TETRA TECH INC - Quarter Report: 2016 March (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

 

 

FORM 10-Q

 

(Mark One)

x                               QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended March 27, 2016

 

OR

 

o                                  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from ___________ to ___________

 

Commission File Number 0-19655

 

 

TETRA TECH, INC.

(Exact name of registrant as specified in its charter)

 

 

3475 East Foothill Boulevard, Pasadena, California  91107

(Address of principal executive offices)  (Zip Code)

 

(626) 351-4664

(Registrant’s telephone number, including area code)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes  x   No  o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes  x   No  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes  o   No  x

 

As of April 25, 2016, 57,929,605 shares of the registrant’s common stock were outstanding.

 

 

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TETRA TECH, INC.

 

INDEX

 

PART I.	FINANCIAL INFORMATION	PAGE NO.
Item 1.	Financial Statements (unaudited)	3
	Condensed Consolidated Balance Sheets as of March 27, 2016 and September 27, 2015	3
	Condensed Consolidated Statements of Income for the Three and Six Months Ended March 27, 2016 and March 29, 2015	4
	Condensed Consolidated Statements of Comprehensive Income (Loss) for the Three and Six Months Ended March 27, 2016 and March 29, 2015	5
	Condensed Consolidated Statements of Cash Flows for the Six Months Ended March 27, 2016 and March 29, 2015	6
	Notes to Condensed Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	23
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	36
Item 4.	Controls and Procedures	36
PART II.	OTHER INFORMATION	36
Item 1.	Legal Proceedings	36
Item 1A.	Risk Factors	37
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	55
Item 4.	Mine Safety Disclosure	55
Item 6.	Exhibits	55
SIGNATURES		56

 

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PART I. FINANCIAL INFORMATION

 

Item 1.           Financial Statements

 

Tetra Tech, Inc.

Condensed Consolidated Balance Sheets

(unaudited - in thousands, except par value)

 

ASSETS		March 27, 2016			September 27, 2015
Current assets:
Cash and cash equivalents		$	113,667		$	135,326
Accounts receivable – net		681,123			636,030
Prepaid expenses and other current assets		56,533			42,125
Income taxes receivable		23,223			10,294
Total current assets		874,546			823,775
Property and equipment – net		74,314			64,906
Investments in and advances to unconsolidated joint ventures		2,011			1,886
Goodwill		716,244			601,379
Intangible assets – net		58,233			40,332
Other long-term assets		27,566			26,964
Total assets		$	1,752,914		$	1,559,242
LIABILITIES AND EQUITY
Current liabilities:
Accounts payable		$	130,473		$	150,284
Accrued compensation		96,864			103,866
Billings in excess of costs on uncompleted contracts		92,125			93,989
Deferred income taxes		24,986			20,787
Current portion of long-term debt		17,066			11,904
Estimated contingent earn-out liabilities		4,658			609
Other current liabilities		109,499			69,003
Total current liabilities		475,671			450,442
Deferred income taxes		31,759			34,759
Long-term debt		343,145			180,972
Long-term estimated contingent earn-out liabilities		6,162			3,560
Other long-term liabilities		46,027			32,711
Commitments and contingencies (Note 15)
Equity:
Preferred stock – Authorized, 2,000 shares of $0.01 par value; no shares issued and outstanding at March 27, 2016, and September 27, 2015		–			–
Common stock – Authorized, 150,000 shares of $0.01 par value; issued and outstanding, 58,077 and 59,381 shares at March 27, 2016, and September 27, 2015, respectively		581			594
Additional paid-in capital		291,500			326,593
Accumulated other comprehensive loss		(132,566)			(143,171)
Retained earnings		689,911			672,309
Tetra Tech stockholders’ equity		849,426			856,325
Noncontrolling interests		724			473
Total equity		850,150			856,798
Total liabilities and equity		$	1,752,914		$	1,559,242

 

See Notes to Condensed Consolidated Financial Statements.

 

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Tetra Tech, Inc.

Condensed Consolidated Statements of Income

(unaudited — in thousands, except per share data)

 

		Three Months Ended						Six Months Ended
		March 27, 2016			March 29, 2015			March 27, 2016			March 29, 2015
Revenue		$	627,384		$	564,763		$	1,188,092		$	1,145,819
Subcontractor costs		(148,619)			(132,009)			(288,371)			(275,985)
Other costs of revenue		(403,976)			(362,957)			(751,772)			(721,238)
Gross profit		74,789			69,797			147,949			148,596
Selling, general and administrative expenses		(40,406)			(42,512)			(79,634)			(84,699)
Acquisition and integration expenses		(15,911)			–			(15,911)			–
Contingent consideration – fair value adjustments		(1,822)			3,113			(2,823)			3,113
Operating income		16,650			30,398			49,581			67,010
Interest expense		(4,251)			(1,804)			(5,911)			(3,594)
Income before income tax expense		12,399			28,594			43,670			63,416
Income tax expense		(8,661)			(9,584)			(16,692)			(18,760)
Net income including noncontrolling interests		3,738			19,010			26,978			44,656
Net (income) loss from noncontrolling interests		6			7			5			(64)
Net income attributable to Tetra Tech		$	3,744		$	19,017		$	26,983		$	44,592
Earnings per share attributable to Tetra Tech:
Basic		$	0.06		$	0.31		$	0.46		$	0.72
Diluted		$	0.06		$	0.31		$	0.45		$	0.71
Weighted-average common shares outstanding:
Basic		58,451			61,153			58,819			61,816
Diluted		59,131			61,723			59,527			62,431
Cash dividends paid per share		$	0.08		$	0.07		$	0.16		$	0.14

 

See Notes to Condensed Consolidated Financial Statements.

