Brian S. Cooper - Chief Financial Officer, Principal Accounting Officer and Senior Vice President Dennis J.

Martin - Chief Executive Officer, President and Director Jennifer L. Sherman - Chief Administrative Officer, Senior Vice President, General Counsel and Secretary

Matthew W. McConnell - Citigroup Inc, Research Division Tejas Patel - KeyBanc Capital Markets Inc., Research Division Walter S.

Liptak - Global Hunter Securities, LLC, Research Division

Thank you. Good morning and welcome to Federal Signal's Second Quarter 2013 Conference Call.

I'm Brian Cooper, the company's Chief Financial Officer. Also on this call with me are Dennis Martin, President and Chief Executive Officer; and Jennifer Sherman, Chief Administrative Officer and General Counsel.

We'll refer to some presentation slides today as well as to the news 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 selecting the webcast.

We'll also post the slide presentation to our website after the call. Before we begin, 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 news release and filings, we reconcile these non-GAAP measures to GAAP measures.

In addition, we will file our Form 10-Q today. And now I'd like to turn the call over to Dennis Martin.

Thanks, Brian, and thanks to everyone on the call for joining us today. We are pleased to be addressing good results and progress in our business.

I'll provide my perspective on key items for the quarter and Brian will then review our financial results. Jennifer will wrap up our prepared comments with an update on our corporate initiatives and our financial outlook.

Before jumping in, I'd like to note that this is Brian's first call with Federal Signal. He's been on board with us for 2 months and we're really glad to have him as part of our team.

Brian brings valuable strategic perspective, leadership and a very wide range of skills. He has extensive experience, including international experience in mergers and acquisitions, treasury, planning, investor relations and running businesses from his previous financial positions at Amoco, United Stationers, Fellowes and most recently, Westell Technologies.

As you can see, our second quarter results were excellent. They've benefited from outstanding performance in our environmental systems and Bronto groups as well as solid demand from our municipal and industrial markets.

We continue to see momentum in key aspects of our financial performance as orders, sales, margins and earnings all increased during this quarter. The results stem from both gradual improvement in our end market dynamics and traction with our initiatives.

We continue to work diligently using 80/20 and lean tools to focus on the right customers and products, to add capacity where it's needed and to become more efficient throughout our business. The results for the quarter versus the same quarter last year reflect all of this.

Orders were up slightly and backlog was down 8%, but remains at a healthy level. Our backlog at Vactor, in particular, had grown as our customers tried to position for deliveries against long lead times.

Vactor has added incremental capacity in Alabama and Texas to help bring these lead times down. The ability to flex capacity in our Vactor and Elgin businesses has been a key initiative, and we're beginning to see the benefits in our reduced backlog, which is good for Vactor production planning and for our customers.

Net sales were up, a strong 9%. ESG continued its growth.

Bronto has been on an upswing, and its deliveries spiked near the end of the quarter. Safety and Security Systems has been doing well, too, but worked through an ERP implementation during the quarter that slowed them down and added some cost.

This was the final location of our ERP system rollout and it went live in May with predictable frustrations. However, SSG recovered somewhat with strong shipments in the month of June and July, and we continue to see incremental costs reducing during the quarter.

Benefiting from our higher sales as well as a variety of business improvements, consolidated operating income was up 15% to $18.2 million. These same factors also helped drive up the Federal Signal operating margin to 8.2% for the quarter, which is our highest quarterly margin in almost 5 years.

I'll talk about margins by business group in a moment. In addition, we have talked a lot about our debt refinancing activities during the recent quarters and the results are clearly evident this quarter.

Interest expense dropped only $1.7 million compared to $5.4 million a year ago and $4.5 million in Q1. This is our first quarter recognizing the full benefit of the refinancing.

I will let Brian describe the large positive tax effect on our reported earnings. However, even without that effect, our adjusted earnings per share were still up an impressive 53% to $0.23 per share.

I'd like to turn to group operating margins for a moment to update you on our progress toward the targets we have set. At 12.3%, ESG's operating margin is already at the top of its targeted range and obviously performing extremely well.

Helped by strong demand at Vactor, Jetstream while Elgin is making steady improvements. SSG margins were impacted during the quarter by unfavorable product mix and the ERP systems changes in the United States.

