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Fastenal Reports Solid Second Quarter as Manufacturing End Markets ReboundFastenal Reports Solid Second Quarter as Manufacturing End Markets Rebound Brian Bernard Sector Director Analyst Note | by Brian Bernard Updated Jul 13, 2021 While Fastenal's top and bottom lines were unchanged from the year-ago period, we thought the wide-moat-rated industrial distributor's second-quarter results were solid. A strong rebound in fasteners and other nonsafety product sales, which increased 28% and 13% year over year, respectively, was offset by a 39% decline in safety product revenue. We were expecting a drop in safety product sales given a tough prior-year sales comparison and the significant decrease in COVID-19 cases in the United States, and the decrease was similar to the 42% decline reported by fellow distributor MSC Industrial for its most recent quarter. Still, Fastenal's $1.5 billion of sales was 10% higher than the second quarter of 2019, which tells us the company's traditional end markets are recovering while pandemic-related sales continue, albeit at more moderate levels. Second-quarter earnings season has just begun, but inflation has already been a hot topic. Fastenal is certainly seeing it (CEO Dan Florness said, "There's a ton of inflation going on") but appears to be managing price/cost well. The firm's gross margin expanded 50 basis points sequentially to 46.5%, but this improvement was mostly due to product mix (for example, higher-margin fasteners grew faster than lower-margin safety products). Operating margin improved 80 basis points sequentially to 21.1% due to stronger gross margin and modestly better operating expense leverage. Management aspires to a 22% operating margin, but our midcycle assumption still assumes a 21% operating margin. Fastenal signed 87 on-site locations during the quarter and now has 1,323 active sites, or about 9% more than the year-ago quarter. It also signed 5,843 Fastenal Managed Inventory weighted devices during the second quarter with a total installed base of 87,567 devices, or 9% higher than last year. After reviewing Fastenal's second-quarter results, we've maintained our $38 fair value estimate. Business Strategy and Outlook | by Brian Bernard Updated Jul 13, 2021 Since opening its first fasteners store in 1967, Fastenal has built one of the largest industrial distribution businesses in the United States. For many years, Fastenal’s growth story was driven by its branch count, which now stands at approximately 1,900. While this expansive footprint is still an important component of Fastenal’s business model, other strategies--including expanding its product portfolio, its vending and inventory management services, and most recently, its on-site program--have become increasingly important growth drivers. The benefits of Fastenal’s vending, inventory management, and on-site services are twofold: Not only do these services drive incremental revenue, they also embed Fastenal in its customers’ procurement processes, which supports higher retention rates and pricing power. We believe Fastenal has a first-mover advantage in both vending and on-site services, introducing the former in 2008 and the latter in 1992 (although the on-site strategy did not become a focused strategy until the past few years), and we see long growth runways for both offerings. In addition to growth through its vending and on-site initiatives, Fastenal is well positioned to benefit from customer consolidation trends. In recent years, customers have been consolidating their maintenance, repair, and operations, or MRO, spending with large distributors to leverage their purchasing power and increase operational efficiency. With its national scale, broad product portfolio, and inventory management services, we believe Fastenal can capitalize on this trend and take market share from smaller and less capable distributors. Because Fastenal’s sales mix is increasingly skewing more toward large national accounts, on-site programs, and more price-competitive MRO products, the company’s gross margins are likely to come under pressure. However, the combination of higher sales volume and containment of selling, general, and administrative costs provides Fastenal the opportunity to realize strong operating leverage and expand operating margins. Management's long-term operating margin goal is 22%, or about a 200-basis-point improvement from current margins. Economic Moat | by Brian Bernard Updated Jul 13, 2021 Product distribution can be a tough business: Low barriers to entry combined with customer and supplier bargaining power can erode returns on invested capital. Despite these competitive pressures, Fastenal’s superior scale has allowed the firm to earn excess returns (20-year average ROIC is approximately 25%), and we expect it will maintain its competitive advantages over at least the next 20 years. As such, we award Fastenal a wide economic moat rating, supported by its scale-driven cost advantages. We think that as one of the larger industrial distributors in North America, Fastenal benefits from scale-driven cost advantages over smaller competitors. The company operates in a very fragmented market (we estimate it has low-single-digit share), and much of its competition comes from smaller local and regional distributors that lack Fastenal’s scale and extensive footprint. We believe the firm’s cost advantages stem from preferential supplier pricing, global product sourcing, an efficient and scalable distribution network, private-label brands, and national accounts. Fastenal has been able to leverage its purchasing scale to globally source products and take advantage of volume-based rebates and other sales incentives. Global sourcing and preferential pricing from suppliers lower the company’s cost of goods sold and promote better gross profit margins relative to smaller distributors that lack such scale. Fastenal’s efficient global distribution network is another source of scale-driven