 

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Tetra Tech, Inc.

Condensed Consolidated Statements of Comprehensive Income (Loss)

(unaudited – in thousands)

 

		Three Months Ended						Six Months Ended
		March 27, 2016			March 29, 2015			March 27, 2016			March 29, 2015
Net income including noncontrolling interests		$	3,738		$	19,010		$	26,978		$		44,656
Other comprehensive income, net of tax :
Foreign currency translation adjustments		26,579			(43,680)			10,105			(68,189)
(Loss) gain on cash flow hedge valuations		(597)			(1,517)			513			(1,997)
Other comprehensive income (loss), net of tax		25,982			(45,197)			10,618			(70,186)
Comprehensive income (loss) including noncontrolling interests		29,720			(26,187)			37,596			(25,530)
Net loss (income) attributable to noncontrolling interests		6			7			5			(64)
Foreign currency translation adjustments, net of tax		(4)			164			(13)			104
Comprehensive income (loss) attributable to noncontrolling interests		2			171			(8)			40
Comprehensive income (loss) attributable to Tetra Tech		$	29,722		$	(26,016)		$	37,588		$	(25,490)

 

See Notes to Condensed Consolidated Financial Statements.

 

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Tetra Tech, Inc.

Condensed Consolidated Statements of Cash Flows

(unaudited – in thousands)

 

		Six Months Ended
		March 27, 2016			March 29, 2015
Cash flows from operating activities:
Net income including noncontrolling interests		$	26,978		$	44,656
Adjustments to reconcile net income to net cash from operating activities:
Depreciation and amortization		21,410			23,948
Equity in income of unconsolidated joint ventures		(896)			(1,842)
Distributions of earnings from unconsolidated joint ventures		1,334			1,694
Stock-based compensation		6,147			5,391
Excess tax benefits from stock-based compensation		(211)			(165)
Deferred income taxes		7,109			1,460
Provision for doubtful accounts		8,047			(1,411)
Fair value adjustments to contingent consideration		2,823			(3,113)
Gain on disposal of property and equipment		(359)			(6,175)
Lease termination costs and related asset impairment		2,946			–
Changes in operating assets and liabilities, net of effects of business acquisitions:
Accounts receivable		35,898			37,289
Prepaid expenses and other assets		(8,694)			6,289
Accounts payable		(27,176)			(39,634)
Accrued compensation		(23,038)			(20,763)
Billings in excess of costs on uncompleted contracts		(9,646)			(8,073)
Other liabilities		3,330			(20,279)
Income taxes receivable/payable		(15,760)			5,494
Net cash provided by operating activities		30,242			24,766
Cash flows from investing activities:
Capital expenditures		(6,007)			(12,096)
Payments for business acquisitions, net of cash acquired		(81,256)			–
Changes in restricted cash		(3,384)			–
Proceeds from sale of property and equipment		969			9,824
Investments in unconsolidated joint ventures		(613)			–
Net cash used in investing activities		(90,291)			(2,272)
Cash flows from financing activities:
Payments on long-term debt		(76,717)			(24,001)
Proceeds from borrowings		170,000			59,095
Payments of earn-out liabilities		(1,001)			(3,199)
Debt pre-payment costs		(1,935)			–
Excess tax benefits from stock-based compensation		211			165
Repurchases of common stock		(50,000)			(68,735)
Dividends paid		(9,382)			(8,630)
Net proceeds from issuance of common stock		6,235			4,316
Net cash provided by (used in) financing activities		37,411			(40,989)
Effect of foreign exchange rate changes on cash		979			(5,366)
Net decrease in cash and cash equivalents		(21,659)			(23,861)
Cash and cash equivalents at beginning of period		135,326			122,379
Cash and cash equivalents at end of period		$	113,667		$	98,518
Supplemental information:
Cash paid during the period for:
Interest		$	7,120		$	3,604
Income taxes, net of refunds received of $2.1 million and $1.2 million		$	19,855		$	11,599

 

See Notes to Condensed Consolidated Financial Statements.

 

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TETRA TECH, INC.

Notes to Condensed Consolidated Financial Statements

 

1.                                      Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements and related notes of Tetra Tech, Inc. (“we,” “us” or “our”) have been prepared in accordance with generally accepted accounting principles in the United States of America (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.  They do not include all of the information and footnotes required by GAAP for complete financial statements and, therefore, should be read in conjunction with the audited consolidated financial statements and related notes contained in our Annual Report on Form 10-K for the fiscal year ended September 27, 2015.

 

These financial statements reflect all normal recurring adjustments that are considered necessary for a fair statement of our financial position, results of operations and cash flows for the interim periods presented.  The results of operations and cash flows for any interim period are not necessarily indicative of results for the full year or for future years.

 

We report our water resources, water and wastewater treatment, environment and infrastructure engineering activities in our Water, Environment and Infrastructure (“WEI”) reportable segment.  Our Resource Management and Energy (“RME”) reportable segment includes our natural resources, energy, international development, waste management, remediation and utilities services.  We report the results of the wind-down of our non-core construction activities in the Remediation and Construction Management (“RCM”) reportable segment.  In the first quarter of fiscal 2016, we re-aligned certain operating units within our reportable segments to improve organizational effectiveness by better aligning operations with similar clients and projects.  Specifically, we re-aligned certain operations that previously provided natural resources services, primarily mining-related, in the RME reportable segment to the WEI reportable segment.  Due to the downturn in the mining industry in recent years, we determined that these operations could be better utilized by supporting infrastructure engineering activities in our WEI reportable segment.  Although these activities had revenue of $28.5 million in the first six months of fiscal 2015, they were approximately break-even in operating income in that period.  Prior year amounts for reportable segments have been revised to conform to the current year presentation.  As a result of the re-alignment of segment results, WEI’s revenue for the first half of fiscal 2015 increased 6.2% and its operating income margin decreased 8.3% compared to the results before the re-alignment.  Correspondingly, RME’s revenue for the first six months of fiscal 2015 declined by 4.6% and its operating income margin increased 6.8% (see Note 10, “Reportable Segments” for further discussion).

