Federal Signal Corporation (FSS) Earnings Call Transcript & Summary

Greetings. Welcome to the Federal Signal Corporation's Second Quarter Earnings Call. [Operator Instructions] Please note, this conference is being recorded. I will now turn the conference over to Felix Boeschen, Vice President, Corporate Strategies and Investor Relations. Thank you, Felix. You may begin.

Good morning, and welcome to Federal Signal's Second Quarter 2026 Conference Call. I'm Felix Boeschen, the company's Vice President of Corporate Strategy and Investor Relations. Also with me on the call today is Jennifer Sherman, our President and Chief Executive Officer; and Ian Hudson, our Chief Financial Officer. We will refer to some presentation slides today as well as to the earnings release, which we issued this morning. The slides can be followed online by going to our website, federalsignal.com, clicking on the Investor Call icon and signing into the webcast. We've also posted the slide presentation and the earnings release under the Investor tab on our website. Before I turn the call over to Ian, I'd like to remind you that some of our comments made today may contain forward-looking statements that are subject to the safe harbor language found in today's news release and in Federal Signal's filings with the Securities and Exchange Commission. These documents are available on our website. Our presentation also contains some measures that are not in accordance with U.S. generally accepted accounting principles. In our earnings release and filings, we reconcile these non-GAAP measures to GAAP measures. In addition, we will file our Form 10-Q later today. Ian will start today with more detail on our second quarter financial results. Jennifer will then provide her perspective on our performance, current market conditions and go over our increased guidance for 2026 before we open the line for any questions. With that, I would now like to turn the call over to Ian.

Thank you, Felix. Our consolidated second quarter financial results are provided in today's earnings release. In summary, in what is typically a seasonably strong period, our businesses were able to deliver 19% year-over-year net sales growth, 21% operating income improvement, an 18% increase in orders, gross margin expansion and a 60 basis point improvement in adjusted EBITDA margin during a record-setting second quarter. Consolidated net sales for the quarter were $670 million, an increase of $106 million or 19% compared to last year. Organic sales growth for the quarter was $31 million or 6%. Consolidated operating income for the quarter was $118.2 million, up $20.5 million or 21% compared to last year. Consolidated adjusted EBITDA for the quarter was $144.4 million, up $26.2 million or 22% compared to last year. That translates to a margin of 21.5% in Q2 this year, up 60 basis points compared to last year. GAAP diluted EPS for the quarter was $1.40 per share, up $0.24 per share or 21% compared to last year. On an adjusted basis, EPS for the quarter was $1.42 per share, an increase of $0.25 per share or 21% from last year. Customer demand remained strong during the quarter with orders of $637 million, representing an increase of $97 million or 18% compared to last year. Backlog at the end of the quarter was $1 billion compared to $1.08 billion last year. In terms of our group results, ESG's net sales for the quarter were $578 million, up $97 million or 20% compared to last year. ESG's operating income for the quarter was $113.9 million, up $22 million or 24% compared to last year. ESG's adjusted EBITDA for the quarter was $138.3 million, up $27.5 million or 25% compared to last year. That translates to an adjusted EBITDA margin for the quarter of 23.9%, an improvement of 80 basis points compared to last year. ESG reported total orders of $548 million in Q2 this year, an increase of $107 million or 24% compared to last year. SSG's net sales for the quarter were $93 million this year, up $8 million or 10%. SSG's operating income for the quarter was $22.1 million, up $600,000 or 3% compared to last year. SSG's adjusted EBITDA for the quarter was $23.2 million, up $600,000 or 3%. That translates to an adjusted EBITDA margin for the quarter of 25.1% compared to 26.9% last year. SSG's orders for the quarter were $89 million compared to $99 million last year. Corporate operating expenses for the quarter were $17.8 million compared to $15.7 million last year, with the increase primarily due to higher post-retirement expenses and increased medical costs. Turning now to the consolidated income statement, where the increase in net sales contributed to a $34.2 million improvement in gross profit. Consolidated gross margin for the quarter was 30.4%, a 40 basis point increase over last year. As a percentage of our net sales, our selling, engineering, general and administrative expenses for the quarter were down 10 basis points from Q2 last year. Other items affecting the quarterly results include a $2.1 million increase in amortization expense, a $200,000 increase in acquisition-related expenses and a $2.5 million increase in interest expense. Tax expense for the quarter was $25.3 million compared to $22 million in Q2 last year, with the increase primarily due to the effects of higher pretax income levels, partially offset by a $1.1 million increase in excess tax benefits associated with stock-based compensation activity. Our effective tax rate for Q2 this year was 22.7% compared to 23.6% in Q2 last year. At this time, we expect that our full year effective tax rate will be approximately 24%, excluding additional discrete tax benefits. On an overall GAAP basis, we, therefore, earned $1.40 per share in Q2 this year compared with $1.16 per share in Q2 last year. To facilitate earnings comparisons, we typically adjust our GAAP earnings per share for unusual items recorded in the current or prior year quarters. In the current and prior year quarters, we made adjustments to GAAP earnings per share to exclude acquisition-related expenses and purchase accounting expense effects. On this basis, our adjusted earnings for the quarter were $1.42 per share compared with $1.17 per share last year. Looking now at cash flow. We generated $113 million of cash from operations during the quarter, an increase of $53 million or 89% from Q2 last year. That brings the total cash generated from operations in the first half of this year to $214 million, an increase of 122% over the first half of last year. During the quarter, we paid down approximately $97 million of debt, ending the period with $391 million of net debt and availability under our credit facility of $1.04 billion. Our current net debt leverage ratio remains low. With our financial position remaining strong, we have significant flexibility to invest in organic growth initiatives, pursue strategic acquisitions, pay down debt and return cash to stockholders through dividends and opportunistic share repurchases. On that note, we paid dividends of $9.1 million during the quarter, reflecting a dividend of $0.15 per share, and we recently announced a similar $0.15 per share dividend for the third quarter. That concludes my comments, and I would now like to turn the call over to Jennifer.