cost advantages. In the age of e-commerce, a large brick-and-mortar footprint has proved to be a weakness for many traditional retailers; however, we think Fastenal’s footprint of approximately 1,900 stores is a strength and a key differentiator over competitors. Unlike many retailers, Fastenal is not dependent on customer foot traffic to drive sales; in fact, most branch revenue is generated from business-to-business transactions that are managed by the company’s sales team. Fastenal’s on-site program places dedicated inventory and staffing in or near customer facilities. The initiative has been growing in popularity, and the firm now operates over 1,300 on-site locations versus 264 in 2015. Customers value Fastenal’s store-based and on-site approach because this business model offers a quick and convenient method for procuring fasteners and other MRO products, while also reducing shipping costs. Fastenal offers same-day delivery for locally stocked inventory, and approximately 90% of sales are fulfilled before 10 a.m. the next day. Because fasteners have a low value/weight ratio, shipping can become very expensive. Fastenal uses a captive fleet of large trucks and smaller vehicles to more efficiently and cost-effectively move its inventory across the United States. We see Fastenal’s insourced shipping capabilities as a key cost advantage over its competition. Fastenal’s scalable distribution network and centralized order fulfillment centers allow the company to cost-effectively serve its customers, and we believe its technological capabilities, including its e-commerce sales channel, integrated customer purchasing and inventory management solutions, and warehouse automation drive distribution efficiencies that would be difficult for smaller competitors to replicate. About 13% of sales are generated from higher-margin private-label products. Since private-label brands boost profit margins, we believe distributors that offer them have a cost advantage over those that don’t. An increasing number of companies have been consolidating their spending with large national distributors. Vendor consolidation allows customers to simplify their procurement processes and leverage their buying power. Because Fastenal has national scale, a global reach, and a robust portfolio of products and inventory-management services, it’s well positioned to capitalize on this trend and take share from smaller local and regional distributors that do not have the scale to profitably service these customers. Although national accounts can generate lower gross profit margins, they also generate higher volumes, which Fastenal can leverage to improve operating margins. Fastenal’s FAST solutions program supports customer procurement and inventory management with vendor-managed inventory, industrial vending, and on-site partnerships. From a customer’s perspective, these solutions can significantly improve supply chain and operational efficiency and reduce costs. From Fastenal’s perspective, these solutions drive incremental sales and build stickier customer relationships as Fastenal becomes deeply embedded in the customer’s procurement process. The company currently has approximately 88,000 installed Fastenal Managed Inventory devices (weighted using a standardized machine equivalent unit), which account for 25% of its nonfastener product sales. Its on-site program has experienced tremendous growth, and Fastenal now operates in over 1,300 customer locations, which represents over 15% of sales. Management believes its vending and on-site programs have plenty of room to grow, estimating that the market could support 1.7 million vending machines and 15,000 on-site locations. About 60% of the company’s fastener sales are used in product manufacturing and construction. Given the hassle of quickly changing suppliers during production runs and ongoing construction projects, we think these types of relationships are relatively sticky. Likewise, we think Fastenal’s technical expertise and custom manufacturing capabilities create stickier customer relationships. Fastenal employees are not only trained to provide replacement fasteners based on size, they can also provide important details such as the replacement fastener’s strength, alloy composition, coating, and whether it meets certain industry or regulatory requirements. Fastenal operates a handful of manufacturing facilities that can provide customers with custom-specified fasteners as well as tool repair and other related services. These types of services account for 4% of Fastenal’s sales. Fastenal is an important conduit between its suppliers and 400,000 active customers, which see the company as a one-stop shop for all their fastener and MRO needs and which find value in the firm’s large assortment of products, technical expertise, and ability to streamline the procurement process. Suppliers find value in Fastenal’s large customer base and capable salesforce and see the firm as a source of growth. Fastenal is a valuable channel partner for its suppliers, and we think its large customer base and ability to outgrow its end markets strengthen its standing with its suppliers. Fastenal uses its reputation with suppliers and its scale to expand its vendor base and product selection, take advantage of sales incentives and volume rebates, and gain preferential access to supplier resources and support, which in turn allows it to offer customers better product selection, pricing, and services. In our view, Fastenal does not have environmental, social, and corporate governance risks that could result in material value destruction. Fair Value and Profit Drivers | by Brian Bernard Updated Jul 13, 2021 Our $38 fair value estimate equates to about 24.5 times our base-case 2021 EPS estimate and represents a forward enterprise value/EBITDA multiple of about 16 times. Our forecast for a 9% sales CAGR through 2025 is 100 basis points better than the average sales growth pace that Fastenal achieved over the previous five years. After tepid