Tetra Tech 10-Q 2008
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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 office and zip code)
(Registrants 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 periods 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 is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of large accelerated filer, accelerated filer, and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):
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 July 28, 2008, 59,444,147 shares of the registrants common stock were outstanding.
TETRA TECH, INC.
Tetra Tech, Inc.
(in thousands, except par value)
See accompanying Notes to Condensed Consolidated Financial Statements.
Tetra Tech, Inc.
(unaudited in thousands, except per share data)
See accompanying Notes to Condensed Consolidated Financial Statements.
Tetra Tech, Inc.
(unaudited in thousands)
See accompanying Notes to Condensed Consolidated Financial Statements.
TETRA TECH, INC.
1. Basis of Presentation
The accompanying condensed consolidated balance sheet as of June 29, 2008, the condensed consolidated statements of income for the three and nine months ended June 29, 2008 and July 1, 2007, and the condensed consolidated statements of cash flows for the nine months ended June 29, 2008 and July 1, 2007 of Tetra Tech, Inc. (we, us or our) are unaudited, and, in the opinion of management, include all adjustments necessary for a fair statement of the financial position, the results of operations and cash flows for the periods presented. The condensed consolidated balance sheet as of September 30, 2007 has been derived from the audited financial statements at that date but does not include all the information and footnotes required by U.S. generally accepted accounting principles (GAAP) for complete financial statements.
The condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended September 30, 2007. Certain prior year amounts have been reclassified to conform to the current year presentation. The results of operations for the three and nine months ended June 29, 2008 are not necessarily indicative of the results to be expected for the fiscal year ending September 28, 2008.
2. Accounts Receivable Net
Net accounts receivable consisted of the following:
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. Substantially all unbilled receivables as of June 29, 2008 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 was determined based on a review of customer-specific accounts, bankruptcy filings by clients, and contract issues due to current events and circumstances.
Billed accounts receivable related to federal government contracts were $113.9 million and $95.5 million as of June 29, 2008 and September 30, 2007, respectively. The federal government unbilled receivables, net of progress payments, were $106.6 million and $88.5 million as of June 29, 2008 and September 30, 2007, respectively. Other than the federal government, no single client accounted for more than 10% of our accounts receivable as of June 29, 2008 and September 30, 2007.
3. Mergers and Acquisitions
All of the following acquisitions were accounted for as business combinations. Accordingly, the purchase prices were allocated to the assets acquired and liabilities assumed based on their fair values. The purchase price allocations for fiscal 2008 acquisitions, except for ARD, Inc. (ARD), are preliminary and subject to adjustments based upon their respective valuations and final determinations of the net assets acquired. None of the fiscal 2007
and 2008 acquisitions, except for ARD, were considered material, individually or in the aggregate, as they did not have a material impact on our financial position, results of operations or cash flows for the respective reporting periods and, as such, no pro forma results are presented.
In the third quarter of fiscal 2007, we acquired (i) all of the outstanding shares of Delaney Construction Corporation, Delaney Crushed Stone Products, Inc. and Delaney Leasing Company, Inc.; and (ii) all of the limited liability company interests of Delaney Properties, LLC (collectively, DGI), which provides planning, development and construction services for wind energy programs, Base Realignment and Closure (BRAC) projects, and water and wastewater treatment and conveyance facilities to its broad-based clients. The purchase price consisted of cash payments of $32.5 million. In addition, the former shareholders will receive, over a four-year period from the acquisition date, guaranteed deferred cash payments in the aggregate amount of $9.0 million and contingent earn-out payments up to an aggregate maximum of $12.0 million upon achievement of certain financial objectives. In the third quarter of fiscal 2008, we paid $2.3 million as a portion of the guaranteed deferred cash payment and $1.2 million as a contingent earn-out payment to the former shareholders. DGI is part of our resource management segment.
In fiscal 2007, we also acquired the following businesses to enhance our service offerings and expand our geographic presence:
The total purchase price for the above acquisitions consisted of initial cash payments of $8.1 million and contingent earn-out payments upon achievement of certain financial objectives over a three or four-year period from their respective acquisition dates.
