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Edited Transcript of FSS earnings conference call or presentation 7-Aug-18 2:00pm GMT

Q2 2018 Federal Signal Corp Earnings Call

OAK BROOK Aug 20, 2018 (Thomson StreetEvents) -- Edited Transcript of Federal Signal Corp earnings conference call or presentation Tuesday, August 7, 2018 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Ian A. Hudson

Federal Signal Corporation - Principal Financial Officer

* Jennifer L. Sherman

Federal Signal Corporation - President, CEO & Director

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Conference Call Participants

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* Christopher Paul Moore

CJS Securities, Inc. - Senior Research Analyst

* Gregory John Burns

Sidoti & Company, LLC - Senior Equity Research Analyst

* Marco Andres Rodriguez

Stonegate Capital Markets, Inc., Research Division - Director of Research & Senior Research Analyst

* Robert Stephen Barger

KeyBanc Capital Markets Inc., Research Division - MD and Equity Research Analyst

* Steven Arthur Friedberg

Seaport Global Securities LLC, Research Division - Associate Analyst

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Presentation

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Operator [1]

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Good day, everyone, and welcome to the Federal Signal Corporation Second Quarter earnings conference. Today's conference is being recorded. And now, it's my pleasure to turn the conference over to Ian Hudson, Chief Financial Officer. Please go ahead, sir.

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Ian A. Hudson, Federal Signal Corporation - Principal Financial Officer [2]

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Good morning, and welcome to Federal Signal's Second Quarter 2018 Conference Call. I am Ian Hudson, the company's Chief Financial Officer. Also with me on the call today is Jennifer Sherman, our President and Chief Executive Officer. We will refer to some presentation slides today as well as to the earnings 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 signing into the webcast. We have also posted the slide presentation and the earnings release under the Investor tab on our website.

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 earnings release and filings, we reconcile these non-GAAP measures to GAAP measures. In addition, we will file our Form 10-Q later today.

I'm going to begin today by providing some detail on our second quarter results before turning the call over to Jennifer to provide her perspective on our performance, market conditions and our outlook for the remainder of 2018. After our prepared comments, Jennifer and I will address your questions.

Our consolidated second quarter financial results are provided in today's earnings release. As a reminder, the second quarter of last year included 1 month of operating results of Truck Bodies and Equipment International, or TBEI, which we acquired in June 2017. With the schedule for deliveries within our backlog entering the quarter and the effects of the extended winter season, which lingered in much of North America into late March, we were anticipating a strong second quarter. Our results exceeded those expectations, driven by impressive organic growth and contributions from our recent acquisitions.

Similar to last quarter, we delivered significant margin expansion with our adjusted EBITDA margin up 350 basis points year-over-year, strong cash flow generation and impressive earnings per share growth. Consolidated net sales for the quarter were $291 million, up $66.6 million or 30% compared to last year with approximately $27 million, or 13%, coming from organic growth. Consolidated operating income for the quarter was $38.1 million, more than double last year's levels. On an adjusted basis, consolidated operating margin for the quarter was 13.4%, up from 10% in Q2 last year.

Consolidated adjusted EBITDA for the quarter was $47.8 million, up $18.8 million or 65%. That translates to a margin of 16.4% exceeding our target range and up from 12.9% last year. Income from continuing operations was $26.9 million in Q2 this year compared to $11.5 million last year. That translates to GAAP EPS of $0.44 per share, which compares to $0.19 per share last year. On an adjusted basis, EPS for Q2 this year was $0.45 this year, which is almost double the $0.23 per share in Q2 last year.

Despite the pull forward of orders that we have noted in the last couple of quarters, order intake in Q2 this year continued to be strong with total reported orders of $277.6 million, an increase of $6.5 million or 2% compared to the prior year quarter. We ended the quarter with a consolidated backlog of $322.3 million, which was up by approximately $100 million, or 45%, compared to last year.

Turning now to the consolidated income statement where the increase in sales contributed to a $24.5 million improvement in gross profit. Consolidated gross margin improved to 27.2% for the quarter, up from 24.4% last year. The margin improvement was primarily due to improved operating leverage associated with production efficiencies, as well as benefits from actions taken in response to increasing commodity costs, favorable sales mix and lower purchase accounting expenses. Jennifer will expand upon some of these factors in her remarks.

Selling, engineering, general and administrative expenses of $40.7 million were up 17% compared to the prior year quarter, largely due to the addition of expenses associated with TBEI. As a percentage of sales, our SEG&A expenses for the quarter were down 150 basis points from Q2 last year. Other items affecting the quarterly results include a $600,000 reduction in acquisition-related expenses, a $500,000 decrease in other income and a $1.2 million increase in interest expense.

Tax expense for the quarter was up $2.2 million, largely due to higher pretax income levels, offset by the impact of the lower U.S. tax rate and the recognition of a $500,000 excess tax benefit associated with stock compensation activity.

The effective tax rate for the quarter was 23.6%, compared to 34.7% in the prior year quarter, reflecting the lower U.S. tax rate and the excess tax benefits. We currently expect a full year effective tax rate of approximately 25%. On an overall GAAP basis, we therefore earned $0.44 per share in Q2 this year compared with $0.19 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 quarter. In the current year quarter, 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 Q2 this year were $0.45 per share compared with $0.23 per share in Q2 last year.

