Tetra Tech Inc (TTEK) 2017 Q2 法說會逐字稿

Good morning, and thank you for joining the Tetra Tech Earnings Call. By now you should have received a copy of the press release. If you have not, please contact the company's corporate office at (626) 351-4664.

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 up the call 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 the 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.

Great. Thank you very much, Regina, and good morning, and welcome to our second quarter of fiscal year 2017's earning conference call.

While Steve Burdick, our Chief Financial Officer will present the specifics of our financials, I'm going to start this morning's call off with a brief overview of the company and some of our key financial metrics.

We had a very strong second quarter for fiscal year 2017, with our results exceeding the top end of our guidance for both net revenue and earnings per share. For the second quarter, our revenue from ongoing operations was $664 million, which is up 8% from the prior year. Our net revenue was $516 million which was also up 8% from the prior year. We generated an operating income of $44 million, up 27% from last year. Now this performance generated a diluted earnings per share of $0.48 for the quarter which is up 30% from the prior year, and I'm very pleased to state that this is an all-time high record for us on earnings per share for a second quarter for the company. And finally, our backlog was up 18% year-over-year at approximately $2.5 billion, another record high for us. Our second quarter performance is a result of Tetra Tech's growth strategy and absolutely strong execution capabilities across our entire global operation.

I would like to present our performance by segment -- our 2 business segments. The Water Environment and Infrastructure business group's net revenue was up 21% from the prior year, and they had an excellent operating margin of 11.1%. The WEI business group's increase in net revenue and excellent margin performance was driven by organic growth in multiple end markets. We saw organic growth in U.S. state and local work, our U.S. federal work and our commercial environmental work. This was an especially strong quarter when you consider the typical winter slowdown that we see each year in Canada.

The Resource Management and Energy business group had a revenue of $315 million which was up 2% from the prior year with a margin of 9.4%. Now that margin is up 50 basis points from the prior year. RME saw growth in our U.S. commercial markets and on-plan performance for Coffey, an acquisition that joined us last year, which has just completed its first year with the company. Our growth in our energy and solid waste markets more than offset the continued reductions in revenues from the oil and gas work that we're seeing both in the United States and Canada. Overall, I'm quite pleased with the expansion of our margins over the past few years. For our ongoing operations, our second quarter margins have increased from 8.3%, which we had back in 2015. The subsequent year, in 2016, we'd increased it to 9.2%, and I'm very pleased to report that we had double-digit margin in the second quarter of 2017 at 10.1%. This is directly in line with our objective to increase our margins to more than 13% basis annually.

I'd now like to provide an overview of our performance by customer. Our work for the U.S. federal clients was up 24% from last year and was 29% of our net revenues in the quarter. Our growth in federal work was driven by projects for the U.S. Department of Defense, the U.S. State Department and the Agency for International Development. This growth was even more impressive in that we saw this growth as it took place in the second quarter that predated the passing of the 2017 appropriations that are just being agreed to even this week.

State and local revenues for the company continue to be very strong for us this quarter with an organic growth rate of 21% year-over-year for the second quarter. This growth has been built on an expanding base of state and local clients across the United States and an excellent success rate in winning new programs, including cutting edge water management and reuse programs in mostly the southern states across the U.S.

Our U.S. commercial work was up 8% year-over-year, driven by strong performance primarily from our environmental units. The growth in environmental and solid waste-related work more than offset the continued reductions that we're seeing in our oil and gas revenues.

In our International revenue, which is work that's contracted for and performed outside of the United States, was down 6% year-over-year and represented 32% of our net revenue. Now this is work that's primarily performed in Canada, United Kingdom, Australia and the Asian Pacific regions for us. Now we continue to grow our differentiated services in water and environmental work internationally, but this work in the second quarter was more than offset by the reductions in our oil and gas revenues in Canada.

In the second quarter, our backlog increased for the fifth sequential quarter resulting in an all-time high for us at $2,497,000,000 or right about $2.5 billion. We again had an excellent book of orders across our global business which included task orders for all sorts of water-related projects and services for the U.S. Army Corps of Engineers; orders for our commercial projects supporting some of the most complex environmental cleanup programs across the United States; award of technically-focused State Department and USAID projects, including a new major program for energy development in Pakistan; and we even saw orders from the Federal Aviation Administration supporting the next generation of air navigation systems.

I would like to note one thing that's unique about Tetra Tech. We continue to use the strictest criteria for tracking and reporting our backlog, which is only to include work that's been awarded, funded and authorized for us to complete the work.

Now I would like to turn the presentation over to Steve to present the details of our financials. Steve?

Thank you, Dan. So as Dan just reviewed our key financial metrics for the quarter, I won't spend time going through the numbers line by line. However, for your reference, this financial overview provides our GAAP financials for the second quarter, and a full reconciliation of our ongoing operations, which Dan just spoke about, to these GAAP financials can be found in the appendix of this presentation and in our second quarter earnings release.

So for those following on the webcast, I'd like to point out 2 items addressed on this financial overview slide. So first, you may recall that in the second quarter of fiscal 2016, both operating income and EPS included charges related to our Coffey acquisition. So you can see that in the difference here. And second, EPS for this second quarter was negatively impacted by about a net of $0.02 of earnings per share from changes associated with the earnout expenses and the wind-down of our RCM segment. So we've revised our estimates on our announced resulting from prior year's acquisitions, and thus, we recognized an aggregate gain of about $7.2 million.