In the first quarter of fiscal 2008, we acquired all of the outstanding shares of capital stock of ARD, which provides applied research, planning, design and implementation services focused on a range of water, energy, environmental and governance issues. ARD manages large, complex international development projects for its clients, predominantly the U.S. Agency for International Development (USAID). This acquisition continues our international expansion as it increases our professional workforce in new geographic areas and technical specialties around the world. ARD is part of our resource management segment. The purchase price consisted of $41.5 million in cash payments. The following table summarizes the estimated fair values of the assets acquired and liabilities assumed as of the date of acquisition:
No pro forma information is presented for fiscal 2008 as the ARD acquisition closed on the first day of our fiscal year. The table below presents summarized unaudited consolidated pro forma operating results, assuming we had purchased ARD at the beginning of fiscal 2007:
In the second and third quarters of fiscal 2008, we acquired certain assets of two civil engineering firms, Daylor Consulting Group, Inc. (Daylor) and WJA P.L.L.C. (WJA). These acquisitions, which were integrated into our infrastructure segment, offer complementary technical expertise and enable us to enhance our infrastructure service offerings. We also acquired all of the outstanding shares of capital stock of INCA Engineers, Inc. (INCA) and certain assets of Quattro Associates, Inc. (Quattro). INCA provides consulting and civil/mechanical engineering services for water infrastructure and transportation projects, including locks, levees and dams projects for the U.S. Army Corps of Engineers (USACE). Quattro provides process design and environmental consulting services to the steel and coke industries. INCA and Quattro are part of our resource management segment. The total initial purchase price for these acquisitions was $12.0 million in cash and resulted in goodwill of $5.3 million. In addition, the sellers have certain earn-out rights that allow them to receive additional cash payments over a three or four-year period upon achievement of certain financial objectives.
Subsequent Event. In the fourth quarter of fiscal 2008, we acquired three consulting and engineering firms: (1) Institute for Public-Private Partnerships, Inc., which advises government and private sector clients including USAID, on public-private partnership structures for infrastructure development; (2) Rothberg, Tamburini & Winsor, Inc., which provides water and wastewater design services to municipalities, mining companies, utilities and industrial clients, and (3) Highlander Environmental Corp., which offers environmental capabilities for oil and gas industry clients. These acquisitions enhance our service offerings and expand our geographic reach. The total initial purchase price for these acquisitions was $19.4 million in cash. In addition, the sellers have certain earn-out rights that allow them to receive additional cash payments over a two or four-year period upon the achievement of certain financial objectives.
4. Goodwill and Intangibles
For the first nine months of fiscal 2008, we recorded $17.9 million, $4.0 million, $0.6 million and $0.6 million of goodwill on our condensed consolidated balance sheet as of June 29, 2008 for the ARD, INCA, WJA and Quattro acquisitions, respectively. These amounts resulted from the excess of the purchase price for each respective acquisition over the fair value of its net tangible and identifiable intangible assets acquired. In addition, we adjusted goodwill for purchase price allocation adjustments related to certain fiscal 2007 acquisitions, and a $1.5 million payment related to the DGI acquisition for an Internal Revenue Code Section 338(h)(10) election to treat the stock purchase as an asset purchase for tax purposes. The changes in the carrying value of goodwill by segment for the nine months ended June 29, 2008 were as follows:
The gross amount and accumulated amortization of our acquired identifiable intangible assets with finite useful lives as of June 29, 2008 and September 30, 2007, included in intangible assets net on the condensed consolidated balance sheets, were as follows:
For the nine months ended June 29, 2008, $0.6 million, $2.8 million and $8.5 million were assigned to non-compete agreements, customer relations and backlog, respectively. These amounts were related to the preliminary purchase price allocations for ARD, INCA, WJA, Daylor and Quattro, and, to a lesser extent, adjustments for certain fiscal 2007 acquisitions. For the three months ended June 29, 2008 and July 1, 2007, amortization expense for acquired identifiable intangible assets with finite useful lives was $1.4 million and $0.5 million, respectively. For the nine months ended June 29, 2008 and July 1, 2007, the amortization expense was $3.9 million and $1.3 million, respectively. Estimated amortization expense for the remainder of fiscal 2008 and the succeeding years is as follows:
5. Discontinued Operation
In fiscal 2006, we sold Vertex Engineering Services, Inc., and this operating unit was accounted for as a discontinued operation in the condensed consolidated financial statements for all reporting periods. For the three and nine months ended July 1, 2007, we reported a gain from discontinued operation, net of tax, of approximately $26,000 and $52,000, respectively.
In December 2006, we retired our senior secured notes and paid off the remaining principal balance of $72.9 million. In connection with this early debt retirement, we incurred pre-payment premiums of $3.1 million and expensed the remaining unamortized deferred financing costs of $1.1 million in the first quarter of fiscal 2007. In accordance with Statement of Financial Accounting Standards (SFAS) No. 145, Rescission of Financial Accounting Standards Board (FASB) Statements Nos. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections, we reported a $4.2 million loss on retirement of debt as part of our income from operations in the first quarter of fiscal 2007.
In May 2008, we entered into an amendment to our Second Amended and Restated Credit Agreement (Credit Agreement) solely to provide additional flexibility with respect to potential future acquisitions. There was no change in the overall size of the revolving credit facility.
7. Stockholders Equity and Stock Compensation Plans
We account for stock-based compensation in accordance with SFAS No. 123 (revised 2004), Share-Based Payment (SFAS 123R). Under the fair value recognition provisions of this statement, stock-based compensation
cost is measured at the grant date based on the value of the award granted and recognized over the period in which the award vests. For the three and nine months ended June 29, 2008, stock-based compensation expense was $2.2 million and $6.1 million, compared to $1.7 million and $4.2 million for the same periods last year, respectively. These amounts are included in selling, general and administrative (SG&A) expenses and to a lesser extent, other contract costs in our condensed consolidated statements of income. Stock-based compensation expense for the three and nine months ended June 29, 2008 may not be indicative of the total expense to be expected for fiscal year 2008.