Now turning to our group results. Within ESG, each of our businesses delivered impressive results in the second quarter with broad-based growth across all of our key market segments. Second quarter sales were $233.3 million, up $59 million or 34% compared to last year. In the fourth quarter of activity, TBEI's incremental sales contribution was almost $40 million. ESG's organic sales growth for the quarter was $19.6 million, or 13%, largely due to increased shipments of vacuum trucks and street sweepers, higher rental income and improved part sales.

ESG's operating income for the quarter was $37.2 million, up from $21 million in Q2 last year, and its operating margin for the quarter was 15.9%, up from the 12% reported last year. Adjusted EBITDA for the quarter was $45.8 million, an improvement of $16.5 million or 56% compared to $29.3 million a year ago. That translates to an adjusted EBITDA margin of 19.6% in Q2 this year, which exceeds our target range and is up from 16.8% last year.

ESG's reported orders of $217.3 million were up $2.6 million compared to the prior year quarter, primarily due to improved orders for vacuum trucks, inclusive of higher demand from customers serving utility markets, partially offset by lower orders for refuse trucks.

Within SSG, second quarter sales were up $7.6 million, or 15%, largely due to higher global sales of public safety products. Operating income for the quarter was $8.2 million, up $2.6 million, or 46%, compared to Q2 last year. SSG's adjusted EBITDA for the quarter was $9.2 million, up $2.5 million from a year ago, and its adjusted EBITDA margin for Q2 was 15.9% this year compared to 13.4% last year. SSG reported total orders of $60.3 million, an increase of $3.9 million or 7% from last year, primarily due to improved international orders for public safety products and higher orders for warning systems.

Corporate operating expenses for the quarter were $7.3 million compared to $7.8 million last year. The decrease was primarily driven by a $700,000 reduction in acquisition-related expenses and lower legal costs, partially offset by increased employee benefit-related costs.

Looking now at cash flow. We generated $27.5 million of operating cash flow in Q2 this year compared to $32.1 million last year. That brings the total operating cash flow generated in the first half of this year to $37.8 million compared to $45.8 million in the first half of last year. The higher earnings in the first half of this year were offset by a $9.2 million increase in income tax payments, which was largely timing related, as well as additions to working capital and rental assets in support of increased demand, and higher incentive compensation payments in comparison to the prior year.

So far this year, we have increased our capital expenditure to $7 million as we make strategic investments in new machinery and equipment. In addition, during the second quarter, we successfully completed an upgrade to our primary ERP system with little disruption to our businesses. During the quarter, we also paid down an additional $18 million of borrowings, bringing the total amount of debt paid down since we completed the TBEI acquisition a little over a year ago to approximately $61 million. That has brought our pro forma debt leverage ratio at the end of June down to 1.8x compared to 2.7x at the closing of the acquisition in June last year. We ended the quarter with $212 million of net debt and availability under our credit facility of $140 million. With the healthy cash flows expected to be generated by our businesses, we remain committed to investing in organic growth initiatives, considering additional M&A opportunities and returning value to shareholders.

On that note, we paid a dividend of $0.08 per share during the second quarter, amounting to $4.8 million, and we recently announced a similar dividend for the third quarter.

That concludes my comments, and I would now like to turn the call over to Jennifer.

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Jennifer L. Sherman, Federal Signal Corporation - President, CEO & Director [3]

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Thank you, Ian. I'd like to begin my comments by talking about some of the items that contributed to the exceptional quarter with both of our groups delivering excellent results. The outstanding second quarter helped us to cross a significant milestone for the company with our trailing 12-month revenues exceeding $1 billion. We had previously set 2020 as the target date by which to achieve this goal and we are pleased to have met the target 18 months early. We will be updating our longer-term goals later this year.

Within SSG, we are starting to see the benefits of some of the investments we have made in recent years to add sales resources as well as expanding our engineering team to support the development of new products. Over the first half of the year, SSG's orders and sales were both up organically by 11%, largely driven by improved demand for public safety equipment, both domestically and within Europe.

With a number of new products added to our suite of offerings, we won a number of new conquest accounts in both geographies. As expected, SSG's adjusted second quarter EBITDA margin improved from a softer first quarter. In addition, the increase in the top line in the second quarter contributed to a 250 basis point year-over-year improvement in SSG's adjusted EBITDA margin. Overall, I'm encouraged with the trajectory that SSG is on.

Within ESG, our 34% sales growth included the effects of continued momentum on the strategic initiatives we have implemented in recent years, like our expansion into the utility market with our safe digging vehicles, exceptional rental demand and higher parts and services revenue. In addition, in a full quarter of activity, TBEI added almost $60 million of sales in Q2, which is typically its strongest quarter.

On the safe digging front, sales of vacuum excavator trucks in the first half of this year are more than double the first half of last year. This has been achieved through penetrating new end markets like utility as well as growth in other industrial markets, including some recovery in direct sales of new equipment into oil and gas markets. We now have a dedicated sales team in place who continue to be active in demonstrating the efficiency and safety features of this technology. So far this year, we have completed approximately 1,600 demonstrations and presentations to potential new customers. That compares to about 600 by the same time a year ago.

It is also encouraging to see continued traction on our non-whole goods initiative, which targets growth in the revenues we generate from rentals, to sale of parts, used equipment and service. This was a key strategic reason for the JJE acquisition which we completed a little over 2 years ago. Under these initiatives, second quarter rental income was up 33% year-over-year, while our parts and services revenues were up almost 10%. The second quarter tends to be strong for aftermarket sales with many of the company's products being used for maintenance activities in North America where usage is typically lower during the periods of harsher weather conditions.

