Tuesday, August 28, 2012

Fastenal Equity Research

Fastenal (NASDAQ: FAST) cheered the market with a decent set of numbers which were in line with analyst estimates. The company represents a decent litmus test of the industrial and construction sectors in the US alongside something like Grainger (NYSE: GWW) or MSC Industrial (NYSE: MSM). In this article I want to provide a brief overview of current conditions and put them in the context of Fastenal’s long term strategy.

Fastenal specializes in selling kinds of fasteners and hardware equipment that are used in construction and industrial applications. As such it is often seen as a proxy for building and manufacturing activity in the US. The best way to gauge any underlying trend is to look at the sales figures for stores that have been open for more than five years. These stores tend to be more cyclical in their revenues because they are more mature in their market share within their local markets. Here are the numbers for revenue growth.

Quarter20052006200720082009201020112012
Q113.712.15.59.1-16.21.717.516.2
Q212.59.85.310.7-25.516.118.510.9
Q312.89.85.89.9-25.21915.6 
Q411.96.181.3-1715.617.1 

It's not hard to see that construction and housing peaked in 2006 or that growth slowed in 2012. Nevertheless these results were pretty good. Revenues increased by 15% with 53 new stores opened in the first half, however gross margins fell to 51.6% in a sign that conditions are about to get tougher.
Now it's time to turn to look at how Fastenal is achieving its long term objectives.


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. to generate 85% of earnings in operating cash flow
As a consequence of the recession, Fastenal 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.

So how are its plans going?


Scorecard on the Pathway to Profit

Firstly, I want to outline how Fastenal is now increasing the share of sales force outside the store.
Q2201020112012
Store Selling Personnel7,3098.5709,290
Non-Store Selling Personnel6048931,071
Percentage Non-Store7.69.410.3
In addition it has been expanding sales from its vending machines, which now make up 20.8% of net sales from 10.5% last year. All of which is helping operating margins in line with the first objective in the strategic plan. These sort of initiativs are helping Fastenal deal with increasing competition from the likes of Home Depot (NYSE: HD) who are trying to encroach on its marketplace.

Turning to the second aim, Fastenal has adjusted its objectives. Due to the recession the average store size has had to be reduced so the new aim is to reach an average store sales of $100-110k a month instead of $125k.

Thirdly, the development of leveraging up on sales has been held back by the recession, but Fastenal is back on track now. I want to highlight the percentage of sales generated by stores with sales of over $100k a month.

Stores Selling over $100k per month for Q2201020112012
Percentage of Total Stores12.213.815.9
These numbers are impressive especially given that Fastenal has been pursuing an aggressive store opening policy over the last few years.

Fourthly, lets look at how working capital as a percentage of sales has developed.

 2008200920102011
Accounts Receivable244,940214,169270,133338,594
Inventories564,247508,405557,369646,152
Working Capital809,187722,574827,502984,746
WC/Sales %34.637.436.535.6
Again, Fastenal has been doing well even if operating cash flow in 2011 was only 75% of net earnings.


Fastenal End Demand is a Combination of Industrial and Residential Construction

In recent years, 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.

Nevertheless, we do appear to be reaching a bottom in the housing market and the company can look forward to some contributions from more housing starts in future. Arguably, this makes Fastenal more attractive than MSC Industrial or Grainger, both of which are more focused on niche markets in the industrial sector.

Evaluation is Key

Fastenal is a well run company which is executing its long term plans very well. The shift in the composition of sales should enable more efficient cash flow generation in the future and the company is managing its inventory much better.

However, it is facing a moderation in growth in the industrial sector even if demand from the residential housing sector will be better going forward. In addition, the valuation is hardly generous. A current PE ratio of 33 and an EV/Ebitda of 18.8x leaves little room for error and given the macro uncertainty, it would take a good amount of confidence over a quick turnaround in order to buy this stock aggressively.

In this regard a stock like Home Depot would be interesting. Although it does not offer the same potential for operational leverage or cyclical exposure, it is more aligned to the housing sector and as yet, its management are not baking in any upside from a return to growth in the housing market. This suggests that there is upside here. In addition the valuation and cash flow metrics look much better than Fastenal right now