3. Mergers and Acquisitions

In the second quarter of fiscal 2017, we completed the acquisition of Eco Logical Australia (“ELA”), headquartered in Sydney, Australia. ELA is a multi-disciplinary consulting firm with over 160 staff that provides innovative, high-end environmental and ecological services, and is part of our RME segment. The fair value of the purchase price for ELA was $9.9 million. Of this amount, $8.3 million was paid to the sellers and $1.6 million was the estimated fair value of contingent earn-out obligations, with a maximum of $1.7 million, based upon the achievement of specified operating income targets in each of the two years following the acquisition.

In the second quarter of fiscal 2016, we acquired INDUS Corporation (“INDUS”), headquartered in Vienna, Virginia. INDUS is an information technology solutions firm focused on water data analytics, geospatial analysis, secure infrastructure, and software applications management for U.S. federal government customers, and is included in our Water, Environment and Infrastructure (“WEI”) segment. The fair value of the purchase price for INDUS was $18.7 million. Of this amount, $14.0 million was paid to the sellers and $4.7 million was the estimated fair value of contingent earn-out obligations, with a maximum of $8.0 million, based upon the achievement of specified operating income targets in each of the two years following the acquisition.

On January 18, 2016, we acquired control of Coffey International Limited (“Coffey”), headquartered in Sydney, Australia. Coffey had approximately 3,300 staff delivering technical and engineering solutions in international development and geoscience. Coffey significantly expands our geographic presence, particularly in Australia and Asia Pacific, and is part of our RME segment. In addition to Australia, Coffey’s international development business has operations supporting federal government agencies in the U.S. and the United Kingdom. The fair value of the purchase price for Coffey was $76.1 million, in addition to $65.1 million of assumed debt, which consisted of secured bank term debt of $37.1 million and unsecured corporate bond obligations of $28.0 million. All of this debt was paid in full from other borrowings in the second quarter of fiscal 2016 subsequent to the acquisition.

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

Accounts receivable	$	71,515
Other current assets	18,869
Property and equipment	14,218
Goodwill	108,323
Backlog and trade name intangible assets	29,445
Other assets	747
Current liabilities	(78,311)
Borrowings	(65,086)
Other long-term liabilities	(4,885)

Net assets acquired	$	94,835

Goodwill additions resulting from the above business combinations are primarily attributable to the existing workforce of the acquired companies and the synergies expected to arise after the acquisitions. Specifically, the goodwill addition related to the fiscal 2017 acquisition represents the value of a workforce with distinct expertise in the environmental and ecological markets. The goodwill additions related to the 2016 acquisitions primarily represent the value of workforces with distinct expertise in the international development, geoscience, and software applications management markets. In addition, these acquired capabilities, when combined with our existing global consulting and engineering business, result in opportunities that allow us to provide services under contracts that could not have been pursued individually by either us or the acquired companies. The results of these acquisitions were included in our condensed consolidated financial statements from their respective closing dates.

Backlog and trade name intangible assets include the fair value of existing contracts and the underlying customer relationships with lives ranging from 1 to 5 years (weighted average of approximately 3 years), and the fair value of trade names with lives ranging from 3 to 5 years.

The table below presents summarized unaudited consolidated pro forma operating results including the related acquisition, integration and debt pre-payment charges, assuming we had acquired Coffey and INDUS at the beginning of fiscal 2016. These pro-forma operating results are presented for illustrative purposes only and are not indicative of the operating results that would have been achieved had the related events occurred at the beginning of fiscal 2016.

	Pro-Forma
	Six Months Ended
	April 2, 2017		March 27, 2016
	(in thousands, except per share data)

Revenue	$	1,332,632	$	1,319,281
Operating income	82,811		62,766
Net income attributable to Tetra Tech	53,424		39,526

Earnings per share attributable to Tetra Tech
Basic	$	0.93	$	0.67
Diluted	$	0.92	$	0.67

Coffey and INDUS combined contributed $213.4 million in revenue and $13.5 million in operating income for the six months ended April 2, 2017. Coffey’s contributions included the benefit of post-acquisition integration with our existing environmental and international development businesses. Amortization of intangible assets for Coffey and INDUS combined was $5.3 million for the six months ended April 2, 2017.

Acquisition and integration expenses for the three and six months ended March 27, 2016 in the accompanying condensed consolidated statements of income are comprised of the following:

	Amount
	(in thousands)

Severance including change in control payments	$	7,280
Professional services	5,685
Real estate-related	2,946

Total	$	15,911

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

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

We measure our contingent earn-out liabilities at fair value on a recurring basis using significant unobservable inputs classified within Level 3 of the fair value hierarchy. We use a probability-weighted discounted income approach as a valuation technique to convert future estimated cash flows to a single present value amount. The significant unobservable inputs used in the fair value measurements are operating income projections over the earn-out period (generally two or three years), and the probability outcome percentages we assign to each scenario. Significant increases or decreases to either of these inputs in isolation would result in a significantly higher or lower liability, with a higher liability capped by the contractual maximum of the contingent earn-out obligation. Ultimately, the liability will be equivalent to the amount paid, and the difference between the fair value estimate and amount paid will be recorded in earnings. The amount paid that is less than or equal to the contingent earn-out liability on the acquisition date is reflected as cash used in financing activities in our condensed consolidated statements of cash flows. Any amount paid in excess of the contingent earn-out liability on the acquisition date is reflected as cash used in operating activities.

