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Federal Signal FSS S
December 20, 2008 - 6:29pm EST by
ali79
2008 2009
Price: 8.55 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 405 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT
Borrow Cost: NA

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Description


I believe Federal Signal’s revenue and operating margins will decline materially in 2009 and 2010 as their main end markets (industrial and municipal markets in the U.S. and internationally) come under extreme pressure. I think EPS will go from approximately $0.65 in 2008 to somewhere between $0.25 and $0.40 between 2009 and 2010. This compares with analyst estimates of approximately $0.69 in 2009 and $0.92 in 2010. At the current price of $8.55, Federal Signal is trading at between 21x and 34x my estimate of trough earnings, a significant premium to other more diversified industrials trading at low double digit 2009 P/E multiples. I believe a more acceptable multiple for Federal Signal given its end market exposure is closer to 10x EPS which would value the stock at under $4, or at least 50% lower than the current price.


Business Description:

Federal Signal is a manufacturing company serving the industrial, fire, and municipal markets in the U.S. and internationally. End markets are broken down into U.S. Industrial / Commercial (23% of revenue), U.S. municipal (29% of revenue) and International (48% of revenue). The Company operates in three segments, Safety Security, Environmental Solutions and Fire Rescue. These segments and their products are described below.


Safety Security Group (SSG) (38% of revenue)
               

Mobile Vehicular Systems (44% SSG revenue) – Manufactures lightbars, beacons and sirens which go on top of police cars, firetrucks, ambulances and tow trucks. These are sold primarily into municipal end markets.
 
 
                Industrial Communications (38% SSG revenue) – Manufactures horns, beacons, lights and parking systems for Industrial and mining plants as well as for municipalities (warning systems). Products sold to Industrial companies with a good portion going to energy related companies.
 
 

                Public Safety Systems (18% SSG revenue) – Has a license plate recognition software and urgent notification software which is sold to law enforcement, cities, states, colleges and national governments. End markets mainly municipal.


Environmental Solutions Group (ESG) (46% of revenue)
               

Sweepers (44% ESG revenue) – Manufactures street, parking lot and industrial sweepers which are bought from municipalities, airports, and construction contractors.
 
 
                Vacuum Trucks (47% ESG revenue) – Manufacture Vacuum trucks for the municipal market such as sewer trucks as well as Vacuum trucks for the industrial market which clean up industrial waste.
 

Water Blasters (9% ESG revenue) – Manufacture water blasters to clean and prepare industrial surfaces, mainly servicing industrial contractors and municipalities.


Fire Rescue Group (FRG) (16% revenue)


Fire Lifts (74% of FRG revenue) – Manufactures articulated aerial devices for rescue and fire markets. Products are sold internationally to international federal governments.
 

Skylifts (22% of FRG revenue) – Manufactures aerial devices for general purposes for construction. Products are sold internationally and compete with other aerials like JLG and Genie.
 
 
Short Thesis:
 
U.S. municipalities (29% of revenue) are under increasing budget deficits for 2009 – U.S. municipal budgets continue to become more strained. As home prices and building permits continue to decline, and income taxes drop due to rising unemployment and lower consumer spending, municipalities will increasingly find themselves with higher budget deficits. Some estimates for municipal budget deficits nationwide by 2010 are as high as 100 billion. About 29% of Federal Signals products go into municipalities.  These products are street sweepers and vacuume trucks in the Environmental Group, and lightbars and siren that are placed on police cars and firetrucks.  These products are some of the most discretionary pieces within the municipal budgets. After speaking with several large municipalities, I believe they will push back buying these types of products for at least the next two years as municipalities attempt to bring costs closer in line with revenue. Federal Signals municipal light bar sales, which are already down almost 15% in the last quarter, are some of the highest margin products in the safety security group. A large dropoff in 2009 and 2010 will impact margins significantly.
 
 
 
The majority of international sales (48% of revenue) come from Western Europe – The majority of international sales and growth over the last few years has come from Western Europe (especially Spain).  This growth has come from every product line at Federal Signal but has been especially strong from the Fire Rescue Group where the Bronto aerial product is used for fires as well as non residential construction.  Another large beneficiary of international sales has come from sweeper products used by contractors.  I believe a struggling Western Europe could have a severe impact on Federal Signal's financials.
 
 

U.S. Industrial Growth has been driven by Energy related demand – U.S. industrial end markets, which comprise about 23% of revenue, has been driven by energy related demand over the last few years predominantly from mining, petrochemical plants and rig demand. The primary products for these customers are sirens, lights and beacons from the Safety Security Group. As commodity prices have risen, there has been an increase in mining and new rig builds which has caused Federal Signals revenue in this division to also increase. Now that commodity prices have been under pressure, I expect that demand for Federal Signals products to decline over the next few years.