Now regarding RCM, we accounted for negotiations of settlements for several claims which resulted in a negative impact to P&L of close to $8 million. Though in the second quarter, our cash impact was essentially nil for the RCM items. Now we only have about 3 projects remaining in RCM and anticipate that the wind-down would be substantially complete in 2017. However, due to the fixed price nature of these construction projects, there could be variances, either up or down, until all the project issues and claims are resolved.

I'd now like to review our cash flow metrics for the quarter. We're very pleased to report that in the second quarter, we not only caught up to but surpassed, several cash flow timing delays from the first quarter to deliver very strong cash flows from operations of $109 million. And year-to-date, our cash flow of $50 million is up 67% year-over-year. Our cash from operations remains healthy and for the remainder of fiscal 2017, we expect the range to be about $160 million to $180 million for the year. This range does include about a $20 million deferred tax payment in the third quarter due to the timing of the payment from future years into fiscal 2017. However, I do also want to point out that these tax items basically had a 0 impact on our EPS in the second quarter.

With such a strong quarterly cash flow, our net debt saw a significant decline both year-over-year and sequentially, totaling about $174 million for the quarter. Now, due to our continued strong cash flow, our leverage ratio of net debt-to-EBITDA is now below our target range of 1 to 2x. We therefore have significant dry powder not only to invest in organic growth but also invest in acquisitions while still having the capital to deliver strong returns to our shareholders, and I will speak to that more, shortly.

So lastly, our day sales outstanding was about 82.3 days in the second quarter. So as we continue to focus on front-end consulting and engineering work, we've been able to do a couple of things. One is, we've decreased our CapEx spend, which will not only benefit our free cash flows in the current year but it will also benefit our EPS in future years. And just as important, we still remain committed to a DSO target of 75 days or less.

Now as we look at our capital allocation and give you an update here, delivering strong returns for shareholders is an essential part of our balanced capital allocation strategy that we've been talking about over the last couple of years. Our long-term goal is to return 1/3 of our free cash flow annually to our shareholders through a combination of both buybacks and dividends, but we can adjust our buybacks either up or down according to different business requirements. So year-to-date, we've paid about $10 million in dividends and repurchased $20 million in stock. And just this week, our Board of Directors approved an 11% increase in Tetra Tech's quarterly dividend to $0.10 per share. But our plan is not to stop there. In November 2016, our board approved a $200 million share buyback program. So without any material acquisitions or unforeseen events, for fiscal 2017 we anticipate spending a total of $100 million in share buybacks this fiscal year. As a result, we will return an estimated 3/4 of our free cash flow to shareholders this fiscal year, and even with these amounts, we continue to delever our net debt.

Now our M&A pipeline is healthy with many opportunities, and we actually have a combined $500 million in both cash and credit facilities available for acquisitions and have the ability to take on additional debt if needed.

So as we continue to increase the return in value to our shareholders, we have an abundant capital to invest in strategic acquisitions that expand both our technical capabilities across end markets and geographies.

So thank you all for your time today, and I will now turn it back over to Dan.

Great. Thank you very much, Steve. I would now like to provide an overview of our markets and our growth outlook for the remainder of the fiscal year. Our overarching approach is to lead with science and grow our high-end consulting and engineering services to provide us a high-value, high-margin business that differentiates us in the marketplace. Now based on our continued execution of this business model, we're forecasting organic growth across all 4 of our client sectors: U.S. federal government, U.S. state and local markets, U.S. commercial, and international.

Now since our last call, we've actually reviewed the markets and we're now increasing our growth rate forecast for both the U.S. federal and the U.S. state and local markets. We expect our U.S. federal work to represent approximately 30% of our business here in the second half of the year and grow at a rate of more than 15% for the year. We expect new opportunities particularly associated with the increase in the 2017 Department of Defense budgets here in the U.S. and the associated military expansion. We expect continued growth also of more than 15% with our U.S. state and local clients. Now our state and local work is up 22% year-to-date in the first half of the year and is driven by an expanding base of local clients and associated growth and backlog for our differentiated water and infrastructure services that we provide for cities and states. We expect a strong growth could actually be further augmented by infrastructure stimulus packages that are being evaluated both at the federal level and that would be cojoined at the state and local markets.

Our U.S. commercial work is expected to grow in a range of somewhere between 1% to 3% rate, with continued increases in industrial work for water treatment, environmental cleanup programs and solid waste, which will be mitigated or offset slightly by lower revenues for U.S. oil and gas services.

And finally, Tetra Tech's international revenue, which is primarily generated in Canada, United Kingdom, Australia, and the Asia Pacific region, overall, I expect our international revenues to grow in the range of 5% to 10% as we leverage Tetra Tech's expertise to access infrastructure stimulus spending that is just beginning to be put into place in Canada and Australia. We expect P3 programs, public private partnerships programs, in Canada and new opportunities in Australia that'll actually allow us to leverage our recent acquisitions and be a driver for our international growth.

