5. Mergers and Acquisitions

In fiscal 2014, we made immaterial acquisitions that enhanced our service offerings and expanded our geographic presence in our WEI and RME segments.

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

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 in the second quarter of fiscal 2016 subsequent to the acquisition.

In the second quarter of fiscal 2016, we also acquired INDUS Corporation ("INDUS"), headquartered in Vienna, Virginia. INDUS is an information technology solutions firm focused on water data analytics, geospatial analysis, secure infrastructure, and software applications management for U.S. federal government customers, and is included in our WEI segment. The fair value of the purchase price for INDUS was $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.

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		107,618
Backlog and trade name intangible assets		29,445
Other assets		747
Current liabilities		(77,606	)
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, goodwill additions related to the fiscal 2016 acquisitions primarily represent the value of workforces with distinct expertise in the international development, geoscience, and software applications management markets. The goodwill addition related to the fiscal 2015 acquisition primarily represents the value of the workforce with distinct expertise in the solid waste market. 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 the 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 purchase price allocation is preliminary and subject to adjustment based upon the final determination of the net assets acquired and information necessary to perform the final valuation. We have not yet completed our final assessment of the fair values of purchased receivables, intangible assets, tax balances, contingent liabilities or acquired contracts. The final purchase price allocations may result in adjustments to certain assets and liabilities, including the residual amount allocated to goodwill. Goodwill recognized largely results from a substantial and technically qualified assembled workforce, which does not qualify for separate recognition, as well as expected future synergies from combining operations.

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

	Pro-Forma
	Fiscal Year Ended
	October 2, 2016		September 27, 2015
	(in thousands, except per share data)
Revenue	$	2,714,658	$	2,749,653
Operating income		152,676		73,209
Net income attributable to Tetra Tech		98,871		20,689
Earnings per share attributable to Tetra Tech
Basic	$	1.70	$	0.33
Diluted	$	1.68	$	0.33

Since their respective acquisition dates, Coffey and INDUS combined contributed $320.6 million in revenue and $13.6 million in operating income for fiscal 2016. Amortization of intangible assets since their respective acquisition dates was $6.7 million for 2016.

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

	Fiscal Year Ended October 2, 2016
	(in thousands)
Severance including change in control payments	$	10,917
Professional services		5,685
Real estate-related		2,946

Total	$	19,548

As of October 2, 2016, all of the acquisition and integration expenses incurred to date have been paid. All acquisition and integration expenses are included in our Corporate reportable segment, as presented in Note 19. 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 the consolidated balance sheets. We consider several factors when determining that contingent earn-out liabilities are part of the purchase price, including the following: (1) the valuation of our acquisitions is not supported solely by the initial consideration paid, and the contingent earn-out formula is a critical and material component of the valuation approach to determining the purchase price; and (2) the former owners of acquired companies that remain as key employees receive compensation other than contingent earn-out payments at a reasonable level compared with the compensation of our other key employees. The contingent earn-out payments are not affected by employment termination.

We measure our contingent earn-out liabilities at fair value on a recurring basis using significant unobservable inputs classified within Level 3 of the fair value hierarchy. 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 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 fiscal 2016, we increased our contingent earn-out liabilities and reported related losses in operating income of $2.8 million. These losses include a $1.8 million charge that 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 remaining $1.0 million loss represented the final cash settlement of an earn-out liability that was valued at $0 at the end of fiscal 2015.

During fiscal 2015, we decreased our contingent earn-out liabilities and reported a related gain in operating income of $3.1 million. This gain resulted from an updated valuation of the contingent consideration liability for Caber Engineering Inc. ("Caber"), which is part of our RME segment.

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

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

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

The fiscal 2014 net gains primarily resulted from updated valuations of the contingent consideration liabilities for Parkland Pipeline ("Parkland") and American Environmental Group ("AEG"), which are both part of our RME segment.

The acquisition agreement for Parkland included a contingent earn-out agreement based on the achievement of operating income thresholds (in Canadian dollars) in each of the first three years beginning on the acquisition date, which was in the second quarter of fiscal 2013. The maximum earn-out obligation over the three-year earn-out period was C$56.0 million (C$12.0 million, C$22.0 million and C$22.0 million in earn-out years one, two and three, respectively). These 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 C$56.0 million. Parkland was required to meet a minimum operating income threshold in each year in order to earn any contingent consideration. These thresholds were C$34.7 million, C$38.2 million and C$41.9 million in years one, two and three, respectively. In order to earn the maximum contingent consideration, Parkland would need to generate operating income of C$42.5 million in year one, C$46.4 million in year two, and C$50.6 million in year three.

The determination of the fair value of the purchase price for Parkland on the acquisition date included our estimate of the fair value of the related contingent earn-out obligation. This initial valuation was primarily based on probability-weighted internal estimates of Parkland'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 Parkland's contingent earn-out liability of C$46.8 million in the second quarter of fiscal 2013. In determining that Parkland would attain 84% of the maximum potential earn-out, we considered several factors including Parkland's recent historical revenue and operating income levels and growth rates, the recent trend in Parkland's backlog, and the prospects for the midstream oil and gas industry in Western Canada.

As discussed below, in fiscal 2014, we recorded decreases in our contingent earn-out liability for Parkland and reported related net gains in operating income of $44.6 million. These gains resulted from Parkland's actual and projected post-acquisition performance falling below our initial expectations concerning the likelihood and timing of achieving the relevant operating income thresholds. The remaining difference compared to the initial value was due to currency translation, and the related liability was $0 at the end of fiscal 2014.

