Description

LB Foster (Ticker: FSTR) is a Pittsburgh based, small cap industrial manufacturer and service provider to the rail and general infrastructure industries. A series of disastrous acquisitions in energy and midstream services in 2014-2015 left the company over levered at the same time the rail business suffered from a secular decrease in coal volumes. The downturn culminated with the company getting kicked out of the Russell 2000 index in June 2021. Over the last two years, FSTR has de-levered from organic cash flow generation, significantly upgraded management, improved corporate governance, and undertaken a new strategy which includes M&A in its high return growth segments of rail technologies and precast concrete. At $9.6/share and $104mn market capitalization, FSTR is too cheap relative to the expected growth in free cash flow over the next few years. FSTR can continue to grow revenue and orders consistent with the 6-8% per year laid out at its Investor Day given tailwinds from the recent US infrastructure packages, stable, large scale commercial and infrastructure construction projects, and steady work in the UK on large rail projects like High Speed Two. Further, recent acquisitions and timely divestitures indicate a greater portion of future revenue growth will come from higher gross margin segments, increasing overall profitability. As it becomes clear profitability and free cash flow are improving, FSTR’s market capitalization may be sufficient to elevate the company back into the Russell 2000 at some point in 2023 or 2024. At that point the company should also be returning capital via a stable dividend or buybacks furthering helping support shares and improve liquidity in the stock. 

New Management and Strategy

CEO John Kasel took over in June 2020 having worked in senior roles in FSTR’s rail division for over 20 years, and CFO Bill Thalman joined from Kennametal in 2021. The duo has divided the businesses into “growth” and “returns” segments. The growth segments of rail technologies and precast concrete are the focus for organic and inorganic reinvestment. The low growth but cash generating “returns” segments are to be optimized for profitability, and they have divested some of the more working capital intensive and lower margin parts of the returns segment.

Per the Investor Day held in December 2021, the company’s long term (2025) targets include: $600mn in revenue, 21% gross margins and $50mn of EBITDA. 2022 has been disappointing in terms of profitability given inflationary headwinds and some noise following recent divestments. However, revenue growth has recently accelerated, the worst of the price / cost mismatch in the backlog is behind them, and strong orders combined with the highest backlog in years sets FSTR up well for 2H 22 and into 2023. LB Foster’s business is highly levered to infrastructure spending, and the company expects federal infrastructure bill related orders to begin to flow in Q4 22 and accelerate into 2023 and beyond.  The anticipated indications from survey and other quoting work translating into orders give the company confidence in the outlook despite a probable recession in the US and Europe.

Growth Segments: Rail and Precast Concrete

LB Foster’s rail segment serves both transit and freight customers and has generated $290mn of LTM revenue through 6/30/2022. Rail revenue can be broken down into three parts:

              1. Rail Products and Distribution: $190-200mn

Ø  This is legacy LB Foster products like rail ties, track components and insulated rail joints. This is a low, 10-20% gross margin segment with steady sales and limited growth.

2. Contract Services: ~ $50mn

Ø  LB Foster has a division in Europe, primarily the UK, that provides contract services and systems integrations to UK passenger rail.

Ø  Gross margins are in the 15-20% range and there is good organic growth in this segment as FSTR adds more capabilities on long tail projects such as Cross Rail and High Speed 2.

3. Friction Management ~ $50mn

Ø  FSTR acquired this business in 2010 with Portec Rail. This segment consists of products that are applied to the rails that reduce fuel consumption and wear and tear on both the rolling stock and the rails themselves. Friction management has the high gross margins of 30-35% and the potential for growth from increased utilization and the adoption of water-based products to help customers (class 1 and transit) and save on fuel and maintenance and meet ESG goals.

In 2019, the rail segment generated $321mn of revenue and a 19.8% gross margin compared to $290 and 19.1% on an LTM Basis. With improved mix from contract services and friction management over the next 2-3 years FSTR should be able to drive rail gross margins to 21% or above. In the UK, for example, FSTR has done well servicing the Cross Rail project which is winding down. High Speed 2 is eight times as large as Cross Rail and FSTR has only increased its scope on projects which should provide steady, high margin work over the coming years. Finally, within the Friction Management segment, FSTR has spent years developing water based, stick solution that can be added to a locomotive rather than applied using a wayside solution. Once the product and concept are proved out and benefits clear, FSTR expects to be aggressive in marketing the suite of products. We estimate that an incremental $15mn of revenue from Friction Management could add another $4-5mn of EBITDA annually.

Infrastructure Solutions and Precast Concrete

FSTR’s precast concrete segment has grown nicely over the years but profitability took a hit in 2022 due to cost inflation and pricing lags. The other segments within infrastructure solutions leave something to be desired and are likely divestment candidates. Steel products are used on bridge construction and repair and are low margin and low growth. The coatings, measurement, and legacy energy products segments account for about $35mn of revenue and are operating at EBITDA break even, but there are signs of life. The coatings facility has work through the rest of 2022 for the first time in years and there are some large projects recently approved that may give the segment a shot in the arm in 2023 and beyond. Importantly, the segment has excellent incremental and high gross margins and the potential benefit from this segment is not included in management’s 2025 $50mn EBITDA target. To give some perspective, in 2019, the coatings and measurements segment alone generated over $100mn, about 20% of revenue but nearly 50% of EBITDA. Flash forward to today and the segment generates less than $35mn of revenue and break-even EBTIDA.