 

2.                                      Accounts Receivable – Net

 

Net accounts receivable and billings in excess of costs on uncompleted contracts consisted of the following:

 

		March 27, 2016			September 27, 2015
		(in thousands)
Billed		$	348,360		$	331,364
Unbilled		342,828			311,823
Contract retentions		28,695			24,333
Total accounts receivable – gross		719,883			667,520
Allowance for doubtful accounts		(38,760)			(31,490)
Total accounts receivable – net		$	681,123		$	636,030
Billings in excess of costs on uncompleted contracts		$	92,125		$	93,989

 

Billed accounts receivable represent amounts billed to clients that have not been collected.  Unbilled accounts receivable represent revenue recognized but not yet billed pursuant to contract terms or billed after the period end date.  Most of our unbilled receivables at March 27, 2016 are expected to be billed and collected within 12 months.  Contract retentions represent amounts withheld by clients until certain conditions are met or the project is completed, which may be several months or years.  The allowance for doubtful accounts represents amounts that

 

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may become uncollectible or unrealizable in the future.  We determine an estimated allowance for uncollectible accounts based on management’s consideration of trends in the actual and forecasted credit quality of our clients, including delinquency and payment history; type of client, such as a government agency or a commercial sector client; and general economic and particular industry conditions that may affect a client’s ability to pay.  Billings in excess of costs on uncompleted contracts represent the amount of cash collected from clients and billings to clients on contracts in advance of revenue recognized.  The majority of billings in excess of costs on uncompleted contracts will be earned within 12 months.

 

Once contract performance is underway, we may experience changes in conditions, client requirements, specifications, designs, materials and expectations regarding the period of performance.  Such changes result in “change orders” and may be initiated by us or by our clients.  In many cases, agreement with the client as to the terms of change orders is reached prior to work commencing; however, sometimes circumstances require that work progress without a definitive client agreement.  Unapproved change orders constitute claims in excess of agreed contract prices that we seek to collect from our clients (or other third parties) for delays, errors in specifications and designs, contract terminations, or other causes of unanticipated additional costs.  Revenue on claims is recognized when contract costs related to claims have been incurred and when their addition to contract value can be reliably estimated.  This can lead to a situation in which costs are recognized in one period and revenue is recognized in a subsequent period, such as when client agreement is obtained or a claims resolution occurs.

 

Total accounts receivable at March 27, 2016 and September 27, 2015 included approximately $42 million and $53 million, respectively, related to claims, including requests for equitable adjustment, on contracts that provide for price redetermination.  During the first half of fiscal 2016 (all in the first quarter), we collected $13.4 million to settle claims of $8.8 million, which resulted in gains in operating income of $4.6 million in the RCM reportable segment.  We regularly evaluate all unsettled claim amounts and record appropriate adjustments to operating earnings when it is probable that the claim will result in a different contract value than the amount previously estimated.  In the first six months of fiscal 2016 (all in the first quarter), we also recognized reductions to operating income in our RCM segment and a related increase in the allowance for doubtful accounts of $7.9 million as a result of our updated assessment of the collectability of certain accounts receivable, of which $4.6 million related to unsettled claims.  In last year’s second quarter, as a result of the assessment of claims, we reduced revenue and operating income by $3.0 million.  In the first half of fiscal 2015, we recorded net gains of $0.2 million related to claims.

 

Billed accounts receivable related to U.S. federal government contracts were $56.8 million and $61.9 million at March 27, 2016 and September 27, 2015, respectively.  U.S. federal government unbilled receivables were $76.0 million and $74.2 million at March 27, 2016 and September 27, 2015, respectively.  The U.S. federal government and one international commercial client each accounted for more than 10% of our accounts receivable at March 27, 2016.  No single client, other than the U.S. federal government, accounted for more than 10% of our accounts receivable at September 27, 2015.

 

We recognize revenue for most of our contracts using the percentage-of-completion method, primarily utilizing the cost-to-cost approach, to estimate the progress towards completion in order to determine the amount of revenue and profit to recognize. Changes in those estimates could result in the recognition of cumulative catch-up adjustments to the contract’s inception-to-date revenue, costs and profit in the period in which such changes are made. As a result, we recognized immaterial net operating income adjustments during the second quarter and first half of fiscal 2016 compared to unfavorable operating income adjustments of $3.5 million and $5.9 million in the comparable periods of last year. Changes in revenue and cost estimates could also result in a projected loss that would be recorded immediately in earnings. As of March 27, 2016 and September 27, 2015, our balance sheet included a liability for anticipated losses of $7.9 million and $10.5 million, respectively. The estimated cost to complete the related contracts as of March 27, 2016 was $36.7 million.

 

3.                                      Mergers and Acquisitions

 

On January 18, 2016, we acquired control of Coffey International Limited (Coffey), headquartered in Sydney, Australia. Coffey had approximately 3,300 staff delivering technical and engineering solutions in international development and geoscience. Coffey significantly expands Tetra Tech’s geographic presence, particularly in Australia and Asia Pacific, and is part of our RME segment. In addition to Australia, Coffey’s international development business also has operations supporting federal government agencies in the U.S. and the United Kingdom. The fair value of the purchase price for Coffey was $76.1 million in addition to $65.1

 

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million of assumed debt.  In connection with the acquisition, we also assumed secured bank term debt of $37.1 million and unsecured corporate bond obligations of $28.0 million, all of which were paid in full in the second quarter of fiscal 2016 subsequent to the acquisition.