Our rental fee utilization levels, both from a time and financial perspective, are tracking ahead of plans for the year with notable strength of demand from customers serving oil and gas markets, utilization levels for our fleet of vacuum excavation equipment has exceeded 90% over the last 6 months. During that time, we've also seen an increase in the number of sales of used equipment, including sales out of the rental fleet.

Earlier in the year, we made the strategic decision to build additional units in anticipation of short-term demand with lead times for certain product lines being extended. During the second quarter, we sold many of those stock units. The effect of higher sales volumes within ESG, favorable sales mix and operating leverage drove an adjusted EBITDA margin of 19.6%, which exceeds the high end of our target range. Our margin also benefited from production efficiencies, particularly at our manufacturing facility in Streator, Illinois, which had a record month of store cleaner and vacuum truck production in April. We also saw margin benefits in the quarter from actions taken in response to anticipated increases in commodity costs. As we mentioned last quarter, the teams have effectively managed their procurement of steel and aluminum faced with the challenges in the market. As a reminder, we had previously locked pricing for the first half of this year at favorable rates. In addition, the majority of our businesses have implemented one or more price increases so far this year, which appear to have been accepted by the marketplace. As a result of these actions, in the second quarter, our pricing actions outpaced the impact of the material cost increases of approximately $0.03 per share.

While material cost increases have had a minimal effect on our business in the first half of the year, we do expect the incremental headwinds will need to be managed in the second half of the year. The majority of our materials are sourced domestically and for the limited amount of components that we do source from overseas, we are not currently subject to the tariffs which were recently introduced. As a result, we are not expecting the direct impact from the tariffs to be significant. However, we are seeing the indirect effects with domestic prices given increasing higher demand. For example, we have locked in our steel purchases for the second half of the year within most of our businesses albeit at higher prices than in the first half of the year. That decision was as much about securing availability of steel given increased demand for domestic steel as it was about pricing.

We have been proactive in our efforts to offset these headwinds with our pricing actions and ongoing execution of our 80/20 initiatives. The situation remains fluid but what we know at this point, we expect the net impact of material cost increases to be a headwind for the balance of 2018 of up to $0.03 per share and this is reflected in our updated outlook.

Our businesses continue to innovate and introduce new products. Entering the third quarter, ESG had a number of new products in the production schedule. These include: our new vacuum excavator trucks, specifically designed to meet new vehicle weight restrictions in Ontario, Canada, as well as a new control system and improved retractable boom offering for our sewer cleaners. As a result, we may experience some short-term production inefficiencies in the normal course of introducing these new products or features. In addition, primarily due to the timing of holidays and vacation schedules, the second half of the year contains approximately 10 fewer production days than the first half. As such, while ESG may not sustain the near 20% EBITDA margin reported in Q2 over the second half of the year, we are expecting year-over-year improvement.

Turning to current market conditions where demand in most of our end markets continued to be strong. As we mentioned on May's earnings call, we estimated that up to 45 million of orders received in the prior 2 quarters had been accelerated from later in 2018 with customers placing orders earlier as they sought to secure availability of certain product lines with extended lead times or to manage the procurement of the related chassis, which also have extended lead times. We had previously indicated that this pull forward of orders might impact the comparability of our orders to prior periods. Although we weren't expecting the same run rate in terms of organic order growth as in the first quarter, I was pleased that the strong order intake at ESG and improved orders of public safety products within SSG contributed to an overall 3% organic order growth. We also talked last quarter about lead times for certain of our product lines becoming extended and the actions we are taking in response. I wanted to give a quick update on that.

At some of our facilities we've added additional shifts and we have the ability to add even more capacity. We've also added resources at key locations. For example, at our Streator plant, we've added 50 people since the beginning of the fourth quarter of last year and are planning to add more as needed. We are fortunate to have a dedicated group of employees and good access to skilled labor at most of our manufacturing locations. In addition, we have made incremental investments in new machinery such as laser cutting tools and robotic welding. These capital investments have quick paybacks and are expected to improve our productivity. We continue to apply our flexible manufacturing model by moving production of certain low-volume product lines to some of our FS solution centers. These actions have freed up valuable capacity as we seek to reduce lead time.

Despite the actions that I just mentioned, current lead times for certain product lines, most notably sewer cleaners, continue to be extended and as a result, approximately $40 million of our current backlog is not expected to be delivered until next year.

Let me now spend a minute updating you on chassis availability. As a recap, for our legacy ESG businesses, while it can vary year-to-year, we typically see a fairly even split between customer-supplied chassis and Federal Signal-supplied chassis. In situations where we are providing the chassis, we have performed a detailed analysis of chassis orders and lead times within each of our businesses and we believe we have secured adequate supply to cover our needs for the rest of 2018. We've also made certain strategic decisions to pre-buy chassis in order to take advantage of short-term customer demand. In the vast majority of cases, TBEI's customers own and provide the chassis on which the dump body is mounted. Although we have not experienced any significant delay so far this year, we are monitoring the availability of chassis at certain of TBEI's locations given our broader reliance on customer-supplied chassis there.