Estimates remain way too high – EPSestimates for 2009 range from $0.60 to as high as $0.84 with the average approximately $0.69.  Not only do those estimates assume that municipalities revenue will only fall a couple percent, but that international sales into Western Europe will continue to be strong. I believe that Federal Signal will fall to a perfect storm of events including slowing municipal spending, slowing industrial spending from energy related customers, and a slow down of order growth for the Bronto product from non residential customers in Western Europe. I believe this will cause revenue to fall up to 20% and margins to contract over 200 basis points over the next two years
 
 
Financials:

 
 
 
 
 
 
 
2007
 
2008E
 
2009E
2010E
Revenue - Segments
 
 
 
 
 
 
 
 
Safety & Security Systems
 
367.2
 
366.8
 
321.0
272.8
 
Bronto
 
 
123.7
 
149.7
 
163.8
139.3
 
Environmental Solutions
 
450.8
 
443.5
 
399.2
367.2
 
 
 
 
 
 
 
 
 
 
 
 
 
Total Revenue
 
 
941.7
 
960.0
 
884.0
779.3
 
 
 
 
 
 
 
 
 
 
 
 
 
Operating Income - Segments
 
 
 
 
 
 
 
 
Safety & Security Systems
 
49.6
 
42.5
 
30.2
24.6
 
Bronto
 
 
7.9
 
11.6
 
11.1
9.1
 
Environmental Solutions
 
40.1
 
38.7
 
30.7
27.2
 
Corporate expense
 
 
(21.2)
 
(26.8)
 
(25.0)
(24.0)
EBIT
 
 
 
 
76.4
 
66.0
 
47.0
36.8
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest expense, net
 
 
(25.9)
 
(19.8)
 
(13.2)
(11.9)
Other income (expense)
 
(4.0)
 
(2.5)
 
(2.5)
(2.5)
Income before taxes
 
 
46.5
 
43.7
 
31.4
22.4
 
 
 
 
 
 
 
 
 
 
 
 
 
Income tax (expense) benefit
 
(4.2)
 
(12.6)
 
(10.7)
(7.8)
Net income from continuing operations
42.3
 
31.1
 
20.7
14.6
 
 
 
 
 
 
 
 
 
 
 
 
 
EPS (basic) from continuing operations
$0.88
 
$0.65
 
$0.43
$0.30
EPS (diluted) from continuing operations
$0.88
 
$0.65
 
$0.43
$0.30
Basic Shares Outstanding
 
47.8
 
47.9
 
47.9
47.9
Fully Diluted Shares Outstanding
 
47.8
 
47.9
 
47.9
47.9
 
 
 
 
 
 
 
 
 
 
 
 
 
Revenue Growth
 
 
 
 
 
 
 
 
 
Safety & Security Systems
 
20.6%
 
(0.1%)
 
(12.5%)
(15.0%)
 
Bronto
 
 
54.6%
 
21.0%
 
9.5%
(15.0%)
 
Environmental Solutions
 
12.9%
 
(1.6%)
 
(10.0%)
(8.0%)
 
 
 
 
 
 
 
 
 
 
 
 
 
Net Revenue
 
 
20.1%
 
1.9%
 
(7.9%)
(11.8%)
 
 
 
 
 
 
 
 
 
 
 
 
 
Operating Margins
 
 
 
 
 
 
 
 
 
Safety & Security Systems
 
13.5%
 
11.6%
 
9.4%
9.0%
 
Bronto
 
 
6.4%
 
7.7%
 
6.8%
6.5%
 
Environmental Solutions
 
8.9%
 
8.7%
 
7.7%
7.4%
EBIT
 
 
 
 
8.1%
 
6.9%
 
5.3%
4.7%


I believe Federal Signal is overvalued and upside to shorting Federal Signal could be 50% over the next two years.  Based on the current stock price, I believe that investors are either assuming that Federal Signal will be able to maintain revenue and margins in the current environment or that municipal spending will begin to increase by 2010 so the company deserves a multiple significantly higher than other industrials. I believe neither of these will be the case and that the company's earnings will materially decline as each of their end markets come under increasing pressure.
 
Risks:
 
Growth in public safety systems pick up materially to help offset declines in the remaining safety security group - Federal Signal's liscense plate recognition software can be used by police officers to identify vehicles with unpaid parking tickets.  The cameras are placed on top of police cars and can alert the policeman when the car drives past a car with unpaid parking tickets.  The bull case for Federal Signal is that these products can grow fast enough to outpace other declines for the rest of the group.  This software accounts for less than 10% of Safety Security Group sales. Although I believe this product is valuable, I do not believe municipalities are interested in buying massive amounts of this product to offset the large declines in the rest of the segment
 
The federal government could bailout municipalities - Although I believe this could be a risk, I believe that even if the federal government did bailout municipalities, the municipalities would use that money to close their current deficits rather than increasing spending on federal signal products.
 
 
 

Catalyst

Earnings coming under pressure over the next few quarters, continued municipal spending risk, continued decline in energy related spending, continued economic decline in Western Europe
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