 

In the second quarter of fiscal 2016, we also acquired INDUS Corporation (“INDUS”), headquartered in Vienna, Virginia. INDUS is an information technology solutions firm focused on water data analytics, geospatial analysis, secure infrastructure, and software applications management for U.S. federal government customers, and is included in our WEI segment. The fair value of the purchase price for INDUS was $17.8 million. Of this amount, $13.1 million was paid to the sellers and $4.7 million was the estimated fair value of contingent earn-out obligations, with a maximum of $8.0 million, based upon the achievement of specified operating income targets in each of the two years following the acquisition.

 

The following table summarizes the estimated fair values of assets acquired and liabilities assumed as of the respective acquisition dates for our acquisitions completed in fiscal 2016 ($ in thousands):

 

Accounts receivable		$	82,736
Other current assets		7,846
Property and equipment		14,723
Goodwill		104,454
Backlog and customer relationship intangible assets		26,188
Other assets		6,142
Current liabilities		(74,641)
Borrowings		(65,086)
Other long-term liabilities		(7,945)
Noncontrolling interests		(500)
Net assets acquired		$	93,917

 

Backlog and customer relationship intangible assets represent the fair value of existing contracts and the underlying customer relationships and have lives ranging from 1 to 5 years (weighted average of approximately 3 years).  The purchase price allocation is preliminary and subject to adjustment based upon the final determination of the net assets acquired and information necessary to perform the final valuation.  We have not completed our final assessment of the fair values of purchased receivables, intangible assets, tax balances, contingent liabilities or acquired contracts.  The final purchase price allocations may result in adjustments to certain assets and liabilities, including the residual amount allocated to goodwill.  Goodwill recognized largely results from a substantial assembled workforce, which does not qualify for separate recognition, as well as expected future synergies from combining operations.

 

The table below presents summarized unaudited consolidated pro forma operating results, assuming we had acquired Coffey and INDUS, including the related acquisition, integration and debt pre-payment charges, at the beginning of fiscal 2015.  These pro-forma operating results are presented for illustrative purposes only and are not indicative of the operating results that would have been achieved had the related events occurred at the beginning of fiscal 2015.

 

		Pro-Forma
		Three Months Ended						Six Months Ended
		March 27, 2016			March 29, 2015			March 27, 2016			March 29, 2015
		(in thousands, except per share data)
Revenue		$	647,612		$	683,436		$	1,319,281		$	1,376,599
Operating income		32,617			29,046			62,766			48,670
Net income attributable to Tetra Tech		20,038			15,844			39,526			22,978
Earnings per share attributable to Tetra Tech:
Basic		$	0.34		$	0.26		$	0.67		$	0.37
Diluted		$	0.34		$	0.26		$	0.67		$	0.37

 

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Since their respective acquisition dates, Coffey and INDUS contributed $88.2 million in revenue and $0.3 million in operating income during the second quarter of fiscal 2016.  Amortization of intangible assets since their respective acquisition dates was $1.6 million during the second quarter of fiscal 2016.

 

Acquisition and integration expenses in the accompanying condensed consolidated statements of income are comprised of the following:

 

		Three Months Ended March 27, 2016
		(in thousands)
Severance including change in control payments		$	7,280
Professional services		5,685
Real estate-related		2,946
Total		$	15,911

 

As of March 27, 2016, $11.7 million of the $15.9 million in acquisition and integration expenses were paid.  All acquisition and integration expenses are included in our Corporate reportable segment, as presented in Note 10.  In addition, in the second quarter of fiscal 2016, we repaid Coffey’s bank loans and corporate bonds in full, including $1.9 million in pre-payment charges that are included in interest expense.

 

In fiscal 2015, we acquired Cornerstone Environmental Group, LLC (“CEG”), headquartered in Middletown, New York. CEG is an environmental engineering and consulting firm focused on solid waste markets in the United States, and is included in our RME segment. The fair value of the purchase price for CEG was $15.9 million. Of this amount, $11.8 million was paid to the sellers and $4.1 million was the estimated fair value of contingent earn-out obligations, with a maximum of $9.8 million, based upon the achievement of specified financial objectives. The results of this acquisition were included in the consolidated financial statements from the closing date. The acquisition was not considered material to our condensed consolidated financial statements. As a result, no pro forma information has been provided.

 

Goodwill additions resulting from business combinations are primarily attributable to the existing workforce of the acquired companies and the synergies expected to arise after the acquisitions.  In addition, these acquired capabilities, when combined with our existing global consulting and engineering business, result in opportunities that allow us to provide services under contracts that could not have been pursued individually by either us or the acquired company.

 

Most of our acquisition agreements include contingent earn-out agreements, which are generally based on the achievement of future operating income thresholds.  The contingent earn-out arrangements are based on our valuations of the acquired companies, and reduce the risk of overpaying for acquisitions if the projected financial results are not achieved.  The fair values of any earn-out arrangements are included as part of the purchase price of the acquired companies on their respective acquisition dates.  For each transaction, we estimate the fair value of contingent earn-out payments as part of the initial purchase price and record the estimated fair value of contingent consideration as a liability in “Estimated contingent earn-out liabilities” and “Long-term estimated contingent earn-out liabilities” on the consolidated balance sheets.  We consider several factors when determining that contingent earn-out liabilities are part of the purchase price, including the following:  (1) the valuation of our acquisitions is not supported solely by the initial consideration paid, and the contingent earn-out formula is a critical and material component of the valuation approach to determining the purchase price; and (2) the former owners of acquired companies that remain as key employees receive compensation other than contingent earn-out payments at a reasonable level compared with the compensation of our other key employees.  The contingent earn-out payments are not affected by employment termination.