8. Earnings Per Share
Basic earnings per share (EPS) is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding. 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 using the treasury stock method.
The following table sets forth the number of weighted average shares used to compute basic and diluted EPS:
For the three and nine months ended June 29, 2008, 1.5 million and 2.6 million common stock options were anti-dilutive, compared to 2.7 million and 3.9 million options for the same periods last year, respectively. These options were excluded from the calculation of dilutive potential common shares because the exercise prices were above the average market prices for the reporting periods.
9. Income Taxes
In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109, Accounting for Income Taxes (FIN 48). Under FIN 48, we may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement. FIN 48 also provides guidance on de-recognition, classification, interest and penalties on income taxes, accounting in interim periods and disclosure requirements for uncertain tax positions.
We adopted the provisions of FIN 48 on October 1, 2007 and did not record any cumulative effect adjustment to retained earnings as a result of this adoption. As of October 1, 2007 and June 29, 2008, the amounts of unrecognized tax benefits were $32.1 million and $37.2 million, respectively, of which $15.4 million would impact our effective tax rate if recognized for both periods. We recognize potential interest and penalties related to unrecognized tax benefits in income tax expense. The amount of interest income accrued as of October 1, 2007 was $8.4 million. The amount of interest income accrued as of June 29, 2008 was $9.4 million and is included in the non-current income taxes receivable.
While the adoption of FIN 48 did not have a cumulative effect on retained earnings, we recorded certain reclassifications that affected the presentation on our condensed consolidated balance sheet as of June 29, 2008. We recorded a reclassification from deferred tax liability to non-current income taxes payable to reflect the amount of expected tax payments related to temporary differences. Our net deferred tax asset balances reflect the expected future net tax deductions. While unrelated to the adoption of FIN 48, the increase in our current income taxes receivable reflects estimated tax payments in excess of our current provision.
We are currently under examination by the Internal Revenue Service (IRS) for fiscal years 1997 through 2004 and the California Franchise Tax Board (FTB) for fiscal years 2001 through 2003 related to research and experimentation credits (R&E Credits). In addition, during fiscal 2002, the IRS approved our request to change the accounting method for revenue recognition for income tax purposes for some of our businesses. In 2002, we filed amended tax returns for fiscal years 1997 through 2000 to claim R&E Credits and to claim refunds due under the newly approved accounting method. At the time the refund claims were filed, we were under examination by the IRS for those years. The claimed refunds are being held pending completion of the IRS examination. The estimated realizable refunds have been classified as non-current income taxes receivable on our condensed consolidated balance sheets.
During the third quarter of fiscal 2008, we received a 30-day letter from the IRS related to the R&E Credits and the accounting method for revenue recognition for fiscal years 2002 through 2004. We are protesting the positions in the letter. We are currently in the IRS appeals process for these same matters for fiscal years 1997 through 2001. During the third quarter of fiscal year 2008, we received a Notice of Proposed Assessment (NOPA) from the FTB related to R&E Credits for fiscal 2001 through 2003. We have protested the position in the NOPA. Management believes that it is reasonably possible we will reach a resolution of the issues for fiscal years 1997 through 2001 under appeal with the IRS in the next twelve months. If the resolution is favorable, the change in unrecognized tax benefits could be significant and we could receive a significant cash refund. However, if the resolution is unfavorable, there may be a material adverse effect on our financial results as a result of an increase in income tax expense, but no material impact on our cash flow in future periods. At this time, an estimate of the outcome cannot be reliably made. With a few exceptions, we are no longer subject to U.S. federal, state and local, or non-U.S. income tax examinations for fiscal years before 1997.
10. Reportable Segments
We currently manage our business in three reportable segments: resource management, infrastructure and communications. Management established these segments based upon the services provided, the different marketing strategies associated with these services and the specialized needs of their respective clients. Our resource management segment provides engineering, consulting and construction services primarily addressing water quality and availability, environmental restoration, productive reuse of defense facilities, strategic environmental resource planning and alternative energy. Our infrastructure segment provides engineering, systems integration, program management, and construction management services for the development, upgrading, replacement and maintenance of civil infrastructure. Our communications segment provides engineering, permitting, site acquisition and construction management services for utility and telecommunication infrastructure projects.
