech as just inherently a more cyclical business than it was four or five years ago and may become more so given the areas where you are looking to grow. Could you give us your thoughts on that and whether we should be expecting kind of more boom and bust going forward?

Well I do think that we’re, there is no doubt that Tetra Tech is more cyclical than where we were 70% or 80% U.S. government work. There is no doubt about that. We have seen it most acutely and we are just quite new to the company. Over this past 12 months with mining, so I will tell I’ve with this company for many decades and it's a first time I have seen that as a company but it's because mining went up to 10% - 12% of the company’s revenues. So it moved we had a portion, now I also will say that what’s coming along with this if you call it cyclicality or volatility is a much higher margin and we’re working very hard to reinvest in the stable federal markets we have that we think are less vulnerable so that we can have a really strong balance for the company, balance meaning stability, predictability something that isn't going to move much but I will say that it's become more of a portfolio approach. So mining has very different drivers than oil and gas which has very different drivers than solid waste which of course are all quite different than the government work which is more stable. So we’re looking it on a portfolio basis and we did need to add additional segments which we have done for instance in industrial water which is commercial, solid waste which is a bit public and private and then oil and gas and I think that as we’re moving this transition and if you think about what we have done here in the company in the past five years we have gone from zero or maybe 1% international to 33% this last quarter. It is the biggest sector of the company. As we move from very little commercial work or very focused commercial work to being much broader with much higher margins, as we have made it a more diverse portfolio business. To a certain extent it should take out this single factors and the single market causing the movement in revenues and profit. So, I actually think by this diversification of our portfolio it will become less cyclical and yet still have the benefit of the higher margins.

Are you still looking it he long-term growth rate as kind of half organic, half acquisition?

Yes, absolutely.

Okay. And one question specifically about the solid waste opportunity. How are you looking at that in terms of whether -- does the opportunity shift for you depending on whether new landfills are built as opposed a bunch of that stuff going to the existing landfill operators?

That’s right, we have done a couple of these and you’re right. Well I’m -- this is an interesting environment because the very large waste handlers and landfill owners that will do that as a profession are largely takeaway’s from cities and municipalities. These often will be built as you just eluded to adjacent to the coal fired power plants, cheaper for transportation and they have all of these benefits. So I expect that there will be some cyclical nature on that piece. I think what will happen is you will design in the winter and you will construct in the summer and we would factor that in as we go forward. So but I do think that moving all of this waste to existing landfills even if they expand their selves just a transportation and handling cost make it close to prohibitive. So, it really lends the market more to folks like ourselves that make a customized solution for the energy generator at their location which requires permitting, designing and then you’re right, seasonally constructing it.

Your next question is from Andy Wittman from Robert W. Baird.

I just wanted to get your thoughts on backlog growth from here. You mentioned that you are walking away from some larger fixed-price work, the federal outlook is a little bit more subdued. What should investors be expecting here at least over the near-term from your backlog trends?

I think that it's -- let me quantify a little bit what we have been removing from our backlog, so I can put this in some context. This past year a little bit more than year we have removed about 200 million from the backlog and if you put that back in or assume that we didn’t have or you could either say, you take the 2 billion from a year ago and normalize it to, if you took that out we would have been -- it was actually 300 million but we took 200 out and so if you put that back in we would relatively flat from last year. So if you sort of take [ph] that portion out you would see that the backlog for the company is flat which is actually a good indicator given that we have moved to more commercial work. So if you actually then normalized it for commercial you actually say that our visibility for the projects has actually increased a bit. But what we have -- so we have taken 200 out from the past year roughly of construction and these are U.S. transportation projects on East Coast, these are construction projects in Afghanistan, Iraq and other portions of the Middle-East and I know I have had people ask me why in the world did you go do construction projects in the Middle-East in Afghanistan? You had some interesting desire to go do that? This work is all being done for the U.S. Army Corp of Engineers or US Department of Defense but we’re under our existing very large IDIQ contracts or indefinite delivery, indefinite quantity contracts that they have asked us to do. So we did this in response to our clients asking us to do this. It's just not been good work for us. We’ve taken the charge a year ago, so it has not had an income impact to us but it has had no margin on the revenue that we have taken out. Now to go to your specifically to your question, what’s it going to look like? We have about 100 million more to go and it will be roughly over the next year and year half but the rest of it then you will actually see the impact of our underlying core business contribute and so I expect this to flatten up, flatten out and go back up including the replacement of that 100 million that we will remove. So I think if you watch from here you will see more of what the core business and our core sectors are contributing, so I do expect it to go up.

Maybe a little bit just on the capital allocation here still under levered today as it sits versus your one to two times. Obviously a very significant -- I would say very significant aspirations on the M&A side. Do you feel any sense of urgency to get the leverage to your targeted level, or do you think that phases in overtime and with a couple hundred million dollars at least just to get the leverage plus the $125 million of annual cash flow? I don't know just kind of seems to us like there might be a little bit more cash that you could possibly deliver only 30% of it or 33% of it back to shareholders. Are we missing something here? Is there maybe more cash that needs to come back to shareholders or is there really that much of an acquisition opportunity?

