L.B. Foster Company: Shareholder Friendly But Great Uncertainty ($FSTR)

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L.B. Foster Company (NASDAQ: FSTR) is a manufacturer and distributor of products for the rail, construction, energy and utility markets, including rail, ties, joints, fasteners, piling, and pipes. Approximately half of its revenues are from construction products, 45% from rail products and the remaining from tubular products. This is a small company, with a market cap of around just $240 million (less than its $266 million book value, though greater than its $178 million tangible book value), of which a whopping 1/4 is net cash. The company generated $24 million in free cash flow over the trailing twelve months, representing an ex-cash yield of 13%.

The company began aggressively repurchasing shares in the last two quarters, reducing its share count by 5.4%. Additionally, the company began paying a dividend for the first time two quarters ago, paying 12 cents a share annually (a paltry 0.4%, but a welcome development nonetheless).

The following chart shows the company’s revenues and margins over time.

L.B. Foster Company: Shareholder Friendly But Great Uncertainty ($FSTR)L.B. Foster Company – Revenues and Margins, 1994 – 3Q 2011

As we see, the company’s margins have been consistently improving since 2004, despite the trough macroeconomic environment of the last few years. In 2011, the company’s revenues increased dramatically, but it is important to note that a portion of this is related to the company’s acquisition of Portec Rail Products. The company’s backlog, which is an imperfect indicator of future revenues, may be signaling a decline in revenues in the near term. The following chart shows the company’s backlog by segment over time, with actual revenues included on the secondary y-axis.

L.B. Foster Company – Backlog and Revenues, 1994 – 3Q 2011

Here we see that, although the company ended 2010 with a record backlog, this has come down substantially in 2011. I’d like to see an uptick in backlog. Another thing that has come down fairly dramatically over the last few years is the company’s cash conversion cycle, as the next chart shows.

L.B. Foster Company – Cash Conversion Cycle, 1994 – 3Q 2011

As you can see from the included components, the company’s inventory got a bit out of hand, with continuous growth (at a rate faster than revenue growth) from 2004 – 2009. The company has done an excellent job bringing this down over the last six quarters. This increased efficiency frees up working capital and thus increases free cash flow that can be used elsewhere (like repurchases and dividends, as noted above). The following chart shows the company’s free cash flow over time.

L.B. Foster Company – Cash Flows, 1994 – 3Q 2011

Here we see that the company’s strong free cash flows have really only materialized in the last three years. Over this period, capital expenditures declined dramatically as a ratio of depreciation (note the difference in the green and red bars in 2005 and 2006!), as well as improved profitability (as shown in the first graph). It would appear that the company’s current capex/depex ratio is closer to normal spending patterns, and that 2005/2006 were anomalies. The difference is that the company is significantly more profitable today than it was prior to 2004.

The following chart shows the company’s cash and debt over time.

L.B. Foster Company – Capital Structure, 1994 – 3Q 2011

In 2007, the company’s cash balance increased significantly as the result of the sale of its stake in Dakota, Minnesota and Eastern Railroad to Canadian Pacific Railway Limited, which resulted in a $123 million gain. The company used this cash to repurchase shares (spending ~$26.5 million in 2008), pay down debt (reduced debt by $63 million over the next four years) and then for the recent acquisition of Portec. Today, the company has approximately $58 million in net cash.

With almost no debt left and a mammoth recent acquisition, the question is what the company will use its future free cash flow for. So far, as noted, we have seen a resurgence in share repurchases and a new dividend. This is fine by me!

There are a few things to note about the company that may be concerning. First, the company’s CEO recently retired and a replacement has yet to be found. A shift in senior management can be good or bad, depending on your perspective, but it appears to me that Stan Hasselbusch did a capable job of managing the company, and this introduced some risk that his replacement will not perform as well.

The larger issue is that there is a product claim which could potentially be quite large, though the company is currently downplaying it. As noted in last quarter’s 10-Q:

Product Claim Update

On July 12, 2011 the Union Pacific Railroad (“UPRR”) notified the Company and CXT Incorporated, a subsidiary of the Company (CXT), of a warranty claim under CXT’s supply contract relating to the sale of prestressed concrete railroad ties to the UPRR. The UPRR has asserted that a significant percentage of concrete ties manufactured in 2006 through 2010 at CXT’s Grand Island, Nebraska facility fail to meet contract specifications, have workmanship defects and are cracking and failing prematurely.

Since late July 2011, the Company and CXT have been working with material scientists and prestressed concrete experts, who have been testing a representative sample of Grand Island concrete ties. While this testing is not complete, we have not identified any appreciable defects in workmanship nor have we identified any material deviation from our contractual specifications for the concrete ties in question. We expect that the testing required to address the product claim will be completed sometime during the first quarter of 2012.

No adjustments have been recorded as a result of this claim as the impact, if any, cannot be estimated at this time. No assurances can be given regarding the ultimate outcome of this matter.

The company’s original disclosure stated the following:

Approximately 1.6 million ties were sold from Grand Island to the UPRR during the period the UPRR has claimed nonconformance. The 2005 contract calls for each concrete tie which fails to conform to the specifications or has a material defect in workmanship to be replaced with 1.5 new concrete ties, provided, that UPRR within five years of a concrete tie’s production, notifies CXT of such failure to conform or such defect in workmanship. The UPRR’s notice does not specify how many ties manufactured during this period are defective nor which specifications it claims were not met or the nature of the alleged workmanship defects.

According to this document [pdf] from 2007, a concrete tie costs approximately $41 per tie. This figure is likely below today’s prices. Though we do not know the exact amount UPRR is claiming are defective, we can make some estimates of the replacement cost by estimating the percentage of ties to be replaced, multiply by the 1.5x penalty in the contract, and multiply again by some present value of the $41 per tie and the cost of labour. Unless you use an excessively small defect rate, the figure quickly becomes material for such a small company.

Though I take comfort in knowing that the company’s experts were not able to identify defects, I am concerned that this could result in costly litigation or damage the company’s reputation even in the best case scenarios, and in the worst case could lead to a massive charge (the company has made no reserve for this particular claim). This is not a risk I am willing to take given the limited information currently available; I find it impossible to properly handicap the expected value of losses, and my assessment of the company’s intrinsic value does not provide a large enough margin of safety as to outweigh the potential losses from this claim. I will keep an eye on the company, as future developments could nullify the risk of the product claim and result in a value opportunity involving this shareholder friendly company with little debt and generating a healthy free cash flow yield.

What do you think of FSTR?


Author Disclosure: No position

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