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Edited Transcript of TTEK earnings conference call or presentation 3-May-18 3:00pm GMT

Q2 2018 Tetra Tech Inc Earnings Call

PASADENA May 7, 2018 (Thomson StreetEvents) -- Edited Transcript of Tetra Tech Inc earnings conference call or presentation Thursday, May 3, 2018 at 3:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Dan L. Batrack

Tetra Tech, Inc. - Chairman, CEO & President

* Steven M. Burdick

Tetra Tech, Inc. - CFO, Executive VP & Treasurer

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Conference Call Participants

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* James Giannakouros

Oppenheimer & Co. Inc., Research Division - Executive Director and Senior Analyst

* Justin P. Hauke

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Associate

* Noelle Christine Dilts

Stifel, Nicolaus & Company, Incorporated, Research Division - VP & Analyst

* Robert Joseph Burleson

Canaccord Genuity Limited, Research Division - MD & Analyst

* Ryan Michael Connors

Boenning and Scattergood, Inc., Research Division - MD & Senior Analyst of Water and Environment

* Sean D. Eastman

KeyBanc Capital Markets Inc., Research Division - Associate

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Presentation

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Operator [1]

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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 will 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.

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Dan L. Batrack, Tetra Tech, Inc. - Chairman, CEO & President [2]

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Thank you very much, Erin. Good morning and welcome to our fiscal year 2018 second quarterly earnings conference call. Overall, I'm very pleased with the results of this quarter. Our strong performance resulted in our achieving the highest ever revenue for the first 6 months of any year in our 51-year history. We're beginning the second half of the year with momentum and increased visibility, especially for our U.S. federal work.

And as a result of our strong second quarter performance and increasing visibility in our outlook, we're raising our guidance for revenue and earnings per share for the 2018 fiscal year.

I'll now begin with an overview of our quarterly results and business outlook, and Steven Burdick, our Chief Financial Officer will provide additional details on our financial performance, tax and our capital allocation. We had a very strong second quarter.

For our second quarter, our revenue from ongoing operations was $699 million, up 5% from last year. Our net revenue was $533 million, up 3% from the prior year, which generated an operating income of $45 million, which resulted in diluted earnings per share of $0.54 for the quarter, up 13% from the prior year.

I'd now like to provide an overview of our performance by customer. Our second quarter performance was led by strong growth for our U.S. state and local, our U.S. commercial and our U.S. federal work. State and local revenues continue to be up this quarter with net revenue growth up 26% year-over-year. This is our seventh sequential quarter of double-digit growth. This increase was a direct result of water infrastructure work in the high growth states across the Southern United States and our continued support for the recovery phase services in response to the hurricanes and fires that struck the United States at the end of 2017.

For U.S. federal net revenue, in the quarter it was up 7% driven by a strong year-over-year growth, primarily with the U.S. Department of Defense. Our U.S. commercial net revenue was also up, it was up 6% year-over-year on a broad base of commercial permitting, technical analysis and design work. And this does include a slight uptick in our U.S. midstream oil and gas services work.

And finally, our international revenue, excluding our oil and gas work in Canada, was up double digits, up 17% year-over-year, reflecting the strength in our Canadian, South American, Australian economies and the addition of our newest acquisition NDY in Australia. Overall, international revenues were down 10%, due to the oil and gas pipeline project we completed in Canada last year.

I'd now like to present the performance of our 2 business segments. The Government Services Group or GSG and the Commercial & International Business Group or CIG. The Government Services Group, GSG Group, includes our U.S. Federal, our U.S. state and local and international development businesses. This group also includes our highly successful emergency response practice and our water infrastructure programs. The GSG business group had an excellent second quarter with 11.8% margin and double-digit revenue growths of 11%. The growth was driven by increases in all of their end markets with continued strength in our water infrastructure and emergency response work.

The Commercial & International Business Group or CIG focuses on our global commercial client base with regional operations in Canada, Australia, South America, and it includes our oil and gas, mining and our energy practices. The CIG margins were improved this quarter to 7.6%, which is up 30 basis points from last year. This is actually quite a good margin for CIG considering this is a low point for their highly seasonal Canadian operations. Revenues for CIG, excluding the Canadian oil and gas work, was up 12% for a broad base of infrastructure work in Canada, Australia, South America and our U.S. commercial work.

I'm very pleased to announce that our backlog this past quarter finished at up over $2.5 billion. Our backlog was up 3.3% sequentially as well as being up year-over-year. In the quarter, we had orders across our international development businesses, including new programs with the United States, Australian and U.K. Development agencies. We also received orders for our recently awarded contracts with the U.S. federal agencies, such as the Federal Aviation Administration and the Department of Defense.

And this past quarter, we were awarded a new $40 million data analytics contract for the FAA, where we're working with the agency to design a state-of-the-art system for tracking medical records. And I'd like to note that Tetra Tech continues to use the strictest criteria for tracking and reporting our backlog, which is only that contracts that are awarded, funded and where we've been authorized to go do to work right now. Due to the recent regulatory changes, by 2019 all public companies in the United States will be required to follow-up backlog reporting definition very similar to ours.