There was also ongoing softness in our VAMA business in Europe and the Victor businesses worldwide. However, we expect SSG's margin to rebound, and we're confident that we are making and working on the right things to expand these margins.

Bronto's operating margin improved significantly to 9.1% in the quarter, in a large part because of strong deliveries on projects with very good margins. Bronto's margin results will vary from quarter-to-quarter as we have seen, given the variability of its shipments and product mix.

Our operational improvements and product design changes improved near-term profitability and do position Bronto well to benefit from market growth. All in all, then this was an exceptionally strong quarter.

I believe it helps demonstrate that we are doing the right things to grow profitably, and we feel good about the rest of our year. We will come back to you after Brian covers some of the financial details.

Brian?

Thanks, Dennis. As Dennis mentioned, I'm now into my third month with the company.

I'm excited to be part of a dynamic team and a strong company, and I look forward to helping drive our profitable growth. I also look forward to regular dialogue with you, our investors and analysts.

I'm going to get into more detail on our financial results for the quarter, which are included in today's press release. Dennis already mentioned that our reported earnings from continuing operations for Q2 include a large noncash tax benefit.

There was also a small reversal of our restructuring charge. Reported earnings were $1.87 per diluted share.

To make comparisons more meaningful, we think that it's helpful to remove the effects of the tax and restructuring benefits, which results in adjusted EPS of $0.23. This is up a robust 53% compared to adjusted EPS of $0.15 in Q2 of 2012.

The tax benefit of $102 million or $1.63 per share obviously, is large and merits some explanation. It resulted from the release of valuation allowance against the company's deferred tax assets.

These tax assets primarily represent the value of tax credits and net operating losses or NOLs that can be carried forward to reduce taxable income and taxes payable in the future. Following accounting guidelines, the valuation allowance was first established in 2010 when the company determined that it had reached a specific threshold of uncertainty about its ability to capture the value of its deferred tax assets through the generation of taxable income.

At this time, the company's financial position and outlook have improved significantly. Based on our improved results and outlook, we have determined as of June 30 that the deferred tax assets are likely to provide future tax benefits.

We therefore have removed the valuation allowance, which reserved the value of those assets. This determination does not change our actual tax payments or cash flow, but it obviously has a large effect on current period earnings.

It also means that starting in 2014, our future earnings will reflect higher but more typical effective tax rates. Again, cash tax payments do not change because of this release of valuation allowance.

As one final point on this, we have not released all of our valuation allowance. Certain tax assets, primarily relating to foreign earnings in certain states, are more uncertain of being utilized, and these remain reserved.

Following accounting guidelines, there also is a reserve that is intended to keep our effective tax rate on the U.S. income at approximately 0 for the remainder of 2013.

Looking at the P&L, we have already noted our 9% increase in net sales and 15% increase in operating income as well as our large step-down in interest expense. You'll note as well that SG&A expenses were up a modest 2%.

Most of the notable comparisons are at the group level, so I will move on to those. In our group results, you can see that orders were up for both for ESG and SSG, partly offset by a reduction at Bronto, so the consolidated orders were up 1% versus last year.

All 3 groups posted increases versus the first quarter of 2013, and we feel that demand remains good. Sales were up nearly 15% at ESG compared to last year's quarter, fueled mostly by improvements in capacity and efficiency at Vactor and Jetstream.

Higher sales and efficiency also drove higher operating income, which was up $3.3 million. SSG saw sales decline by 4% versus last year, and operating income was down by $2.7 million.

These results reflected some disruption related to the U.S. implementation of an ERP system from which SSG is recovering, although incremental costs will continue through Q3.

There was also some softness in SSG's international demand. Bronto turned in strong second quarter sales, up 13%, in part benefiting from the timing of deliveries near the end of the quarter, and its operating income doubled.

Corporate expenses for the quarter were $4.6 million, which is relatively low and about the same as in Q2 last year. In Q2 of this year, we have a number of items that we would not expect to repeat in future quarters.

These include the reversal of restructuring charges, adjustments to health plan accruals and cost reimbursements under a third-party agreement. Without the benefit of these offsets to Q2 expense, corporate expenses, excluding hearing loss, are likely to be higher by at least $1 million per quarter for the balance of the year.