Now as we compete in these markets we serve and focus on delivering differentiated services to our clients, we continue to build our reputation as a premier firm in consulting and engineering, and I'm very pleased to announce that Tetra Tech has been ranked as the #1 water firm for the 14th consecutive year as reported by the industry-leading journal, Engineering News-Record, just in April of 2017. We also moved up to the #5 position on the ranking of Top 500 Global Design Firms based on our 2016 financial performance, and at the same time, we continue to hold our #1 rankings in environmental management, solid waste, water treatment and desalination.

Now when we acquired Coffey, which is just over a year ago -- mid-January of a year ago, we had a very clear objective to combine their local experience in the Asia Pacific region and particularly in Australia, with our expertise in water and environment. Now after they joined us, we quickly moved to combine our teams and focus on key clients including the Australian military or their Department of Defense, and I'm very pleased to give you an update on our progress. In this fiscal year, we've won several new major programs together with the Australian Department of Defense, and most recently added 8 new task orders totaling $16 million, which may sound like a small number but when we weren't during this work before, it's actually quite significant. These task scores put us at the forefront of new programs in Australia and leverage our highly specialized expertise in new emerging contaminants and environmental remediation. Now the budgets for this client, the Australian Department of Defense, are expected to increase on the order of 7% a year and represent a new growth market opportunity for Tetra Tech and our Australian operations.

Now here in the U.S., Tetra Tech has a long history of supporting the U.S. Department of Defense, and it's really all the branches, the Army, Navy, Air Force and even the National Guard, with essential consulting and engineering design services, both here in the U.S., domestically, and the U.S. operations that are taking place all around the world. Today we have over $5 billion in existing contract capacity across the Department of Defense. We hold over 40 indefinite delivery, indefinite quantity contracts just with the Army to provide engineering services, and we are a key contractor and design supporter for the Army Corps of Engineers.

Now the Department of Defense budget for 2017, which is just now being finalized, includes an increase of $15 billion over last year, providing us even more opportunities. Now Tetra Tech's role of supporting the Department of Defense is to provide master planning, site restoration and remediation, emissions clearance, engineering design services and data analytics and asset management services. What that means, that if a base is going to be expanded, redesigned or even closed, Tetra Tech can support the military in a broad range of services and activities from the earliest assessments and planning to the detailed design and even the final closure or expansion of these bases.

Now we're already seeing an increase in real early investigations and studies that are typically a precursor to an increase in the design and engineering opportunities for us. So this all looks very positive. We expect with the new budgets that are now in place for 2017, and more than 7 months into the fiscal year already, we think we see our federal clients are now going to be moving quickly to obligate funds before the end of the fiscal year.

With these projected growth rates in these end markets, we've updated our guidance for the year, and so at this point, I'd like to present our guidance for the third quarter and our updated guidance for all of fiscal year 2017. Our guidance is as follows. For the third quarter, our guidance for net revenue is a range of $510 million to $540 million, with an associated ongoing earnings per share of $0.50 to $0.55. Now for the entire year, based on a very strong first half of the year and outlook, we've updated our net revenue guidance for the entire year by increasing the bottom end of our range from $2,000,000,000 to $2,050,000,000, to an upper range of $2,100,000,000, with an associated ongoing earnings per share of $2.10 to $2.25. This updated guidance for earnings per share represents a $0.10 increase at the bottom end of that range and a $0.05 increase in the top. I would note that this guidance that I've just provided does exclude contributions from future acquisitions. It does anticipate a $0.26 per share intangible amortization on a noncash charge that we'll take, an effective tax rate of 32%, and with 50 million -- 58 million shares outstanding at the end of the year.

In summary, we had an excellent second quarter, exceeding both our net revenue and earnings per share guidance. Our backlog reached an all-time high, up 18% from last year, and for the fifth quarter, sequentially, grew. Our focus on high-end consulting, engineering and our leading with science approach to our project is resulting in increased margins and significant differentiation in the marketplace.

And in closing, we had an excellent first half of 2017. We have momentum going into the third quarter, excellent visibility with our backlog and are well positioned to benefit from the increased budgets and a focus on infrastructure in all the markets we serve, both here in the U.S. and globally.

And with that, I'd now like to open the call up for questions. Regina?

(Operator Instructions) Our first question comes from the line of Tahira Afzal with KeyBanc Capital Markets.

Dan, you're seeing momentum continue in a lot of your state and local businesses. But now we've also started to see a pretty nice visible tickup in your DoD USAID businesses. What's the next step for you? I mean how do you build on this momentum and maintain it? Clearly, these are secular cycles, that seem like they'll be pretty sustained. But is this -- given you're seeing a lot of strength, given that your free cash flow is coming in strong, what are you really focused on as you look to add even more value for shareholders?