On the year-end earnings call, I discussed our ongoing commitment to utilizing a portion of the savings from tax reform to accelerate our longer-term growth initiatives such as developing new products and enhancing our sales channel. Since April, we've held brainstorming sessions with cross functional teams from 6 of our businesses intended to generate a company-wide portfolio of long-term growth opportunity. Approximately 50 individual concepts have been identified to date and we are currently in the process of evaluating which to pursue further. Although the related expense during the first 6 months of this year has been minimal, we are expecting to incur additional costs in the second half of the year as we further evaluate the market viability of the concepts with the greatest potential.

When we announced the TBEI acquisition last June, we noted our expectation that the cash flows generated by TBEI and our other businesses would help us de-lever quickly. As Ian mentioned, we've paid down approximately $61 million of debt in a little over a year, which is ahead of our initial expectations. Our pro forma debt leverage at the end of the quarter is now down to a level that gives us significant flexibility to fund both organic growth initiatives and M&A.

Acquisitions remain a priority for the deployment of our free cash flow. Our deal pipeline remains active. With a healthy cash flow generation and strong financial position, we are well positioned to pursue strategic acquisition candidates.

As we consider potential acquisitions, as part of our financial criteria we target businesses either currently operating within our target EBITDA ranges or those which have the ability to operate within the ranges after applications of our 80/20 or ETI principles. I want to walk you through some of the success we've had in applying our ETI principles at JJE.

Since we completed the acquisition little over 2 years ago, we have focused on multiple projects improve the profitability of their business model. The focus of these projects has ranged from optimizing pricing for product lines that are not manufactured by us, discontinuing low-margin product lines, modifying the terms of transactions and targeting growth of higher margin offerings, including the sales into industrial markets, rentals and parts.

As a result of these actions, in the second quarter JJE was able to deliver its highest quarterly EBITDA margins since we completed the acquisition. ETI continues to be an important part of our culture and we continue to educate our people on its principles. In fact, this month, over 40 employees are attending a several day training event on ETI.

Turning to our outlook. With the acquisitions that we have completed in recent years, we have seen a change in our quarterly earnings pattern, both last year and this year. Seasonal strength in deliveries of our equipment to customers in colder climates, the timing of TBEI shipments and higher rental and aftermarket demand were among the factors which may lead to this year's second quarter earnings being stronger than other quarters. With our current backlog, favorable conditions in our end markets and continued traction on organic growth initiatives, we are expecting our adjusted earnings per share in the second half of 2018 to improve by 21% to 33% in comparison to the same period of last year, despite headwinds associated with increased commodity costs.

Given our outstanding performance in the first half of this year and our positive outlook for the second half, we are again raising our full year 2018 adjusted EPS outlook to a new range of $1.26 to $1.32 from a range of $1.15 to $1.22. That would equate to a year-over-year improvement of between 48% and 55%.

In summary, the first half of the year reflected outstanding performance. Our teams are performing at a very high level and remain focused on delivering high-quality results. We remain committed to investing in our businesses and our people to generate sustained long-term success for our shareholders. Our foundation is strong and we are focused on delivering profitable long-term growth through the execution of our strategic initiatives.

At this time, I think we're ready for questions. Operator?

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Questions and Answers

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Operator [1]

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(Operator Instructions) We'll go first to Chris Moore at CJS Securities.

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Christopher Paul Moore, CJS Securities, Inc. - Senior Research Analyst [2]

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Maybe start with the big picture. Kind of from a kind of infrastructure standpoint. The ability to continue to grow rapidly like you are. Is that at some point going to require new plants or can you kind of talk about your capacity there?

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Jennifer L. Sherman, Federal Signal Corporation - President, CEO & Director [3]

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As we look for the remainder of 2018 and into '19, we feel very comfortable with the flexible manufacturing model that we have in place, so we'll be able to support the anticipated growth. I talked before about our FS Solution centers. 3 of those centers can build trucks, and we're able to move production to those centers as needed. We also have the ability to flex manufacturing between facilities both at our TBEI businesses and within our legacy ESG businesses. So we don't anticipate any major additions of plants in the next couple of years. There could be a situation where we might do a nominal plant expansion at one of our facilities, but that's less than $5 million.

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Christopher Paul Moore, CJS Securities, Inc. - Senior Research Analyst [4]

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Got you. That's helpful. Steel side though is the good discussion, just to make sure I understand. So, in terms of the second half, first of all, I mean, the turnaround at TBEI pricing is quick so that's less of an issue there on the sales side. Is that correct?

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Jennifer L. Sherman, Federal Signal Corporation - President, CEO & Director [5]

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They are able to put price increases and they all -- through relatively quickly. We do have some extended backlogs for a couple of our product lines, so there is a delay there. But overall, they're able to get the price realization. We expect though in the second half, as I mentioned in my comments, that overall increased material costs could be up to a 3% headwind and we have factored that into our guidance.

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Christopher Paul Moore, CJS Securities, Inc. - Senior Research Analyst [6]

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Right. Got it. Obviously, you guys are really cooking at this point in time. Always kind of looking at the other side. Can you maybe -- we've had a discussion a little bit, but talk a little bit about kind of how you're positioned now in terms of what Federal Signal looks like versus the last downturn and why things might be -- the outlook might be a little bit brighter even when the media market, et cetera, starts to turn a little bit.

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Jennifer L. Sherman, Federal Signal Corporation - President, CEO & Director [7]

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I think there is a couple of things that we should think about. First of all, since the last downturn, we've diversified our revenue stream. The company now is about 50% industrial and 50% municipal. And as we do modeling, they don't overlap, particularly given the nature of the products, in many situations that we manufacture. Number 2, is we've done a lot of work in terms of reducing our breakeven levels at our plants. We've also put this flexible manufacturing model in place which helps us on the upside and helps us on the downside. So, for example, we have a plant with the TBEI businesses that does a lot of overflow work that we can reduce if we need to and we also have the ability to move production from our solution centers back into our main facility. So we've got a lot of levers that we pull and it's something that we spend a lot of time on in terms of understanding what we can do in downturns.

