Monday, December 3, 2012

Fastenal Research and Analysis

There are fewer companies that report more details on trading performance than Fastenal (NASDAQ: FAST) and I think its results are a key barometer for how the US construction markets are trending. According to the company, sales typically comprise of 75-80% from residential construction customers and 20-25% from industrial so it is a good gauge of house building prospects.

In summary, there were signs of a slowdown in the Spring, but Fastenal reported a recent and tantalizingly strong uptick which has also been supported by things like the Architectural Billings Index. Will it last or will it be another variable data point in a mixed year?  I happen to think the former.

Fastenal’s Profit Drivers

I like the company because it has a number of good profit drivers. I’m going to discuss four of them here. First, as a leading player in a fragmented market, it has the opportunity to expand its store numbers and consolidate its industry.  Second, this expansion should bring about improvements in working capital and inventory management. Third, it is expanding the percentage of sales from non-store sources (vending machines) and lastly it has upside kicker from an improvement in the residential construction market.

As ever, it is the last point that investors will focus on in the near term. I’ll return to that point later but first I want to focus on the long term drivers, specifically what Fastenal’s objectives are and how it is measuring up.

Fastenal’s Long Term Objectives

I’m going to go back to the plan laid out in 2007 which I originally highlighted in an article linked here

  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 (this has subsequently been pushed out to 2014)
  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
  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

Essentially the objectives are typically the kind of thing you might expect from a business with an opportunity to improve operational performance with an expansion strategy. It’s time to look at the numbers.

Fastenal’s Immediate Prospects

First here are revenue growth numbers for stores open more than five years.

There is an obvious slowdown this year, but very recently there has been some cause for optimism. Fastenal helpfully breaks down monthly sequential sales movements and gives the comparison versus historical movements. I’ve graphed them for 2012 below…

…it’s hard to get too excited about the September number because it has been such a variable year but the Architectural Billings Index has perked up recently too…

... or is this yet another false dawn for the housing market?

Possibly but the longer that the lack of new supply comes and prices keep rising then the more the likelihood that the housing market will see a sustained upturn. Indeed the most recent corporate news on housing is positive. Both Wells Fargo and JPMorgan (NYSE: JPM) are seeing better market conditions. In particular Jamie Dimon, CEO of JPMorgan, said that housing ‘has turned a corner’. One would hope that he means it because he reduced the amount of provisions for loan losses. It's a nice way to improve profits, but it will bite JPMorgan back if housing makes a downturn. No matter it is another positive sign for housing.

Fastenal is more of a housing play than companies like Grainger (NYSE: GWW) or MSC Industrial (NYSE: MSM). Those companies have more of an industrial focus and for investors in those companies, here is the breakdown of revenue growth for industrial customers for Fastenal.

Longer Term Scorecard

Going back to the long term plans, a key aim is to increase sales via vending machines…

Above shows a strategy which is working well. In a sense Fastenal has to do this because competition is coming from the likes of Home Depot (NYSE: HD) who are trying to encroach on its market share in store. In addition, Home Depot is expanding online sales and, bolts and fasteners strike me as exactly the kind of product that can be easily shifted to e-commerce.

What about the plan to increase average sales per store?

Fastenal is increasing the amount sold per store (currently at $88.3k) and (as shown above) the percentage of stores selling above $100k, so increasing the number of stores is not having a detrimental effect on average sales per store. This suggests the company has plenty of room for growth. Will it hit the $125k target by 2014? It’s possible but I suspect Fastenal will need some assistance from the economy.

The Bottom Line

I like Fastenal and I like prospects for the residential construction sector but it’s very difficult to argue that the stock is good value. Fastenal’s proposition of mid teens EPS growth coupled with significant long term operational improvements is a compelling offering, but investors always need to factor in a margin of safety in their assumptions.

I’m bullish about the housing market but not bullish about buying richly priced stocks, especially as it is far from clear how the economy will fare next year. Frankly an evaluation of EV/Ebitda of 18.7x is not cheap and nor is its current free cash flow yield anything to write articles home about.  It’s a good company but there is better value elsewhere.

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