Precast Concrete: Room for Improvement

Through its CXT Concrete subsidiary, LB Foster has a strong brand in custom, purpose built precast concrete buildings such as bathroom facilities, shower facilities, concession stands, and other multipurpose built rooms. If you have visited a State or National Park, you’ve probably used a CXT bathroom. In addition, there is growing use case for CXT structures in other private sector applications like utility infrastructure and equipment. CXT also produces septic tanks, pump tanks, box culverts, bridge beams and a variety of other custom-made concrete products at its three facilities in the US. The three facilities are in growth regions: Boise, Idaho, Dallas, Texas and West Virginia (near Pittsburgh).

Prior to the recent acquisition, the precast divisions gross and EBITDA margins were below public peers. For example, in 2021, FSTRs precast division gross and EBITDA margins were 17.6% and 4.6% respectively, well below public peers Smith Midlands and NW Pipe, who have EBITDA margins between 15-20% at similar levels of revenue. Management puts the poor performance down to cost / price mismatch on its government backlog and indicates that margins will improve as it puts the mismatched backlog behind it this year and sells more into the private sector.

FSTR stands to gain from the passage of the Great Outdoors Act, which provides $1.9bn per year for five years to address deferred maintenance backlog at National Parks as well as the broader infrastructure package. For historical context, post 2008 stimulus targeted at Parks, the Dallas facility alone did over $40mn of revenue compared to $25-30mn today.

Capital Allocation and Recent M&A

FSTR’s track record in acquisitions outside of the rail segment is abysmal over the last decade. The 2014 energy deals left the company over levered and led to massive write offs. New management, who had nothing to do with the energy deals, fully acknowledge their faults and has not stood still. Consistent with what was laid out at the 2021 Investor Day, the company has pursed M&A in its growth verticals: precast concrete and rail technologies, while also divesting lower margin, working capital intensive low to no growth businesses.

Below summarizes recent M&A:

1. Divested Steel Pilings (Proceeds of $24mn)

2. Acquired Scratch and IV – UK Rail Technology  ($8mn Revenue, $1.8mn EBITDA paid $8.8mn)

3. Divested Canadian Rail Products Segment ($14mn revenue, $1.5mn EBITDA received $7.8mn)

4. Acquired Vanhoose Co Precast ($28mn of revenue, $7.2mn Adj EBITDA, paid $50.5mn)

The most important deal, done in August 2022, is the acquisition of Vanhoose for $50.5mn or 7.5x 2021 EBITDA. The deal should be immediately accretive to FSTR’s margin and growth profile and has significant potential revenue synergies. Vanhoose Co’s 2021 gross and EBITDA margins were 28.6% and 26% respectively, well above FSTR’s.

Vanhoose Co sells two proprietary branded products: Envirocast (precast insulated walls) and Envirokeeper (stormwater management and storage systems). For a period of three years LB Foster can sell these products through its other facilities and geographic regions. After three years, it can sell the products but must pay a royalty to the Vanhoose Co founders. Finally, Vanhoose Co has recently completed a second facility outside of Nashville. This facility can produce the same quantity of product as its first facility, and thus should enable the acquired company to double its revenue over a 3-4 year period as it ramps up sales, staffing, and training. Between the increase in high margin capacity and the ability to sell more high margin products in their other regions, the acquisition feels like a home run.  

The deal was funded entirely with debt on FSTRs credit facility at a current interest rate around 5%. After the quarter ended 6/30/2022, FSTR’s gross debt fell to $38mn following a pay down of about $12mn from a tax refund and divestment proceeds, and leverage stood at 2.7x and 2.0x on a gross/net basis. Including the new $50mn of debt and adding back Vanhoose Cos Adj EBITDA for covenant purposes, FSTR’s gross and net leverage ratios are 3.4 and 3.1x on a pro forma basis. Covenants are based on gross leverage with step downs beginning in Q4 2022 from 3.75 to 3.25x by 6/30/2023. 2H 22 should be a source of cash from operations given working capital release and profitability, and management has guided to below 2.7-2.8x on a gross basis by the end of 2022.

Free Cash Flow Potential Under Appreciated

Below is a table of how to think about possible FCF generation from 2H 22 – 2025. In addition to growth and an improved mix from high gross margin segments, FSTR has considerable net operating loss carryforwards that it will utilize to minimize cash taxes on its US based earnings. FSTR has a net deferred tax asset worth $33mn or $3/share. Unlike many old, unprofitable companies with no income to offset their NOLs, FSTR will utilize the DTA over the coming years to free up cash for additional M&A, deleveraging, or shareholder returns. Finally, 2024 is final year of FSTR’s required $8mn annual payments to Union Pacific under the legal settlement for faulty rail ties.

Outlook and Valuation

FSTR’s orders and backlog are the highest they have been in years. Importantly, according to management, this doesn’t include any material benefit from major infrastructure legislation passed over the last eighteen months. Given the way funding flows, orders should begin to come in late Q4 and into 2023 supporting the company’s organic growth estimate of 6-8% per year for the next few years. LB Foster’s returns on capital have been weak over the last decade but are improving. Below is one way to think about what the business is and could be worth. As FSTR grows profitably and de-levers, its ROIC will improve to support the valuation. On an LTM basis, pro-forma for Vanhoose Co the company trades at 7.5x EBITDA and just 6.0x 2023 EBITDA of $31mn (only 1 street analyst estimate), which we believe is too low. From $10/share today, LB Foster is likely a $20-25 stock by the end of 2023 with a clear path to $40/share by 2025. Importantly, despite the recessionary conditions, following the Vanhoose Co acquisition, management believes the company is more or less on track to meet its 2025 goals. As laid out, with upside potential from Vanhoose Co, if anything, the bias is to the upside.

Catalyst

Doubling of LTM 6/30/ EBITDA in 12-18 months from organic growth and recent acquistion as tailwinds from infrastructure packages support long term revenue and free cash flow generation. Eventual market cap growth and improved valuation to be added back into Russell 2000.