Well, I think that the state and local work that we've seen in the last 3 quarters sequentially from Q4, we were up 30%. We were up mid-20s in the first quarter and we were up over 20 for state and local. While it's strong, I think we're actually not up to -- we have actually a confluence of 3 things that actually make us still early in this growth. I think number one is, we're actually seeing budgets increase. I think that there is an increase in specialized products such as storm water and water collection out in the Southwest, which is California; desalination in Texas and in Florida based on water quality; and intrusion with respect to solidity on the other items. And I think these are just getting started. Budgets are up, funding is up, our business is up. So I think this isn't toward the end. And many of the projects that we've been awarded at the state and local level are at the very beginning. So these aren't at the middle and end. These are actually at the very beginning. We've also seen some excellent inclusion of Tetra Tech now in public-private partnerships which are design-build, where we're actually the designer. And so we see these are big projects that actually have multi-year visibility. So for all of those reasons that we actually see the state and local work having sort of a long runway to it. And the one part that we've not even included in our guidance here in the U.S. is any incremental contribution from the stimulus. And I know that the federal government, executive branch has talked about $1 trillion. We've seen other numbers that range both above and below that, but I think that any type of movement in those areas will actually be incrementally upside for those. Now the Department of Defense, I think I said about a year ago, we were not seeing exactly this type of growth, but it was from a low point, both on spending and contracting. I actually think that we can do much better. Most of the work and the growth we've seen is for task orders and projects that were awarded to us through our existing vehicles. And I think actually coming to an agreement with the budget between the House and Senate and the executive branch will actually allow new contracts to come out. And so our growth in DoD hasn't even been on new contracts. And the one thing I've said internally, and actually our staff has come back to me, if the focus of the administration is more planes, more boats and more infantry, if you have planes, you have to have a runway, you have to have infrastructure, you have to have permitting, you have to have design work, you have to actually have infrastructure first, and that's us. If you're going to have a ship, you have to have some place to put it. You have to have a bird. It has to float on water. You have to have sediment, you have to have dredging, you actually have to have all the planning. That's what we do. And finally, for infantry, you have to actually have some place for them to reside, and that's everything from military family housing to barracks to infrastructure. Essentially, these are small cities that require power, water, waste, and that's what we do. So we think we'll be one of the earliest benefactors as this money actually flows through, because by the time you can build it, everything else has to be done first, and that's what we do. And as we move more and more to the earlier stages of the projects, which is high-end consulting, lead with science, which is certainty of completion of the design and the permitting and allowing these to go through, I think we're certainly, if not the best choice, one of the best choices out there. And I think that's why we're still very early on growth both in state and local and Department of Defense. And by the way, other things that are upside, oil and gas, we've actually factored in a 1% to 3% for commercial growth in the U.S. because of a significant reduction in oil and gas. If anything comes back, we are very well poised to be -- have a significant upside, and most of that's going to be driven to margin because that's the most profitable work that we have in the company.

Right. I Remember that, Dan. It's pretty high-margin work. I know you seem to have been taking a more conservative stance from the oil and gas side in Canada, though. Well, I'm hearing things are picking up there a bit too. Is there -- is that more of a story for you guys for fiscal year '18? Is that how we should think about it?

I think so. We are hearing positive things, meaning, notices from our clients and solicitations will come up, procurements will come out, the planning for new solicitations. But until we actually see them on the street and we've won them, we don't want to be taking any credit or claiming that we're seeing a resurgence yet. But we're hearing the same things, and you're right, we are being cautious. You could say that we're conservative, but I would hope that -- this forecast actually converts to reality here. But I do think it would likely be a 2018 effect to the company.

Your next question comes from the line of Andy Wittmann with Robert W. Baird.

I guess one of the things that caught our eye was the increase in the buyback for the year, Dan. But to return a $100 million is, obviously, a lot more significant than you previously forecasted. What is it saying that you're upping it for this year about the M&A environment, if anything, in relation to maybe the number of deals that you might be seeking or even valuations that are out there that you're choosing to buy your own company rather than maybe others?

Yes. You know, I'm actually glad you asked that question, Andy, because the one thing we do not want to communicate, and I guess we couldn't quite think of how to include it in our prepared remarks, but there's no connection, no connection between the buyback and the number and level of opportunities we have out in the M&A environment. The reality is, with $100 million of cash generated -- $109 million of cash generated just in the second quarter, it was very clear that even if we did a significant amount of acquisitions in this fiscal year, that we would still continue to delever the balance sheet to a level that would move us farther and farther away from our target of 1 to 2 leverage of our earnings to EBITDA. So after taking a look at it, we are forecasting out a cash generation for Q3 and Q4. We got a little bit more aggressive, a little bit more proactive, and the fact is, we can do a reasonable amount of acquisitions in fiscal year 2017 still between now and the end of the year and do the $100 million buyback, and we'll still deleverage the balance sheet and move farther away from a range of 1 to 2. And it's just not where we want to be. It's not efficient for our shareholders. We are bullish on the stock and our performance. We're bullish on our end markets, and so these should be looked at in things that we're doing in parallel, not a cause and effect because of a lack of acquisition opportunities to increase this. So they are independent and should not be looked at in conjunction. Now with respect to the multiples, I will say there's no doubt it's awe-inspiring to a certain degree with some of the multiples that are being paid and the consolidation in the market, but those are not our targets of where we shop and how we find people. We do not go out and our primary -- and I would say almost not at all, through investment bankers in an auction process where we're looking to pay someone to monetize their firm and to partner. Who we're looking for is actually strategic partners, people that are looking to join Tetra Tech for a long-term strategy to enhance and further our #1 positions technically and with our clients. That's what our focus is. And we want to pay them a fair amount. In fact, we want to be a full and fair payment for their acquisitions and for them to join us, and then we want to see them get paid again as they join the success of the company that both Tetra Tech and they together realize as we go forward. So we say they can get 2 payments by joining Tetra Tech, both the acquisitions, when they join us, and the success that we have together. But where we find that these are direct one-on-one negotiations almost exclusively and not through investment banker auctions that are yielding really heavy multiples.