 

We measure our contingent earn-out liabilities at fair value on a recurring basis using significant unobservable inputs classified within Level 3 of the fair value hierarchy (as described in “Critical Accounting Policies and Estimates” in our Annual Report on Form 10-K for the fiscal year ended September 27, 2015). We use a probability-weighted discounted income approach as a valuation technique to convert future estimated cash flows to a single present value amount. The significant unobservable inputs used in the fair value measurements are operating income projections over the earn-out period (generally two or three years), and the probability outcome percentages we assign to each scenario. Significant increases or decreases to either of these inputs in isolation

 

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would result in a significantly higher or lower liability, with a higher liability capped by the contractual maximum of the contingent earn-out obligation.  Ultimately, the liability will be equivalent to the amount paid, and the difference between the fair value estimate and amount paid will be recorded in earnings.  The amount paid that is less than or equal to the contingent earn-out liability on the acquisition date is reflected as cash used in financing activities in our consolidated statements of cash flows.  Any amount paid in excess of the contingent earn-out liability on the acquisition date is reflected as cash used in operating activities.

 

We review and re-assess the estimated fair value of contingent consideration on a quarterly basis, and the updated fair value could differ materially from the initial estimates.  Changes in the estimated fair value of our contingent earn-out liabilities related to the time component of the present value calculation are reported in interest expense.  Adjustments to the estimated fair value related to changes in all other unobservable inputs are reported in operating income.  During the second quarter and first half of fiscal 2016, we increased our contingent earn-out liabilities and reported related losses in operating income of $1.8 million and $2.8 million, respectively.  The $1.8 million charge in the second quarter reflects our updated valuation of the contingent consideration liability for CEG.  This valuation includes our current projection of CEG’s financial performance during the earn-out period, which exceeded our original estimate at the acquisition date.  The remaining $1.0 million loss represents the final cash settlement during the first quarter of fiscal 2016 of an earn-out liability that was valued at $0 at the end of fiscal 2015.

 

During the second quarter and first half of fiscal 2015, we decreased our contingent earn-out liabilities and reported a related gain in operating income of $3.1 million.  This gain resulted from an updated valuation of the contingent consideration liability for Caber Engineering (“Caber”), which is part of our Oil, Gas & Energy reporting unit in the RME segment.

 

The acquisition agreement for Caber included a contingent earn-out agreement based on the achievement of operating income thresholds (in Canadian dollars) in each of the first two years beginning on the acquisition date, which was in the first quarter of fiscal 2014.  The maximum earn-out obligation over the two-year earn-out period was C$8.0 million (C$4.0 million in each year).  These amounts could be earned on a pro-rata basis for operating income within a predetermined range in each year.  Caber was required to meet a minimum operating income threshold in each year to earn any contingent consideration.  These thresholds were C$4.0 million and C$4.6 million in years one and two, respectively.  In order to earn the maximum contingent consideration, Caber needed to generate operating income of C$4.4 million in year one and C$5.1 million in year two.

 

The determination of the fair value of the purchase price for Caber on the acquisition date included our estimate of the fair value of the related contingent earn-out obligation.  This initial valuation was primarily based on probability-weighted internal estimates of Caber’s operating income during each earn-out period.  As a result of these estimates, we calculated an initial fair value at the acquisition date of Caber’s contingent earn-out liability of C$6.5 million in the first quarter of fiscal 2014.  In determining that Caber would earn 81% of the maximum potential earn-out, we considered several factors including Caber’s recent historical revenue and operating income levels and growth rates.  We also considered the recent trend in Caber’s backlog level and the prospects for the oil and gas industry in Western Canada.

 

Caber’s actual financial performance in the first earn-out period exceeded our original estimate at the acquisition date.  As a result, in the fourth quarter of fiscal 2014, we increased the related contingent consideration liability and recognized a loss of $1.0 million.  This updated valuation included our assumption that Caber would earn the maximum amount of contingent consideration of $4.0 million in the first earn-out period.  In the second quarter of fiscal 2015, we completed our final calculation of the contingent consideration for the first earn-out period and paid contingent consideration of C$4.0 million (USD$3.2 million).  At that time we also evaluated our estimate of Caber’s contingent consideration liability for the second earn-out period.  This assessment included a review of the status of ongoing projects in Caber’s backlog, and the inventory of prospective new contract awards.  We also considered the status of the oil and gas industry in Western Canada, particularly in light of recent decline in oil prices at the time.  As a result of this assessment, we concluded that Caber’s operating income in the second earn-out period would be lower than our original estimate at the acquisition date and our subsequent estimates through the first quarter of fiscal 2015.  We also concluded that Caber’s operating income for the second earn-out period would be lower than the minimum requirement of C$4.6 million to earn any contingent consideration.  Accordingly, in the second quarter of fiscal 2015, we reduced the Caber contingent earn-out liability to $0, which resulted in a gain of $3.1 million.  The second earn-out period ended in the first quarter of fiscal 2016 with no further adjustments.

 

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At March 27, 2016, there was a total maximum of $17.8 million of outstanding contingent consideration related to acquisitions.  Of this amount, $10.8 million was estimated as the fair value and accrued on our condensed consolidated balance sheet.