Now I'd like to turn the presentation over to our CFO, Steve Burdick, to present the details of our financials. Steve?

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Steven M. Burdick, Tetra Tech, Inc. - CFO, Executive VP & Treasurer [3]

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Thank you, Dan. So for those following along on the webcast in the appendix of this presentation, you can find a full reconciliation of our GAAP results, which are presented on this slide to our ongoing results, which Dan addressed previously.

So turning to our financial results for the quarter, as Dan just highlighted, revenue, operating income and EPS for the second quarter of 2018 were outstanding. In fact, net revenue of $532.8 million and ongoing EPS of $0.54 both exceeded the upper end of our guidance ranges for the quarter. The fiscal 2018 second quarter revenue of $700.3 million and net revenue of $532.8 million increased over last year. These increases came from a growth across all our end markets but were specially led by our state and local projects as well as those activities in the U.S. federal government.

Our continued focus on front-end differentiated consulting and engineering work has resulted in improved profitability for Tetra Tech as well as a decreased risk profile for our overall business. And as a result, our second quarter earnings per share of $0.51 increased double digits over last year.

For the second quarter, cash flow provided by operations totaled $81.3 million. The second quarter is typically a strong cash generator, as we move away from the year-end and Christmas holidays. In addition, due to the year-to-date 10% increase in revenue, there was a greater need to use our working capital in order to fund this growth.

Our net debt increased year-over-year and totaled $275.8 million at quarter end. Our leverage ratio of net debt-to-EBITDA remained at the low end of our target range. And as a result of our leverage of 1.2x, we continue to have the ability to invest in our organic growth as well as in acquisitions, while having sufficient capital to deliver returns to our shareholders.

Lastly, our days sales outstanding was 92.4 days for the second quarter. Our DSO goal is to be at 75 days or less, half of the delta from our actual 92 days to this goal of 75 is due to the timing of collections from our disaster recovery work that must be processed through several layers of the federal and local government agencies. The other half is due to various ongoing claims that are in the process of being concluded upon with our clients. These are both timing issues, which should result in improved operating cash flow in the future.

Our capital deployment strategy calls for a balance of investing in our business, managing the balance sheet and returning cash to our shareholders. So we continue to target a net debt leverage ratio of 1x to 2x. So let me update you on what we've done to date on capital allocation.

We've closed 3 strategic acquisitions in fiscal 2018, Glumac, BridgeNet and, as Dan just stated, most recently NDY. Ultimately, our strong free cash flow also provides us with sufficient capital to return to shareholders through both buybacks and dividends. For the second quarter, we paid $5.6 million in dividends and bought back $25 million in stock. And just this week, our Board of Directors approved our 17th consecutive dividend to be paid in June.

In fact, we are increasing this dividend by 20% to $0.12 per share per quarter. Delivering significant returns to our shareholders remains a key part of our balanced capital allocation strategy and we plan to continue to provide strong returns for shareholders in the form of buybacks and dividends throughout fiscal 2018. Thanks for your time today.

And I'll now hand the call back over to Dan.

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Dan L. Batrack, Tetra Tech, Inc. - Chairman, CEO & President [4]

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Great. Thank you very much, Steve. I'd now like to give you some insight into the markets that we expect to drive revenue in the latter half of the 2018 fiscal year.

The U.S. federal government and our state and local work are expected to provide a very strong and reliable underpinning to the completion of our year. As we enter the second half of the fiscal year, we expect the U.S. federal bidding activity to continue to increase as the various agencies we work with begin to award their 2018 funds.

As you know, the federal budget or the omnibus spending bill was just signed on March 23 of 2018. The spending bill increased budget significantly in all the major federal agencies that we work for, including the Department of Defense, which is up 14.2% over its prior year authorization amount. Even programs that we expected to be down, such as the State Department recovered significantly in the final appropriations, resulting in a 14.8% increase in their operating budget compared to the expected 20% to 30% reduction.

Tetra Tech has an excellent portfolio of federal contracts that provide us with a combined capacity of over $15 billion across a diverse group of agencies and services line.

Our state and local work continues to be a very strong growth market for us. We had continued success in key markets such as the recently awarded projects in California, Texas and New York. And on the emergency response front, another key local market for us, we are moving to early recovery stage programs beginning the long-term process of assessing and developing mitigation strategies for infrastructure that was affected by the 2017 hurricanes.

And the recently passed U.S. federal budgets include $89 billion in supplemental appropriations, which will support our state and local clients in funding their disaster recovery programs. While our U.S. federal and state and local projects provide us with very good visibility and continued momentum, the oil and gas markets offers the most potential for upside in the second half of the year. There continues to be optimism that oil prices will rise or at least stabilize at the current levels and as a firm that specializes in midstream consulting and engineering services, we're very well positioned to capitalize on the build-out of the oil and gas pipeline related infrastructure or the takeaway capacity that's needed in the United States. Our oil and gas clients can award work very quickly when they have a need and we can rapidly mobilize when we receive these orders and it could be a contributor still in the second half of this year.