Hard to ask my next question without getting a stock answer, but I'm going to try. Given what you said about being able to do deals, still deleveraging. So the implication there is that there's lots of cash. You've got a steadier business model now without the fixed price construction activities, albeit a little bit more predictable in terms of the cash flows in particular. Is there room, do you think, for the board to maybe reconsider the dividend policy? I mean 100% is great, but you could pay -- make an argument that it should be a lot higher or the whole idea that only returning 1/3 of the cash flow in your model should be increased to some other level. Is that something that the board kicks around on a regular basis? Could I just hear your thoughts on that perspective.

Steve will speak to it in some of the technical details, but I'll give you actually maybe a bit more of a big picture answer with respect to not just being a canned answer. Yes, it is something that we kick around. Yes, it is something we discuss. But I will tell you that, in order for Tetra Tech to be very flexible and to actually achieve our leverage range and be acquisitive as we have been, we actually didn't want to -- and currently, it's not our objective to get into a fixed amount of dividends that we don't have the flexibility to turn, not that it's easy to turn it up, but once you've turned it up, it creates a new floor. And so any adjustment to move it down is really off the table. And so our commitment to both the dividends that we pay and an annual increase, and this is a multi-year increase we've done again at this time, we want to give ourselves flexibility in that if we have multiple opportunities, we do not want to say that we can't bring the best company to join Tetra Tech that gives us access to clients, geography or technical services because we've committed to a dividend that's either or. Now I know today it's easy to say you have almost an amazing amount of capacity available because we're sitting here at 0.8 of leverage and we didn't do anything with the buybacks, we'd go down to approaching 0. But the reason we've not moved the dividend up appreciably is in order to give us flexibility to grow the company and to bring folks on, and that we've moved that discretionary use of cash through a share buyback rather than pushing it to dividends where we would have less flexibility.

Okay, I think that's going to be -- Steve you can chime in if you want, but I think that answers most of the questions. I did have one kind of operational question, and the questions were around solid waste end market. This is an end market that, I think over the last year, has actually seen some challenges. And maybe I'm wrong on that, but I think that's right. It hasn't been growing. But this -- now it seems like a -- one of the material drivers must be offsetting some of the other challenges that you're seeing in U.S. commercial. So I was just wondering if you could comment on, one, kind of the overall (inaudible) of that business now as well as any trends that you're seeing there. Is it one project, or is it broad-based projects, in terms of how it's going to inform the outlook from here for solid waste? Are we back on a growth trajectory, in other words?

Yes. It has been a bit stagnant, I would say. I think it's between $150 million to $200 million annual revenue for us. It's a business line. So it's well less than 10% of the business. It is a mix of both state and local. So we do work for cities and states, counties -- mostly cities and counties, and we also do work for the major landfill owners. So we do the design of the new cells and cap covers and landfill gas recovery. I will say that it has -- I don't want to say the word disappointed, but it has not met our expectations because we felt that the combusted coal rules for landfilling on an accelerated basis, this coal-fired power plant waste material, was going to be a big driver. And in fact, we expected it to be significant. Now there've been a number of legal challenges, states have pushed back, the administration has not been as aggressive on enforcement or moving. So we do think that it has slowed the business, so that has been flat and we've seen modest growth at the state and local and commercial level. It is very broad. No single project. No group of 2 or 3 or 5 projects represent any material amount. That's been very broad-based, and it's mostly been, again, in the southern states. And so if we can see the -- either closed down for economic reasons, from coal to natural gas, that's beneficial for us and that's a lot of landfilling, or if they continue to operate, I think even the utilities that operate these, do want to see that they don't carry long-term environmental liabilities with the waste project. So regulatory enforcement directives are not. I think this is an end market that's going to grow. It just may not be as quick as we thought.

Your next question comes from the line of Bobby Burleson with Canaccord.

So just curious in terms of outsourcing to contractors and kind of the federal budget -- the evolving federal budget, and Tetra Tech's role going forward. What types of work do you guys have the highest, kind of, competitive advantage in terms of institutional memory you guys have built up over time doing the work for the client?

