The Bull Case For Tetra Tech Inc.

With Quiver Quantitative’s recent institutional holdings data, we can see that hedge funds and asset managers have been increasing their holdings in Tetra Tech Inc. TTEK. Firms such as Amundi, T. Rowe Price, and Lord, Abbett & Co. have all recently added to their TTEK positions. Most notably, T. Rowe Price increased shares held by 5.95% (as filed on 9/30), bringing their total TTEK holdings to 743,045 shares worth around $123.3 million dollars at current market prices. With this in mind, we took a closer look at some of the reasons why many investors may be bullish on Tetra Tech Inc.

In November, Tetra Tech reported Q4 and FY results for the FY of 2023. During the year, revenue was up 40%, with a backlog of $4.79 billion dollars (up $1.05 billion dollars YoY). With a great year behind the company, Tetra Tech also initiated FY24 revenue and EPS guidance at double-digit growth, marking the continuation of strong growth for the business going forward. Tetra Tech Chairman Dan Batrack commented on the quarter, “As we completed fiscal year 2023, our differentiated Leading with Science® approach to the water, environment and sustainable infrastructure markets generated the highest financial results of any quarter and year in our history. In addition to our all-time high results in revenue, earnings and backlog, we accomplished significant strategic milestones this year, including closing the largest transaction in our history, enhancing our capital structure, and expanding our Tetra Tech Delta technologies to include a subscription software practice”. He went on to say, “Our clients are continuing to increase funding for water and environmental programs, including climate change mitigation and adaptation to address water security, coastal flooding, energy transition and biodiversity protection. With our market leadership in these key areas, we booked nearly $2 billion in new orders in the fourth quarter and increased our backlog by more than $1 billion over last year. Building on this momentum, we expect double-digit revenue growth in fiscal 2024 and further margin expansion”. As we can see, the business is benefitting from secular tailwinds in environmental and water programs, as their clients continue to focus on climate change mitigation and adaptation. Climate change is a serious issue going forward, and we expect this part of the business to continue to grow rapidly. With this strong fiscal year performance in mind, we believe that Tetra Tech is a compelling investment opportunity trading at fair value (which we will discuss later).

Tetra Tech, Inc. is a prominent global provider of high-end consulting and engineering services, specializing in areas such as water, environment, sustainable infrastructure, renewable energy, and international development. The company prides itself on its innovative approach, aptly named "Leading with Science®," to deliver sustainable and resilient solutions for complex challenges faced by both public and private sector clients. Their expertise is widely recognized, evidenced by consistent top rankings in various categories by Engineering News-Record (ENR), including water, environmental management, and renewable energy sectors. With over 50 years of experience, Tetra Tech has expanded its services to more than 100 countries, working on over 100,000 projects in fiscal 2023 alone, supported by a diverse workforce of 27,000 associates. Their success stems from a blend of advanced analytics, artificial intelligence, machine learning, and digital technology solutions, alongside a commitment to diversity, equity, and inclusivity. Tetra Tech's business model focuses on adding long-term value through sustainable consulting, engineering, and technology solutions, which has been instrumental in their growth and ability to deliver high performance for shareholders.

Tetra Tech operates in a highly competitive market, offering a broad range of consulting, engineering, and technical services in sectors like water, environment, sustainable infrastructure, renewable energy, and international development. Competition in this industry varies significantly based on the business area, client sector, project's technical requirements, geographic location, and financial terms. Clients typically select service providers based on a balance of quality, innovation, timeliness, and cost, seeking the best overall value. Tetra Tech's primary competitors include prominent firms like AECOM, Arcadis NV, Black & Veatch Corporation, and Jacobs Solutions, Inc., among others. Management is solid, and their capital allocation priorities do a great job of creating long-term shareholder value. Management likes to return value to shareholders via share repurchases. In October of 2021, Tetra Tech’s Board of Directors authorized a share repurchase program that authorized the repurchase of up to $400 million dollars worth of common stock. In FY23, management didn’t repurchase any shares, however, in FY22, management repurchased 1,341,679 shares of common stock at an average price of $149.07/share. As of October 2023, Tetra Tech still has $347.8 million dollars left authorized for future share repurchases. In addition to repurchases, management also offers quarterly cash dividends. In November of 2023, management declared a $0.26 per share cash dividend for the fourth quarter of FY23. As we can see, management likes to return excess value to shareholders via repurchases and dividends, creating excess shareholder value.

In terms of management incentives, management is incentivized well, with a compensation structure for NEOs that does a great job of aligning shareholder and management interests. The compensation structure includes a base salary, a performance-based cash award, and long-term incentives paid out in the form of equity (specifically, PSUs and RSUs). Long-term equity awards are based 50% on EPS growth performance and 50% on relative TSR (total shareholder return). Annual cash awards are paid via specific performance thresholds that are unique to what an NEO does (for example, a CCO and CFO work on different things and therefore have different KPIs to meet that are important to the business). We are a big fan of the metrics weighted in the long-term equity awards. With management being incentivized to have a high total shareholder return metric, you can bet that shareholders are in good hands over the long-term when it comes to stock price appreciation. Additionally, EPS growth is a great metric as well, as it provides shareholder value (think of EPS as your earnings in the business). The compensation structure allows management to build equity in the business over the long term, which does a great job of retaining executive talent while aligning shareholder and management interests (if management has equity in the business, they are incentivized to drive maximum shareholder return). 

