One of my favorite types of stocks to find are businesses that hold leadership positions in niches that are off the beaten path. Often holding a No. 1 or No. 2 market share in these smaller industry nooks, these companies sometimes have a wider-than-expected moat because would-be competitors have little incentive to disrupt such diminutive areas.
Federal Signal (NYSE: FSS) is a perfect example of this concept. It manufactures “vehicles and equipment that serve the maintenance and infrastructure end markets” along with public safety equipment. However, Federal Signal isn’t content with just maintaining its leadership position in its niche markets.
Acquiring high-quality companies in adjacent, similar verticals to its existing business lines, Federal Signal has become a 13-bagger since 2011. With the company’s share price recently dipping 14% from its all-time highs, here’s why now might be the time to consider buying.
Meet Federal Signal
To get a better understanding of what exact product areas Federal Signal covers, let’s look at its two business segments:
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Environmental Solutions Group (83% of sales): Product categories in this segment include vacuum trucks (also known as “safe digging” trucks), street sweepers, industrial cleaning, dump truck bodies and trailers, multipurpose maintenance vehicles, road marking, metal extraction support, and aftermarket. Management believes it holds a No. 1 market share in North America across all of these verticals, except industrial cleaning, where it is the second largest.
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Safety and Security Systems Group (17% of sales): Federal Signal’s smaller unit sells products such as public safety equipment (lights on a police car, for example), signaling, and warning systems. Again, the company holds a No. 1 or No. 2 market share in each vertical.
While Federal Signal generates 41% of its sales from the cyclical industrial sector, it is able to offset these fluctuating sales somewhat because an even larger 51% of its revenue comes from publicly funded sources, like governments.
Making the company all the more resilient is the fact that its aftermarket vertical is its largest business line, accounting for 27% of revenue. Consisting of parts and services, rental offerings, and used equipment sales, Federal Signal’s aftermarket business adds valuable recurring-maintenance revenue and equipment-as-a-service for customers not yet ready to buy new products.
Meanwhile, the company’s second-largest unit, vacuum trucks — which accounts for 22% of sales — is benefiting from the ongoing adoption of safe digging practices across North America. While only 19 states had adopted safe digging as a best practice as of 2020, several more appear to be in the pipeline. Using vacuum excavation from pressurized air or water to dig, as opposed to backhoes, shovels, or mechanical excavators, safe digging is more environmentally friendly, less damaging to infrastructure, and less dangerous.
However, as promising as the company’s two biggest sub-segments are, Federal Signal isn’t resting on its laurels, having made 11 acquisitions since 2016, expanding into new verticals as it goes.
High-quality acquisitions power Federal Signal’s growth
Leaning into its acquisitive ways, Federal Signal looks for reasonably priced, niche-market leaders — either by product, geography, or end market — that can deliver “through-cycle margins in line or higher than the company’s current target.”
An excellent example of the company’s growth by mergers and acquisitions (M&A) was its 2021 purchase of Ground Force Worldwide for $45 million and its buyout of TowHaul in 2022 for $46 million. Combining these two new businesses, Federal Signal became the leader in the metal-extraction and support-equipment niches, which could grow rapidly due to the ongoing shift toward electric vehicles (EVs). Since EVs average six times the mineral inputs as traditional internal combustion vehicles, the company should see no shortage of business anytime soon from its new adjacent business line.
Similarly, Federal Signal’s most recent acquisition of Trackless Vehicles for $54 million last year moved the company into yet another complementary business sub-segment focused on equipment for snow and ice, tree care, and vegetation.
Currently generating a return on invested capital (ROIC) of 15% versus a weighted-average cost of capital (WACC) of 10%, the company is creating value for shareholders, generating outsize profits compared to its debt and equity. Since 51% of Federal Signal’s cash from operations has gone to M&A since 2021, the company is proving to be a proficient acquirer.
With sales growing by 10% annually over the last decade — and with management targeting low, double-digit growth in the future — expect more of the same M&A mastery from Federal Signal.
A dividend grower trading at a fair price
Quadrupling its dividend payments since 2014, Federal Signal has proven to be a promising dividend-growth story. While it only pays a dividend yield of 0.5%, the company’s payout ratio is only 15% — meaning that it could triple its payments and still have plenty of room left over for M&A.
While Federal Signal’s price-to-earnings (P/E) ratio has steadily risen since the pandemic, its current mark of 26 is roughly equal to the S&P 500‘s average of 27.
Following the company’s 14% dip in price, this market-average valuation seems fair for a company with a proven track record of generating multibagger returns through its M&A focus on niche industries. An investment in Federal Signal looks to be a great long-term proposition that offers a small but quickly growing dividend.
Should you invest $1,000 in Federal Signal right now?
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Josh Kohn-Lindquist has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
1 Unstoppable Multibagger Up 1,280% Since 2011 to Buy and Hold Forever was originally published by The Motley Fool
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