I'd now like to provide our guidance for the third quarter and our updated guidance for all of fiscal year 2018. Our guidance is as follows, for the third quarter, our net revenue guidance range is from $525 million to $555 million, with an associated diluted ongoing earnings per share of $0.62 to $0.68. Now based on our performance to date and business outlook, we've raised our guidance for fiscal year 2018 for both net revenue and earnings per share as follows.

For all of 2018, we've increased our net revenue guidance to $2.15 billion to $2.25 billion, with an also increased level of our diluted ongoing earnings per share to $2.50 to $2.62.

Now the assumptions for the fiscal year 2018 guidance are as follows. This guidance does exclude $0.18 per share of the one-time impact for the U.S. tax law. It does include intangible amortization of $18 million or $0.22 per share for the year, does anticipate a 26% effective tax rate for the full year, an approximate 57 million average diluted shares outstanding and it does exclude any contributions from acquisitions that we would make in the second half of this year.

In summary, we had a very strong second quarter with net revenues and earnings per share exceeding the high end of our guidance for the quarter. Our strong water infrastructure and hurricane recovery services in key regions of the United States resulted in the seventh consecutive double-digit growth of our state and local business. The recently passed U.S. federal budgets and strengthening oil and gas markets provide us with greater visibility and upside opportunities in the second half of this fiscal year. And as a result, we've raised our quarterly dividend by 20% and increased our full-year guidance for both net revenue and earnings per share.

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

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from the line of Sean Eastman from KeyBanc Capital.

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Sean D. Eastman, KeyBanc Capital Markets Inc., Research Division - Associate [2]

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I just wanted to start out on 2019. I realize it's earlier than you'd like to provide guidance, but I'm just hoping that maybe you can speak to what your markets are telling you in terms of a sustainable growth rate and what could be some of the really key incremental drivers for '19, particularly given that this year we've seen some pretty outsized growth in a couple of your core markets.

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Dan L. Batrack, Tetra Tech, Inc. - Chairman, CEO & President [3]

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That's a good question, Sean, and we're certainly not providing guidance into 2019. But we certainly would be happy to share with you what we're seeing in the marketplaces [at end] of the second half of the year and they would be indicative of how we expect things to set trends moving into next year. Each of our U.S. government markets are actually growing quite well. And if you -- I'll start with the largest single market for us or single set of clients with the U.S. federal government, we expect that to continue to grow at a 5% to 10% rate. You can see for this past quarter, we were right in the middle of that 7% and now with the clarity on the budget, we actually expect that that could increase as we move towards the second half of this year and it would look to probably continue that momentum. Other one nice thing about the federal level, they actually increased the debt ceiling and passed it for a 2-year period. So we don't expect that this will have another short-term review and so it provides not only a view for 1 year of the funding levels, but actually 2 years. So that looks a bit more promising. On state and local, it is interesting we've -- it has been great, it's 26% this past quarter, about 9% of that was an emergency response. But what I would call our sustainable underlying baseline work of water infrastructure for municipal entities, cities, states, counties was up at 17% for this past quarter. We expect that to continue at a 10% to 15% rate. There is actually a rising tide, we've seen additional funding at the states because of bonds, because of tax receipts and others, actually mean that there's more dollars going into these programs. So we do think it has a longer term sustainable support and there's been a lot of consolidation in our marketplace, which has created a lot of disarray, so we have had the opportunity to take market share, which has put us at the upper end of that range of 10% to 15%. In fact, we've been well over 20% in our baseline work, we were above that again this last quarter at 17%. So I expect that to continue well, I don't want to understate the emergency response or the disaster response activities, because while we get a early, very large revenue and quick response to support the short-term needs, longer-term funding, particularly with the federal appropriations of just under $90 billion to actually evaluate what can you do with this infrastructure to make it more resilient, what can you do to recover it, move it, harden it, and those are projects that are actually much larger and much longer. And that's how we would look to transition our short-term work to longer-term, and that largely comes through our state and local clients, where we have 400 different clients in standing task orders and contracts with those entities across the country. Now of course, the one that can be up, we don't have it baked into our guidance. It falls under our U.S. commercial and actually our Canadian activities is oil and gas. And I will say in Canada, things actually are looking a bit better. In fact, I'd say in the last 30 to 60 days, we've had more bidding opportunities than we've had in the past year and a half. And so we do think that that is looking brighter. Now bidding opportunities don't mean revenue yet. But it is something we'll keep you updated on. In international, I just couldn't be happier with the infrastructure support that we're getting on bids and performance in Canada and actually the synergies of the entities that we've acquired in Australia working together. And as I shared in my prepared comments, we were 17% international this last quarter, if you just take out the one oil and gas project in Canada and that actually puts it among the best performers in the company. And I see that actually continuing. So I know that's a little bit of a long answer, but that sort of encompasses all of the major operations in the company out to the end of the year and gives some insight going into 2019.