growth in 2015 and 2016, sales grew almost 11% in 2017 and 13% in 2018, but growth slowed to 7% in 2019 due to a broad slowdown in industrial demand and 6% in 2020 due to the coronavirus pandemic. We expect about 3.5% sales growth in 2021 as the pandemic remains a headwind, but after 2021, we project Fastenal will generate low-double-digit average top-line growth as it gains traction with its industrial vending and on-site programs and takes share from smaller competitors. We believe Fastenal's growth initiatives will allow it to grow faster than the MRO market. Historically, Fastenal’s store and vending count has exhibited a very strong correlation with the company’s sales; however, we think the on-site count will become an increasingly important factor as that business model gains prominence. As Fastenal’s store growth moderates, we think the vending and on-site initiatives will become the principal drivers of sales growth. We assume that Fastenal will face gross margin pressure due to a growing mix of on-site and national account businesses, which tend to generate lower gross margins. However, we expect the combination of higher sales volume and selling, general, and administrative cost containment will result in operating leverage that will more than offset gross margin compression. Over our five-year explicit forecast, we model operating margins expanding about 150 basis points to 21.5% by 2023-24 with a moderated 21% midcycle assumption (2025). Risk and Uncertainty | by Brian Bernard Updated Jul 13, 2021 Since 1993, Fastenal has significantly expanded its product portfolio beyond its core fastener offerings. Today, fasteners represent about 30%-35% of the company’s sales. While we believe a broad product portfolio is an important component of Fastenal’s business strategy, we worry that a growing mix of lower-margin nonfastener sales could expose the firm to increased competition and dilute margins. We do not believe that Amazon Business or other Internet-based distributors will have a meaningful impact on Fastenal’s fasteners business; however, these competitors could certainly affect Fastenal’s MRO business. Although Fastenal’s vending, vendor-managed inventory, and on-site services are key differentiators that support the firm’s pricing power, these types of services may not be an insurmountable advantage over the long run. As national accounts and on-site relationships gain prominence, Fastenal could face gross margin pressure, but these accounts also provide an opportunity for to gain market share and increase volume, which should drive better operating leverage and improved operating margins. Still, given the competitive environment, volume gains may not be enough to offset pricing concessions needed to win larger national contracts. In addition, end users could choose to not participate in Fastenal’s on-site program. Because a meaningful portion of Fastenal’s sales are generated from heavy manufacturing and construction, performance is no doubt affected by cyclical downturns. Still, free cash flow generation has been quite resilient even during periods of declining sales, and the firm has historically used little or no debt, so we think it will maintain its financial flexibility throughout the business cycle. Capital Allocation | by Brian Bernard Updated Jul 13, 2021 We assign Fastenal an Exemplary capital allocation rating. This rating reflects our assessments of a sound balance sheet, exceptional investment, and appropriate shareholder returns. Since 1996 (and through 2020), we calculate that the firm has allocated approximately $7.5 billion of shareholder capital to fund dividends (55% of that $7.5 billion), capital expenditures (30%), share repurchases (12%), and acquisitions (3%). We calculate that 92% of that $7.5 billion was funded with operating cash flow, while debt issuances and other sources of funding account for the rest. Fastenal's reinvestment in high-growth opportunities--for example, vending and on-site locations--has bolstered the top line but also generate strong returns on invested capital. In our view, management's well-executed strategy has helped embed Fastenal in its customers’ procurement processes, which supports higher retention rates and pricing power. Fastenal’s capital expenditures/sales ratio has averaged about 4% over the past five years and is significantly higher than peers'. Fastenal’s expansive branch network, vending business, and captive trucking fleet explain the firm’s higher capital intensity relative to most peers. Still, Fastenal generates industry-leading ROICs. Given Fastenal's strong reinvestment record and our outlook for continued success, we assess the firm's investment strategy as exceptional. Given Fastenal's relatively conservative use of leverage and consistent free cash flow generation, we assess the firm as having a sound balance sheet. The company began paying a cash dividend in 1991 and has consistently increased its dividend since then. Share repurchases have historically been a less important component of Fastenal’s capital allocation strategy; however, the firm has periodically repurchased shares since 2005. Between 2005 and 2009, Fastenal spent $191 million to repurchase 6.1 million shares, and between 2013 and 2016, it spent $415 million to repurchase 10.1 million shares. The most significant buyback activity occurred in fiscal 2015, when management viewed Fastenal stock as undervalued and took on debt to repurchase 7.1 million shares for $293 million. We believe Fastenal's shareholder distribution policy is appropriate, given the solid and dependable free cash flow generation. Dan Florness has been CEO since January 2016 and was CFO from 1996 until his promotion to CEO. Holden Lewis joined Fastenal in August 2016 as CFO. Before that, he was a sell-side analyst at FBR Capital Markets, Oppenheimer, and BB&T Securities. Lewis’ background is unique in that he covered Fastenal for many years before joining the firm. |
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