Well I agree with you. If you do the calculation of 33% of the cash flow it would take us several -- in fact if you extend it out it will be very difficult to get to the one or two times leverage with that type of return of capital. However if you actually take a look at the opportunities out there in these markets I think they are there and I think that will expend the remaining balance of the cash to facilitate acquisitions and I will tell you primarily New Orleans gas and selected other areas that will help build and maintain the base business that gives us stability. I will say just a word about acquisitions because that’s really indirectly an acquisition question. Do you have acquisitions that you can see and that you will pay for that will utilize your cash that will move you to a 1 to 2 times leverage position? And the answer to that is absolutely yes. Of course the question will be, so where are they? And I will tell is well the process we have gone through here over roughly the last six months even nine months, so really this fiscal year and even back to late summer is we were quite focused on middle to larger sized acquisitions in the oil and gas space with our primary focus. These range somewhere between 100 million and 300 million per year in annual revenues, that’s what our focus was. We were quite -- I have spoken on this call in the past two quarters that we were quite close on the alter on these meaning having consummated the acquisition. In fact, at the base of our own team if we should actually send out a press release saying we made it over the winning threshold. It's absolutely not our practice and until it's been closed we don’t announce anything. And sure enough what happened was, last moment renegotiations for higher price and we have remained disciplined. So what is causing this slight delay is our discipline to ensure that acquisitions will be accretive on a GAAP basis in the first year of their acquisition joining the company. So what that has caused us to do is to adjust our strategy and to move the sides and scale of the acquisitions down from a 100 to 300 range to something closer to a 25 million to a 100 million which I would call small to the lower end of middle size for us. There is much more opportunity out there, there are more candidates. It's a lower risk from us because it's not as big a bet. We can be very much more focused on where we add them, it's whether it's in Northern Alberta or British Columbia for the natural gas in support of LNG or in the U.S. for the Permian and that is exactly what we’re doing. So that’s what accounts for this period where we haven't actually identified publically a closed deal. But I will tell you they are out there, we’re focused on them and the pipeline looks quite good.

Just acquisition multiples I appreciate that you have remained disciplined. We have heard that those multiples are moving up in the private sector relative -- just look at the public multiples. They have expanded as well. One, are you seeing that in the market and, two, with looking at smaller deals in the capital allocation, do you need to scale-up your M&A team to evaluate all those deals in the three to five year time horizon that you are looking at? Do you have the resources to execute on that just internally?

It actually is easier and I will tell you why it's easier. So I don’t think that’s going to actually scale up our M&A team because we don’t have a large dedicated corporate M&A team that’s driving up our SG&A. Our deals as we have spoken to before are mostly directly sourced from our operations and will comprise our M&A due diligence team or actually folks in our operations in that industry and how that we have grown our oil and gas to 400 million we actually have a lot more folks internally that can go out and support us from a technical standpoint. We do have virtual teams that we take out of our corporate finance and accounting and legal teams that support this. So I actually don’t see that as an issue and in fact, I think it's easier for us now that we have more scale in the oil and gas before we had just a small team that we looked at two of them, we were just trying to figure out how we can divide this people up. So we’re actually much better suited now than we were a year ago.

Your next question comes from Tahira Afzal from KeyBanc.

Number one, I guess, just talking about the seasonal local markets, you know, you have talked in the past about how healthy it is, and you have some completions and difficult comps coming up, but as you look forward in terms of your bidding activity and the prospects you have could you give us some color on that market? And I guess the second question in regards to prospects as well it's really the Canadian pipeline market, the midstream market, but where you could see some large EBC Awards coming out in 2015. I would like to get a sense of your discussions with potential customers there.

As far as state and local, state and local I have mentioned this before, this is probably as a good quarter that would be an example of my characterization of our revenue in that space. We would have three large construction turnkey transportation projects on the East Coast that are state and local projects, two of them largely are completed this past quarter. They should fully complete here in the third quarter and so if you take those out because those are projects that each are roughly a $100 million each, so the throughput is actually quite large. But if you axe that out and pro forma numbers and take those out, our underlying business is actually quite strong. It's growing organically at a mid-single budgets and it's really quite profitable and it's more in-line with margins that we have as a company. So there is so much -- I won't use word noise on it, because it's not noise but it's being overshadowed so much by these large construction, you can’t see the underlying numbers now we still have one project that will go out for about another 18 months so about 50 million to 75 million left on that. So it's not insignificant but the collectively the three of them drove the numbers up from 10% of our overall business up to a high of roughly 14%. So we saw 40% increase and I had spoken over the last couple of years, that is not representative of the broad based growth in the state and local market. But I will share with you now is we’re seeing mid-single digit growth. It is broad based, it does run from the East to the West Coast and it is actually, we’re seeing plenty of opportunities in that business. So I think the first part of your question, state and local looks good and you will start to see the underlying performance of that now as the two projects have burned off and the last one moves toward completion over the next few quarters. So that will start to become more and more visible. With respect to midstream in Canada, sounds like you’re as excited as we are, I think that’s a great market. Our Canadian folks think that that also is a great market, we have a good presence in Alberta. We’re doing more than $200 million a year in Alberta from upstream in the oil sands to midstream which is how do you move that material and natural gas. We’re very focused in British Columbia to add to that and we do know the clients, we’re working with the TransCanada, we’re working with the Canadian Enbridge, we’re working with all the major or many of the major midstream firms in Canada and I expect that as we have more capability in bringing the rest of the resources we have of the company to bear on that and it will be even better. So it is if I had to pick one area if you said, out of all the things Tetra Tech has what’s at the top of your list to invest in? And would love [ph] to think that you’re most excited about? I would say Canada Midstream Oil and Gas.