Well, we talk about competitive advantages here a lot at Tetra Tech and where we focus. And I'll tell you, the things that we focus on are client relationships, institutional memories. So I'll give examples. For the Department of Defense, Tetra Tech goes back 40 years -- more than 40 years with the number of the branches with the U.S. Department of Defense. I'll tell you, it really does break down, not so much at the Pentagon level, but actually at the base or the installation or the facility itself. And in many instances, of course, the military commanding officers, the base engineers get transferred to different assignments every 2 to 3 years, sometimes they make 4 years. They move. We don't. We are the bridge between this rotational assignments of the Department of Defense staff and these sites. We did do the investigations at sites that date all the way back to the late '70s and '80s. We have done most of the design work at a number of the facilities and these are everything from the large naval bases all up and down the West Coast of the United States all the way through Alaska, some of the outposts. We actually have the data. We have the sites and we have people that are outside these bases. Now I do know the one thing I get comments on is, Tetra Tech has well over 300 offices -- or actually close to 400 offices. And the question is why don't you consolidate all of those offices down to some smaller number. Some competitors do that. We don't. And it's not because I like more offices. It does require a bit more administration, but we want to be local immediately outside the base, outside the office of our client. We want to be there, and it is, by definition, the institutional knowledge for these bases and sites. So these are not -- I'm not talking project offices that come and go. I'm actually talking about institutional memory and actually the continuity even as our clients change within their assignments. And yes, and as the federal government has put, the federal work force is declining. That puts even more reliance and emphasis on contractors like ourselves.

Okay. So I guess the implication there is that the work you're doing, in some cases, cannot be taken in-house by the client.

No. And I will say the one thing about the new administration that we actually are pretty positive on, the new administration believes that private industry can do it more efficient and more effectively, and we're there to actually help support that.

Okay, great. And then, in terms of oil and gas, it sounds like I'm assuming areas where you've taken up your outlook. You've omitted, I guess, commercial in terms of changing anything at this point. Is it still down 20% year-over-year, kind of, implied in the guidance?

It is. Actually, I'll give you a little more detail on that. In Canada, it's down more like 30%. It was about 30% reduction year-over-year the first half. We expect a similar number in the second half. The U.S. is actually a little bit better. We were down about 25% in the first half. We think that's actually going to moderate, maybe, 15% the second half. But -- so that would save an implied year-on-year reduction for the year in the U.S. oil and gas around 20-ish-percent on an overall annual basis. That's already embedded into our guidance.

Okay. And at this point in the game, is there still an opportunity for that to perform a little bit better than the guidance?

There is. I will say that there are a number of proposals and opportunities with the oil and gas clients. I will say that's the one area or one of the few areas that can move to book and burn big numbers very quickly, because in the commercial sector, particularly in the commodities, oil and gas and mining, if a project has to move forward often, it's with a very short time frame. So it is possible we could see an upside on that. But we are roughly 5 months left in our fiscal year, so this window is beginning to close with respect to meaningful contribution this fiscal year.

Okay. And then you mentioned the mining, and we're seeing some mining, kind of, equipment book-to-bill get quite positive in March for some of these -- for the mobile equipment. And I'm just curious, are you seeing any developments there? If these guys are spending more money on equipment, is there increased activity? I'm thinking of kind of the Michigan area, kind of Midwest area.

You know, it's been at a -- on life support level for the past couple of years. We've seen very small signs of upticks, I know people like to use the words, green shoots. It's very small, early indicators. But I would say it's so spotty and inconsistent that -- I won't say it's getting any worse, but I haven't yet seen the reality of contracts giving us a trend. And if we do see that, we'll certainly include it in our calls when we see some material indication of a pickup.

You guys are at record backlog, and the backlog just keeps getting stronger and stronger. Are you doing a lot of organic kind of hiring here? Like how do you make sure the capacity doesn't become an issue? I'm sure if you'll draw a line out, 1 year or 2, that backlog number gets even bigger. So do you have the staffing available right now to get enough headroom?

Well, we do. And I will say that if you follow the industry, overall, there's been an amazing amount of consolidation and changes and changing of companies through sale or even breakups. And I will say that for very high-end engineers and scientists and chemists and technical professionals, a lot of them are looking for stability, a clarity of where they're going and consistency of ownership. So they're not -- no bidding contracts making all sorts of changes and that's something that we represent, maybe, best-in-class in the entire industry. And so we have been a net attractor of some of the best talent in the entire industry through some of these, really, Tier 1 competitors that are actually looking from their staff for stability, best-in-class position and a technical differentiation. So we have been in that a beneficiary of all these changes that have been taken place.

Your next question comes from the line of Noelle Dilts with Stifel.

A lot of good questions have been asked so far, but I just thought I'd see if we can get an update on -- given that you are still really actively pursuing acquisitions, can you talk about some of the areas and markets that are of particular interest to you at this point?

Yes. I can speak to a few, and we sort of break them up into 3 categories. Geographic, presence to move to an area that we're either underrepresented or not represented geographically. Areas -- second would be areas that we're looking to add new clients, that there's very high barriers to entry with the client. So we'd actually look to bring someone on who can bring us existing contracts or relationships. And the third then is someone who'll bring us a technical resource or technical capability that doesn't exist. So with respective to geographic, the one area that where -- well there are some locations in the U.S. that we're underrepresented. A lot of them are sort of the mid-Eastern seaboard of the U.S. so the Atlantic, mid-Atlantic area. It's an area that we've been underrepresented, and so geographically that area. And then internationally, of course, Europe is an area that we are quite interested in. We think we can actually bring best-in-class in a number of technical areas. So those are, geographically, areas we'd be looking at. With respect to technical areas, we're actually looking to add technical resources in Australia to expand our ability to provide city and Australian state capability, so environmental, water and what I'd call -- we would call municipal infrastructure work in Australia. A good example, we did do one acquisition this last quarter, Ecological Associates of Australia joined us. We really do want to take from just being an engineering and geotech first-in-class provider in Australia, and we want to move that to environmental and infrastructure and water. And so we look for water and those items in Australia. We're very actively looking, and we think we can make a big move there. And then technically, we are focused on smart water, which is really in at the nexus of, or an intersection of, water experts, that can actually implement it through smart sensors and instrumentation and smart meters and others for watershed and large scale water system management. And so those are technical areas, and that would mostly be here in the United States. So those are the areas that we're specifically looking for, and we're -- I would say none of those are higher priority than the other. And so whichever is the best opportunity, that's a market leader we're looking to have join us.