As always, the cost and timing for hearing loss litigation are difficult to predict. Reflecting all of these factors, Q2 consolidated operating income was $18.2 million, up 15% compared to $15.8 million a year ago.

Turning to the balance sheet and cash flow. Net cash provided by continuing operations was strongly positive at $24.1 million during the quarter.

The largest positive factors in Q2 included earnings and reductions in inventory, offset by some timing effects in accounts payable. Since 2012, we have added metrics, objectives and focus around the management of working capital, which can help our cash flow and return on capital, and we will continue to drive for working capital improvements.

Total debt was $144 million at the end of Q2, which is down $14 million since the beginning of the year. That brings us to a leverage ratio of 2.1x adjusted EBITDA compared to 4x at the end of Q2 a year ago.

And based on our lower leverage, our interest rate should drop from about 3 1/4% during Q2 to about 3% during Q3. Finally, the effective income tax rate for the quarter before the effects of releasing valuation allowance was about 6%.

Our income tax rate can vary based on a wide variety of factors. On a normalized basis, excluding discrete items and effects from the valuation allowance, we believe our income tax rate for 2013 should be about 32%.

With no valuation allowance effects expected in 2014, at this stage, we would estimate an effective tax rate for 2014 in a similar range. Of course, with the availability of our NOLs and other deferred tax assets, our cash taxes payable on income should be much lower.

Cash taxes will vary primarily based upon where income is earned. That concludes my comments on the financial results.

I'd like to hand off to Jennifer to talk about the company's goals and outlook for 2013.

Thank you, Brian. I'd like to start by touching base on the same slide that I addressed with you on our call last quarter.

We promised you updates on our progress against these goals, which are long-term and strategic in nature. First, you all recognize that we have completed our major debt refinancing and our businesses and balance sheet are much healthier.

Our aim now is to generate cash flow and maintain a sound capital structure that will allow us to manage risks, make prudent investments for profitable growth and return value to shareholders. We will continue to evaluate our progress, and our board is committed to looking at our dividend policy on a regular basis.

Our solid results this quarter support and strengthen our belief that we are on track with other corporate goals, which all contribute to advance our growth and profitability. We saw solid growth at Vactor and Jetstream, which helps build our base with industrial customers.

This is a step in a longer journey to diversify our customer base with industrial growth. Elgin's results continue to improve, and SSG is improving its position as well.

In response to lower demand and throughput, we have worked to build efficiencies and profitability, and we've developed products that are more competitive in a price-sensitive environment. We believe that we can benefit further as municipal markets gradually strengthen.

As we discussed on the last call, we are also making targeted investments to help spur organic growth within our businesses. For example, over the last several years, the focus of many of our engineering teams has been on product cost reduction in support of our 80/20 initiatives.

While we will continue to move forward with these important projects, our engineering teams have reexamined and in some cases, relaunched our new product development innovation processes. We believe that it's critical that new product development be linked to understanding our customers' needs in current and adjacent markets.

Consequently, we've made a number of organizational changes to achieve this alignment. We will continue focusing our investment and dedicated resources to develop products with an emphasis on our high-growth industrial-based businesses.

These efforts are underway, but it takes time to bear fruit, and we continue to hammer away at manufacturing efficiencies in all of our businesses. This will include lean manufacturing changes, product redesigns like [indiscernible] and other efforts identified with our 80/20 tool.

We are keeping our focus on all of these areas. Our strong second quarter also calls for a relook at our expectations for the balance of 2013.

From a macroeconomic perspective, the U.S. economy and our municipal markets seem to be stabilizing or even strengthening a bit.

There is also recent news that Europe may be starting to return to growth, which may provide a boost for us in the longer term. However, to this point, we have not seen any significant uptick in our European-based demand.

Although, we will likely encounter some headwinds and surprises, there obviously are some good trends within our businesses themselves, such as good backlogs to build on. ESG had an extremely strong quarter, and we expect it to have a very solid second half.

SSG's rebound in the second half, while it will carry some [ph] incremental cost from its ERP implementation into the third quarter, we believe that the third quarter should be more profitable for SSG. Bronto, while it may have difficulty duplicating its very strong second quarter, should steadily work its backlog and produce reasonable profitability.

