Caffital Research Nov. 16, 2023 1:42 PM ET
Summary
Tetra Tech provides consulting services globally and is focused on growth through acquisitions and sustainability solutions.
The company reported Q4 earnings on the 15th of November which we'll cover in this article.
The company is poised to grow, but the current valuation seems to price in a too high amount of growth, making the risk-to-reward quite poor in my opinion.
Tetra Tech (NASDAQ:TTEK) provides consulting services globally. The company is geared for modest growth through constant acquisitions and an offering that encompasses multiple sustainability solutions, bringing growth through megatrends. Although the stock has historically had a very good return and the company is executing well financially, the stock’s current valuation seems very high.
The Company & Stock
Tetra Tech provides consulting and design services to customers in the United States as well as internationally. The company services both the public and private sectors. Tetra Tech divides the company’s operations into two segments – Government Services Group (GSG), and Commercial/International Services Group (CIG). The Government Services Group segment represented around 40% of Tetra Tech’s revenues, with 60% coming from the Commercial/International Services Group segment. The company further divides its operations by customer type:
Tetra Tech has a good number of solutions around sustainability, which I believe to be a good driver for growth as ESG and environmental issues are growing in concern. The company has solutions around lake restoration, sustainable water management solutions, and a solution for decarbonizing buildings – Tetra Tech is covered well for the future with many megatrends around sustainability.
The stock has historically performed very well. In the past thirty years, the stock has appreciated at a CAGR of 13.3% on top of a minimal dividend yield that currently stands at 0.67%.
Financials
Tetra Tech has achieved a good amount of growth in the company’s long-term history. From FY2003 to FY2023, the company has achieved a compounded annual growth rate of 7.9%:
The achieved growth isn’t completely due to organic efforts – Tetra Tech constantly acquires small businesses to grow the company’s top- and bottom line. Altogether, the company’s accumulated cash acquisitions from FY2002 to FY2022 add up to almost $1.5 billion, a notable amount when compared to Tetra Tech’s current market capitalization of around $8.5 billion.
In addition to consistent acquisitions, the company has achieved quite a consistent EBIT margin in the company’s history with an average EBIT margin of 8.1% from FY2003 to FY2023. The margin has reached a higher level with increases from FY2019 forward. In FY2023, the company achieved an EBIT margin of 11.2%:
I believe that Tetra Tech's medium- to long-term financial trajectory should be good - the company has been able to position itself as a prominent operator in sustainability solutions, which should have a great increase in demand in the future - the current positioning should provide Tetra Tech with opportunities to grow revenues. On the margin side, I wouldn't expect too much leverage - the company's trailing gross margin stands at around 20%, which doesn't seem to leave room for a much higher margin. In addition, further small acquisitions should increase the company's size considerably.
Reported Q4 Results
Tetra Tech reported its Q4/FY2023 results in the post-market on the 15th of November. The company surprised the markets very positively - Tetra Tech reported net revenues of $1057 million, well above analysts' expectation of $987 million - the company's net revenues grew by 44% year-over-year due to organic efforts and the acquisition of RPS Group. More positive than the revenue surprise is Tetra Tech's reported adjusted EPS - the company reported a normalized EPS of $1.78 against analysts' expectation of $1.44. The reported figure is impressively 23.6% above the estimated level.
The company guides for FY2024 revenues of $4.05 billion to $4.25 billion, with the middle point of the guidance being very near analysts' current expectation of $4.14 billion. The EPS was guided to be in the range of $5.7 to $6.0, against an estimate of $5.90 - in total, the guidance seems to be mostly in line with the market's expectations despite the Q4 performance being well above expectations.
Valuation
The sustainability solutions seem to have caught investors’ eyes – Tetra Tech currently trades at a forward P/E of 27.9, in my opinion pricing in a great amount of growth. The ratio has mostly been rising, as Tetra Tech’s ten-year average P/E of 23.4 is below the current one:
To further contextualize the valuation and to estimate a fair value for the stock, I constructed a discounted cash flow model. In the model, I factor in further small acquisitions in the coming years, as they seem to be a constant part of Tetra Tech’s operations. After FY2023, I estimate the growth to be 11% as the company integrates RPS and continues organic growth in addition to small acquisitions, representing around the middle point of Tetra Tech's guidance. After a 9% growth in FY2025, I estimate a growth of 7% for FY2026 to FY2030, representing a growth near the historical CAGR. After FY2030, I estimate Tetra Tech’s acquisitions to slow down, improving the cash flow conversion but slowing down growth. The growth slows down into an organic rate of 3% into perpetuity.
I believe that Tetra Tech’s margins should be quite stable in the future. For FY2024, I estimate an EBIT margin of 11.3% representing a tiny margin expansion of 0.1 percentage points, in line with analysts’ expectations. After the year, I believe that Tetra Tech can expand the margin back into an eventually achieved level of 11.9%. The estimated level is above Tetra Tech’s achieved long-term margin, but seems to be a more fair estimate as the company has represented a good margin performance from FY2019 forward.
The mentioned estimates along with a cost of capital of 9.72% craft the following DCF model with a fair value estimate of $114.37, around 29% below the stock price at the time of writing:
In Q4, Tetra Tech had $13.0 million in interest expenses. With the company’s current amount of interest-bearing debt, the company’s annualized interest rate comes up to 5.90%. The company leverages debt quite moderately – I estimate a long-term debt-to-equity ratio of 15% for the company.
On the cost of equity side, I use the United States’ 10-year bond yield of 4.55% as the risk-free rate. The equity risk premium of 5.91% is Professor Aswath Damodaran’s latest estimate for the United States, made in July. The beta of 1.00 is estimated by Yahoo Finance using monthly data from a period of five years. Finally, I add a small liquidity premium of 0.2% into the cost of equity, crafting the figure at 10.66% and the WACC at 9.72%.
How I'd Turn Bullish
My thesis revolves around a good financial performance, but a too steep valuation - simplified, the thesis has two main points that could modify my belief of the risk-to-reward. Tetra Tech's financial performance could still vary widely from my estimates especially in terms of revenue growth - if the company proves to grow faster than I anticipate in the sustainability solutions, the bearish thesis could prove to be wrong. Also, the beta of 1.00 could be subject to change - Tetra Tech has proven to perform in a stable manner through the current economic turbulence as the public sector represents a good portion of Tetra Tech's earnings; a lower beta would improve the estimated fair value in the DCF model substantially. I believe that these two factors pose the most prominent risks to my bearish thesis on the stock.
Takeaway
Tetra Tech seems to be geared for growth in the future. The company has executed its strategy of constant acquisitions and a growing sustainability positioning very well. Tetra Tech also reported a very good Q4 result, although the FY2024 guidance was still very much in line with analysts' expectations. Even with a strong Q4, the stock doesn’t seem like a very good opportunity in my opinion – the stock seems to be priced for a too high amount of growth as my DCF model estimates a very significant downside. Because of the steep valuation, I have a sell rating for Tetra Tech for the time being.
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