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Ian A. Hudson, Federal Signal Corporation - Principal Financial Officer [8]

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Chris, I think one of the things that Jennifer talked about, kind of the diversification of our end markets on the revenue side. The other thing to think about is prior to the acquisition of JJE, Federal Signal typically just sold new equipment. And one of the strategic initiatives behind the acquisition was that we now have a more diverse revenue streams in that we provide new equipment, we rent, we sell parts and service, and we sell used equipment out of the fleet as well. So I think in addition to the diversification of our end markets, we've also diversified our revenue streams as well.

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Operator [9]

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We'll go next to Greg Burns at Sidoti.

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Gregory John Burns, Sidoti & Company, LLC - Senior Equity Research Analyst [10]

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In terms of the strong utilization you're seeing in the rental fleet, can you just talk about maybe your plans on investing further in your equipment on that side of the business? As well as can you maybe just talk about how you're managing that fleet to meet the demand?

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Jennifer L. Sherman, Federal Signal Corporation - President, CEO & Director [11]

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Sure. As we think about rentals, we think not only about our rental fleet but we also look at our rental partners, and we have several strong rental partners. So first thing is, is that when we bought JJE, the rental fleet was about $80 million. We talked about incremental investments of up to $20 million of additional equipment. So depending on the demand and sale of used equipment, that will fluctuate within that $80 million to $100 million from quarter-to-quarter. But we continue to see strong demand from our rental partners and that's what has driven some of the organic order growth improvement during the first half of this year.

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Gregory John Burns, Sidoti & Company, LLC - Senior Equity Research Analyst [12]

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Okay, great. You mentioned the end market diversity with industrial and your need now being roughly evenly split. But could you just talk about the growth rates within those markets? Has the strong performance of late been levered to 1 over the other?

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Jennifer L. Sherman, Federal Signal Corporation - President, CEO & Director [13]

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We've seen -- so far this year, we've seen strong growth in both markets and a lot of that has really been driven, we believe, by the new products that we've introduced into the marketplace, particularly on the vacuum excavation side and some of the new features on our sewer cleaning products. And then as I started my portion of the comments today, our SSG teams have really done a super job on the Public Safety Systems space in terms of new product introduction and we're starting to see the benefits right now. So overall, the growth has been strong.

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Gregory John Burns, Sidoti & Company, LLC - Senior Equity Research Analyst [14]

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Okay, great. And I'm looking at the full year guide. Obviously you put it up here, but it seems like most of that is related to the upside we saw in the second quarter. I mean, is the second half -- is it mostly margin headwinds that are impacting the -- your view of the second half? As opposed to maybe slower top line growth?

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Ian A. Hudson, Federal Signal Corporation - Principal Financial Officer [15]

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Yes. I think -- we talked, Greg, about in the second quarter, we talked about that as typically TBEI's strongest quarter. So that's a consideration. There's also the seasonal aspect in the summer months of rentals and some of the aftermarket work we saw in the second quarter. We actually saw the spring cleanup season, because of the weather issues in much of North America, that actually got pushed into the second quarter. And while that -- we're hearing that, that spring cleanup's best season hasn't really been extended, it's more been compressed into the summer months really. We talked about the headwinds with the commodity costs, but I think even with that, the second half year, we're looking at improvement of between 21% and 33% for second half of the year over last year. So we still feel that there's good growth in the second half of the year.

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Jennifer L. Sherman, Federal Signal Corporation - President, CEO & Director [16]

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And I'd also point you to kind of the strength of our backlog, too, which will contribute to that growth.

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Gregory John Burns, Sidoti & Company, LLC - Senior Equity Research Analyst [17]

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Okay. One last one, on the backlog, how much of that is organic growth versus inorganic?

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Ian A. Hudson, Federal Signal Corporation - Principal Financial Officer [18]

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The growth, it's all -- it's effectively all organic at this point. I mean, TBEI's backlog is essentially the same as what it was when we acquired them. So it's essentially all organic growth.

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Operator [19]

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And we'll go next to Walter Liptak at Seaport Global.

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Steven Arthur Friedberg, Seaport Global Securities LLC, Research Division - Associate Analyst [20]

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Steve Friedberg filling in for Walt today. I wanted to touch upon orders. I see it was up organically at 3%, I get the pulled-forward. I was hoping you guys can kind of parse out what product categories either were up -- was it street sweepers are up, or any color around that.

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Ian A. Hudson, Federal Signal Corporation - Principal Financial Officer [21]

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Yes, it's -- probably the biggest driver of the growth, Steve, I would say, is on the vacuum trucks side. We've seen improved demand both on our traction with the utility initiative. But other end markets where we're reinforcing the safety and the efficiency aspects of our safe digging technology. And so we're seeing good traction on that both on the utility side as well as in the other industrial end markets. The other thing is -- I would point to is, probably on the SSG side, we've seen some nice growth in the orders both domestically and within our European public safety business. That had a slightly down year, I would say, last year with some of the political uncertainty in Catalonia, which has now stabilized and since then, we've seen some nice growth in the order flow both in that business and domestically with some of the new product introductions we've seen.