Thank you, Ian. We are proud of our second quarter financial results, which included new second quarter records across net sales, adjusted EBITDA, adjusted EPS and orders, thanks to outstanding contributions from both of our groups. These results underscore the resilience and durability of our business model, the momentum behind our growth initiatives and the unwavering commitment of our teams. Over the last several years, we have continued to diversify our revenue streams and end market exposure to different funding sources. As a result of these efforts, we have strengthened the core of our business while muting cyclicality and driving growth over a prolonged period. Within our Environmental Solutions Group, we delivered 20% year-over-year net sales growth, a 25% increase in adjusted EBITDA and an 80 basis point improvement in adjusted EBITDA margin. Growth in our aftermarket business, leveraging the power of our platform to drive internal margin initiatives and proactive price/cost management were all meaningful organic contributors. Acquisitions also contributed approximately $75 million of net sales during the quarter with New Way and Mega driving notable increases in sales of refuse trucks and mineral extraction support equipment. Organic net sales growth was also broad-based across several of our ESG vehicle categories, including vacuum trucks, dump truck bodies and other specialty equipment. From a capacity perspective, the combination of large-scale capacity expansions that we completed between 2019 and 2022, good access to labor and continued investments in several productivity-enhancing projects position us well to absorb more volume into our existing footprint. Consistent with prior years, in 2026, we expect approximately half of our annual capital expenditures to be focused on various growth initiatives with the other half focused on maintenance investments. Shifting to aftermarket. Demand for our aftermarket offerings remained strong, aided by contributions from recent acquisitions. For the quarter, aftermarket revenue increased 24% year-over-year, primarily driven by higher demand for aftermarket parts, higher used equipment sales and rental income growth. We are experiencing strong rental demand as rental income grew by 16% year-over-year, led by growth in our safe digging and combination sewer cleaners. As a reminder, our aftermarket ecosystem spanning parts and service, rental, rent-to-own and used equipment offerings further unlocks previously underserved customer cohorts for Federal Signal. Our teams are diligently focused on driving more parts revenue across the enterprise. This is a multifaceted approach. First, our Build More Parts initiative, whereby we are vertically integrating certain parts production remains in early innings. We are investing in manufacturing capacity dedicated to this initiative in the second half of the year. Second, as our addressable installed base of vehicles has grown, we are expanding our geographic footprint of aftermarket parts and service locations to better serve our customers and capture more parts opportunities. For perspective, since 2019, we have added approximately 20 service centers, and we see additional footprint expansion opportunities. Third, as we integrate acquisitions, this aftermarket ecosystem becomes a powerful flywheel. As part of these plans, our teams are currently pursuing aftermarket growth opportunities across Trackless, New Way and Mega. In the aggregate, aftermarket represented approximately 25% of ESG revenue in Q2 this year. Shifting to our Safety and Security Systems Group, where the team delivered another quarter of solid results with 10% top line growth, a 3% increase in adjusted EBITDA and an adjusted EBITDA margin of 25.1% towards the midpoint of our recently raised target range of 22% to 28%. This performance was primarily driven by a combination of volume increases across our public safety and industrial signaling product verticals, proactive price/cost management and realization of certain cost savings, somewhat offset by mix headwinds. Lastly, we had another outstanding quarter of cash generation with $113 million of operating cash flow, representing cash conversion of 131% of net income. On an annual basis, we continue to target 100% cash conversion. Before I comment on current market conditions, I would like to provide some additional context around our end market exposure. As referenced earlier, when I first became CEO in 2016, one of our main objectives was to reduce the cyclicality of earnings streams by decreasing our reliance on any single funding mechanism, economic end market or customer cohort. The result is a substantially more durable revenue profile today compared to 10 years ago, including less reliance on traditional municipal budgets, a significantly larger aftermarket presence and increased exposure to various niche industrial markets such as road marking, metal extraction support, hydro excavation and dump trucks. We have also strategically diversified funding mechanisms within our publicly funded verticals. These funding sources include water taxes, Canadian provincial and local budgets, law enforcement and police budgets, trash collection fees, airports, U.S. state budgets, military and European local and federal exposure. To provide some perspective on this, while a little more than half of our revenue base is tied to some sort of publicly funded mechanism, the largest publicly funded source, U.S. water taxes, impacts less than 15% of our total net sales. Shifting now to current market conditions. On an underlying basis, excluding the impact of third-party Labrie refuse orders received in Q2 last year, our orders this quarter increased by $103 million or 19% year-over-year with healthy demand across both our Safety and Security Systems Group and our Environmental Solutions Group. Within our Environmental Solutions Group, orders were up 24% year-over-year, including high single-digit organic growth. Within product lines, we experienced strength in organic demand for vacuum trucks, led by strong increases in orders