As we have discussed before, of course, shipping schedules for its large orders and product mix can result in significant variability in Bronto's results. At the corporate level, expenses will likely rise somewhat in the second half compared with the run rate in Q2, as Brian explained.

We also have to be mindful of potential costs related to our defense against hearing loss litigation, which can be material and difficult to predict. As we noted last quarter, there may be higher costs in the second half of this year.

Interest expense should be similar to Q2 levels in each of the last 2 quarters. Weighing all of these factors, we are raising our outlook for 2013.

We had previously discussed an adjusted EPS range of $0.55 to $0.65. Our current estimate is for adjusted earnings to be in the range of $0.62 to $0.72 per share.

These ranges exclude debt settlement charges from Q1, as well as the benefits from restructuring of reversals and release of the income tax valuation allowance. Overall, we had very positive results for a second quarter that reflect hard work across the entire company and some nice early payback from the strategies we are pursuing.

We are looking forward to carrying our momentum into the second half of 2013. I will now turn the call back over to Dennis for closing remarks.

Thanks, Jennifer. We have accomplished a lot in the in the last 2.5 years.

Our success is attributable to the efforts of our outstanding employees, our distributors, our dealers and our customers. I have spent time with our major dealers and distributors and many of our customers, and I'm continuously impressed by their driving commitment to our products and our company.

I also spend a significant portion of my time in the field with our employees. We are fortunate to have a passionate group of employees who are committed to profitably growing their company.

And as I previously discussed, we are committed to developing our employees through talent management and continuing education. As an organization, we are focused on deliberate succession management at every level of the company and are continually improving our organizational structure to best support profitable growth of Federal Signal.

With that, I think we're ready to open the line for questions.

Could you talk about some of the process improvements and capacity additions at ESG that enabled the big volume uptick and maybe touch on whether you think you have enough backlog to sustain this level of volume over the remainder of the year?

Yes. What -- when we talk about the capacity expansion of Vactor, we have to go back to the downturn of 2009.

We reduced our employment indirectly but thereby, more than 1/3. And since -- as we started to see a build in activity, we have more than exceeded that in bringing new folks back into the business.

The capacity was affected as new people came into the business, they're able to bump. So we had about well into the 300 or 400 job changes in the last 2 years there.

So as that stabilized and as we've returned to using our friends at Guzzler in Alabama and our other FS solutions locations to build equipment, we've been able to flex the assembly production of Vactor's to meet this very important demand that we've seen. We have actually also utilized capacity at our Elgin facility to assist with important weldments and other products that go into the Vactor's.

So as you think about the future, the backlog that we see and the order rates that we see are substantial enough during the rest of the year to support the level of activity we've seen at Vactor. The -- last year, because we were still in this uptick in the getting our production going, we extended our backlogs and our dealers added orders in advance.

And now as we've gotten into a more steady state with our capacity, we're seeing the order flow on a more continuous consistent basis, which is really good for us and for them. So the backlog change is not a negative at ESG.

Okay, great. That's very helpful.

And on a separate topic, you've discussed some of your investments and new product development in the industrial businesses. Are these contributing to growth in 2013?

Maybe could you highlight a few examples of where you see the best industrial growth opportunities?

We're seeing some, Matt, in 2013. I'll give an example.

Our Jetstream business introduced a new gear-driven machine, which I've talked about before, for the international market. And we've been -- that allowed us to expand.

We've added accessories there. Our industrial safety business has implemented some systems in some very key strategic hazardous places, which has allowed us to grab some business.

Our Vactor products, our guzzlers and hydro-excavators, certainly, in the industrial markets has contributed. And likewise, we have an initiative at our sweeper business to go after industrial sweeping applications.

So we are seeing some activity. But I think the real future is in the future for that.

This is actually Tejas filling in for Steve. Just wanted to go ahead and get started.

So nice job on the operations in the quarter, and seems like on the demand side, things are starting to stable or stabilize even in the current environment where you're not really seeing any tailwind from the end markets. So how much more margin expansion can you see given that top line remains about stable?