During the first quarter of fiscal 2006, we developed and started implementing the initial phase of a plan to combine operating units and re-align our management structure. Throughout fiscal 2007 and to date, we consolidated some of our reporting units under common management structure, information systems and back-office functions. These changes have had no impact on our operating segment structure to date. As a result of our exit from the wireless communications business in fiscal 2006, the remaining portion of the communication business, known as the wired business, represents a small part of our overall business. In addition, the wired business operating units increasingly perform services and serve clients that are similar in nature to those of the infrastructure business. The wired business operating units provide engineering, permitting, site acquisition and construction
management to state and local governments, telecommunications and cable operators, utility companies and other commercial clients. We continue to assess our operating and management structure, including the alignment of our wired business operating units. Should further changes be effected, we will evaluate the impact on our segment reporting as appropriate.
Management evaluates the performance of these reportable segments based upon their respective income from operations before the effect of amortization expense related to acquisitions. 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 cost of the services performed. All inter-company balances and transactions are eliminated in consolidation.
The following tables set forth summarized financial information concerning our reportable segments (as of and for the periods noted below):
(1) Other income (expense) includes corporate costs not allocable to the segments. The nine months ended July 1, 2007 included a $5.7 million reversal of accrued litigation liabilities.
11. Major Clients
For the three and nine months ended June 29, 2008, we generated 14.0% and 14.2% of our revenue from the USACE, a component of the U.S. Department of Defense (DoD), compared to 17.3% and 13.5% for the same periods last year, respectively. For the three and nine months ended June 29, 2008, we generated 15.0% and 14.5% of our revenue from the U.S. Air Force, also a component of the DoD, compared to 9.6% and 12.3% for the same periods last year, respectively. Our resource management and infrastructure segments generated revenue from all client sectors. Our communications segment reported revenue only from state and local government and commercial clients.
The following table presents revenue by client sector:
(1) Includes revenue generated from our international clients. Revenue related to projects performed in foreign countries for U.S. government and commercial clients was reported as part of our federal government and commercial client sectors, respectively.
12. Comprehensive Income
We include two components in comprehensive income: net income during a period and other comprehensive income. Other comprehensive income consists of translation gains and losses from subsidiaries with functional currencies different than our reporting currency.
For the three and nine months ended June 29, 2008, comprehensive income was $16.1 million and $42.6 million, respectively. For the three and nine months ended July 1, 2007, comprehensive income was $12.4 million and $32.3 million, respectively. We recorded an insignificant net translation loss for both the three and nine months ended June 29, 2008 and July 1, 2007.
13. Commitments and Contingencies
We are subject to certain claims and lawsuits typically filed against the engineering, consulting and construction profession, alleging primarily professional errors or omissions. We carry professional liability insurance, subject to certain deductibles and policy limits, against such claims. However, in some actions, parties are seeking damages that exceed our insurance coverage or for which we are not insured. While management does not believe that the resolution of these claims will have a material adverse effect on our financial position, results of operations or cash flows, management acknowledges the uncertainty surrounding the ultimate resolution of these matters.
In January 2007, a stockholder filed a putative shareholder derivative complaint in the Superior Court of the State of California, County of Los Angeles against certain current and former members of our Board of Directors and certain current and former executive officers, alleging proxy fraud, breach of fiduciary duty, abuse of control, constructive fraud, corporate waste, unjust enrichment and gross mismanagement in connection with the grant of certain stock options to our executive officers. We were also named as a nominal defendant in this action. The complaint sought damages on our behalf in an unspecified amount, disgorgement of the options which are the subject of the action, any proceeds from the exercise of those options or from any subsequent sale of the underlying stock and equitable relief. On April 11, 2008, the court entered a Judgment and Order of Dismissal (the Judgment) in this matter, and the appeal period has expired. Accordingly, the Judgment is final and the lawsuit has been dismissed.
In May 2003, Innovative Technologies Corporation (ITC) filed a lawsuit in Montgomery County, Ohio against Advanced Management Technology, Inc. (AMT) and other defendants for misappropriation of trade secrets, among other claims. In June 2004, we purchased all of the outstanding shares of AMT. As part of the purchase agreement, the former owners of AMT agreed to indemnify us for all costs and damages related to this lawsuit. In December 2007, the case went to trial, and the jury awarded $5.8 million in compensatory damages against AMT. In addition, in January 2008, the jury awarded $17.0 million in punitive damages against AMT plus unquantified legal fees. The court entered the above judgments in January 2008. No amounts have been paid to date; however, we have posted a $1.0 million bond as required by the court. In July 2008, the Common Pleas Court of Montgomery County issued a decision and final appealable order in response to AMTs post-trial motions. AMTs motion for judgment notwithstanding the verdict was denied, and AMTs motion for a new trial was conditionally denied. However, AMTs alternative motion to vacate or remit the verdict was conditionally granted, and ITC may either elect to accept $2.0 million in compensatory damages and $5.8 million in punitive damages or have a new trial on the appropriate amount of damages. No decision was rendered regarding attorneys fees or pre-judgment interest. We have filed a notice of appeal with the second district court of appeals in Ohio. We believe that the reasonably possible range of exposure is from $0 to approximately $10 million. As of June 29, 2008, we recorded a liability representing our best estimate of a probable loss. Further, in the same period and for the same amount, we recorded a receivable from the former owners of AMT as we believe they have the ability and intent to fully honor their indemnification to us for any and all costs and damages related to this lawsuit pursuant to the terms of the purchase agreement.