for safe digging trucks, dump truck bodies and trailers and aftermarket offerings. Lastly, our backlog stood at $1 billion at the end of the first quarter, down approximately $80 million or 8% year-over-year, with $75 million of this reduction associated with the planned decline in third-party Labrie refuse backlog, which was discontinued in the fourth quarter of 2025. At the end of the quarter, our third-party Labrie refuse truck backlog stood at approximately $44 million. As a reminder, net sales of our backlog-intensive products represented approximately 45% of net sales last year. With that said, given the size of our backlog, we continue to enjoy strong forward visibility for our backlog-driven product lines. In fact, while we are making progress, lead times for certain of our products remain elevated compared to our target levels. As I reflect on our performance through the first half of 2026, I am most pleased with the early financial benefits we are starting to realize from the collective power of the growth platform that we have built over the past decade. The power of this platform spanning several key centers of excellence, including procurement, our Federal Signal operational system, supply chain optimization, aftermarket, dealer development, sales channel alignment, data analytics and new product development underpins my confidence in our ability to achieve continued earnings growth in 2027 and beyond. Going forward, it is our intent to further invest in scaling these centers of excellence, which will support both our M&A integration engine and unlock incremental margin expansion opportunities across the enterprise that we have identified. We expect to incur additional expenses in the second half of this year as we scale these centers of excellence. Simply put, as we contemplate the next phase of growth at Federal Signal, this platform is what will allow our teams to pursue more strategic market share and operational improvement initiatives at a faster pace each year, driving an increasingly unique customer value proposition and an increasingly idiosyncratic earnings growth opportunity through various economic conditions. As a reminder, through cycles, we target annual low double-digit top line growth split roughly evenly between inorganic and organic growth. At the same time, we are committed to growing profitably and have implemented associated EBITDA margin targets for our group that we've increased several times over the past years. A couple of highlights. Starting with margins. As I just noted, we are excited by a number of initiatives that we believe will drive further margin expansion as we begin to leverage the power of our platform more deliberately. We have identified 4 categories of expansion opportunities over a multiyear time frame. First, the continued growth of our aftermarket business, which carries an attractive margin profile. Through cycles, we expect aftermarket revenue to grow slightly faster than the overall company. Second, execution on several operational initiatives. Some of the largest untapped categories we have identified are focused on optimizing our procurement spend across our specialty vehicle verticals and scaling our 80/20 processes as we internalize our Federal Signal operating system across the broader enterprise. Third, driving increased volumes through our expanded footprint while investing in select automation opportunities. And fourth, the successful execution and integration of acquisitions. Over a multiyear time frame, all 4 of these categories, aftermarket, operational initiatives, leveraging our capacity and M&A, will be important contributors to margin expansion. On that note, in early July, we completed the acquisition of Western Technology, a manufacturer of proprietary portable explosion protected lighting solutions for niche end markets such as industrial processing, petrochemical or aerospace. We see strong synergy opportunities as Western will expand our industrial signaling product portfolio, allowing our teams to utilize our existing sales channel and manufacturing operations. Going forward, we see further opportunities to grow SSG through strategic M&A. We have also been pleased with the integration progress our teams are making at New Way and Mega. We are still in the early stages of our multiyear integration plans, but so far, both acquisitions have exceeded our internal margin and profit contribution expectations in the first half of 2026. Recall, in September of last year, when we announced the New Way transaction, we outlined $15 million to $20 million of annual synergies to be achieved by the end of 2028 with synergies split roughly even between cost and revenue. At this time, we are pleased to share that we are tracking ahead in the realization of our cost synergy targets, and we continue to identify incremental opportunities. The early successes of both of these integrations is a testament to our best-in-class record of achieving or exceeding our targeted synergies and the vast majority of the 17 acquisitions we have completed during my tenure as CEO. With each acquisition, we continue to learn and improve. And I want to acknowledge the outstanding efforts of our teams whose collective accomplishments have created significant shareholder value. Looking ahead, there's more to come. We are energized by an active M&A pipeline as we continue to evaluate strategic opportunities across both of our operating groups. Turning now to our outlook for the remainder of 2026. With our record-setting second quarter performance, our current backlog and continued execution against our strategic and operational initiatives, we are raising our full year adjusted EPS outlook to a new range of $5.12 to $5.30 from the prior range of $4.80 to $5.05. We are also raising our full year net sales outlook to a new range of between $2.58 billion and $2.67 billion from the prior range of $2.57 billion to $2.66 billion. Lastly, we are reaffirming our CapEx outlook of between $45 million and $55 million for the year. With that, we are ready to open the line for questions. Operator?

