FSS - Federal Signal: Strong Signals

2023-08-13 06:00:00 ET

Summary

• Federal Signal's shares have seen a strong start to 2023, driven by strong results in the first half of the year.
• After the company has not always operated consistently in the past, recent momentum is impressive.
• Despite the strong operational performance, valuations remain demanding, and the company faces a transition to electrification in its environmental division.

In February, I believed that shares of Federal Signal ( FSS ) were trading at a too demanding valuation, even as the underlying business was performing quite well.

This came after a successful revamp of the business in recent years, as it has been combining organic growth with bolt-on M&A. With these achievements being recognized by the market, which pushed up valuations to multiples in the mid-twenties, those levels were far too high in order to see appeal.

Ever since, shares have seen another strong start to 2023, driven by strong results in the first half of the year, as I grow ever more impressed with the performance, yet not yet enticed by the risk-reward proposition here.

The Base Case

Federal Signal produces specialty equipment such as products used by street sweepers, sewer cleaners, and security. A $25 stock in the 1990s fell to just $5 in the aftermath of the 2009 recession, after which the stock had recovered to the lower-thirties in early 2020.

This came as the business has grown the sales base to $1.2 billion in 2019, on which the company posted earnings of $1.79 per share. As the company saw modest growth and announced some bolt-on deals, shares broke the $50 mark in January 2023, as they traded at $53 when I looked at the shares in February.

That review took place before the release of the 2022 results, although that the company guided for 2022 sales at $1.425 billion at the time of the release of the third quarter results, with earnings seen around $1.95 per share. This came as net debt was reported around $300 million, translating into a 1.5 times leverage ratio based on $200 million in EBITDA. This was ahead of a $14 million deal for Blasters and a $40 million deal for Trackless Vehicles, with these bolt-on deals set to add to growth in 2023, but not alter the investment case in a meaningful fashion.

With earnings seen at $2.00 per share, and earnings likely improving towards $2.20 per share in 2023, I was very cautious at 24 times my estimate of forward earnings, as the latest two bolt-on deals might increase leverage towards the 2 times leverage ratio. This made me cautious as I wondered if the safety provider provided a safe proposition for shareholders, certainly after a rather spectacular share price development in 2022 and 2023.

Still Rocketing On - $60 Now

Since February, shares of Federal Signal have risen from $53 to $60, as they even traded at a high of $65 per share in the meantime.

Early in March, Federal Signal reported its 2022 results as a 30% increase in fourth quarter sales to $392 million was driven by a 24% organic growth rate. This looked rather strong as full year adjusted earnings came in at $1.96 per share. These results were largely in line with expectations, yet the 2023 outlook was rather convincing as the company guided for 2023 sales to rise to $1.58-$1.72 billion, with adjusted earnings seen between $2.15 and $2.40 per share.

As a testament to the strong operating performance, the company announced a 10% hike in the dividend, although that a quarterly dividend of $0.11 per share is not too compelling in this interest rate environment.

In May, Federal Signal announced first quarter results which showed a strong start to the year as the company hiked the lower end of the sales guidance to $1.62 billion, with earnings now seen between $2.21 and $2.43 per share. In July, the company hiked the full year guidance again after another strong (second) quarter . Sales are now seen between $1.65 and $1.72 billion, with earnings seen as high as $2.30-$2.46 per share.

Net debt of $360 million is in line with expectations yet given the strong operating momentum, EBITDA is trending close to a quarter of a billion here, rapidly reducing (relatively) leverage ratios.

And Now?

Since February, shares have risen by approximately 15%, to an important extent driven by an increase in the earnings guidance. This makes that valuations remain demanding at 24-26 times current earnings, all while leverage improves a bit faster than previously thought, as the share price performance is really backed up by strong operational performance.

That being said, valuations remain demanding in an ever higher interest rate environment, as Federal Signal furthermore has a transition to undergo. With most of the sales derived from the environmental division, which holds a certain promise with it to clients, electrification is key in this area. Fortunately, many of these applications (sweepers, among others) lend themselves pretty good for electrification.

Given all this, I can only congratulate management and investors for a decent performance, as I have been too cautious with a neutral stance in the recent past, while the company has delivered upon its promises. While I grow more appreciative of the performance, I fail to become too upbeat at the same time given the risk-reward here amidst a premium valuation.

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