On July 25, 2008, a domestic real estate investment trust (the REIT) that owns and rents apartments filed suit against us and a former employee in the United States District Court for the Eastern District of Virginia. The suit alleges that employees at one of our operating divisions in Colorado participated in a scheme to defraud the REIT in connection with contracts for environmental clean-up work between us and the REIT. The suit seeks as much as $19 million in damages. Based on the information gathered to date and on the advice of legal counsel, we believe we have defenses and potential counter-claims to the allegations raised by the REIT, and we intend to defend ourselves vigorously. Given the early stage of the litigation, it is not possible to accurately predict the ultimate resolution of this matter.
In July 2008, we, one of our subsidiaries, and a limited number of current and former employees and officers were served with a complaint that was filed by Sullivan International Group, Inc. (SIG) in the Superior Court of the State of California in San Diego County. The complaint alleges, in part, that we breached the Small Business Administration (SBA) mentor-protégé agreement we had entered into with SIG. The complaint contains additional allegations that are based, in part, upon SIGs interpretation of the SBAs mentor-protégé program regulations. Management believes the allegations, in general, are not factually or legally correct. As of June 29, 2008, SIG owed us $1.6 million under promissory notes. SIG is in default on its payment obligations under these notes. We plan to vigorously defend against the allegations in the complaint, and obtain repayment of the amounts owed under the promissory notes.
14. Recent Accounting Pronouncements
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS 157), which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. This statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. In February 2008, the FASB issued Staff Position No. FAS 157-2, Effective Dates of FASB Statement No. 157, which defers the effective date of SFAS 157 for all nonrecurring fair value measurements of nonfinancial assets and liabilities until fiscal years beginning after November 15, 2008. We are currently evaluating the impact SFAS 157 may have on our financial statements and disclosures.
In February 2007, the FASB issued Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities Including an Amendment of FASB Statement No. 115 (SFAS 159). SFAS 159 provides companies with an option to measure, at specified election dates, many financial instruments and certain other items at fair value that are not currently measured at fair value. A company that adopts SFAS 159 will report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. SFAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS 159 is effective for fiscal years beginning after November 15, 2007. We will implement the new standard effective in fiscal 2009. We are currently evaluating whether we will elect the fair value measurement principles for certain assets and liabilities.
In December 2007, the FASB issued Statement No. 141 (revised 2007), Business Combinations (SFAS 141R). SFAS 141R establishes the principles and requirements for how an acquirer: (i) recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree; (ii) recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase, and (iii) determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. SFAS 141R makes significant changes to existing accounting practices for acquisitions. SFAS 141R is to be applied prospectively to business combinations consummated on or after the beginning of the first annual reporting period on or after December 15, 2008. We will implement the new standard effective in fiscal 2010. We are currently evaluating the impact, if any, SFAS 141R will have on our future business combinations.
In December 2007, the FASB issued Statement No. 160, Noncontrolling Interests in Consolidated Financial Statements an Amendment of ARB No. 51 (SFAS 160). SFAS 160 establishes accounting and reporting standards that require: (i) noncontrolling interests to be reported as a component of equity; (ii) changes in a parents ownership interest while the parent retains its controlling interest to be accounted for as equity transactions, and (iii) any retained noncontrolling equity investment upon the deconsolidation of a subsidiary to be initially measured at fair value. We do not currently have any less than wholly-owned consolidated subsidiaries. SFAS 160 is to be applied prospectively at the beginning of the first annual reporting period on or after December 15, 2008. We will implement the new standard effective in fiscal 2010.
In December 2007, Emerging Issues Task Force 07-01, Accounting for Collaborative Arrangements (EITF 07-01) was issued to prescribe the accounting for collaborations. It requires certain transactions between
collaborators to be recorded in the income statement on either a gross or net basis when certain characteristics exist in the collaboration relationship. EITF 07-01 is effective in fiscal 2010 for all of our collaborations. We are currently evaluating the impact, if any, EITF 07-01 will have on our financial statements.
In April 2008, the FASB issued FASB Staff Position 142-3, Determination of the Useful Life of Intangible Assets, (FSP 142-3). FSP 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS 142, Goodwill and Other Intangible Assets. FSP 142-3 shall be effective for fiscal years beginning after December 15, 2008 (fiscal 2010 for us). We are currently assessing the impact of FSP 142-3 on our consolidated financial position and results of operations.
In May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles (SFAS 162). SFAS 162 identifies the sources of accounting principles and establishes the framework for selecting the principles used in the preparation of financial statements that are presented in conformity with GAAP. SFAS 162 shall be effective 60 days following the Securities and Exchange Commissions approval of the Public Company Accounting Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles. The adoption of this standard will not have a material impact on our consolidated financial position, results of operations or cash flows.