[Operator Instructions] Our first question is from Steve Barger at KeyBanc Capital Markets.

Really appreciate the commentary about diversity of funding mechanisms just because visibility into that has been a big investor topic for the past month or 2. Overall, how would you characterize funding across those different sources and just visibility for the back half and into next year?

Yes. Thank you, Steve. As I mentioned in my prepared remarks, we've been very purposeful in terms of diversification of those funding sources really with the objective of creating a very resilient and durable business model. So as we look across that, we say plus or minus 55-ish percent comes from public revenue. And as I talked about in my prepared remarks, the largest portion of that would be water taxes, which is less than 15%. Within that public revenue, there's also Canada, which is an important end market for us. There's also the European market. There's a little piece of the U.S. and military portion of that. And then there's a little piece of refuse fees in there. But there's also -- we get a lot of questions about the municipal piece. And probably the way to think about it is the way that we think about how do we categorize our businesses. So you think about the other specialty equipment category where our pure-play municipal business resides that other special equipment category is about 25% of our overall business. Within that category, you've got refuse, which is the largest portion in that category. You have our metal extraction business, you've got our road marking and high-pressure water blasting business and you have our Elgin street sweeper businesses. And those 3 businesses, each one of them is kind of mid- to high single-digit percentage of our overall net sales. So we get a lot of questions about the municipal exposure. And our truly only pure-play municipal exposure would be street sweepers. And those budgets have been holding. They're funded primarily through property taxes and sales taxes. And when you look at the external data, it continues to grow consistent with GDP type rates. And although our street sweeper orders were down in Q2, there were other parts of that other specialty equipment that were strong. So our metal extraction orders were up, our road marking and jet streams were solid, and our refuse orders were slightly above where we had planned. And I think we talked about last September that we thought in 2026 that, that refuse market would be down. But overall, we feel very good about those diversification of funding sources and then the outlook going forward. The last thing I would say is -- 45% of our business is backlog driven, and that gives us pretty good visibility. And that $1 billion of backlog sets us up for a good second half and a strong beginning to 2027.