Tetra Tech is an efficient business, operating at a high ROIC ratio that showcases the business’ efficiency with allocating capital. The business currently operates at a LTM ROE of 21.1% and a LTM ROIC of 16.8%. With the business currently operating at a WACC of 9.3%, the business operates at a ROIC to WACC ratio of 1.81x, showcasing the business’ ability to generate returns on capital greater than its weighted average cost of capital. Businesses that are able to efficiently allocate capital and generate high returns on capital are considered compounders, businesses that are able to rapidly compound earnings and intrinsic value over the long-term, handsomely rewarding shareholders in the process. Looking further at efficiency metrics, we can see that EBIT and EBIT margins have grown / expanded handsomely within the last decade. Since 2014, Tetra Tech has grown EBIT at a CAGR of 16%, with EBIT margins expanding from 5.1% of revenue to 11.2% of revenue in that same time frame. This growth in operating income (EBIT) and operating income margins shows the increased operational efficiency of the business (operating income has been able to outgrow SG&A expenses, leading to margin expansion).

Analyzing Tetra Tech’s income statement, we can see some stellar sustained growth in revenue, gross profit, and earnings within the last decade. Since 2014, Tetra Tech has grown revenue at a CAGR of around 7.3%, with gross profit growing at a CAGR of 9.9% in that same time period. The excess growth in gross profit relative to revenue can be attributed to expanding gross margins (15.2% of revenue in 2014 compared to 19.3% of revenue today). In terms of earnings, EBITDA has grown at a CAGR of 12.4% since 2014, with EPS growing at a CAGR of 11.8% in that same time frame. The growth in EPS can largely be attributed to share repurchases. Tetra Tech is a cannibal, decreasing shares outstanding by 15% since 2014. 

Looking at Tetra Tech’s balance sheet, we can see that the business operates in solid financial health. The business currently has around $169 million dollars worth of cash and equivalents on the balance sheet, with $879.5 million dollars worth of long-term debt on the balance sheet. While this low cash to long-term debt ratio may be a red flag for some investors, we don’t believe that it should be a cause for concern. The business currently operates at an interest coverage ratio of 8x, meaning that the business generates $8 dollars in EBIT for every dollar of interest expense that the business incurs. As we can see, the business has plenty of runway to cover its long-term debt obligations, and the business still carries a decent chunk of cash on the balance sheet, which it can use to further pay off debt, reinvest back into the business, repurchase shares and/or offer/increase a dividend.

Analyzing Tetra Tech’s cash flow statement, we can see some stellar sustained growth in net income and free cash flow within the last decade, showcasing the business’ increased operational efficiency in that time frame. Since 2014, Tetra Tech has grown net income at a CAGR of 9.7% since 2014 (it must be noted that this growth rate is affected by a large goodwill impairment in FY15, where net income fell almost 70% YoY. It took until FY17 for the business to get back to pre-FY15 net income figures). In terms of free cash flow, free cash flow has grown at a CAGR of 12.2% since 2014. This growth in free cash flow can be attributed to expanding free cash flow margins (in addition to solid top-line revenue growth). In 2014, Tetra Tech operated with free cash flow margins of 5.8% of revenue, compared to today where the business operates with free cash flow margins of 9.1% of revenue. This free cash flow margin expansion acts as a catalyst for future cash flow generation. With revenue continuing to grow in the mid-single digits YoY, and with continued free cash flow margin expansion, Tetra Tech will continue to generate more and more cash in a sort of compounding effect. Tetra Tech can use this cash to plowback into the business through reinvest opportunities to help the business scale (a characteristic of a compounding business). It can also use the cash to pay down debt (which can help fuel faster growth), repurchase shares, or increase / offer a cash dividend (both of which return excess value to shareholders).

After conducting a reverse discounted cash flow analysis, we can see that Tetra Tech is trading at share prices that imply a 10.36% growth rate (CAGR) in free cash flow over the next decade, using a perpetuity growth rate of 3% (largely in line with US GDP growth) and a discount rate of 9.3% (Tetra Tech’s WACC). Tetra Tech is a high quality business based on what we have discussed above, and we believe that this growth rate implied by current share prices is a fair value for the business. Tetra Tech has grown revenue at mid-single digits within the last decade, and free cash flow margin expansion has acted as a catalyst for further cash flow generation. While past performance is not indicative of future results, we believe that this growth rate in cash flow assigned by the market is very fair / realistic given prior revenue growth and cash flow margin expansion. Oftentimes, high quality businesses like Tetra Tech trade at elevated valuations due to the quality of the business. High quality compounding businesses usually have very good future earnings expectations, which leads the market to price these businesses highly. This valuation is based purely off of our proprietary models, and we encourage all investors to do their own due diligence when it comes to analyzing Tetra Tech, as your analysis may lead to a different viewpoint on the business.

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This article is from an external contributor. It does not represent Benzinga's reporting and has not been edited for content or accuracy.