I think if the top line stays stable, we might have 1/2 a basis -- 50 points or something. It -- I think we're seeing some volume tailwind, too, actually.

So there's volume and operations in there, it's not strictly. If we see Europe return and Bronto business return to some -- in some of the other traditional markets, there's some opportunity there, too.

Our police business likewise is still growing in revenue but has opportunity, as we've said in the past, with our targets on SSG. We're well below the range we think we can achieve.

Yes. And, Tejas, this is Brian.

I -- the other thing you might keep in mind is that SSG will probably be returning to a little more normal levels. And Bronto is at a really good level this quarter, so there's some room for improvement especially out of SSG.

Great. And then just a follow-up on that.

And I'm not looking for guidance, but given the revenue and margins are coming through right now, and it's visible, is it reasonable to think that next year's results, even in an environment where, again, demand is kind of stable-ish, it would be fair to assume that next year would come in better given the internal initiatives you guys you put in, in the end market and if that does actually come through?

I'll refer you back to our margin targets for the individual businesses. So we have Bronto, ESG and SSG, and we put those out there a few years ago, believing that they were achievable with some return of volume.

And so we still believe that. So I think from a guidance point of view for next year, that's about as far as I'd be willing to go.

Got you. No, that's helpful.

And maybe if you could just talk about, for the quarter just price in both on the municipal and the industrial side and if you're seeing any competitive pressure there.

We always see competitive pressure and we're always aggressive on price. So we do have price contributing to our growth, and we do it in very specific ways in terms of how we handle options and discounts.

And so it's always very competitive, but we're -- got to keep pushing as far as we can, so...

Great. And then if you could just talk about -- I'm sorry, I lost my track here.

So okay, just to take a step back, cash flow improving, but as you think of capital allocation strategy, what are the priorities? I mean, I know in the past, you've talked about debt reduction as being the majority of it.

But given that your interest expenses has kind of come down and in the past, you've also kind of talked about earning your ability for growth, taking yourself out of the box, if you will. So if you could just kind of talk about the priorities of that cash flow and then potential for just the use of that access capital.

Yes. I think from a strategic point of view externally, certainly, debt reduction, return of the dividend at some point, and I'll say at some point, we do think that repurchase of shares in the future is a possibility as well.

But we really start thinking about the internal and the markets first. We want to make sure that as we return to profitability, that we invest properly in new product development, people development and process development.

And we've really made that the first priority along with debt. So it's debt and development.

And -- but we'll rapidly move into bigger thinking in terms of, do we want to acquire product lines or are there other initiatives that we should think about? So this is relatively new for us to be able to look positively ahead.

And this is only the second quarter we've really been past the financing. But I think debt first, product and people development second.

Then we'll think about the other capital structure issues and acquisitions.

I wanted to ask about the guidance and make sure that we get our numbers right for next quarter and the back half. The upside to the adjusted EPS was pretty significant, and you -- I realize -- you have corporate expenses going up, and you put out new EPS guidance.

They look a little bit conservative, and is that because of ESG revenue coming down or the profitability in Bronto? Or are you just being conservative on the back half?

Well, I wouldn't tell you I was being conservative. But I mean, no, I was just kidding.

It really -- it's really -- if you look at the mix in Bronto, we -- we're in very competitive markets at Bronto. So some of that plays into it.

We are still recovering from our ERP implementation at SSG. So it's difficult to know how rapidly we'll get back on track there, although our shipments are back on track significantly.

So we feel pretty good about that. But I think we will look at this quarter-by-quarter and make the adjustments that are necessary in our forward-looking statements.

And I really do refer back to the margin targets we have set for ESG, SSG and Bronto because I think that was really our best collective engineered thought, if I will, in terms of where we can go. And as you know, we'll continue to evaluate that as we get further through the year.

Okay. Got it.

On that -- the ERP implementation, how much sales do you think push from second to, I guess, the third or fourth quarter because of the ramp of the ERP system?

Yes, I think it was relatively small. I think we had more of an impact on extra expense and manufacturing to push product out.

We did a lot of manual activities in May and June to recover, even though our teams have done a great job preparing for this. There are just so many things that go on inside of business that you just -- you miss some things.