Really comprehensive answer. I appreciate that. And I guess just to recap, if I look at that in aggregate, the funding mechanisms look secure as you go into the back half and next year?

Yes.

Perfect. And then you talked about investing in aftermarket capacity, which obviously makes sense as that approaches 25% of ESG revenue. What dollar level are you investing toward? And as you've grown that business, what's the incremental return on capital for those aftermarket investments?

Yes. I think, Steve, we've maintained the CapEx guide of $45 million to $55 million for the year. So we're not talking about significant CapEx in terms of these investments that we're making. They're relatively modest investments that we're making to mainly existing facilities just primarily to drive the build more parts initiative. So in terms of the incremental -- I think Jennifer mentioned in her prepared remarks, the margin on the aftermarket business is more attractive. The delta isn't quite as significant as you may see in some other industries for a couple of reasons, primarily, we command some pretty good margins on our existing equipment sales as well. But it is a slightly more attractive return. And as we go forward, that's one of the things that we think about when we see the opportunity to drive further margin expansion is just the continued growth of the aftermarket business. So the returns they're attractive, certainly, when you look at the relatively low level of investment in the facility that we're referring to here.

Yes, I'd just add a little bit of color to that. The team is -- I was with the team at their off-site up in Canada last month, and the team has identified some geographic expansion opportunities. And we will be opening up some new offices, again, very low CapEx. Number two, as in my prepared remarks, I talked a lot about build more parts, and that's an area we will be investing and we see a lot of growth potential. And then again, we really like the durability and resilience of this aftermarket segment. And we manufacture work trucks and they need parts and they need service. And rental income was up year-over-year. Used equipment sales were up. This continues to be a very important part of the Federal Signal family.

Our next question is from Ross Sparenblek with William Blair.

It looks like some strong order growth in the quarter. I believe organic ESG orders were like they're up around 9%, although you noted that street sweepers were down in the second quarter. When we think about the muni channel overall, can you just give a sense of what the inventory channels look like? Do you think it's kind of balanced? Was there potentially some prebuy and destocking now or any other dynamics?

Yes. So we didn't see a lot of prebuy this quarter, and we haven't built in prebuys for the rest of the year in terms of our projections. We continue to monitor the EPA regulations, understanding that they're not finalized. And if something does change there, it could potentially be upside. With respect to refuse, as we announced -- when we announced the transaction last year, we expected that refuse would be down this year, and that's what we built into our valuation model and the price that we paid. And right now, refuse is on the order side is operating slightly ahead of our model. And as I mentioned on the call, with respect to integration and some of the cost synergies, we've realized some of those earlier than we anticipated. With respect to inventory in the channel, many of our specialty vehicle categories don't really carry a lot of channel inventory. So we feel really good about what we're seeing right now. And again, kind of building what I said earlier, aftermarkets represented about 25% of ESG's revenue this quarter. And we saw a very strong performance there. They were up 24% year-over-year. And each of those rentals was up, used equipment was up and parts was up. So again, as we look at kind of those different end markets and the different pieces, we feel really good, and that's what led to the significant increase in our guidance for the second half of the year.

Okay. That's helpful. So the expectation then is the chassis disruption that started to alleviate in 2024. I mean that's in the rearview and potentially going into next year, we'll have smoother comps and just kind of a normal GDP plus type of activity in the channel.

What we know today, the answer is yes.

Okay. That's helpful. And then just on the margin side, nice lift in the EPS guide, some interest there, but SG&A is stepping up. So maybe just some moving parts there, higher SG&A in the second half potentially, maybe what type of incrementals we should be underwriting? And I get the sense of the confidence here is coming from just the progress making on the aftermarket side.

Yes. I think a couple of things, Ross. I think obviously, the momentum that we're seeing on the aftermarket side of the business and also some of the traction we're seeing on the integration of the acquisitions -- they're tracking -- both Mega and New Way are tracking slightly ahead of where we thought they would be. So that has some margin upside for the year. I think when we went into the year, we were expecting those acquisitions to be slightly dilutive. But I think where we sit today, we actually think that that dilution is not going to be there. So I think if you look at the guide for the year, that would imply that we're expecting margin improvement on a year-over-year basis. So yes, the investments that we referred to, they are in the second half of the year, but not overly material in the sense that when you look at the context of the raise for the rest of the year that's implied in the guide.

