FSS

Federal Signal Corporation 2006 Annual Report Summary

Business Context and Reporting Period

This summary covers the Form 10-K for Federal Signal Corporation for the fiscal year ended December 31, 2006. The Company designs and manufactures safety and security systems, fire rescue apparatus, environmental solutions (street sweepers, vacuum trucks), and industrial tooling. Operations are organized into four segments: Safety and Security Systems, Fire Rescue, Environmental Solutions, and Tool. The Company operates 33 plants in 13 countries, serving customers in approximately 100 countries.

Key Financial Metrics (2006)

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 8% to $1.21 billion, driven by higher volumes in safety and environmental products and increased pricing across all segments.
• Profitability: Operating income rose 10% to $69.9 million. Gross profit increased 13% as pricing and volume gains offset higher material costs. However, income from continuing operations decreased 22% due to a less favorable effective tax rate (19.4% in 2006 vs. a 7.6% benefit in 2005).
• Discontinued Operations: Net income improved significantly compared to 2005, primarily because the loss from discontinued operations decreased from $48.5 million in 2005 to $11.7 million in 2006. This includes the sale of the Cutting Tool Operations (completed Jan 2007) and the disposal of the North American refuse business.
• Cash Flow: Operating cash flow declined 58% to $29.7 million, attributed to increased working capital requirements, inventory pre-buying for 2007 emission regulations, and higher pension contributions ($11.5 million vs. $7.7 million).
• Segment Performance: Environmental Solutions saw a 28% increase in operating income. Fire Rescue operating income improved 170% excluding one-time supplier recoveries and closure costs. Tool Group operating income declined 27% due to a weak automotive market and business system conversion errors.

Guidance, Outlook, and Risks

Outlook: Management anticipates that financial resources and liquidity will be adequate to meet operating needs. The backlog increased 4% to $403 million, with a substantial majority expected to be filled in 2007. Orders increased 12% in 2006, with strong growth in non-US orders (23%) and US industrial/commercial orders (14%).

Risks and Contingencies:

• Cyclicality: Results are heavily dependent on US municipal and government spending, which lags the broader economy.
• Legal Proceedings: The Company is defending over 2,500 firefighters in lawsuits alleging hearing loss from sirens. No reserve has been established as the Company contests the allegations.
• Supply Chain: Risks exist regarding the availability and cost of raw materials and critical components (engines, transmissions).
• Debt Covenants: The Company is subject to restrictive debt covenants, including a minimum interest coverage ratio of 3.0.
• Accounting Changes: The Company adopted SFAS 123(R) for stock-based compensation in 2006, reducing income before taxes by $2.3 million.

Investor Verification Checklist

• Verify the impact of the 2006 effective tax rate (19.4%) compared to the 2005 tax benefit, and assess the sustainability of future tax rates.
• Monitor the status of the firefighter hearing loss litigation and potential future reserve requirements.
• Review the progress of the Fire Rescue segment's restructuring and profitability improvements following plant consolidations.
• Assess the impact of rising raw material costs on future gross margins, given the Company's reliance on aluminum and steel.
• Confirm the execution of the Cutting Tool Operations sale (completed Jan 2007) and the realization of the expected $25 million gain.
• Track working capital trends, specifically inventory levels, in anticipation of 2007 engine emission regulation changes.