Wednesday, January 19, 2011

Fastenal Set for Good Growth but What About the Evaluation?




Hardware wholesaler and retailer Fastenal gave results recently and, the market bid the stock down, they beat on revenues but earnings were slightly shy. For Q4 Fastenal reported revenues of $573.8m and EPS of 44c. Analysts forecasts were for $563m and 45cents respectively.

Before I get into more detail on Fastenal, I want to outline the Co’s main objectives as laid out in the ‘pathway to profit’. I do these write-ups to serve as a reference point for future research and I find this sort of benchmarking useful.


Fastenal Pathway to Profit

This is a set of strategic end points that was originally laid out in 2007, but it has seen adjustment due to the effects of the recession.

  1.  to continue growing our business at a similar rate with the new outside sales investment model
  2. to grow the sales of our average store to $125 thousand per month in the five year period from 2007 to 2012
  3. to enhance the profitability of the overall business by capturing the natural expense leverage that has historically occurred in our existing stores as their sales grow, and
  4. to improve the performance of our business due to the more efficient use of working capital (primarily inventory) as our average sales volume per store increases
  5. 85% of earnings in operating cash flow

As a consequence of the recession the Co reduced the growth of new store openings and headcount additions. Furthermore in 2010, Fastenal pushed out the $125k a store target until 2014 but announced that it was possible to hit the profit objectives (23% operating margin) anyway, thanks to cost cutting.


Scorecard on the Pathway to Profit

Firstly, I want to outline how Fastenal is now increasing the share of sales force outside the store…


Q1 2007
Q3 2008
Q4 2009
Q1 2010
Q2 2010
Q3 2010
Q4 2010
Store Personnel
6383
8280
7007
7004
7118
7450
7611
Non-Store Sales
616
599
597
594
591
639
712
Percentage
8.8
6.7
7.9
7.5
7.7
7.9
8.6
 source: Fastenal, Earnings View

Secondly, as discussed earlier the aim of sales of $125k per month per store has been pushed out by two years but, they think they can hit the 23% operating margin target early.

Thirdly, the development of leveraging up on sales has been held back by the recession. I want to highlight the percentage of pre-tax profits generated by stores with sales of over $100k a month.



Stores Selling over $100k per month
2008
2009
2010
Percentage of Stores
20.7
12.7
19.1
Percentage of Pre-Tax Profits
53.3
48.8
52
 source: Fastenal, Earnings View

Again, there is a return in the numbers but they are still not back to 2008

Fourth, looking at working capital as a percentage of sales tells a similar story.


2008
2009
2010
Accounts Receivable
244940
214169
270133
Inventories
564247
508405
557369
Working Capital
809187
722574
827502
WC/Sales %
34.6
37.4
36.5
source: Fastenal, Earnings View 

In essence, Fastenal have been held back from achieving the ‘pathway to profit’ objectives but look set to get there in future.



Fastenal End Demand is a Combination of Industrial and Residential Construction

In these results, Fastenal has benefited most strongly from a cyclical recovery in industrial production and less so from ongoing demand from maintenance. However, commercial residential construction customers (which usually represent 20-25% of their business) are still in a funk, despite the recorded growth. I would guess that this growth is coming of a very low base and, until the US housing market recovers, it will not come back in a meaningful way.


Fastenal Revenue Growth

On the conference call, Fastenal argued that

‘think it's a reasonable target. Some of the puts and takes would be if you look at the historical patterns, we normally touch start our January at or above where our October daily average was, which puts us in the 20% range in January. If you start out there, even if it slowed down a little bit, you should be able to hit the 15% to 20% for the year. Right now, we do not predict that it will be slowing down. So we're pretty confident in the 15% to 20% sales range at this point.’
Looking at the October number for stores opened for more than two years, it is 18.8% growth. Considering that most analysts have 2011 GDP growth to be similar to 2010, they could hit this again in 2011. Moreover, they are opening 150-200 new stores in 2011. Assuming $10k per month for 175 stores over the year gives another 21m or about .9% to 2010 revenues. Adding these two numbers together gives 19.7% for the year.

On top of that, 2010 saw very weak housing starts data. I think this will continue into 2011 as there remains a substantial amount of shadow inventory. However, the market has stabilised and I think there could be stronger activity in the second half. In addition, increasing employment and discretionary spending should aid Fastenal. I think they could achieve 16% revenue growth next year. I’ve shaved off 2% points to reflect on the slowing in the rate of growth of industrial investment spending.


Fastenal Evaluation

This would give $2.62bn in sales, which could give $2.20 in EPS or $324m in net earnings. If operating cash flow is again around 85% this gives $275m in operating cash flow, if capex is around $70m (new stores etc) this gives $205m in free cash flow.

I would want to buy it at a forward FCF/EV of around 4% which would give it a share price of $35. I find myself in a curious position of thinking forecasts are too light but that the company is overvalued. Frankly, I don't buy the analysts forecasts of 20% growth for next five years. Fastenal maybe recovering, but we are not going back to a housing boom anytime soon.