But -- so our impact was on expense. We believe we may have lost a few hundred thousand dollars' worth of orders.

Maybe. We don't really know.

But we do know is that our July shipments at ESG were really strong as they were in June. So we feel good about bouncing on the bottom and coming right back up.

Our teams work like you can't imagine, people would work to really accomplish the turnaround there to get it going. And we're excited about the future with our new ERP system there.

We had 3 different systems operating there, and now we have one. And we should be able to do a better job forecasting, planning and delivering results for our customers.

Okay, got it. And it's probably tough to quantify, but can you put a number on the amount of incremental costs from the ERP?

Well, we -- it is hard to quantify, but we think it may have been around $1 million or between $0.5 million and $1 million, probably closer to $0.5 million.

Okay. And a lot of that will come back in the third quarter [indiscernible]

Some of it was overtime and related to actual direct labor. We had leadership management on the factory floor helping with shipments.

And sorry, there was some impact, but maybe $0.5 million, a little more, but...

Okay. And then...

[indiscernible]

Yes. Good.

Okay, so -- yes, sorry to interrupt. Yes, just the last one for me is that the -- as I look at the segments, it's ESG, and it sounds like Vactor was the primary reason for the revenue increases.

And you -- so I want to make sure I'm understanding this. You're working down backlog now on the back half of the year, so the Vactor business should be able to continue with this higher level of revenue and profitability?

Actually, in clarification, all the businesses and ESG did well. Our sweeper business did well.

It's a more conservative business that did well. Jetstream did well, and Vactor certainly, with this -- the flow that we have there, did well.

Our order rates have been -- this is the first quarter in a few that we've said our orders are flat. They're actually slightly up.

So we think that, that turn has really affected all those ESG businesses.

Okay. So can you get the same level of shipments in the third quarter as you did in the second in ESG?

It's practical.

Great. And just to follow up on capital allocation, you mentioned dividends, share buybacks and product development as possible uses of capital.

So how would bolt-on M&A fit within the product development category. And you mentioned...

Yes, I think I mentioned that. If I didn't, it's my oversight.

We have a strategy that thinks about M&A in a bolt-on way to really enhance what we're doing in the business. But Jennifer touched on something that's really important.

We've had our engineering teams working on cost reduction for 2.5 years and effectively working on cost reductions. They've also introduced some new products during that period of time.

But we've really reenergized them with our new innovation focus, and we're -- we actually are adding some talent there, too. So I think it's just a mix, and I think we'll -- as these opportunities come up, we'll weigh product development against acquisition.

And I think there's no -- you can't say road and say, "Okay, we got to get down the left-hand turn there." Because I think as things come up, we're going to just do our best to evaluate them.

We have not had a good history of acquisitions. So we're going to be conservative and precise, and we want to make sure these are in areas where we have the skills to manage them.

And so we're excited about it.

It's Tejas again. Just wanted to follow up to a earlier question I asked on pricing within municipal and industrial markets.

If you could just kind of talk about where you're seeing the best demand dynamics that would allow you to kind of drive that pricing second half.

I think every bid has to be analyzed and we have to do the best we can on every bid. So whether it's our police business, our Jetstream, our direct businesses, we deal with both dealers, and we deal with distributors, and we deal directly.

So I think we have to be competitive. And so our folks are very close to the market.

We listen to the drumbeat, and we're going to do everything that we can.

I wondered about the price cost with backlogs priced. Some of the product looks like it might be -- have been in backlog for 6 months or maybe more, and material costs haven't come down.

What are you thinking about on price cost and margins, especially in ESG in the back half?

Yes. That's an interesting question.

I don't think we're going to see a cost impact in terms of material costs. And I -- and as we priced our backlogs, we were thoughtful about the future, I don't know if that makes sense to you.

But we tend to be thoughtful about timing of the actual production cycle. And some of the orders were 8 or 9 months out, and we think we accounted for that as we took the orders.

Okay. I think -- yes, it seems like that's it.

But I do want to say that our investors and our employees and shareholders have our commitment as a leadership team that we're going to continue to really keep the pressure on profitable growth and the development of our team. So we're looking forward to it.

We'll go back to work and talk about the third quarter in a couple of months. Thank you.

Thank you.

Thanks.