FSS - Federal Signal: Good Business Trades At Too Demanding Valuation

Summary

• Federal Signal has revamped the business successfully in recent years.
• FSS stock has seen reasonable organic growth, accompanied by bolt-on dealmaking.
• This has been recognized by the market, as forward earnings multiple in the mid-twenties simply feels too rich.

In September, I saw a solid sign for shares of Federal Signal ( FSS ) on the back of improved positioning and performance in recent years. The company has been continuing to pursue bolt-on dealmaking, something which has created quite a re-rating already.

The Business

Federal Signal is a producer of specialty equipment which includes street sweepers, sewer cleaners, safety and security products. Already a $25 stock in the 1990s, shares were down to just $5 in the aftermath of the recession in 2009.

The company has been reshuffling its portfolio ever since, having to grow to a $1.2 billion sales base in 2019 on which it posted earnings of $1.79 per share, with this earnings performance pushing shares up to a high of $30 early in 2020. Shares rose to the $40 mark in the fall of 2021 as that probably reflected fair value amidst earnings power trending around the $2 per share mark with leverage being very reasonable. Moreover, a focus and classification of activities under the Environmental Solutions group and Safety & Security Systems group have made investors upbeat on the long term growth potential of these markets.

Shares rallied to the $50 mark late in 2021, but fell back to the low-thirties in the spring of 2022, to trade around the $39 mark in September of last year. The company provided a 2022 outlook in spring of the year with full year sales seen rising to $1.40 billion, and adjusted earnings seen just below the $1.90 per share mark (on an adjusted basis).

In September, the company announced another $46 million bolt-on deal, this time acquiring TowHaul, to add lowboy trailers, gooseneck equipment and dragline bucket transporters to its product line. With shares trading at 20 times earnings and leverage reported around 1.5 times EBITDA, the valuation looked very fair.

Doing Well

Since September, shares of Federal Signal have seen quite a move higher. In fact, they have risen to $53 per share, gaining 35% in the time frame of less than half a year.

In November, Federal Signal posted third quarter sales of $346 million, up 16% on the year before, largely driven by a 9% increase in organic sales. Inflationary pressures hurt margins a little bit, with adjusted earnings per share up 10% to $0.53 per share. The company hiked the full year sales guidance to a midpoint of $1.425 billion, increasing the earnings guidance to $1.95 per share. Net debt rose toward the $300 million mark, with EBITDA trending in excess of $200 million now.

To further ignite growth of the business, Federal Signal announced a $14 million deal to acquire Blasters, a leading manufacturer of truck-mounted water blasting equipment, albeit that the earn-out has the potential to increase the total price to $22 million. No other financial details were announced on the transaction.

In February, Federal Signal acquired Trackless Vehicles, a manufacturer of multi-purpose municipal sidewalk tractors in a $40 million deal, with earn-outs potentially increasing this price tag by around 10%. The Ontario-based Canadian business employs 90, and it set to add $26 million in sales. The sales multiple just in excess of 1.5 times sales actually marks a small discount compared to Federal's own valuation here, with the deal adding nearly 2% to total sales.

And Now?

Given the substantial move higher in the shares, Federal Signal's valuation has risen quite a bit. Pro forma sales now surpass the $2 per share mark, as recent quarterly earnings trends and some accretion from recent deals makes a $2.20 per share number for the year possible, but even in that case we are seeing shares trade hands at 24 times forward earnings, with leverage moving up towards the 2 times leverage ratio.

The question is if the safety provider is still offering a safe proposition here for shareholders, certainly after a rather spectacular move higher in recent times. The company continues to perform just fine and continues to embark on bolt-on dealmaking, but for now it seems that the risk proposition has not been too enticing, as shares have run-up a bit too much recently.

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