Monday, January 28, 2013

Fastenal Still Looks Expensive

Fastenal (NASDAQ: FAST) investors would have looked at the upcoming results with a sense of trepidation following MSC Industrial’s (NYSE: MSM) recent report. The good news is that they weren’t as bad as some had feared and the stock rallied. However, the underlying trends aren’t so positive for the industrial sector in general and much of the growth was related to expanding sales via its vending machines. In summary, this is good execution from Fastenal and augers well for MSM (which is also expanding roll-out of vending machines) and given a second half recovery in the US the company has upside.

Fastenal’s Pathway to Profit

As ever with Fastenal, investors need to keep their eyes on the long term objectives of the company. The so called ‘pathway to profit’ is a series of objectives and metrics with which Fastenal’s performance is benchmarked. I stress this mainly because I am struggling to find a reason why the evaluation of the company is so high. Perhaps the market is merely pricing all of these metrics as a given? I don't know, but whatever the reason Fastenal has done something to win investors over.
A summation of the pathway to profit objectives:
  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
We need to understand these objectives in order to put the recent results in the proper context.

Vending Growth Masks an Underlying Slowdown

In the conference call Fastenal discussed the drop-off in demand in its core fastener business and naturally attributed it to a slowing macro-environment. It is perfectly feasible to expect end demand to correlate to its OEM customer production and therefore with industrial demand trends. Indeed, Fastenal reported slowing growth in the key metric that I like to follow.

Specifically, here are the growth rate figures for stores open more than five years. It looks like a clear slowdown to me.

This is confirmed when looking at how the sales numbers this year have been compared to normal sequential movements at the company.

Indeed fastener sales growth slowed to 2.5% in the final quarter from 15% in the first. So the economy did slow end market demand.

On a more positive note Fastenal managed to take initiatives to grow revenues in the non-fastener area. Indeed, a combination of these initiatives in government, metalworking and the previously mentioned vending operations mean that Fastenal can find ways to generate secular growth. In a similar sense a company like Grainger is looking to expand its online activities while MSC is doing both. Another underestimated competitor in the future could be Home Depot. While it is not an obvious rival in specialized lines of business, it obviously has the scale to be able to leverage up its e-commerce offering in the sector, particularly if this will entail selling its in-store brands through online channels.

Essentially these companies have these opportunities because the marketplace is so fragmented and characterized by lots of small local suppliers. This gives Fastenal the opportunity to consolidate the market and build on economies of scale.

As for how vending sales are expanding:

The growth here is wonderful for cash flow generation and helps Fastenal capture economies of scale in line with its plans outlined above. Indeed the plan is to ramp up capital spending this year in order to drive secular growth from vending.

Where Next for Fastenal?

A quick look at analyst estimates sees high double digit earnings growth forecast for the next couple of years. It also indicates a forward PE ratio of nearly 30x which looks a bit rich to me. Granted this ratio will come down with any kind of pick-up in industrial activity in the US, but I still think it is too expensive a proposition. Moreover at some point, growth from vending machine based revenues will slow. For now the company isn’t worried, and vending machines represent a great way to increase margins and cash flow conversion.

An attractive company, but every investment comes at a price and an enterprise value of more than 19x EBITDA simply isn’t cheap enough.

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