Tuesday, September 29, 2020

A Small Cap Equity holding: Federal Signal Corporation (FSS, $28.93): “Federal Signal to Contribute to Coronavirus Clean-Up” by: Adán Jiménez, AIM Student at Marquette University

  Federal Signal Corporation (FSS, $28.93): “Federal Signal to Contribute to Coronavirus Clean-Up”

By: Adán Jiménez, AIM Student at Marquette University

Disclosure: The AIM Equity Fund currently holds this position. This article was written by myself, and it expresses my own opinions. I am not receiving compensation for it and I have no business relationship with any company whose stock is mentioned in this article.


• Federal Signal Corp. (NYSE: FSS) is a leading manufacturer of industrial vehicles and machinery used for a wide range of infrastructure projects, especially street and sewer cleaning. The company also manufactures safety and security equipment such as lights and sirens. Federal Signal serves governments and commercial clients in the United States and Canada.

• FSS has been a hot stock since Jennifer Sherman was appointed CEO in January 2016. Prior to the corona crash in March this year, the stock had increased ~130%.

• Under new leadership and through the development of innovative products and key acquisitions, the company has seen average revenue growth ~20% per year and expanded operating margins from 8% to 12% from 2016 to 2019.

• Federal’s “Safe Digging” water and air pressure machines are effective and sustainable excavation tools that are widely accepted in Canada and increasingly in the US (19 of 50 states today). This suggests an attractive long-term opportunity in which Federal is a leading player.

• The industry took a massive hit as the pandemic strained government and commercial budgets, but orders have recovered tremendously and backlogs are near all-time highs and expected to grow.

Key points: Federal Signal competes against primarily small private companies in the US and Canada. About 75% of the company’s sales are to federal and municipal governments that have demonstrated a consistent need to upgrade their machinery. The pandemic has certainly hurt the financial position of these government entities in the short-term; however, the company’s cleaning and security products are deemed “essential,” which we know to be good news for a business.

Not only did the pandemic tighten the budgets of the company’s key clients, it also hurt the company’s ability to market their products. The global lockdown completely shut down trade shows and equipment demonstrations—key tactics the company uses to drive sales. As a result, revenue was down 17% compared to the same quarter last year. Still, the company was able to use this difficult time to acquire PWE, a distributor of maintenance and infrastructure equipment in southeastern United States, for an attractive $6 million. They also paid down $36 million in debt.

Furthermore, average weekly orders were 24% higher in June than in May and the company ended the quarter with a backlog of $333 million, compared to $348 in Q2 2019, indicating a strong recovery from the market crash. One of the original drivers for the addition of FSS into the AIM small cap fund was their aftermarket parts and services initiative which has been growing over 10% per year. Despite the tough market conditions, sales in this segment continue to make up an increasing share of total revenue. 

Federal also continues to diversify its revenue streams, decreasing its dependence on publicly funded sources from 60% last year to 50% today. This is made possible largely through the company’s continued success in acquisitions of leading manufacturers in attractive markets. Through strong free cash flow generation and access to credit markets, acquisitions (74% of cash allocation) will continue to drive Federal’s performance. Management has also approved $91 million of share repurchases which provides additional support to a historically bullish stock.

What has the stock done lately?

At the beginning of the month, a significant market correction stemming from uncertainty regarding the election, the coronavirus, and federal stimulus began to unravel. In this time, the S&P 500 has dropped 5.4%, with industrials falling more than that in the past week. There has been no fundamental change to the prospects of Federal Signal, therefore it seems like the 9.5% drop in the stock is largely a short-term market reassessment of valuation.

Source: FactSet

Past Year Performance: Prior to the market decline at the beginning of the month, FSS stock was up ~3% which has certainly lagged the market but is unsurprising for a cyclical industrial company. It’s important to note that this stock was added to the small cap portfolio in early April and had increased over 25% prior to the current market downturn.

Source: FactSet

My Takeaway

Federal Signal is a name that the AIM Small Cap Fund has been in and out of a few times in the last five years. It’s been a strong performer since the appointment of CEO Jennifer Sherman in 2016. The board has also elected an effective CFO and COO in the last few years. Management continues to identify strategic targets for M&A activity and has executed these initiatives even in the middle of a pandemic. The company’s leverage remains low and has ample room to continue to expand operations in this way. Federal also continues to improve its organic growth through the development of their parts and services aftermarket initiative and constant innovation of their products. The company has ~35% market share in a highly fragmented market that it is attractive for further penetration. Federal’s sustainable and efficient “Safe Digging” excavation practices are in the early stages of adoption in the United States which suggests long-term opportunity. Q2 2020 was undoubtedly the bottom for Federal and I believe we made a good choice in adding this stock at market lows back in April. The stock’s performance this year is largely clouded by the volatility of the market as a whole, but the drivers of the investment thesis are playing out favorably and have lots of room to run. For these reasons, I recommend we maintain our position in FSS in the AIM Small Cap Fund in order to see further development of the original investment thesis.