Okay. So on the SG&A side, the expectation is that as a percentage of sales, they should be stepping down year-over-year in the back half?

Yes. I think more of the upside is probably in the gross margin area as opposed to SG&A. I mean we're not adding significant costs from an SG&A standpoint. They're really not relatively nominal investments that we're referring to. So most of the uplift, I think, would be on the gross margin front.

Yes. We are adding some people, though, to drive some of the longer-term benefits that I identified with respect to the power of the platform.

Our next question is from Tim Thein with Raymond James.

The question is on aftermarket and thinking about the initiatives you're putting in place to expand that and obviously, real nice growth in the quarter. I think in the past, we've talked about maybe a long-term target that -- of that part of the portfolio getting to 30-ish percent of ESG revenues. And I recognize that year-to-year, there can be fluctuations depending on where those OEM volumes are coming in and how that impacts the overall kind of percentage. But as you've now integrated New Way and you think about some of these company-specific initiatives, how are you still thinking about that as kind of a realistic target? And any sort of -- I know the time line is hard to put on it, but is 30% of segment revenue still kind of achievable target to put out there?

Yes. I think I have a couple of things to add to that. One is, as I stated in my prepared remarks, we would expect aftermarkets to grow faster than the company. My objective is I want to grow both the numerator and the denominator. So -- and a couple of critical things are going to contribute to the growth of aftermarket. One, it's going to be somewhat dependent on what acquisitions we do. New Way, as we talked about when we purchased the company, we're 2 full quarters in, but parts are about 11% of their overall revenue. So we see some upside as we move forward, and that's an important synergy that the teams are working on. Many of our businesses right now are running at 30% on the parts side. But there's no structural reason why it can't be 30%. And as I mentioned earlier, a lot of it is going to depend on the M&A and the mix of the businesses that we buy. But we are fully committed to growing aftermarkets. Again, what I talk about internally all the time is the durability and resilience of our business model and aftermarket is an important part of that.

Got it. Okay. And maybe just to make sure I got what Ian was going through. So the net income guide goes up, I don't know, $17 million, $18 million on a pretty marginal change in revenue. Is it the traction -- the growth in aftermarket and some of the M&A integration performing better than expected? Are those kind of the 2 big drivers.

Yes. there's a lot of pieces, as you can probably imagine. But if you think about the big ticket items, the growth in the aftermarket business and then the traction on the recent acquisitions. I think Jennifer mentioned that we're tracking ahead of the cost synergies that we originally kind of communicated at the time of the New Way transaction. So those would be kind of the 2 bigger pieces.

I think some of the operational improvements that our teams are working on. And again, what I think is important to understand here is it's not any one thing. We have a number of initiatives. And we don't need every single one of them to hit. We just need enough of them to hit. And so as we look at the second half of the year and we looked at where we stand, we have a lot of confidence of our teams to execute on those initiatives and set us up for a strong 2027.

Our next question is from Walt Liptak with Seaport Research.

I'd like to ask one from 50,000 feet. So you've been beating your EPS numbers and raising guidance so far this year. And the orders this quarter look really good. So when you think about how your year is progressing, is it execution on the Build More Trucks initiative that's resulting in the EPS upside? Or is it something else?

One of the things about Federal Signal is that we're not overly reliant on any one initiative. As I mentioned earlier, we've got a number of different initiatives. So in this quarter and for the rest of the year, it's strong year-over-year growth in aftermarket. They're up 24%. Strong performance by the acquisitions, strong performance by our Mineral Extraction Group, solid performance by the Road Marking group, strong performance by the Vacuum Truck Group. SSG had another solid quarter. Our TBI businesses had a very solid quarter. I go through all that detail to say we've got just broad-based strength, and that's really what gave us confidence in terms of the guidance raise for the second half of the year. And as we're very focused on 2027 and what do we need to do to continue to drive these many initiatives across Federal Signal in order to continue to build both the resiliency and durability of this business model, the diversification around the end market of the business model and set us up for not only a strong second half of the year, but a strong '27.