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Sean D. Eastman, KeyBanc Capital Markets Inc., Research Division - Associate [4]

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Yes. That's helpful. It sounds like there is a lot of momentum, really broad-based momentum, across the business, you're hinting at a pretty strong positive growth outlook being sustainable, and I'm looking at the backlog here, it's up around 1% year-over-year. I assume what you're saying about the federal budget visibility and potentially some oil and gas that you are expecting some pretty good backlog momentum here in the near term?

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Dan L. Batrack, Tetra Tech, Inc. - Chairman, CEO & President [5]

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I do think our backlog does look favorable. I'm really glad to see it move back up from last quarter and this is in light of really very slow federal orders. So it wasn't the U.S. federal government that drove the backlog going up, It was really broad-based contributions from all of the other sectors, state and local, U.S. commercial, all across international. And so with a little bit of contribution from some of the spending being put in place from the budgets that were just passed at the federal government, we look for that to have a favorable longer term continued upside on the backlog front. And by the way, at just over $2.5 billion, I believe it's about the third highest backlog in the company's history that we've ever completed at quarter end. So it's not that far from an all-time high, where we're at right now. So to move up from here is actually pretty encouraging for the company.

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Operator [6]

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And our next question comes from the line of Ryan Connors from Boenning and Scattergood.

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Ryan Michael Connors, Boenning and Scattergood, Inc., Research Division - MD & Senior Analyst of Water and Environment [7]

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So I want to talk about margins a little bit. It seems like you had some very nice positive momentum on the gross margin line and I wondered if you could talk to us about the drivers there, in particular, whether the improved labor utilization you've talked about in the past is playing a role there and then where you see that headed going forward?

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Dan L. Batrack, Tetra Tech, Inc. - Chairman, CEO & President [8]

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That's a good question. I'm glad you took note on the gross margins. Obviously, one of entities that had helped us, it was a pleasant surprise during the quarter. It was the performance in the CIG Group. It was up 30 points year-over-year. And actually that's the entity that had the oil and gas large contract that we had in Canada a year ago, that was actually quite significant. And with it actually not being present this year compared to a year ago, I expected more pressure and actually it to be flat or even slightly down year-over-year, but it was up 30 basis points and that translates into utilization more work, we actually saw more orders in the U.S. side on the commercial within CIG and so that actually worked out quite well for us and to translate into the performance for CIG and contributed to the gross margin being up. I'll also say that utilization with the revenue increase is a quite significant increase in the government services group, because it translates into having our existing staff more utilized, does contribute to the gross margin. So we don't need to add additional overhead to generate that revenue. And finally here at Tetra Tech, we've been very focused for a number of years, for well over a decade, in having moved the entire company to a common platform. If you join Tetra Tech, we actually want to make life easier. We want to run the company on a single accounting, HR project management platform. And we did complete a number of the newer acquisitions, translating them over to -- transitioning them over to our platform, which actually caused us to have to spend less on multiple systems, which then translated over to a greater gross margin. So we do think those are all increases that should be sustainable. And the one that I'm really looking to see it moving is CIG. CIG has had, so the commercial international group, has had margins that are below our government services group because of the cyclical low position we've seen in commodity prices. And with many of the mining activities now looking to coming back, a little bit more stability and upside on oil and gas, it would be great to see our CIG group not only match our government services but outpace it and I think that probably won't outpace it in the remainder of 2018, but certainly that's possible in 2019 and that will do a lot to the collective margin of the company, it will show up in gross, it will flow all the way through operating income and you'll see it in EPS. So the upside, GST has been a great performer, very steady, very predictable, but I think it might be time for CIG to make its big comeback and actually lead the way for us.

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Ryan Michael Connors, Boenning and Scattergood, Inc., Research Division - MD & Senior Analyst of Water and Environment [9]

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And my second one, Dan, was actually more -- a bit of a housekeeping item, contingent consideration was a headwind in the quarter, obviously, you don't look at that as part of your ongoing EPS and guidance but there still is a fairly material liability there on the balance sheet, so can you just give us any color about how we might think about modeling that going forward?

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Dan L. Batrack, Tetra Tech, Inc. - Chairman, CEO & President [10]

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I'll let Steve Burdick will update exactly what moved in the quarter on it because it has sort of the opposite effect of what you might think. But our acquisitions, all of our acquisitions that have joined us have a contingent consideration, which by [layman] are known as an earnout, and so we do want to make sure that they're actually bought into us, that they perform in alignment with what they financially anticipate, and our goal is that we would actually pay every bit of that out. It actually is embedded in the purchase price and we have a great track record of the performance of the acquisitions meeting or exceeding their actual performance in the quarter but the accounting rules have an interesting opposite impact on the company, that if they beat what they even anticipated performing, we do take small charges and actually have Steve speak to that as to what that impact was just here in the second quarter.