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Steven Arthur Friedberg, Seaport Global Securities LLC, Research Division - Associate Analyst [22]

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Okay. And then as we look towards the second half of 2018 and if I recall correctly, Q4 is going to be a tougher comp. How should we expect the growth rate moving into Q3 and Q4?

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Ian A. Hudson, Federal Signal Corporation - Principal Financial Officer [23]

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Yes, we -- Steve, we typically see a nice pickup in orders in the fourth quarter because in the usual situations, we have our annual price increase that goes into effect the first of the year. And so, that's part of the reason we see a pickup in orders in the fourth quarter. We did see that pull forward because of the extended lead times of sewer cleaners. We saw that in the fourth quarter of last year. We estimate $15 million to $20 million of the orders were pulled forward. And so that's a factor of which, as you say, the fourth quarter orders last year were exceptionally strong. But I think if you exclude those effects that I just referenced, I think we're -- that would be -- we would look -- normalize the orders for that sort of level, that's where we would expect them to be.

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Steven Arthur Friedberg, Seaport Global Securities LLC, Research Division - Associate Analyst [24]

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Great. And if I could just squeeze in one more. It looks like margins in SSG were up significantly. I guess, what is the -- I guess -- what inning are you guys in, in margin improvement? And where do you think this segment can get to?

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Ian A. Hudson, Federal Signal Corporation - Principal Financial Officer [25]

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Yes. I think we put out our margin target ranges for that business as 15% to 18%. I think year-to-date, we're still a little shy of the low end of that range. So I still think there is room for improvement. The one thing I would say is with that business, it's -- the top line is very important. And I think we saw some of that with growing the top line, a lot of that falls through the bottom line just the way that our cost structure is there. And so that really benefited us in the second quarter where we were operating within our target ranges. That was on the back of a softer first quarter that we expected. And so by the end of the year, we'd expect, I think, to be operating within those ranges.

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Operator [26]

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We'll move next to Steve Barger at KeyBanc Capital Markets.

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Robert Stephen Barger, KeyBanc Capital Markets Inc., Research Division - MD and Equity Research Analyst [27]

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So I'll try the orders from a different direction. The last 6 quarters, you averaged $270 million per quarter. I know you had that acceleration that drove levels above $300 million in 4Q and 1Q. But with that behind you now and as you think about current muni and industrial markets, do you think that the environment supports order rates in the low to mid-$200 million per quarter level going into next year? Or how do you think about that?

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Jennifer L. Sherman, Federal Signal Corporation - President, CEO & Director [28]

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We haven't seen any slowing down right now and it's something that we monitor closely. Our end markets continue to be strong. There is seasonality that we try to talk about on the call that we've seen both last year and this year in the second quarter. That's been with the acquisitions of TBEI and JJE because of the rental demand and the nature of the TBEI equipment. TBEI's second quarter is typically its strongest quarter. So I think you have to factor that into it. But overall, we feel pretty comfortable -- we can look out the next couple of quarters and we look at the pipeline, that things are very good.

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Robert Stephen Barger, KeyBanc Capital Markets Inc., Research Division - MD and Equity Research Analyst [29]

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For ESG orders that have gone into backlog over the past few quarters, can you talk about mix in pricing relative to what you delivered in 2Q?

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Ian A. Hudson, Federal Signal Corporation - Principal Financial Officer [30]

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Yes. I think, Steve, mix-wise it's -- we talked about, it's heavy sewer cleaners. There's a good portion of the ESG backlog which is sewer cleaners and we talked about, there's about $40 million of our backlog that is unlikely to be delivered this year that would likely slip into 2019. From a pricing standpoint, with those product lines that had the extended lead times, some of those orders were taken in 2017 prior to the price increase that went into effect. The further out you get in heading into Q3 and Q4, the more price we will realize on those orders because they will have the price increase that is reflected in those.

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Jennifer L. Sherman, Federal Signal Corporation - President, CEO & Director [31]

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Yes, I guess I would say overall, I think the teams have done an excellent job in terms of addressing the material cost increases. As we mentioned, we -- it was 3% benefit in the first half of the year and if you look at the position we're in versus other companies right now, they've done a nice job of securing availability of critical materials and locking in prices for the second half of the year. And although it could be up to a $0.03 headwind, we're in a pretty good shape.

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Robert Stephen Barger, KeyBanc Capital Markets Inc., Research Division - MD and Equity Research Analyst [32]

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Yes. And just from an overall mix standpoint, you'd rather be delivering sewer cleaners than street sweepers, right? Just from a margin performance standpoint. Is that correct?

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Jennifer L. Sherman, Federal Signal Corporation - President, CEO & Director [33]

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Depends on who they are going to.

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Robert Stephen Barger, KeyBanc Capital Markets Inc., Research Division - MD and Equity Research Analyst [34]

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So when you say you have more street sweepers, are those industrial street sweepers in the backlog or muni? I'm sorry, sewer trucks.

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Jennifer L. Sherman, Federal Signal Corporation - President, CEO & Director [35]

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We have more -- we have more sewer cleaners not street sweepers.

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Robert Stephen Barger, KeyBanc Capital Markets Inc., Research Division - MD and Equity Research Analyst [36]

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Got it, more industrial (inaudible).

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Jennifer L. Sherman, Federal Signal Corporation - President, CEO & Director [37]

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But our street sweeper business has done an excellent job in terms of improving the margin performance of that business.

