Fastenal: Operationally Sound, But Cycle Pressures May Be More Challenging (NASDAQ:FAST)

There is little to find fault with at Fastenal (FAST) from an operational perspective, and valuation is pretty binary – either you’re comfortable paying a hefty premium to buy/own a top-quality industrial supplier, or you’re not. That doesn’t mean that Fastenal is completely immune to larger cyclical concerns, as the shares have historically had a tougher time in periods where IP growth is slowing off recent peaks.

Fastenal shares are up a bit from my last update, outperforming MSC Industrial (MSM) and the broader industrial sector, but underperforming Grainger (GWW) and Applied Industrial (AIT). Little has changed with my basic thesis – I have no meaningful long-term operational concerns with Fastenal, but I remain concerned that the demanding valuation will make sustained outperformance more challenging in the future.

Leveraging A Manufacturing Recovery

With Fastenal providing monthly sales updates, the odds of big surprises around earnings are lower, but Fastenal nevertheless delivered a slightly better than expected quarter with its December results.

Revenue rose a little under 13% in organic terms, with average daily sales growth closer to 15%, good for a roughly 2% beat versus the Street. Fastener sales continue to accelerate with the industrial recovery, rising 24%, while safety sales rose less than 4% and “other” sales rose 13%. Management estimated that price contributed more than four points to growth.

Gross margin rose 90bp from the year-ago period and 20bp from the prior quarter, beating by 10 basis points. Management noted an improved margin on safety, but said that mix didn’t really play a role in the improved margin, which I find strange given the stronger sales of what should have been higher-margin products.

Operating income rose almost 14%, beating expectations by about 3%. While some analysts seem bothered by the higher opex in the quarter, Fastenal beat on operating margin by 20bp (so, more than just the gross margin beat), so I’m not quite sure why that was an issue for some analysts, particularly in an environment where labor and logistics costs are rising.

Going Deeper Into The Weeds, The Data Are A Little Less Positive

Fastenal reported significantly more growth with national accounts (up 23%) than smaller customers (up 9%), and while growing its business with these larger customers has been a management priority, it generally comes at the cost of lower gross margin (though that can be offset in part by lower opex to serve those accounts).

Management did note that product availability had improved during the quarter, and Fastenal seems to be doing better here than spot-buy vendors. Sourcing is arguably an underappreciated competitive advantage for Fastenal, and one that may well become more apparent and appreciated if supply chain challenges persist through 2022. On a less positive note, the impact of inflation on inventories is still a significant unknown – while distributors can do well in a “Goldilocks” inflation environment, I’d argue the current one is at least a little hotter than “Goldilocks”.

Looking at the on-location growth drivers of FMI (vending machines) and OnSite, the numbers were mixed. Vending placements are picking up again after the pandemic made site access more problematic, but I think getting back to sustained mid-teens (or higher) growth could be challenging. Likewise, OnSite KPIs remain weak, with 44 new signings in the quarter.

Management has targeted 375 to 400 signings for ’22 and I do expect a rebound with improved access to customer locations (and customers moving away from “survival mode”), but even prior to the downturn Fastenal was having problems consistently hitting its quarterly 90+ target (missing that target in 5 of 8 quarters from Q1’18-Q4’19).

None of these are red flags, but they are important components to the growth story and Fastenal’s ongoing ability to gain share. Likewise, I do expect the company will need to invest more resources in building its e-commerce capabilities, as this is currently around 10% of sales but likely to head higher in the future.

The Outlook

With a solid industrial recovery underway, and a possibly underappreciated non-resi construction recovery later in 2022 and into 2023, I am a little more bullish on Fastenal’s near-term revenue expectations. I’ve boosted my ‘22/’23 numbers by about 5%-6%, and that helps boost my long-term revenue growth rate a little further into the 6%’s – reflecting what I expect to be ongoing share gains over the long term.

On the margin side, I haven’t done as much. While improved volumes should improve overhead absorption and I think Fastenal will be able to pass on price increases, I do expect higher costs to offset this. That leads to a 23% EBITDA margin assumption for ’22 (on par with ’20 and ’21), with margin improving slowing toward 23.5% over the next few years. Free cash flow was lower than I expected due to working capital, but I expect that to normalize over the coming years and my long-term assumptions aren’t materially different.

The Bottom Line

As has long been the case with Fastenal, none of my typical valuation approaches work with this company, as the shares trade well above what would normally be fair value. I don’t expect that to suddenly matter for the share price, but I would note that there’s a historical trend for the shares to not do as well in periods where IP growth is contracting (and we seem to be at that point in the cycle). With that being the case, investors who don’t own Fastenal and are comfortable with paying a premium may want to keep a close eye on this recent correction as a relatively rare opportunity to buy a dip.