Okay, great. And then, I just wanted to focus a bit on the Canadian market. Given that you've spent so much time building up operations there. Can you kind of break out what you're seeing in oil and gas versus the rest of the market? And just given this headwind you're facing in oil and gas with the completion of the large project, can you help us think about when that market will -- Canada overall will bottom and start to inflect up?

Well, we feel -- actually we look at Canada almost in 2 buckets right now, and I think you said it well, it's sort of oil and gas and then everything else. And maybe I could say oil and gas and maybe I could say mining, because at one point mining was really quite, quite large for us up there, with a few uranium and other specialty minerals, potash. Let me start with the good news. We actually see that the work for the provinces and for the cities and even for commercials with respect to development infrastructure, water systems and even 3Ps, we've had some very good success. In fact, if you Google or take a look, our clients have been announcing, Tetra Tech's been hired as either directly or as part of large consortium teams. You can go find those. Some of those are on very, very large projects. We've had great success there. We're seeing growth both in Québec, which we have a significant presence, all the way to British Columbia. So I'd say really across the country. We're seeing growth on what you might call the municipal business, and that's going well. However, oil and gas, we do have some very large oil and gas projects that are twilighting. In fact, the biggest one we had essentially just finished this last quarter or 2. We do have other opportunities, but they will come in smaller pieces. So it'll take 3, 4, 5 projects to equal the one big one. We are proposing on and being considered on multiple projects, but I would say these are individual projects. It's not we're submitting on 20, and we only need to win 3 or 4. We're submitting on 4 or 5, and need 2 or 3. So it's -- I would say it's a -- I don't want to call a complete absence, but a lack of significant number of opportunities, at least at this time. So that's why we remain very cautious on the oil and gas side in Canada.

Your next question comes from the line of Tate Sullivan with Sidoti.

The consistent mentions of the high-quality backlog. I mean do you have an internal EBITDA margin target as part of that good visibility?

You know, we do. We actually do have an embedded margin in the projects we bid. Obviously, we bid a project from the bottom up. We have a margin included in it. Only when we want it, and they've -- as I said before, they've signed a contract, they've funded it and authorized us to go do it, till we get to work. We are very cautious on making claims on embedded profitability on the backlog because, I believe, having been a project manager and project engineer for many, many years, the difference between a proposed margin and a deliberate margin can be night and day. And so I will tell you that the margins embedded in our backlog are equal to or slightly better than what we're even reporting as performance. But I find that it's much easier to underperform on a proposed margin than to significantly overperform. You can watch a 10% margin go to 0 a lot easier than you can watch 10% go to 20% usually. And so I prefer to actually demonstrate the embedded margin in our backlog with our quarterly actual results.

Okay. I mean I was just -- I mean can back into the implied EBITDA margin from your guidance. I mean I get you up to almost 12, and then I was just trying to get some visibility into where it could go from there too. And then, just detail oriented on Page 6, the backlog slide. Sorry, if I missed this earlier. You have the ceiling for project orders. Is that not in the current backlog to clarify?

That's correct. We're approaching $15 billion in contract ceilings, and it's a great example, as you can see, that when we receive a contract, we do not put it in backlog until they give us an actual assignment. We generally refer to those as task orders or authorized execution. So those numbers are not in the backlog.

Your next question comes from the line of Ryan Connors with Boenning and Scattergood.

A couple of questions. First, I wanted to take the flip side of the earlier question regarding staffing bandwidth, because if you look in the quarter, it looks like there was actually a 2% decline in personnel. So if you can just give us some perspective, Dan, on what's going on there and maybe where in the last quarter release you're adding people versus where you're downsizing and why? And what the outlook is for labor utilization in dollar terms?

Yes, absolutely. Absolutely. Well, how I work -- how our business works is, in the summertime we have a lot of people out doing field surveys or doing oversights, we're doing investigations, we have drill rigs, we do sampling, we're on dredging sites, we're actually doing surveys and other items. In the wintertime, we do -- so those staff, in order to be efficient and to keep our staff utilized, a lot of those staff are either part-time, come off our payroll, or -- so we seasonally are significantly lower in headcount in the winter than we are at the summer. And so if you take a look between Q1, which included October, November, December, things are still going through the fall but the lowest headcount, and it is a seasonally adjusted number all the time. We do not hold staff where we don't have work. We actually do manage it. So what you're seeing is actually the natural cadence of the staffing for our business. So that's not a reduction that would be indicative of the work we have. With respect to adding, it's mostly where we work in the winter, which is where it's warmer, and you can get outside and do staffing work. So in the southern states in the U.S., in those locations. So I wouldn't -- when you look sequentially, that's really not a great representation. If you wanted to take a look, you could take a look at the second quarter from a year ago. We were at 15,556, so let's call it 15,500. And this year, we're at almost 16.3 for Q2 to Q2. That would be a better indicative -- indication. So we added about 800 new staff in Q2 to Q2, and last year, we included Coffey already. So it's not from an acquisition.

Got it, okay. That makes sense. And the other one was, just it seemed like the delta between the segment's margins, so WEI more than 300 basis points above RME now in the quarter, which is the biggest gap that that's been at in a while. Obviously, there are some discrete things from quarter to quarter, but it seems like that segment is kind of galloping ahead and coming at a higher-margin business over time. When you talk about the high-quality backlog and so forth, I mean is that skewed toward that business? And should we expect that gap to continue to grow in the water segment's favor? Or is that just short-term noise?

Well, the WEI, Water, Environment and Infrastructure is inherently mostly government work. So the federal state, local. It -- typically they would have lower margins as compared to RME, given favorable economic conditions. I would say it's just great execution by the project management and the technical staff and leadership within WEI. So I actually am -- I don't want to say this on this call because I think they're doing well enough already, but honestly, they're doing a great job, absolutely a great job. There is ability to have a bit more margin expansion there. But inherently, the profits on cost-plus work and certain other government work would show that these are nice. They are at the high end of a range that we would expect. Really the issue is the RME, and RME had historically had the highest margins in the company by far, driven by oil and gas, and a 30% reduction in Canada and 25% to 20% in the U.S. was putting significant pressure on RME. So it's not so much that WEI can continue to outperform and drive that separation. It's really we need a bit of economic turnaround to drive the margins up on RME and I actually look to the day, hopefully soon, that you would say that RME is outpacing WEI without WEI coming down at all. I think RME has the ability to be well above 15%, and that gives incredible leverage to our model on overall margin and returning of earnings to our shareholders.

Our final question comes from the line of Ryan Cassil with Seaport Global.

A lot of my questions have been answered, but a couple of things. I guess the first, your comments on Tahira's first question on the federal side, just kind of partnering that with your expectations for federal for the year. You've left some room for deceleration and perhaps that's conservatism, but it doesn't sound -- it sounds like you actually wouldn't be surprised, based on what you said, to see an acceleration in that business. Do you agree with that? Or am I getting a little over my skis there?

No. I actually agree with you, but the reason we aren't more -- we aren't translating that opportunity at the upside into even more raise on our revenue guidance or others are for every time we see a budget approved, for instance, this week and more funding put into DoD, these are all great things. Agreement that a funding has been put across other key clients, for us, those are great things. But it seems like the next minute, if not certainly the next day or 2, there's threat of shutting the government down and all sorts of things. So I do see many opportunities. It would not surprise us for that 15% -- greater than 15%, and that's why we put greater than. We didn't actually include a range, because we could easily be, at the federal level, 20% or significantly higher. But on the other hand, if something comes out of left field and shuts everything down, we want to be prudent or cautious. So the reason isn't because we see any material foreboding clouds. In fact, it's quite the opposite, but there is an awful lot of different information coming out on any given week. So I think we just like to be cautious at this time.

Okay, makes sense. And then the last one for me is a little bigger picture, but perhaps, you'll take a swing at it. On your state and local business, I mean everything just seems rock-solid. We've heard from competitors and customers that the demand is there for the permitting and front-end work. But at the same time, I guess where we're not seeing it is the follow-through on construction activity and demand for equipment that relates to the actual construction of projects. So I was wondering if you agree with that? And if you do, what you'd think it takes to get those projects moving? And I guess lastly, is there any risk that as this continues, that your customers will ultimately get backed up on projects and could slow some of the front-end work that you guys do?

Well, the question is, why isn't the front end not translating into the back end to a certain extent. And I do think it's with respect to certainty of funding, that might come from the federal, that might be tax-relief related, so it might be tax incentives. It may be stimulus. Actually, dedicated earmarked funds. It's lots of things like that, that I think are causing some hesitation in converting it from a plan or a permit to actually construction. And so we have found in the years past that even if a projects not constructed, it can still be excellent for the front end. Things change, development takes place around the project sites. So if you design something or permit something and you wait for 3 months, 6 months, 1 year, you may get to do that all again. So we certainly have seen opportunities where we get to design or look for other alternatives for value engineering on something to make it better and more efficient. So just because something's not constructed, it doesn't mean it has a direct impact to our work. And in fact, when it doesn't get constructed, quite often it's a net positive for us because we can find other ways to design it or find even a more efficient alternative for our client. And if you can spend a few dollars on planning and save a lot of dollars on construction, that's an incredible value. So that's how we see where we're at. So I have seen what you're talking about. A little bit less conversion from front end to back end, and I think it's certainty of funding and tax implications and other items. So I don't know if that's helpful.

Yes. No, it is. Appreciate it.

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

Well, thank you very much, Regina, and thank every one of you for being on the call and for your insight questions and interest in Tetra Tech. I look forward to speaking with all of you next quarter, and we'll do a very focused job on doing the best we can for our clients, projects and building our book of business as we go forward to the second half of 2017. Thank you very much, and have a great rest of the week. Bye.

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