We review and re-assess the estimated fair value of contingent consideration on a quarterly basis, and the updated fair value could differ materially from the initial estimates. Changes in the estimated fair value of our contingent earn-out liabilities related to the time component of the present value calculation are reported in interest expense. Adjustments to the estimated fair value related to changes in all other unobservable inputs are reported in operating income. During the first half of fiscal 2017 (all in the second quarter), we recorded decreases in our contingent earn-out liabilities and reported related gains in operating income totaling $7.1 million. These gains resulted from updated valuations of the contingent consideration liabilities for INDUS and Cornerstone Environmental Group (“CEG”).

The acquisition agreement for INDUS included a contingent earn-out agreement based on the achievement of operating income thresholds in each of the first two years beginning on the acquisition date, which was in the second quarter of fiscal 2016. The maximum earn-out obligation over the two-year earn-out period was $8.0 million ($4.0 million in each year). These amounts could be earned on a pro-rata basis starting at 50% of the earn-out maximum for operating income within a predetermined range in each year. INDUS was required to meet a minimum operating income threshold in each year to earn any contingent consideration. These minimum thresholds were $3.2 million and $3.6 million in years one and two, respectively. In order to earn the maximum contingent consideration, INDUS needed to generate operating income of $3.6 million in year one and $4.0 million in year two.

The determination of the fair value of the purchase price for INDUS on the acquisition date included our estimate of the fair value of the related contingent earn-out obligation. The initial valuation was primarily based on probability-weighted internal estimates of INDUS’ operating income during each earn-out period. As a result of these estimates, we calculated an initial fair value at the acquisition date of INDUS’ contingent earn-out liability of $4.7 million in the second quarter of fiscal 2016. This amount had increased to $4.9 million at the end of fiscal 2016 due to the passage of time for the present value calculation. In determining that INDUS would earn 59% of the maximum potential earn-out, we considered several factors including INDUS’ recent historical revenue and operating income levels and growth rates. We also considered the recent trend in INDUS’ backlog level.

INDUS’ actual financial performance in the first earn-out period was below our original expectation at the acquisition date. As a result, in the second quarter of fiscal 2017, we evaluated our estimate of INDUS’ contingent consideration liability for both earn-out periods. This assessment included a review of INDUS’ financial results in the first earn-out period, the status of ongoing projects in INDUS’ backlog, and the inventory of prospective new contract awards. As a result of this assessment, we concluded that INDUS’ operating income in both the first and second earn-out periods would be lower than the minimum requirements of $3.2 million and $3.6 million, respectively, to earn any contingent consideration. Accordingly, in the second quarter of fiscal 2017, we reduced the INDUS contingent earn-out liability to $0, which resulted in a gain of $5.0 million.

The acquisition agreement for CEG included a contingent earn-out agreement based on the achievement of operating income thresholds in each of the first three years beginning on the acquisition date, which was in the third quarter of fiscal 2015. The maximum earn-out obligation over the three-year earn-out period was $9.8 million ($3.25 million in each year). The annual amounts could be earned primarily on a pro-rata basis for operating income within a predetermined range in each year. To a lesser extent, additional earn-out consideration could be earned for operating income above the high-end of the range up to the contractual maximum of $9.8 million. CEG was required to meet a minimum operating income threshold in each year to earn any contingent consideration. These minimum thresholds were $2.0 million, $2.3 million and $2.6 million in years one, two and three, respectively. In order to earn the maximum contingent consideration, CEG needed to achieve operating income of $4.5 million in year one, $4.8 million in year two and $5.1 million in year three.

The determination of the fair value of the purchase price for CEG on the acquisition date included our estimate of the fair value of the related contingent earn-out obligation. The initial valuation was primarily based on probability-weighted internal estimates of CEG’s operating income during each earn-out period. As a result of these estimates, we calculated an initial fair value at the acquisition date of CEG’s contingent earn-out liability of $4.1 million in the third quarter of fiscal 2015. In determining that CEG would earn 42% of the maximum potential earn-out, we considered several factors including CEG’s recent historical revenue and operating income levels and growth rates. We also considered the recent trend in CEG’s backlog level.

In the second quarter fiscal of 2016, we recorded an increase in our contingent earn-out liabilities and related losses in operating income of $1.8 million, which reflected our updated valuation of the contingent consideration liability for CEG. This valuation included our updated projection of CEG’s financial performance during the earn-out period, which exceeded our original estimate at the acquisition date. The first earn-out payment of $2.3 million was made in the fourth quarter of fiscal 2016, at which time a $3.9 million contingent consideration liability remained for the last two years of CEG’s earn-out period.

During the second quarter of fiscal 2017, we evaluated our estimate of CEG’s contingent consideration liability for the remaining two earn-out periods. This assessment included a review of CEG’s financial results to-date in the second earn-out period, the status of ongoing projects in CEG’s backlog, and the inventory of prospective new contract awards. As a result of this assessment, we concluded that CEG’s operating income in both the second and third earn-out periods would be lower than our previous estimate. Accordingly, we reduced the CEG contingent earn-out liability to $1.8 million as of April 2, 2017, which resulted in a gain of $2.1 million in the second quarter of fiscal 2017.

During the second quarter of fiscal 2017, when we determined that INDUS’ and CEG’s operating income would be lower than our previous estimates, including our original estimates at the acquisition dates, we also evaluated the related goodwill for potential impairment. In each case, we determined that the related reporting units’ long term performance was not materially impacted and there was no resulting goodwill impairment.

In the first half of fiscal 2016 (all in the first quarter), we also recognized a $1.0 million loss, which represented the final cash settlement of an earn-out liability that was valued at $0 at the end of fiscal 2015.

At April 2, 2017, there was a total potential maximum of $12.2 million of outstanding contingent consideration related to acquisitions. Of this amount, $3.4 million was estimated as the fair value and accrued on our condensed consolidated balance sheet.