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Steven M. Burdick, Tetra Tech, Inc. - CFO, Executive VP & Treasurer [11]

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Thanks, Dan. So in the quarter, we had about $1.9 million in contingent consideration charges and that resulted, as Dan alluded to, better than expected profitability for 2 acquisitions, one was an Australian environmental acquisition from prior year or from last year. So they just completed their first year, and they did better than expected. So therefore, the earnout that we paid was more than what was originally anticipated. The second one was a solid waste acquisition that we acquired 3 years ago, they're completing their third year and their final earnout and as a result of their better than expected profitability, we also are paying out more for the earnout this year than what was expected. So that's really where it was coming from in the quarter.

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Dan L. Batrack, Tetra Tech, Inc. - Chairman, CEO & President [12]

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Just a note here that, it's a point that I think is important for others that have looked to join us, that we have paid out in almost all instances the full amount of earnout, and in fact even greater numbers than anticipated because, of course, folks are concerned that it it's earnout, perhaps it's not going be realized, now those that have joined us not only realize that number, but the great examples this past quarter even more than that, which is actually reflective of a higher-than-expected performance than they even came in at.

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Ryan Michael Connors, Boenning and Scattergood, Inc., Research Division - MD & Senior Analyst of Water and Environment [13]

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And then I do have one last one, a little more bigger picture type question. But there's been some talk it seems in some of the industry trade rags about design firms moving back down stream and adding construction and contracting capabilities, that seems like bit of a reversal of where we've been moving in the industry the last decade or so and certainly runs counter to the direction that Tetra Tech has moved. So can you give us your take on that. What that means from an industry perspective and whether your thinking has changed there at all?

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Dan L. Batrack, Tetra Tech, Inc. - Chairman, CEO & President [14]

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Yes, I think it's a great question. That's just a great question and I think what I've observed, and been in this industry for many decades now personally, and, of course, at the company 50 years and I think what happens is or what is happening, is it's really been a fork in the road so to speak, 2 divergent areas. And those companies that have consolidated become larger and have done more significant transformational acquisitions and in order to perpetuate these larger to move a much, much larger firm, you need a much larger project, which is typically construction. And that's where they've gone. That is really a size over quality or quantity over quality, we are highly focused on quality over quantity and that goes all the way from acquisitions to the type of work -- we are a consulting, design engineering firm. There's no doubt that's what we are. We do have the ability with professional capability to follow all the way as owners' engineer and even provide oversight of the construction in compliance with the design specs and materials, but we have launched a number of firms that are -- have gone construction, there are many out there that that is their legacy, their heritage and they are fantastic at it. And we love to team with those folks and become partners and joint ventures, where we do take projects on a full turnkey basis, we'll have them as key partners or subcontractors and vice versa when the construction [leads]. But those that are inherently consulting firms or consulting and engineering firms and look to move into construction, we have seen it be quite a high risk and generally -- and we speak this first hand because we did experience this in 2012, 2013 and saw the light that -- fortunately in time to back up, put the company in reverse back up and go back down the proper path, but the cost of risks and liabilities at construction when that isn't your first calling of what your company is about, can be huge liabilities and those that recognize that and back up in time will be bruised and battered and some of the DSO, that Steve has talked about, with receivables even 3, 4 years later are still on items that we're working through on that decision that was made 4 years ago. Now those that embark upon it now can save their company. Those that don't can actually -- may offline give you a big list of those that didn't back up in the time and don't [get listed].

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Operator [15]

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Our next question comes from the line of Jim Giannakouros from Oppenheimer.

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James Giannakouros, Oppenheimer & Co. Inc., Research Division - Executive Director and Senior Analyst [16]

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If I may tag on to a couple of Ryan's questions. I would have expected just because you've migrated more to, I thought, cost plus et cetera, away from fixed price as you kind of migrated away from project activity. I'm still seeing that 32% or so level in fixed price that's comparable to what you were doing in fiscal '15, why hasn't that shifted? Is that a reflection of that you're taking on lower risk fixed price on the front end? How should I understand that line in your disclosures?

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Dan L. Batrack, Tetra Tech, Inc. - Chairman, CEO & President [17]

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Yes, that's great. That's a great observation. I will say that not all fixed price is created equal, not at all. And in fact, our goal is to take on fixed price contracts where we have a expertise and where our client has asked us to do something. So if it's can you design a pump station for a fixed price? We've designed many thousands of them, they want certainty and design around designing of a pump station. We know how many sheets it will take. We know what the [character] or what the structural components are, what -- all the different aspects of it. We have typicals to take off of and so, let's say, it's a million dollar design project for a pump station, for example. It can rain, it can snow, we can have strikes out there and it doesn't impact our ability to complete that project on time, on budget in a favorable margin. Whereas a $1 million construction project, that would be fixed price. It has risks of weather, has risks of material, has risks of labor and has work risks of warranty and so while they both would be called fixed price, one actually is fully in our control and would be self-performed and the other is something that we're heavily reliant on others in areas outside our -- outside of our control. And furthermore, the fixed price is typically direct negotiated on the technical services or the consulting work that we do with our clients under existing contracts, where quite often fixed price construction activity would be -- sometimes we refer to it as rip and read for the government, which is just rip open the sheets and see for the lowest prices. So I think we have moved while the percentage doesn't look appreciably different, the actual execution and the quality of the work is night and day, it could not be farther different than what it was several years ago.