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Robert Stephen Barger, KeyBanc Capital Markets Inc., Research Division - MD and Equity Research Analyst [38]

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But just to be clear, the sewer cleaners that you have in backlog or more focused on industrial customers or more on muni?

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Ian A. Hudson, Federal Signal Corporation - Principal Financial Officer [39]

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There is slightly weighted to industrial but there's still decent municipal sewer cleaners in the backlog. But it's probably slightly weighted on the industrial side.

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Robert Stephen Barger, KeyBanc Capital Markets Inc., Research Division - MD and Equity Research Analyst [40]

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You talked about the brainstorming sessions for new products. Can you just talk broadly about what kind of ideas you're coming up with?

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Jennifer L. Sherman, Federal Signal Corporation - President, CEO & Director [41]

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Sure. Since we talked about this in -- at the end of our first quarter earnings call, we've had meetings with 6 of our businesses. And it's interesting because the ideas, most of them are less than $10 million ideas. But what I'm really encouraged is by the quality of the ideas. The next -- and the number of ideas. So the next stage of this process is we're bringing in marketing resources to understand both from the need for this product in the marketplace and we're understanding channel, which is always a critical question. So as we set the stage for kind of a long-term growth, I always talk about if we could take 50 of these ideas and not all 50 are going to hit, but if a portion of them hit in the long term, that puts us in a very good position as we try to diversify our revenue streams.

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Robert Stephen Barger, KeyBanc Capital Markets Inc., Research Division - MD and Equity Research Analyst [42]

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Are these primarily physical products or do you have any service-based revenue ideas?

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Jennifer L. Sherman, Federal Signal Corporation - President, CEO & Director [43]

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Both.

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Robert Stephen Barger, KeyBanc Capital Markets Inc., Research Division - MD and Equity Research Analyst [44]

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Anything that you can bring to market that could be a revenue contributor in 2019 or is this all so early-stage that it's really more further out?

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Jennifer L. Sherman, Federal Signal Corporation - President, CEO & Director [45]

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I think that it'd be second half of 2019, but most of it is longer term.

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Ian A. Hudson, Federal Signal Corporation - Principal Financial Officer [46]

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And Steve, this isn't -- this is separate from our kind of our routine regular new product development process. This is intended to be more of a longer-term growth initiative thing, it like -- there's still ongoing new product development and some of those will impact 2019.

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Jennifer L. Sherman, Federal Signal Corporation - President, CEO & Director [47]

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I guess, the other thing I would add is it's a number of relatively smaller ideas that we're incubating within the businesses. And it's a mix of product and services.

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Robert Stephen Barger, KeyBanc Capital Markets Inc., Research Division - MD and Equity Research Analyst [48]

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Okay. And just shifting gears to the market opportunity for rental. What percentage of share do you have versus how big you think that business can get for you? Have you tried to boil it down to an addressable market opportunity and where you think this goes?

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Ian A. Hudson, Federal Signal Corporation - Principal Financial Officer [49]

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I don't know if we've gotten that far, Steve. One of the things that we do track is the number of turndowns; that's a metric we look at. So the term, by turndowns, we mean the opportunities when customers come to our solution centers looking for rentals. How many opportunities we are turning down or -- and so that's something that we look at. As Jennifer talked about, we also have very strong rental partners. Some of our dealer partners have very good sized rental fleets and they are outstanding partners that we have. So some of our new equipment sales, we are obviously selling into those rental fleets to replenish fleets as those customers are able to sell out with their fleets. So we monitor a couple of things in terms of tracking the size of our fleet. It's really on the utilization side and then the number of turndowns.

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Robert Stephen Barger, KeyBanc Capital Markets Inc., Research Division - MD and Equity Research Analyst [50]

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Have you -- I don't think you've disclosed what utilization rate is. Have you?

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Ian A. Hudson, Federal Signal Corporation - Principal Financial Officer [51]

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Not in total but we target -- on the time utilization side, we target 70% and then we also have financial utilization metrics that we target as well. We don't -- I mean, we are tracking ahead of both of those targets this year and the metric we talked about is on the hydro side, which we've seen particular strength in rentals of the hydros in our fleet. That's been at a 90% plus level for about the last 6 months now.

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Jennifer L. Sherman, Federal Signal Corporation - President, CEO & Director [52]

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And I think the other important point to consider is it's not just the rentals. It's the rentals, it's the sale of used equipment out of the rental fleet which there is a strong demand for. And then it's the associated parts and service business that goes with that.

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Robert Stephen Barger, KeyBanc Capital Markets Inc., Research Division - MD and Equity Research Analyst [53]

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Right. And so when you think about rental growth over the longer term or even from the medium term, how much of this is coming from taking share from existing competitors versus extending your footprint into areas that really just aren't served by these rental products right now?

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Ian A. Hudson, Federal Signal Corporation - Principal Financial Officer [54]

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Yes. I think some of it, Steve, might be just, particularly with the hydros we've seen strong utilization in customers serving oil and gas markets. And we're -- what we're seeing is something of try-before-you-buy type approach where they are renting for a period of time before they are buying -- either buying a new piece of equipment or purchasing a used piece of equipment. So we've seen something of a shift from certain customers serving those markets as well.

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Robert Stephen Barger, KeyBanc Capital Markets Inc., Research Division - MD and Equity Research Analyst [55]

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And last question from me...