 

4.                                      Goodwill and Intangible Assets

 

The following table summarizes the changes in the carrying value of goodwill:

 

		WEI			RME			Total
		(in thousands)
Balance at September 27, 2015		$	210,748		$	390,631		$	601,379
Goodwill additions		9,030			95,424			104,454
Goodwill adjustments		–			2,000			2,000
Foreign exchange impact		713			7,698			8,411
Balance at March 27, 2016		$	220,491		$	495,753		$	716,244

 

As a result of the Coffey and INDUS acquisitions in the second quarter of fiscal 2016, our goodwill increased $95.4 million and $9.0 million in the RME and WEI segments, respectively.  The $2.0 million goodwill adjustment resulted from the final valuation of our purchase price allocation of net assets acquired in the CEG acquisition.  Foreign exchange impact relates to our foreign subsidiaries with functional currencies that are different than our reporting currency.  The gross amounts of goodwill for WEI were $302.9 million and $293.1 million at March 27, 2016 and September 27, 2015, respectively, excluding $82.4 million of accumulated impairment.  The gross amounts of goodwill for RME were $529.0 million and $423.8 million at March 27, 2016 and September 27, 2015, respectively, excluding $33.2 million of accumulated impairment.

 

We perform our annual goodwill impairment review at the beginning of our fiscal fourth quarter.  Our most recent review was performed at June 29, 2015 (i.e. the first day of our fourth quarter in fiscal 2015).  In addition, we regularly evaluate whether events and circumstances have occurred that may indicate a potential change in the recoverability of goodwill.  We perform interim goodwill impairment reviews between our annual reviews if certain events and circumstances have occurred, such as a deterioration in general economic conditions; an increase in the competitive environment; a change in management, key personnel, strategy or customers; negative or declining cash flows; or a decline in actual or planned revenue or earnings compared with actual and projected results of relevant prior periods.

 

We estimate the fair value of all reporting units with a goodwill balance based on a comparison and weighting of the income approach (weighted 70%), specifically the discounted cash flow method and the market approach (weighted 30%), which estimates the fair value of our reporting units based upon comparable market prices and recent transactions and also validates the reasonableness of the multiples from the income approach.  The resulting fair value is most sensitive to the assumptions we use in our discounted cash flow analysis.  The assumptions that have the most significant impact on the fair value calculation are the reporting unit’s revenue growth rate and operating profit margin, and the discount rate used to convert future estimated cash flows to a single present value amount.

 

In the fourth quarter of fiscal 2015, we determined that our Waste Management Group (“WMG”) reporting unit in our RME segment had an estimated fair value that exceeded its carrying value by less than 20%. In our discounted cash flow model for WMG, we assumed annual revenue growth rates of 3% to 5% based on historical trends in WMG and the solid waste industry, projections for future solid waste activity, and WMG’s backlog and prospects for new orders. We discounted the resulting cash flows at a rate of 11.0%. Our market based assessment resulted in a value approximating a 1.0 multiple of revenue for the 12 month period preceding the valuation date. The discounted cash flow value, combined on a weighted-average basis with the results of our market analysis, resulted in an estimated fair value for WMG of $103.5 million compared to our carrying value including goodwill of $93.9 million. No changes occurred during the first half of fiscal 2016 that would significantly change these amounts. As of March 27, 2016, the goodwill amount for WMG was $56.5 million.

 

Although we believe that our current estimate of fair value is reasonable, our analysis is primarily dependent on our future level of revenue from our solid waste clients.  However, the extent of our future activity is uncertain.  We currently anticipate that if WMG’s future revenue grows by less than 2.0%, or market prices for similar businesses decline by more than 10%, WMG’s goodwill could become impaired.

 

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Additionally, if the yield on 20-year U.S. treasury bonds (our assumed risk-free rate of return) or the additional return investors require for alternate investments, including those similar to WMG, increases, we may be required to increase the discount rate used in our cash flow analysis.  If all of our operating assumptions remain constant, but we are required to increase the discount rate in our cash flow model to 14.0% or higher, WMG’s goodwill could become impaired.

 

The gross amount and accumulated amortization of our acquired identifiable intangible assets with finite useful lives included in “Intangible assets - net” on the condensed consolidated balance sheets, were as follows:

 

		March 27, 2016										September 27, 2015
		Weighted- Average Remaining Life (in Years)		Gross Amount				Accumulated Amortization				Gross Amount				Accumulated Amortization
		($ in thousands)
Non-compete agreements		0.7		$	841			$	(701	)		$	819			$	(587	)
Client relations		3.5		118,344				(75,732		)		106,676				(67,726		)
Backlog		1.9		18,634				(3,429		)		2,115				(1,444		)
Technology and trade names		1.3		2,518				(2,242		)		2,506				(2,027		)
Total				$	140,337			$	(82,104	)		$	112,116			$	(71,784	)

 

As a result of the Coffey and INDUS acquisitions in the second quarter of fiscal 2016, our identifiable intangible assets increased $20.5 million and $5.7 million in the RME and WEI segments, respectively.  Additionally, foreign currency translation adjustments increased our net identifiable intangible assets by $1.5 million in the first half of fiscal 2016.  Amortization expense related to the identifiable intangible assets for the three and six months ended March 27, 2016 was $5.4 million and $9.8 million, respectively, compared to $4.8 million and $10.8 million for the prior-year periods.  Estimated amortization expense for the remainder of fiscal 2016 and succeeding years is as follows:

 

		Amount
		(in thousands)
2016		$	12,618
2017		22,525
2018		11,863
2019		5,456
2020		4,285
Beyond		1,486
Total		$	58,233

 

5.             Property and Equipment

 

Property and equipment consisted of the following:

 

		March 27, 2016				September 27, 2015
		(in thousands)
Land and buildings		$	3,661			$	3,661
Equipment, furniture and fixtures		182,856				176,883
Leasehold improvements		30,194				21,582
Total property and equipment		216,711				202,126
Accumulated depreciation		(142,397		)		(137,220		)
Property and equipment, net		$	74,314			$	64,906

 

The depreciation expense related to property and equipment, including assets under capital leases, was $6.0 million and $11.3 million for the three and six months ended March 27, 2016, respectively, compared to $5.9 million and $12.8 million for the prior-year periods.  In the first six months of fiscal 2015, we sold assets comprised primarily of equipment of a total book value of $3.6 million for net proceeds of $9.8 million, and recognized a corresponding gain of $6.2 million.  This equipment was primarily related to our RCM segment.