In the second quarter of fiscal 2014, we updated the estimated cost to complete a large fixed-price contract at Parkland, and determined that the project would be break-even compared to the significant profit estimated the previous quarter when the project was initiated. As a result, during the second quarter of fiscal 2014 we reversed $5.3 million of profit previously recognized on the project. This variance, and our updated estimate that the revenue for the remainder of the project would produce no operating income, resulted in our conclusion that Parkland's operating income in the first and second earn-out periods would fall below the minimum operating income thresholds in each such year. As a result, we reduced the contingent earn-out liability for the first and second earn-out periods to $0, which resulted in gains totaling $24.7 million ($5.6 million and $19.1 million in the first and second quarters of fiscal 2014, respectively).

In the fourth quarter of fiscal 2014, we updated our projection of Parkland's operating income for the third earn-out period. This assessment included a review of the projects in Parkland's backlog, the inventory of prospective new contract awards, and the forecast for economic activity in the Western Canada oil and gas sector. As a result of this assessment, we concluded that Parkland's operating income in the third earn-out period would be lower than our original estimate at the acquisition date and would fall below the minimum operating income threshold. As a result, we reduced the remaining contingent earn-out liability balance for the third earn-out period to $0, which resulted in a gain of $19.9 million.

The acquisition agreement for AEG 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. The maximum earn-out obligation over the two-year earn-out period was $27.1 million ($11.3 million annually plus a $4.5 million one-time payment based on minimum operating income 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 $27.1 million. AEG was required to meet a minimum operating income threshold in each year in order to earn any contingent consideration. These minimum thresholds were $10.0 million and $11.0 million in years one and two, respectively. In order to earn the maximum contingent consideration, AEG would need to achieve operating income of $17.5 million in year one and $18.5 million in year two. In addition, if AEG achieved operating income of at least $9.0 million during both earn-out periods, AEG would receive $4.5 million at the end of the second earn-out period.

The determination of the fair value of the purchase price for AEG on the acquisition date included our estimate of the fair value of the related contingent earn-out obligation. This initial valuation was primarily based on probability-weighted internal estimates of AEG'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 AEG's contingent earn-out liability of $21.5 million in the second quarter of fiscal 2013. In determining that AEG would attain 79% of the maximum potential earn-out we considered several factors including AEG's recent historical revenue and operating income levels and growth rates. We also considered the recent trend in AEG's backlog level and the prospects for the solid waste industry in the United States.

AEG's first earn-out period ended on the last day of the first quarter of fiscal 2014. As a result, during the first quarter of fiscal 2014, we performed a preliminary calculation of the contingent consideration for the first earn-out period and concluded that AEG's operating income in that period would be higher than both our original estimate at the acquisition date and our previous quarterly estimates. As a result, we increased the contingent earn-out liability for the first earn-out period, which resulted in an additional expense of $1.0 million. The contingent consideration of $9.1 million for the first earn-out period was paid in the second quarter of fiscal 2014.

During calendar 2014, which corresponds to AEG's second earn-out period, adverse weather conditions hindered AEG's ability to complete its project field work. As a result, in the third quarter of fiscal 2014, we updated our projection of AEG's operating income for its second earn-out period. This assessment included a review of the status of on-going projects in AEG's backlog, and the inventory of prospective new contract awards. As a result of this assessment, we concluded that AEG's operating income in the second earn-out period would be significantly lower than our original estimate at the acquisition date, would fall below the minimum operating income threshold, but would still exceed $9.0 million of operating income in order to earn the additional tranche. As a result, we reduced the contingent earn-out liability, which resulted in a gain of $8.9 million in the third quarter of fiscal 2014.

During the fourth quarter of fiscal 2014, we performed an updated projection of AEG's operating income for its second earn-out period based on actual results and the forecast for the remainder of the second earn-out period. Based on this analysis, we concluded that AEG's operating income in the second earn-out period would be lower than the $9.0 million needed to receive the $4.5 million of contingent consideration that remained accrued for performance in both earn-out years. As a result, we reduced the contingent earn-out liability to $0, which resulted in a gain of $4.5 million in the fourth quarter of fiscal 2014, and net gains of $13.2 million for all of fiscal 2014.

Each time we determined that Caber's, AEG's and Parkland's operating income would be lower than our original estimate at the acquisition date, we also evaluated the related goodwill for potential impairment. In each case, we determined that the lower income projections were the result of temporary events, and did not negatively impact the reporting unit's longer term performance or result in a goodwill impairment.

At October 2, 2016, there was a total maximum of $15.5 million of outstanding contingent consideration related to acquisitions. Of this amount, $8.8 million was estimated as the fair value and accrued on our consolidated balance sheet.

The following table summarizes the changes in the carrying value of estimated contingent earn-out liabilities:

	Fiscal Year Ended
	October 2, 2016			September 27, 2015			September 28, 2014
	(in thousands)
Beginning balance (at fair value)	$	4,169		$	7,030		$	81,789
Estimated earn-out liabilities for acquisitions during the fiscal year		4,745			4,100			6,242
Increases due to re-measurement of fair value reported in interest expense		271			136			1,846
Net increase (decrease) due to re-measurement of fair value reported as losses (gains) in operating income		2,823			(3,113	)		(58,694	)
Foreign exchange impact		–			(785	)		(3,507	)
Earn-out payments:
Reported as cash used in operating activities		–			–			(1,984	)
Reported as cash used in financing activities		(3,251	)		(3,199	)		(18,662	)

Ending balance (at fair value)	$	8,757		$	4,169		$	7,030