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Jennifer L. Sherman, Federal Signal Corporation - President, CEO & Director [56]

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We also believe that we work closely with our rental partners, but we believe there's a number of situations where collectively, either between us or our rental partners, where we are taking market share or we're introducing a product that historically Federal Signal has not had. Where before, we just sold new equipment, now you're able to either buy new equipment, buy used equipment or rent from us. And then we can also, when appropriate, service that rental equipment.

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Robert Stephen Barger, KeyBanc Capital Markets Inc., Research Division - MD and Equity Research Analyst [57]

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Right. No, it sounds like it's progressing well. For the equipment that's going to the oil field, is most of that still going north to where it's frozen in the winter? Or are you getting more traction in southern basins?

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Ian A. Hudson, Federal Signal Corporation - Principal Financial Officer [58]

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Yes, there is -- right now, there's a lot of good activity and kind of the southern parts of the U.S. Texas in particular is a strong market for us right now. So it's not exclusively in North America, Canada. There are obviously -- we've got businesses in Canada and the U.S. and we have a rental fleet that is in both geographies. And so, the U.S. rental fleet is very strong in Texas. And then there's also the Canadian rental fleet; it's particularly strong in Ontario.

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Operator [59]

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We'll go next to Marco Rodriguez at Stonegate Capital Markets.

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Marco Andres Rodriguez, Stonegate Capital Markets, Inc., Research Division - Director of Research & Senior Research Analyst [60]

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Just wondering if you could talk a little bit about working capital usage for you guys. Just kind of walk us through perhaps your expectations for the second half of '18.

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Ian A. Hudson, Federal Signal Corporation - Principal Financial Officer [61]

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Yes. I think one of the things we've mentioned, Marco, is just with some of the extended lead times, we've made some strategic decisions to pre-buy some chassis and we've also built some, what we call stock units really just to try and take advantage of some short-term demand. So given some of the market conditions, we have made that decision. Our second quarter benefit is from some pretty strong sales of stock units. We will likely continue to try and build some of those stock units in the second half of the year, so that might be a drag on working capital for the second half of the year. We've also talked about potentially adding some units to the rental fleet as well. But I think if you look at kind of working capital as a percentage of sales, year-over-year, I think you'll see some meaningful improvement. And that's really helping our cash flow and we've talked about kind of the paying down debt faster than we expected. And I think the working capital management has been a big piece of that.

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Marco Andres Rodriguez, Stonegate Capital Markets, Inc., Research Division - Director of Research & Senior Research Analyst [62]

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Got it. And in terms of the debt pay-down, as you mentioned, you guys kind of accelerated and you were ahead of plan in terms of where you wanted your leverage to be. Can you give us any insight as far as through second half of the year into '19? Do you expect to continue to accelerate paying down debt or do you kind of normalize at the level you're at right now in terms of your leverage ratios?

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Ian A. Hudson, Federal Signal Corporation - Principal Financial Officer [63]

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I think it really -- I mean, we talked about acquisitions and our deal pipeline right now, which is pretty active. I think it really depends on the opportunity that comes up. I think in the absence of any acquisition, we'll likely continue to pay down debt in the short-term.

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Marco Andres Rodriguez, Stonegate Capital Markets, Inc., Research Division - Director of Research & Senior Research Analyst [64]

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Got you. And then in terms of the acquisition landscape for you guys, it's active and I hear those comments. But can you provide any sort of qualitative information in terms of -- is the number of targets, are they accelerating? Are the numbers increasing? And then also if you can maybe talk a little bit about what you're seeing in terms of the valuations out there.

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Jennifer L. Sherman, Federal Signal Corporation - President, CEO & Director [65]

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Yes. The acquisition pipeline is full from us and there's a wide variety of sizes of acquisitions. And right now, again we've talked about being kind of a disciplined acquirer of assets. And in some cases, the valuations have gotten high and we won't be pursuing those acquisition opportunities where it isn't acceptable returns for Federal Signal. Again, we talked about the opportunity. Will those acquisitions advance our strategic initiatives? Will they operate within the target EBITDA ranges? Is there an opportunity for us to apply our 80/20, or ETI, principles to those acquisitions to improve its business performance? So we've got a number of opportunities, but I'm committing to that we'll be a disciplined acquirer of assets as we move forward.

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Marco Andres Rodriguez, Stonegate Capital Markets, Inc., Research Division - Director of Research & Senior Research Analyst [66]

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Understood. And just then in terms of the acquisition targets that are out there or any potential that might come up here. Just given the fact that you're a year over, or a year past the TBEI acquisition, I'm assuming your capacity to take on another sizable acquisition is pretty easy.

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Jennifer L. Sherman, Federal Signal Corporation - President, CEO & Director [67]

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I always talk about financial bandwidth and management bandwidth. With the $61 million that we paid off in debt, we think our financial bandwidth is -- we have a number of different options there. And we believe we finished most of the integration activities of TBEI. So we believe we have the management bandwidth also, so we're in a good position. But again, it's got to have the right returns for Federal Signal.

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Operator [68]

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(Operator Instructions)

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Jennifer L. Sherman, Federal Signal Corporation - President, CEO & Director [69]

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Okay. In closing, I would like to reiterate that there are -- we are confident in the long-term prospects for our businesses and our markets. We would like to express our thanks to our stockholders, employees, distributors, dealers and customers for their continued support. Thank you for joining us today and we will talk to you again next quarter.

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Operator [70]

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And once again that does conclude today's conference. Again, I'd like to thank everyone for joining us.