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James Giannakouros, Oppenheimer & Co. Inc., Research Division - Executive Director and Senior Analyst [18]

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And on Ryan's question on the margins in both segments and you gave good color that you think commercial compounds back with oil and gas, if and when that does rebound. But in government services. I mean, I've always thought that 13% or so is kind of the entitlement margin level or at least really good and healthy level [you are] there, does that move either way with how you envision your mix of business or competitive environment as a federal growth going forward, how should we be thinking about the margin progression there?

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Dan L. Batrack, Tetra Tech, Inc. - Chairman, CEO & President [19]

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Yes, it's around 13%. So I've seen on an annual basis, we've been hitting that or slightly better here with the GSG Group. We do believe that based on utilization or really volume in that group, that margin could go up a bit from there and we have been performing higher than that, particularly in the summer quarters where we've got a lot of our field crews and survey folks out busy. I was pretty happy at 11.8% in this winter months of January, February and March with the government group. So I do think it has a bit of movement, but I think 13, could we do 14? Yes, for an annual. Could it get 15? Possibly, but by the nature of the government work on T&M cost plus, largely I do believe it's range bound within a point or 2 with respect to the upside. And so that's not what's going to be the primary driver of the overall enterprises margins going up. You have seen CIG and as you had mentioned, we do have opportunity there, I said 8% or so, 9% at the bottom of the cycle at the top of the cycle will be between 15 and 20, and our governments are between 10 and 15 depending on where on a government funding they are. So the swings are much larger and it could put the collective company then at longer term, we could hit 15 or greater if we hit the top of the cycle. So CIG, or the commercial and international activities will be those that have the greatest range. And since we're at the bottom, it has the biggest upside but I've actually been very happy with the numbers that have been performed at GSG and there is some upside, but it's not significant on margin, it is on revenues. So topline will drive that operating income generation.

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James Giannakouros, Oppenheimer & Co. Inc., Research Division - Executive Director and Senior Analyst [20]

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And one more if I may on the guidance for the rest of this year. I mean, you seem comfortable on the federal side, commercial is seeing strong oil and gas firming as you've mentioned, but your outlook, you correct me if I am wrong, it really reflects first half outperformance, doesn't really reflect an increase in the fiscal second half outlook, can you talk about what's keeping you conservative there and then any color on revenue break out? I apologize if I missed any comments on what's embedded in your guide from a segment perspective, net revenues.

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Dan L. Batrack, Tetra Tech, Inc. - Chairman, CEO & President [21]

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No, I think you got it exactly right, Jim. What we did is, based on the outperformance or the beating our own guidance, our own estimates for Q1 and Q2, we just flow that through the annual guidance. So that's what the amount has increased, certainly on the revenue side, we have had a bit better margin. So you did see us move the increase on EPS even more so. Now a little bit of that is tax, no doubt about it. The new tax legislation was put in place, but we went from -- I gave an example on our guidance coming into the fiscal year, we were at $2.20 EPS and with this latest increase, we've gone up to $2.50. So we've increased $0.30 and that actually is much greater than what just to beat in the Q1 and Q2 because we didn't beat by $0.30 in the first 2 quarters. Now again, there is some contribution from tax. What we did do is we already had embedded in the years' forecast for ourselves increases in federal between 5 and 10, state and local 10 to 15, U.S. commercial 5 to 10 and International, ex the Canadian issue, our large project [twilighting], 10 to 15, those are all pretty healthy numbers, they were already embedded in the growth rates. And so that's why we didn't move up it even further in the second half with those numbers increasing, because we already had embedded pretty healthy growth rates.

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James Giannakouros, Oppenheimer & Co. Inc., Research Division - Executive Director and Senior Analyst [22]

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And any color on the growth rates by segment, the expectations there for FY '18?

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Dan L. Batrack, Tetra Tech, Inc. - Chairman, CEO & President [23]

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We do have those by segment GSG, government is between -- state and local were between 5% and 10% and that's with international development about 5%, our federal between 5% and 10% and state and local 10% and 15%, so puts you between both of those as sort of middle-to-upper single digits, what you've seen between 7% and 10% and on -- if you would ex oil and gas, we've seen it between 5% and 10% on our CIG, ex the 1 project in Canada.

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Operator [24]

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Our next question comes from the line of Bobby Burleson from Canaccord.

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Robert Joseph Burleson, Canaccord Genuity Limited, Research Division - MD & Analyst [25]

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Curious if we can -- it sounds like mining is coming back somewhat in Australia to a certain degree and I'm wondering if we can maybe characterize or go back to the way we discussed the Coffey margins in the past, it seems like mining coming back, it was kind of a call option on that, can you just kind of talk about what the potential impact on margins might be if we think about the Coffey business in Australia?

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Dan L. Batrack, Tetra Tech, Inc. - Chairman, CEO & President [26]

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Yes, that's -- you've got that exactly right. So we actually at the very bottom of the cycle when Coffey joined us a few years ago had very low margins sort of just above breakeven. We believe that by adding additional work for them in some of the municipal and commercial and government clients that we have that we could bring them up to 10%, and which we're right about there. We did achieve in roughly 1-year going from breakeven up to right about double digits. We're happy there, but that was without the mining work coming back. At the top of the cycle, you've seen reports from other mining sector clients, his numbers are 20% in North, they're about a $200 million a year operation in Australia itself in the immediate surrounding area. And so if you think about that, we're at 10%, we could double that number if we get to the top of the cycle. Now we're not anywhere close to that, in fact we're just hopefully getting some lift off of the bottom. So it will be incremental on the upside, but we think that number could add in their particular region and their generation as many as an additional 10 points. So you can do that math on $200 million, you get 20, which is actually pretty meaningful to the company.

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Robert Joseph Burleson, Canaccord Genuity Limited, Research Division - MD & Analyst [27]

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And it sounds like not much headcount growth would be necessary to do that?

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Dan L. Batrack, Tetra Tech, Inc. - Chairman, CEO & President [28]

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No, I think it would require some headcount growth. We did downsize one thing that we were aggressive on with our management in Australia was we did actually to get to the 10%, it wasn't just transferring work across, it was actually rightsizing our back office in direct expenses. So we did close down offices, we did downsize staff. So we are, as is the hallmark of the company, we do staff to the work we have. So you can take up that type of level, it would drive both top line, it would drive margin and we would need to add staff.

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Robert Joseph Burleson, Canaccord Genuity Limited, Research Division - MD & Analyst [29]

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Okay. And then in terms of disaster recovery, you've got this $89 billion supplemental funding at the federal level. And I'm wondering when do we see those dollars flowing through and this next phase of work you guys are doing, what's the size of those types of projects and any difference in the margins you might see?

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Dan L. Batrack, Tetra Tech, Inc. - Chairman, CEO & President [30]

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You know the timing is, we have included in previous quarterly investor calls and we've had it -- I believe it is on our website, with respect to sort of the different phases of the work. So when an event takes place in the first 3 to 6 months, and that was our first quarter and part of second quarter, is get out there, do the initial valuation, get things up and operating, that's sort of the initial emergency response activity. They are hallmarked by lots and lots of projects, high spend and a short duration. Then you typically will go down, you'll have -- and projects then will begin to come about at roughly the 1-year period and then it will go out for several years, which is actually doing a more detailed engineering structural evaluation, civil evaluation process and coming up with feasible alternatives. We have had some success in that area, historically we've been primarily focused just on the first phase, but we're very focused on what I think is actually the strongest aspect we have technically, which is what do you do to fix it now, so that it will last. And what do you do to harden it, or make it more resilient and that can even include pick it up and move it to higher ground. And so those are things that we're doing now, we've had some good success at the local level, at the programmatic level and I expect there to be a slight dip in the spending [at use] typically quarters 3 and 4 after an event and then pick back up and they will be larger projects, typically 10x the size and duration that are typically measured in years. So anywhere from 1 to 3 or 4 years. So I expect to see those actually pick up, probably be in early fiscal year '19 and they would actually be larger and longer in duration. And then, of course, once the selection of the alternative has been done and once you've done the feasibility study, that would work and your preliminary design, then it moves [direct to] implementation and we could be the consultant design and oversight engineer or the owners' engineer and those projects are another order of magnitude larger than even the feasibility and those will go out 5 to 7, 8 even 10 years, which we saw on Katrina down in the New Orleans area.

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Robert Joseph Burleson, Canaccord Genuity Limited, Research Division - MD & Analyst [31]

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And it sounds like there is better visibility at the federal level in terms of this 2-year funding. And I'm wondering is that changing the types of projects you're seeing, is there going to be longer duration works that maybe you hadn't been seeing when we were kind of just with 1-year visibility?

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Dan L. Batrack, Tetra Tech, Inc. - Chairman, CEO & President [32]

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We hope so. We hope that it actually gives a bit more confidence to those at the different civil and defense departments that we work for, but to be fair we're just over 30 days since it was actually just signed. And so we're still very early on that and I think we'll be able to give more insight, first-hand insight probably in the next quarter or 2, which is -- we see it translate from. We now have the money and the funds and we're able to then move it to appropriations and projects that will move forward. So we are really very early on it, but it is a good sign that they can add additional confidence that they can move forward with funding that's in place.

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Operator [33]

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And our next question comes from the line of Justin Hauke from Baird.

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Justin P. Hauke, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Associate [34]

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Two really quick ones here. So just on the emergency response work and I appreciate your comments on the opportunity that it would develop over time. But just to kind of orient expectations for next year, it looks like the impact was about $5 million for the quarter and about, I guess, $25 million year-to-date. So it's, call it, 2% of your revenue, should we be thinking of that as a headwind looking into the beginning of next year because that work is lumpy and the longer-term opportunity wouldn't be as problematic on that are or is that not the right number to be thinking about?

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Dan L. Batrack, Tetra Tech, Inc. - Chairman, CEO & President [35]

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No, I think you got the numbers pretty good. So I think that -- and we've been aware of this, that given the response work we did at the very end of the fourth quarter, which is really the month of September, we are on a federal calendar, but really primarily in our first quarter, which was the months of October, November, December, those are the months that we did roughly $25 million of incremental additional contribution to our first quarter of this fiscal year. Which, of course, helped drive us up to record performance in this first half. It will be a difficult comp on our state and local work because of that contribution, if no additional events take place, then you would have that. It will partially be offset, we believe, by work that we'll do on the more programmatic level, identifying longer term solutions. So I think that will be mitigated because that does ramp up. Now if you do have another active hurricane or a flood season or a storm season and you end up with something similar to last year and you have this programmatic work, if you put those 2 together, you could actually say you had built up higher even the last year. But you're right, they are episodic, they are lumpy and certainly we are doing some work for many municipalities in preparation of the hurricane season that starts in June officially and preparedness works, so that perhaps the impacts won't be as much, but our year-to-year comps that will be a bit more difficult on state and local, really will become most acute in Q1 of '19.

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Justin P. Hauke, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Associate [36]

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I just want to make sure we were kind of thinking about that the right way. And then the second part of the question sort of same theme, but, obviously, the commercial margins were good this quarter. Government services group were down a little bit. I was a little surprised by that given that the storm work was a little bit higher margins. So was there a difficult comp on that on a year-over-year basis or anything else in the margins, just for the segment?

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Dan L. Batrack, Tetra Tech, Inc. - Chairman, CEO & President [37]

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Yes, that's a great point. I thought we were pretty good during the second quarter, what I would call representative of our ongoing operations in government services, 11.8%. That was actually very solid, in fact maybe even a little better because of our revenue flow-through that we [didn't] expect. Yet, that was 100 basis points or 1% lower than we had last year, last year we had a lot of projects on our government services side that actually came to close out, and as part of close out and better performance on the projects, we had pick-ups. And so there were one-time adjustments for absolute completion of the projects and that's why last year, if you take a look in the government services group, it was really an all-time high margin quarter. So it's a year-to-year comp, it is not as if something came down. It's down from that comparable, but if you take a look at historical performance in the second quarter, government services group was really on top of their game.

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Operator [38]

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And our final question comes from the line of Noelle Dilts from Stifel.

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Noelle Christine Dilts, Stifel, Nicolaus & Company, Incorporated, Research Division - VP & Analyst [39]

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First just wanted to dig a little bit more into Canada. You talked about seeing some improving conditions there. Can you talk about what you're seeing, particularly, on the oil and gas side of these bigger projects or more kind of small to medium opportunities that you're seeing?

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Dan L. Batrack, Tetra Tech, Inc. - Chairman, CEO & President [40]

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Yes, in fact what I would say is the increased opportunities in Canada have really been in the oil and gas midstream. So the pipeline sites for us, it's been mostly small to middle diameter of work. It's not been on the large transmission for us. So we have seen more that have come out, they've come out from the majors up there and we have responded to those. We should know here as we enter towards summer if we're successful or not. We do think that things have picked up a bit and some of the capacity of some of the very large transmission folks have begun this year with a few projects that were awarded a year ago. So perhaps there's a little less supply in the market. Some have been driven out of the market, others have gotten a bit busier because of other types of projects. So we hope the competition is a little bit down, the necessity or the priority of actually having these projects online at a given time schedule actually increases the likelihood that they will go forward and that they need someone who has available capacity and that's definitely, yes. So that's where we're seeing the increase in Canada, and it is mostly in Alberta is where we've seen it, which is also a coincident with where our capability and resources are. So we would hope to be successful.

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Noelle Christine Dilts, Stifel, Nicolaus & Company, Incorporated, Research Division - VP & Analyst [41]

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And then second, I recognize this is a sensitive topic, but Tetra Tech has been in the news recently on this Hunters Point project. So can you just help us understand what you think is important for investors who are seeing these headlines to know and really what we should think of as important from an investment perspective?

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Dan L. Batrack, Tetra Tech, Inc. - Chairman, CEO & President [42]

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It's a good question, Noelle. We are definitely aware of the allegations of the former employees of a subcontractor that worked for us up in the Bay area. I will say we've come out publicly about the press releases and I'll repeat it that we emphatically denied these allegations and this extreme speculation and outright sensationalisation in the media. In fact, the relationship to it in reality has long since departed in the most significant way. We do stand by all of the work and these allegations are definitely not representative of any part of Tetra Tech whatsoever. Now with all that said, we do take any allegation regardless how salacious it is very seriously. We are investigating and assessing these further. We have taken this seriously and looked into it immediately upon being aware of these, which actually goes back many years. This is for activities that took place primarily a decade or more ago and these are allegations from someone who is a former employee of a subcontractor, so quite removed. We will give you an update if there is any impact, if any, as our assessment develops, that's really sort of an overview of that activity. Well, with that, I'd like to thank you all for your insight, for following the company, for your questions and interest in Tetra Tech and really do look forward to the second half of this year and speaking with all of you again on our next quarter. Thank you very much and bye.