This Quarterly Report on Form 10-Q, including Managements Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements regarding future events and our future results that are subject to the safe harbor provisions created under the Securities Act of 1933 and the Securities Exchange Act of 1934. These statements are based on current expectations, estimates, forecasts and projections about the industries in which we operate and the beliefs and assumptions of our management. Words such as expects, anticipates, targets, goals, projects, intends, plans, believes, seeks, estimates, continues, may, variations of such words, and similar expressions are intended to identify such forward-looking statements. In addition, any statements that refer to projections of our future financial performance, our anticipated growth and trends in our businesses, and other characterizations of future events or circumstances are forward-looking statements. Readers are cautioned that these forward-looking statements are only predictions and are subject to risks, uncertainties and assumptions that are difficult to predict, including those identified below, as well as under the heading Risk Factors, and elsewhere herein. Therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements. We undertake no obligation to revise or update any forward-looking statements for any reason.
We are a leading provider of consulting, engineering, construction and technical services focused on resource management and infrastructure. We serve our clients by defining problems and developing innovative and cost-effective solutions. Our solution usually begins with a scientific evaluation of the problem, one of our differentiating strengths. Our solution may span the life cycle of a project, which includes research and development, applied science and technology, engineering design, program management, construction management, construction, and operations and maintenance.
Since our initial public offering in December 1991, we have increased the size and scope of our business, expanded our service offerings, and diversified our client base and the markets we serve through internal growth and strategic acquisitions. We expect to focus on internal growth and continue to pursue complementary acquisitions that expand our geographic reach and increase the breadth and depth of our service offerings to address existing and emerging markets. As of June 29, 2008, we had approximately 8,400 full-time equivalent employees worldwide, located primarily in North America.
We derive our revenue from fees for professional and technical services. As a service-based company, we are labor-intensive rather than capital-intensive. Our revenue is driven by our ability to attract and retain qualified and productive employees, identify business opportunities, secure new and renew existing client contracts, provide outstanding services to our clients and execute projects successfully.
We provide our services to a diverse base of federal and state and local government agencies, as well as commercial and international clients. The following table presents the approximate percentage of our revenue, net of subcontractor costs, by client sector:
(1) Includes revenue generated from our international clients. Revenue related to projects performed in foreign countries for U.S. government and commercial clients was reported as part of our federal government and commercial client sectors, respectively.
We manage our business in three reportable segments: resource management, infrastructure and communications. Management established these segments based upon the services provided, the different marketing strategies associated with these services and the specialized needs of their respective clients. Our resource management segment provides engineering, consulting and construction services primarily addressing water quality and availability, environmental restoration, productive reuse of defense facilities, strategic environmental resource planning and alternative energy. Our infrastructure segment provides engineering, systems integration, program management, and construction management services for the development, upgrading, replacement and maintenance of civil infrastructure. Our communications segment provides engineering, permitting, site acquisition and construction management services for utility and telecommunication infrastructure projects.
The following table represents the approximate percentage of our revenue, net of subcontractor costs, by reportable segment:
Our services are provided under three principal types of contracts: fixed-price, time-and-materials and cost-plus. The following table presents the approximate percentage of our revenue, net of subcontractor costs, by contract type:
Contract revenue and contract costs are recorded primarily using the percentage-of-completion (cost-to-cost) method. Under this method, revenue is recognized in the ratio that contract costs incurred bear to total estimated costs. Revenue and profit on these contracts are subject to revision throughout the duration of the contracts and any required adjustments are made in the period in which the revisions become known. Losses on contracts are recorded in full as they are identified.
In the course of providing our services, we routinely subcontract services and, under certain USAID programs, issue grants. Generally, these subcontractor costs and grants are passed through to our clients and, in accordance with industry practice and GAAP, are included in revenue. The grants are reported as part of our
subcontractor costs on our condensed consolidated statements of income. Because subcontractor services can change significantly from project to project, changes in revenue may not be indicative of our business trends. Accordingly, we also report revenue less the cost of subcontractor services, and our discussion and analysis of financial condition and results of operations uses revenue, net of subcontractor costs, as a point of reference.
For analytical purposes only, we categorize our revenue into two types: acquisitive and organic. Acquisitive revenue consists of revenue derived from newly acquired companies that are reported individually as separate operating units during the first twelve months following their respective acquisition dates. Organic revenue consists of our total revenue less any acquisitive revenue.
Our other contract costs include professional compensation and related benefits, together with certain direct and indirect overhead costs such as rents, utilities and travel. Professional compensation represents a large portion of these costs. Our SG&A expenses are comprised primarily of marketing and bid and proposal costs, and our corporate headquarters costs related to the executive offices, finance, accounting, administration and information technology. In addition, we include a large portion of stock-based compensation, depreciation of property and equipment, as well as a full amount of amortization of identifiable intangible assets, in SG&A expenses. Most of these costs are unrelated to a specific client or project and can vary as expenses are incurred to support corporate activities and initiatives.