 

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6.             Stock Repurchase and Dividends

 

On November 10, 2014, the Board of Directors authorized a stock repurchase program under which we may repurchase up to $200 million of our common stock over the succeeding two years.  In the first half of fiscal 2016, we repurchased through open market purchases under this program a total of 1,896,760 shares at an average price of $26.36, for a total cost of $50.0 million.

 

On November 9, 2015, the Board of Directors declared a quarterly cash dividend of $0.08 per share payable on December 11, 2015 to stockholders of record as of the close of business on November 30, 2015.  On January 25, 2016, the Board of Directors declared a quarterly cash dividend of $0.08 per share payable on February 26, 2016 to stockholders of record as of the close of business on February 12, 2016.  Dividends totaling $9.4 million and $8.6 million were paid in the first half of fiscal 2016 and fiscal 2015, respectively.

 

Subsequent Event.  On April 25, 2016, the Board of Directors declared a quarterly cash dividend of $0.09 per share payable on May 27, 2016 to stockholders of record as of the close of business on May 13, 2016.

 

7.             Stockholders’ Equity and Stock Compensation Plans

 

We recognize the fair value of our stock-based compensation awards as compensation expense on a straight-line basis over the requisite service period in which the award vests.  Stock-based compensation expense for the three and six months ended March 27, 2016 was $3.4 million and $6.1 million, respectively, compared to $2.6 million and $5.4 million for the same periods last year.  The majority of these amounts were included in “Selling, general and administrative (“SG&A”) expenses” in our condensed consolidated statements of income.  There we no material stock compensation awards in the second quarter of fiscal 2016.  For the six months ended March 27, 2016, we granted 241,932 stock options with an exercise price of $27.16 per share and an estimated weighted-average fair value of $8.05 per share to our non-employee directors and executive officers.  The executive officer options vest over a four-year period, and the non-employee director options vest after one year.  In addition, we awarded 137,777 performance shares units (“PSUs”) to our non-employee directors and executive officers at a fair value of $31.63 per share on the award date.  All of the PSUs are performance-based and vest, if at all, after the conclusion of the three-year performance period.  The number of PSUs that ultimately vest is based 50% on the growth in our diluted earnings per share and 50% on our total shareholder return over the vesting period.  Additionally, we awarded 215,539 restricted stock units (“RSUs”) to our non-employee directors, executive officers and employees at a fair value of $27.16 per share on the award date.  All of the executive officer and employee RSUs have time-based vesting over a four-year period, and the non-employee director RSUs vest after one year.

 

8.             Earnings Per Share (“EPS”)

 

Basic EPS is computed by dividing net income available to common stockholders by the weighted-average number of common shares outstanding, less unvested restricted stock for the period.  Diluted EPS is computed by dividing net income by the weighted-average number of common shares outstanding and dilutive potential common shares for the period.  Potential common shares include the weighted-average dilutive effects of outstanding stock options and unvested restricted stock using the treasury stock method.

 

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The following table sets forth the number of weighted-average shares used to compute basic and diluted EPS:

 

		Three Months Ended						Six Months Ended
		March 27, 2016			March 29, 2015			March 27, 2016			March 29, 2015
		(in thousands, except per share data)
Net income attributable to Tetra Tech		$	3,744		$	19,017		$	26,983		44,592
Weighted-average common shares outstanding — basic		58,451			61,153			58,819			61,816
Effect of dilutive stock options and unvested restricted stock		680			570			708			615
Weighted-average common stock outstanding — diluted		59,131			61,723			59,527			62,431
Earnings per share attributable to Tetra Tech:
Basic		$	0.06		$	0.31		$	0.46		$	0.72
Diluted		$	0.06		$	0.31		$	0.45		$	0.71

 

For the three and six months ended March 27, 2016, 0.8 million and 0.5 million options were excluded from the calculation of dilutive potential common shares, respectively, compared to 1.3 million for both same periods last year.  These options were not included in the computation of dilutive potential common shares because the assumed proceeds per share exceeded the average market price per share during the period.  Therefore, their inclusion would have been anti-dilutive.

 

9.             Income Taxes

 

Our effective tax rates for the first half of fiscal 2016 and 2015 were 38.2% and 29.6%, respectively.  In the second quarter of fiscal 2016, we incurred $13.3 million of acquisition and integration expenses and debt pre-payment fees for which no tax benefit was recognized.  Of this amount, $6.4 million resulted from acquisition expenses that were not tax deductible and $6.9 million resulted from integration expenses and debt pre-payment fees incurred in jurisdictions with current and historical net operating losses where the related deferred tax asset was fully reserved.  Additionally, during the first quarter of fiscal 2016, the U.S. Protecting Americans from Tax Hikes (“PATH”) Act of 2015 was signed into law.  This law permanently extended the federal research and experimentation tax credits (“R&E Credits”) retroactive to January 1, 2015.  Our income tax expense for the first quarter of fiscal 2016 included a tax benefit of $2.0 million attributable to operating income during the last nine months of fiscal 2015, primarily related to the retroactive recognition of the R&E Credits.  Our income tax expense for the first quarter of fiscal 2015 included a similar retroactive tax benefit of $1.2 million attributable to operating income during the last nine months of fiscal 2014.  Excluding these items, our effective tax rates for the first half of fiscal 2016 and 2015 were 32.7% and 31.5%, respectively.

 

At March 27, 2016, approximately $55.0 million of undistributed earnings of our foreign subsidiaries, primarily in Canada, were expected to be permanently reinvested.  Accordingly, no provision for U.S. income taxes or foreign withholding taxes has been made.  Upon distribution of those earnings, we would be subject to U.S. income taxes and foreign withholding taxes.  Assuming the permanently reinvested foreign earnings were repatriated under the laws and rates applicable at March 27, 2016, the incremental federal tax applicable to those earnings would be approximately $5.6 million.

 

We review the realizability of deferred tax assets on a quarterly basis by assessing the need for a valuation allowance. As of March 27, 2016, we performed our assessment of net deferred tax assets. Significant management judgment is required in determining the provision for income taxes and, in particular, any valuation allowance recorded against our deferred tax assets. Applying the applicable accounting guidance requires an assessment of all available evidence, both positive and negative, regarding the realizability of the net deferred tax assets. Based upon recent results, we concluded that a cumulative loss in recent years exists in certain foreign jurisdictions. We have historically relied on the following factors in our assessment of the realizability of our net deferred tax assets:

 

·                  taxable income in prior carryback years as permitted under the tax law;

 

·                  future reversals of existing taxable temporary differences;

 

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·                  consideration of available tax planning strategies and actions that could be implemented, if necessary; and

 

·                  estimates of future taxable income from our operations.

 

We considered these factors in our estimate of the reversal pattern of deferred tax assets, using assumptions that we believe are reasonable and consistent with operating results.  However, as a result of cumulative pre-tax losses in certain foreign jurisdictions for the 36 months ending March 27, 2016, we concluded that our estimates of future taxable income and certain tax planning strategies did not constitute sufficient positive evidence to assert that it is more likely than not that certain deferred tax assets would be realizable before expiration.  Based on our assessment, we concluded that it is more likely than not that the assets will be realized except for the assets related to loss carry-forwards in foreign jurisdictions for which a valuation allowance of $8.7 million has been provided.

 

10.          Reportable Segments

 

Our reportable segments are described as follows:

 

WEI:  WEI provides consulting and engineering services worldwide for a broad range of water and infrastructure-related needs in both developed and emerging economies.  WEI supports both public and private clients including federal, state/provincial, and local governments, and global and local commercial and industrial clients.  The primary markets for WEI’s services include water resources analysis and water management, environmental restoration, government consulting, and a broad range of civil infrastructure master planning and engineering design for facilities, transportation, and regional and local development.  WEI’s services span from early data collection and monitoring, to data analysis and information technology, to science and engineering applied research, to engineering design, to construction management and operations and maintenance.

 

RME:  RME provides consulting and engineering services worldwide for a broad range of resource management and energy needs.  RME supports both private and public clients, including global industrial and commercial clients, U.S. federal agencies in large scale remediation, and major international development agencies.  The primary markets for RME’s services include natural resources, energy, international development, remediation, waste management and utilities.  RME’s services span from early data collection and monitoring, to data analysis and information technology, to science and engineering applied research, to engineering design, to construction management and operations and maintenance.  RME supports Engineering, Procurement and Construction Management (“EPCM”) for full service implementation of commercial projects.

 

RCM:  We report the results of the wind-down of our non-core construction activities in the RCM reportable segment.  The remaining work to be performed in this segment will be substantially complete in fiscal 2017.

 

Management evaluates the performance of these reportable segments based upon their respective segment operating income before the effect of amortization expense related to acquisitions, and other unallocated corporate expenses.  We account for inter-segment sales and transfers as if the sales and transfers were to third parties; that is, by applying a negotiated fee onto the costs of the services performed.  All significant intercompany balances and transactions are eliminated in consolidation.  The Corporate segment operating losses in the second quarter and first six months of fiscal 2016 include the $15.9 million of acquisition and integration expenses described in Note 3.

 

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The following tables set forth summarized financial information regarding our reportable segments:

 

Reportable Segments

 

		Three Months Ended								Six Months Ended
		March 27, 2016				March 29, 2015				March 27, 2016				March 29, 2015
		(in thousands)
Revenue
WEI		$	226,008			$	237,736			$	466,391			$	485,533
RME		403,949				326,409				719,666				642,685
RCM		10,753				18,151				31,579				52,581
Elimination of inter-segment revenue		(13,326		)		(17,533		)		(29,544		)		(34,980		)
Total revenue		$	627,384			$	564,763			$	1,188,092			$	1,145,819
Operating Income (Loss)
WEI		$	16,391			$	15,455			$	36,420			$	36,968
RME		27,477				20,083				52,920				46,122
RCM		(386		)		5				(5,668		)		(3,416		)
Corporate (1)		(26,832		)		(5,145		)		(34,091		)		(12,664		)
Total operating income		$	16,650			$	30,398			$	49,581			$	67,010
Depreciation
WEI		$	1,203			$	1,338			$	2,371			$	2,715
RME		4,171				3,516				7,705				7,050
RCM		185				675				377				1,336
Corporate (1)		409				400				818				1,692
Total depreciation		$	5,968			$	5,929			$	11,271			$	12,793
(1)                Includes amortization of intangibles, other costs, and other income not allocable to our reportable segments.

 

		March 27, 2016				September 27, 2015
		(in thousands)
Total Assets
WEI		$	280,853			$		287,112
RME		534,578				422,133
RCM		28,965				57,612
Corporate (1)		908,518				792,385
Total assets		$	1,752,914			$		1,559,242
(1)                Corporate assets consist of intercompany eliminations and assets not allocated to our reportable segments including goodwill, intangible assets, deferred income taxes and certain other assets.

 

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