Our final question comes from David Rose from Wedbush Securities.

I just had a few follow-up questions. I was wondering if you could kind of break it up for us, and we had a long discussion about the backlog. So maybe to look at it a little differently is if you can provide us -- you talked about contract capacity added in this quarter. Can you provide us a year-over-year comparison in contract capacity and maybe break that out, into a couple of key markets?

I would say that our contract capacity a year ago was roughly 12 billion and most of that of course large contract capacity largely comes from the U.S. federal government and I would say that we’re out to approaching 15 billion. So over the past, if you take a look at my notes, over the past five quarters it's up almost 3 billion.

So I mean the year-over-year increase -- as if it were new order so the addition to contract capacity? Does that make sense?

Well what we had was a year ago in aggregate we had roughly 12 billion in contract capacity and today we have roughly 15 billion.

So you added three this year and what did you add last year at this time?

Well it actually -- the year before was actually less and so the federal government was actually more constricted in new contracts so year before it would have only gone up perhaps 1 to 1.5.

So what I am trying to get at is sort of a bookings number?

Yes bookings is different. Let me just clarify, booking is different than -- Tetra Tech is different that contract capacity and in fact I didn’t spend any time on our backlog chart but just for the other listeners on this call let me just clarify one item. We at Tetra Tech track one number and we actually track it with great level of specificity for backlog. So when we receive an order it only goes into our backlog if it's contracted for us, obviously, you have to sign a legally binding contract. The client has funded it, they actually have the money and they put the money aside for it for us or for our execution and number three, they have authorized us to go spend it now and that’s just over $1.8 billion in our backlog. We track every single one of those, they come in, they come in with a booking rate and it's this first step before turning it to revenue. Now I do now -- I believe we’re the only ones who track our backlog in this manner. Others and this is a broad industry certainly including the EMC industry -- take the contract capacity. So for instance the $700 million new contract that we were awarded by USAID as 90 days but currently since it's a brand new contract, have not committed any dollars to the contract the first task orders are coming out. So the amount that’s included in our backlog from that contract is zero. And so while we track and do a year-over-year analysis flex analysis on it is with specificity, our backlog or contracted, funded and authorized tasks. We do not factor anything with respect to contract vehicle and I do know that many in this industry and somewhat of a common practice is to take the contract capacity, say that -- they call it factoring and say, well let’s get 80% of that. So that 700 million if I get 80%, I’m just going to book 560 million in backlog, drop it and then tell our shareholders our backlog is up 500 million. You can’t spend that money until it's actually funded and authorized. So with respect to bookings on backlog year-over-year we’re down close to 10% on the amount of new awards. That 1.8 billion we have right now, most of that will burn off in this next year. So we will book over the next 12 months most of that $1.8 billion in new bookings.

So the new bookings is number is down 10%?

Yes.

And then if we can talk about the commercial business. Given that it was impacted by weather in the quarter, what should we expect for the growth year-on-year in Q3 for commercial? So when we look at the slide presentation next quarter, what do you think your commercial business is going to look like year-on-year in terms of growth?

We’re thinking it's going to be up sort of mid-single digits.

Okay. And then lastly, this goes to Steve's comment earlier about actions the Company has taken to improve the DSOs. Can you outline a couple of those so that we can get in the 70's range from the 80's? Specific where you’re doing?

Yes, so I think our higher DSO has been affected by some claims and milestone billings in the second quarter. I think also our second quarter revenue was a bit lower so the way we do that calculation it brought the DSO up a little bit. But in addition there were some collections that we expected in March that slipped into April. We have actually received those here over the last couple of weeks and that’s actually had an impact of about four days to our DSO almost immediately. So we have gotten it down closer to the 80 days. But in addition we’re working towards a resolution of a lot of these different claims. We expect to collect our fair amount and we expect to get a lot of those things resolved and have a much greater focus on our working capital between now and the end of the year such that we get down to that 75 to 80 day range that I talked about earlier.

Is there a new billing system or a new set of processes or procedures that need to be implemented?

No there is just more focus on managing our working capital to get those amounts collected and bring the cash in in-house.

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

Thank you very much, Ginger. And I would like to thank all of you for your questions and interest in Tetra Tech and I look forward very much to speaking with you all again next quarter. Have a good rest of the week and good bye.

Ladies and gentlemen this concludes the conference for today. Thank you all for participating and have a nice day. All parties may disconnect now.