Our revenue, expenses and operating results may fluctuate significantly from quarter to quarter as a result of numerous factors, including:
· Unanticipated changes in contract performance that may affect profitability, particularly with contracts that are fixed-price or have funding limits;
· The seasonality of the spending cycle of our public sector clients, notably the federal government, the spending patterns of our commercial sector clients, and weather conditions;
· Budget constraints experienced by our federal as well as state and local government clients;
· Acquisitions or integration of acquired companies;
· Divestiture or discontinuance of operating units;
· Employee hiring, utilization and turnover rates;
· The number and significance of client contracts commenced and completed during a quarter;
· Creditworthiness and solvency of clients;
· The ability of our clients to terminate contracts without penalties;
· Delays incurred in connection with a contract;
· The size, scope and payment terms of contracts;
· Contract negotiations on change orders and collections of related accounts receivable;
· The timing of expenses incurred for corporate initiatives;
· Reductions in the prices of services offered by our competitors;
· Threatened or pending litigation;
· The impairment of our goodwill or identifiable intangible assets;
· Changes in accounting rules, and
· General economic or political conditions.
We experience seasonal trends in our business. Our revenue is typically lower in the first half of the fiscal year, primarily due to the Thanksgiving, Christmas and New Years holidays. Many of our clients employees, as well as our own employees, take vacations during these holidays. Further, seasonal inclement weather conditions occasionally may cause some of our offices to close temporarily or hamper our project field work. These occurrences result in fewer billable hours worked on projects and, correspondingly, less revenue recognized. Our revenue is typically higher in the second half of the fiscal year, due to favorable weather conditions during spring and summer that result in higher billable hours. In addition, our revenue is typically higher in the fourth fiscal quarter due to the federal governments fiscal year-end spending.
ACQUISITIONS AND DIVESTITURES
Acquisitions. We continuously evaluate the marketplace for strategic acquisition opportunities. Due to our reputation, size, financial resources, geographic presence and range of services, we have numerous opportunities to acquire both privately held companies and subsidiaries or divisions of publicly held companies. Once an opportunity is identified, we examine the effect an acquisition may have on our long-range business strategy and our results of operations. Generally, we proceed with an acquisition if we believe that it would have a positive effect on future operations and could strategically expand our service offerings. As successful integration and implementation are essential to achieve favorable results, no assurance can be given that all acquisitions will provide accretive results. Our strategy is to position ourselves to address existing and emerging markets. We view acquisitions as a key component of our growth strategy, and we intend to use both cash and securities, as we deem appropriate, to fund acquisitions. We may acquire other businesses that we believe are synergistic and will ultimately increase our revenue and net income, strengthen our strategic goals, provide critical mass with existing clients, and further expand our lines of service. These factors will likely contribute to purchase prices that result in the recognition of goodwill and other identifiable intangible assets.
In the third quarter of fiscal 2007, we acquired DGI, which provides planning, development and construction services for wind energy programs, BRAC projects, and water and wastewater treatment and conveyance facilities to its broad-based clients. This acquisition enables us to provide a wider range of service to our current and prospective wind energy clients, as DGI offers complementary capabilities and customer relationships. DGI is part of our resource management segment. In fiscal 2007, we also acquired VCL, VNL, STE, MEG, GORE and NEA. The purchase prices consisted of initial cash payments and, over a four-year period from their respective acquisition dates, guaranteed deferred cash payments and/or contingent earn-out payments upon achievement of certain financial objectives. MEG has been integrated into our infrastructure segment, and the other acquisitions have been integrated into our resource management segment.
In the first quarter of fiscal 2008, we acquired ARD, which provides applied research, planning, design and implementation services focused on a range of water, energy, environmental and governance challenges. ARD manages large, complex international development projects for its clients, predominantly USAID. This acquisition continues our international expansion, as it increases our professional workforce by approximately 730 employees in new geographic areas and technical specialties around the world. ARD is part of our resource management segment. In the second and third quarters of fiscal 2008, we acquired certain assets of two civil engineering firms, Daylor and WJA. These acquisitions, which were integrated into our infrastructure segment, offer complementary technical expertise and enable us to enhance our infrastructure service offerings. We also acquired all of the outstanding stock of INCA and certain assets of Quattro. INCA provides consulting and civil/mechanical engineering services for water infrastructure and transportation projects, including locks, levees and dams projects for the USACE. Quattro provides process design and environmental consulting services to the steel and coke industries. INCA and Quattro are part of our resource management segment.
In the fourth quarter of fiscal 2008, we acquired three consulting and engineering firms: (1) Institute for Public-Private Partnerships, Inc., which advises government and private sector clients including USAID, on public-private partnership structures for infrastructure development; (2) Rothberg, Tamburini & Winsor, Inc., which provides water and wastewater design services to municipalities, mining companies, utilities and industrial clients, and (3) Highlander Environmental Corp., which offers environmental capabilities for oil and gas industry clients. These acquisitions enhance our service offerings and expand our geographic reach. The total initial purchase price for these acquisitions consisted of cash. In addition, the sellers have certain earn-out rights that will allow them to
receive additional cash payments over a two or four-year period upon the achievement of certain financial objectives.
Divestitures. To complement our acquisition strategy and our focus on internal growth, we regularly review and evaluate our existing operations to determine whether our business model should change through the divestiture of certain businesses. Accordingly, from time to time, we may continue to divest certain non-core businesses and reallocate our resources to businesses that better align with our long-term strategic direction. We had no divestitures in fiscal 2007 or fiscal 2008.
BUSINESS TREND ANALYSIS
General. Our business continues to grow as we focus on organic growth and pursue complementary acquisitions that expand our geographic reach and increase the breadth of our service offerings to address existing and emerging markets. In the third quarter of fiscal 2008, we experienced overall revenue growth of 39.7% from organic and acquisitive revenue from federal government and commercial clients compared to the same quarter last year. Our revenue from our federal government, state and local government, and commercial businesses was approximately 55%, 16% and 29%, respectively.
Federal Government. In the third quarter of fiscal 2008, our federal government business experienced strong revenue growth of 61.3% compared to the same quarter last year. Approximately half of this growth was driven by acquisitive revenue from ARD and, to a lesser extent, INCA. The balance resulted primarily from the continuation of increased activity on our Iraq and domestic projects for the DoD. We anticipate that our federal government business will experience strong growth in fiscal 2008 compared to fiscal 2007 due primarily to our increased work with USAID and increased BRAC spending. However, due to the DoDs funding practices on projects in Iraq as well as the changing geopolitical landscape in Iraq and the U.S., it is difficult to forecast our work in Iraq beyond fiscal 2008.
State and Local Government. In the third quarter of fiscal 2008, our state and local government business declined 1.9% compared to the same quarter last year. The decline resulted from the conclusion of a large fiber-to-the-premises project and reduced activity on a large construction management project. The decline was partially mitigated by increased workload from combined sewer overflow (CSO) projects and revenue from our INCA acquisition. Although our revenue declined slightly from last year, our revenue, net of subcontractor costs, grew 12.6% due to increased self-performance of work on state and local government projects. Many state and local government agencies are facing increasingly challenging economic conditions, including budget deficits, declining tax revenues, and difficult cost cutting decisions. Simultaneously, states are facing major long-term infrastructure needs, including the maintenance, repair and upgrading of existing critical infrastructure and the need to build new facilities. In 2006, voters in several states approved infrastructure bond measures, and many of those bonds have now been sold or are in the process of being sold to provide the funding needed to advance critical projects. Additionally, new infrastructure bond measures and related tax proposals are being planned for ballots in 2008 through 2010. The funding risks associated with our state and local government programs are partially mitigated by the regulatory requirements driving these programs, such as court mandated consent decrees, as well as demographic shifts and increasing demand for water and wastewater services. Accordingly, these programs generally occur regardless of budget pressures. Consequently, we anticipate that infrastructure projects will be initiated and funded during the remainder of 2008, and our state and local government business will remain relatively flat in fiscal 2008. We will remain vigilant in monitoring and evaluating state and local government budgets as they are approved for the new fiscal year and will continue to assess any potential future impacts to our state and local business.
Commercial. In the third quarter of fiscal 2008, our commercial business experienced strong growth of 37.5% across all three segments compared to the same quarter last year. This growth was driven largely by increased demand for our alternative energy services and, to a lesser extent, increased activity on environmental remediation, geotechnical consulting and telecommunications infrastructure projects. We anticipate that our commercial business will experience moderate growth in fiscal 2008.
RESULTS OF OPERATIONS
Overall, our results for the third quarter of fiscal 2008 reflect a significant improvement as compared to the same quarter last year due to our focus on organic growth and the strategic pursuit of acquisitions that enhance our service offerings and expand our geographical presence. We continued to experience business growth from all three
reportable segments, particularly from international development projects associated with our ARD acquisition, Iraq and domestic work from the DoD, as well as alternative energy, environmental remediation, geotechnical consulting and telecommunications infrastructure projects. Our revenue, net of subcontractor costs, grew across all client sectors and all reportable segments. The increase in our contract costs substantially corresponded to our revenue growth. Our SG&A expenses increased as a result of our business growth and our investment in marketing and business development to drive that growth. Further, we incurred additional SG&A expenses related to our new acquisitions. Our net interest expense decreased as a result of lower interest expense from our debt due to lower interest rates. The decrease was partially offset by lower interest income from short-term cash investments resulting from the lower interest rates, compared to the same quarter last year.
The following table presents the percentage relationship of certain items to revenue, net of subcontractor costs: