Fastenal Company (NASDAQ:FAST) Q2 2023 Earnings Call Transcript

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Fastenal Company (NASDAQ:FAST) Q2 2023 Earnings Call Transcript July 13, 2023

Fastenal Company misses on earnings expectations. Reported EPS is $0.52 EPS, expectations were $0.53.

Operator: Good morning and welcome to Fastenal 2023 Second Quarter Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. At this time, I would now like to hand the call over to Taylor Ranta of Fastenal Company. Thank you. You may begin.

Taylor Ranta: Welcome to the Fastenal Company 2023 second quarter earnings conference call. This call will be hosted by Dan Florness, our President and Chief Executive Officer; and Holden Lewis, our Chief Financial Officer. The call will last for up to 1 hour and will start with a general overview of our quarterly results and operations, with the remainder of the time being open for questions and answers. Today's conference call is the proprietary Fastenal presentation and is being recorded by Fastenal. No recording, reproduction, transmission or distribution of today's call is permitted without Fastenal consent. This call is being audio simulcast on the Internet via the Fastenal Investor Relations homepage, investor.fastenal.com.

A replay of the webcast will be available on the website until September 1, 2023 at midnight Central Time. As a reminder, today's conference call will include statements regarding the company's future plans and prospects. These statements are based on our current expectations and we undertake no duty to update them. It is important to note that the company's actual results may differ materially from those anticipated. Factors that could cause actual results to differ from anticipated results are contained in the company's latest earnings release and periodic filings with the Securities and Exchange Commission and we encourage you to review those factors carefully. I would now like to turn the call over to Mr. Dan Florness.

Dan Florness: Good morning, everybody and thank you for our second quarter earnings call. Before I start on Fastenal matters, I'd like to share a message. When I joined Fastenal back in 1996, one of the things that was unique in my joining is that I stepped into the role of Chief Financial Officer, Bob Kierlin offered me the opportunity. And so, I joined in an unconventional way in that I didn't start in a branch or in a distribution center and work my way up through the organization. And sometimes when you join an organization that promotes from within, you're not sure -- kind of reception you'll get when you join. One of the first people I met was Colleen Quad [ph], it was Bob Kierlin sister. She had retired in a retirement.

She worked for Fastenal a few years in sales support. One of the nicest ladies I ever met and we lost Colleen [ph] earlier this year. And to her children and grandchildren, you have my condolences and as well as to Bob on the loss of your sister. What a wonderful lady and we were all blessed to know her. We started back in 67. So our 5 founders aren't in their 20s anymore. And Van McConnon -- Henry McConnon [ph], he goes by Van, he was our first employee. In fact, I think that's how he earned his stake in Fastenal, did well with that stake and I'm proud of them. He lost his wife Wilma earlier in the year and the same message. Van was -- could not have been more of a welcoming person to me when I joined the organization and here is my condolences in the loss of his wife to spring.

With that, I'll move on onto the Fastenal quarter. Second quarter '23 is a challenging quarter. Last fall, when we -- or last December, when we had our leadership meetings and our planning discussions for 2023, the ISM had weakened. We knew that 2023 was going to have some slugging aspects to it. We warned -- we cautioned our team. Second quarter and third quarter will be tough quarters to get through and prepare yourself, prepare your teams from the standpoint that we're going to have to manage our expenses really well. We'll have to keep all of our heads skewed on the right way because there's been -- it's been an interesting number of years between tariffs and COVID and congested supply chains and inflation and all this stuff, there's noise, noise, noise.

We're going to experience something we have experienced for a number of years and that's a slowing economy and prepare for what that means and get the muscle memory back. But it was a challenging quarter. Our earnings came in at $0.52, rising about 4.5%. Softer manufacturing activity led our data sales growth to decelerate. We grew 5.9% in the second quarter. We did not leverage. That's an important element of our business. Our sales grew 5.9% but as we're cycling through some mix changes and Holden, touch on a little more detail. Our gross profit dollars grew about 3.6% and our operating expenses grew 4.1% and I'm not real good with math but I know that's not a good combination if you want to leverage your earnings. And one of the elements is, we didn't anticipate it softening quite as much as it did and that 4.1% needed to be a little bit lower.

We didn't adjust our variable costs quite quickly enough. As we've seen in prior time frames when the economy is weakening and it affects our ability to grow, the high amount of working capital on our balance sheet really can influence our ability to generate cash and given my old role as CFO, second quarter is a painful quarter for us typically because we have 2 tax payments. And when you're a profitable organization, you operate a lot of business in the United States, you pay a lot of good tax. And so second quarter hits us really hard. And normally, we -- for every dollar in earnings, we generate $0.60 to $0.70 in operating cash flow. I don't recall us ever having a second quarter where we generated more cash -- operating cash flow than earnings perhaps Holden will cite an example where we did.

But -- and maybe it was 2009. But that's a strong cash flow as we've ever seen for this time of year. And it also -- and a chunk of it is from not just what's happening in the economy and the working capital needed to fund receivables and to fund inventory for growth. In the last several years as supply chains were really getting congested, the message that I made very clear to our supply chain folks and our teams, we have a covenant with our customer and that is worded supply chain partner, we will not let our customers down in their supply chain. If that means we need an extra 15 and extra 30, an extra 45 days of inventory, don't get ahead of yourself but we need to have inventory to support the business, period. And when the ports on the West Coast of North America were getting congested, the economy is turning back on, everything was getting congested, we beefed up our inventory.

We started -- we were harvesting that. We were doing it in the first quarter. We're doing it this quarter. I think the team has done a wonderful job. It means we have capacity now to look at our balance sheet and say, where does it make sense to make strategic investments in inventory. I'm not saying there's stuff on the table right now but that discussion can be had, whereas a year ago and 2 years ago, we couldn't really even think about it because we were focusing all of our energy on something else. In the second quarter, we made some leadership changes. First off, Jeff Watts, who's led our international -- who joined Fastenal back in 1996, so he's been here for 27 years and started in our Canadian organization when we were -- when we had just a handful of locations in Ontario.

He's led our international sales efforts since 2015 and he will oversee all of our sales efforts across the planet. And obviously, we know each other really well. The team in the U.S. -- international knows them really well because he's led that team for quite a few years. But the U.S. team is no stranger to a 27-year employees. So we know each other well but I believe we'll have greater coordination on our efforts. And Jeff has a very entrepreneurial approach to how he leads a business and I welcome him and look forward to the success he's going to see. Terry Owen, who's been in EVP Operations role, we formalized this role and that he's our Chief Operating Officer. And this bullet was added kind of late in the process. I found out yesterday as a team that I should mention this since we had announced it this quarter.

And there's an error in our release. I thought I'd let you know and it's probably not material in the true aspects of life. But it is Terry has been here 28 years and I know he joined in June of 1999. And if I do the math, I think it's 24. So sorry, we didn't catch that error in our process. But in conclusion, cyclical factors aside, the last several years, we've taken a lot of steps to improve both our labor and our inventory productivity. And I believe this forms an excellent foundation for our ability to generate long-term share gains in the marketplace. Switching to the next page. Onsites, I'll state the obvious. 86 Onsite is a disappointing number. Our aspiration internally has been to drive that to 100 per quarter, 400 per year. That's been our stated aspect mentioned internally.

Prior to COVID, we hit 362 and that was a ramp-up from 80 in 2015 to 176 to 270 to 336 to 362 per year. When COVID came along, it really impaired our ability to sign Onsites because the last thing you want when you're worried about people being around you is inviting a bunch of folks of Blueshirt to come in and operate inside your four walls. And so we saw that drop dramatically. We recovered to about -- we did 356 signings last year. We broke 102 out of four quarters. Perhaps some of the leadership changes we made in the last 60 days created some distraction, perhaps we're not as focused as we should be. But that number needs to be 400 a year or more. And right now, we've adjusted our number. We think we'll probably come in similar to last year, somewhere in the 350s.

And with that said, the fact that our Onsites are up, we have 15% more Onsites than a year ago. That's a great number. We're just not building the pipeline the way we need to. FMI Technology, that's a different story. So, our goal in Onsite is 100 a quarter. Let's get there and then figure out how we take it to 110, 120 but let's get to 100 first. Same with FMI technology, it's not 100 a quarter, it's 100 a day. And I'm pleased to say in the fourth quarter -- excuse me, the second quarter, we did 106 per day. And that's market share gains. That's us going out and planting new flags in new locations to improve the supply chain for our customer, illuminate the supply chain for our customer and us being a great supply chain partner. That's a huge positive.

I believe it tells me the marketplace is conceding the space to us. Maybe I'm wrong on that but I believe it is because we are so far out ahead of the marketplace. Year-to-date, I told the Board yesterday we're with the 106 this quarter -- we had our Board meeting yesterday, with 106 this quarter, we're at 100 year-to-date. I misspoke, we're actually at 99, but I'm really pleased with what the group is doing there. And the 39.8% of our sales went through our FMI platform in the second quarter. News flash, it was 40% in June. So we hit the number -- we hit 40%. Now we need to get to 45% and 50% but continue to see really nice progress there. E-commerce continues to grow handsomely for us and grew about 45% in the quarter. For us, this has been a different journey than other things because a lot of e-commerce is unplanned spend.

If you think about our FMI Technology, that's all about planned spend. That's stuff you're using daily, weekly, every month in your business and it makes sense to stage it accordingly. E-commerce, a lot of that is stuff that you're hopping on to order. So it's unplanned. Historically, not a strong suit for us. And I'm pleased to say it's growing to be a bigger piece of our business. It's, as I mentioned, 45%. The EDI portion of it is up 37% and that's typically larger customers. The web portion of it can be large or small and that's up almost 70%. And to give you a magnitude of how that's changed and again, we're not great at this piece of the business, but we can be. But with that said, in 2015, when I stepped into this role, the web portion of it was less than 2% of sales and we were at $3.8 billion, $3.9 billion of the company back then.

So about $75 million going through web sales back in 2015. In 2023, in the second quarter, it was 6.5% of sales. So right now, we're on a 12-month run rate of about $7.5 billion. So that's a business that's approaching $500 million and we're not that good at it, but we can be. And so it's 6.5x bigger than it was a handful of years ago. And obviously, it's been accelerated by the events of the last few years, COVID is a perfect example. What really accelerated as people do -- some people are working remotely. Some people are ordering a lot more stuff electronically. We're seeing that in our numbers and we're getting better at it every day. And when you push the FMI technology and the e-commerce together and you think about our digital footprint, that was 55.3% of sales in the second quarter of '23, was 47.9% a year ago.

We thought we could get to 65% this year. We've tweaked it to 60%. I don't know if I completely agree with our language there about FASTStock conversions. I think it's really -- part of it is the case of we're doing more and more every day. But some of the activity, because a lot of the FASTStock, for example, is going into fastener installs. It's going into OEM production areas, it's going in the MRO production and we're doing more transactions every day. However, the transactions are a little bit smaller because industrial production is slowing down in our business. And so we might be doing more orders. There are just fewer of them. And I'll cite you a few statistics. In January of 2022, our FASTStock, we did 234,000 scans of orders through our tool which is 11,100 every day.

So our employees are going out with an Android device and scanning 11,100 planograms every day and generating about a $250 order. Actually, it's closer to 260. And then in January of this year, that 11,100 had grown to 14,700 and between January and June, that 14,700 scans per day is now 16,300. That's a combination of market share gains and conversion of -- instead of going out with a yellow note pad, we're going out with an Android device in scanning bins. And so that's a huge win in our system from efficiency. It's a huge win from a standpoint of ability to take market share. But looking at the numbers, our average order size was $258 in calendar 2022. And in January, that number had dropped to $246. So it was down about 4.7%. And I think there's enough transactions going on there that, that's probably more a tone of the economy than anything else because when you're doing 300,000 a month, it's not a mixed thing.

Bolts, Tools, Screws, Hardware
Bolts, Tools, Screws, Hardware

Photo by Tekton on Unsplash

Between January and June, the $246 order dropped about $222, so it's down $24 which is 9.6%. That's primarily activity that's declining in the industrial marketplace. And there might be an element between January and June of a little bit of deflation because there's some fasteners in there, but it's mostly about activity. Just thought I'd share those start to get in the weeds. And I will share one last thing before I turn it over to Holden. And that is, again, this FASTStock tool, this Android device that we have out there. In October of -- excuse me, in the summer and fall of 2019, we did a beta version out in the Southern California of that device and work through some bugs, work through some bugs and started rolling it out to regions late in the year with a planned 2-year rollout.

COVID-hit and we accelerated that rollout and we rolled it out across the company by June of 2020. So, we rolled -- we had a 2-year rollout in 6 months. And today, that's about 12% of our revenue. The -- in October of this year, we plan to roll out what we call our order pad which will be on the same device. It will be an internal-facing device and use it in beta for -- in the October time frame. If all goes well, our goal would be to roll it out in Q4. And essentially, it's a tool for our personnel when they're out visiting a customer, not only can I take a recurring order, I could easily take a customer asking for something or I can do a search on it and I can respond to the customer right in front of them. That's a capability we've never had and we plan to have -- we expect to have that by the end of this year for 2024.

A second piece, that's an internal facing app. We've also developed an external-facing app called FASTScan, it's with beta customers right now. Our goal is in August to have that out in the Apple store and the Google Play for customers. If they choose to download that and that would be a bin stock app for customers. It's primarily smaller customers or customers that might be a few hours from a facility in Montana or in Western Canada, where they can do some bin stock scans themselves, transmit the orders so when we visit, we aren't surprised by a stock out and it makes for a better supply chain for that customer base. That will be, again, coming out in August. And depending on what we -- the success we find with our order pad, our goal would be next summer to roll that out in the customer-facing app as well.

Again, we're not great at the web portion of our business. It's a $0.5 billion business within Fastenal now but we can be and we're building tools to do that because we think that's a better reaction to some of the buying habits that's going on in the marketplace. With that, I'll turn it over to Holden.

Holden Lewis: Great. Thanks, Dan. One loose thread there perhaps to pull a little bit. Last time we had cash conversion of this level. It was actually in the second quarter of 2020. For those who don't remember the second quarter of 2020, there was an event occurring at the time that we now know as the pandemic. But I really think it reinforces the point. It took a once-a-century event to create a second quarter that despite several tax payments, produced cash conversion in that 100% range. And the fact that our teams are able to do that in a quarter where thankfully, there has not been anything remotely looking like a pandemic. Again, I think really gets to the success of the teams in managing kind of the post-pandemic environment.

So yes but it does take a condition of that sort. Jumping into the details on Slide 5 of the deck. Daily sales increased 5.9% in the second quarter of 2023. Since March, we have seen overall business activity moderate which culminated in June daily sales growth of up 4.7%. The most meaningful change in trend has occurred in our manufacturing customer. This segment grew 10.4% in the period despite sustained sub-50 PMIs and flat to negative industrial production. This reflects the impact of our investment in Onsite and greater sales focus on key account plan spend which tends to be significant within manufacturing. Even so, we did experience weaker sequential in May and June that represents a macro-driven change from the long string of strong sequentials that we had from 2021 to February of this year.

As it relates to pricing, they contributed 190 to 220 basis points to growth in the period, declining approximately 470 basis points from the second quarter of 2022 and approximately 100 basis points from the first quarter of 2023. This trend is not a surprise and will likely continue in the second half of 2023. Other factors cited in recent quarters, specifically weakness among some large retailer customers, lack of growth in our rest of world geography and contraction in our construction end market remain factors in the current quarter but the dynamics around these areas were largely unchanged from prior periods. While we continue to pursue key account plan spend in construction, this market has historically had a disproportionate amount of smaller transactional spend where we are currently putting less emphasis.

We believe this shift contributes to manufacturing outgrowth, better labor leverage and better asset efficiency. We have experienced manufacturing-driven weak sequentials in 3 of the last 4 months. Regional leadership continues to characterize customer sentiment as cautious with greater scrutiny over operating and capital spending and some mention of slower or deferred orders. As usual, we have limited forward visibility but most indicators seem to be pointing to the immediate outlook remaining soft. Now to Slide 6. Operating margin in the second quarter of 2023 was 21%, down from 21.6% in the prior year. The incremental operating margin was 11%. Gross margin was 45.5%, down 100 basis points in the prior year. This decline is almost entirely due to product and customer mix as we experienced widening sales growth outperformance of non-fasteners over fasteners and of Onsite growth over non-Onsite growth.

Freight was favorable gross margin, reflecting record freight revenues that allowed for good leverage of our captive fleet, reduced use of external freight providers, lower fuel expenses and reduced shipping costs. The benefits of freight were offset by higher organizational or GAAP expenses. Reductions of purchasing and shipping activities of imported products, stemming from a smoother and more predictable supply chain relative to the year ago period caused higher prior period cost to be relieved from the balance sheet to the P&L. The impact of price cost was immaterial to gross margin in the second quarter of 2023. On the operating expense side, we produced 40 basis points of leverage which was not sufficient to fully offset the decline in gross margin.

This was due entirely to payroll expenses, of which we experienced 60 basis points of leverage which was related to lower incentive compensation of last year's record level. This was offset by modest deleveraging of both occupancy costs and other expenses. There were 3 distinct elements playing out in our operating margin in the second quarter of 2023. First, I alluded to the GAAP expenses. The GAAP expenses had the convergence of a difficult comparison, aggressive inventory reductions and shortening product order cycles. This alone is a 50 basis point negative impact and is unlikely to repeat by anywhere near the same magnitude in the second half of 2023. Second, certain expenses such as 16% growth in IT spending and 13% growth in cost for FMI devices represent planned and prudent investments in our business, the impact of which is magnified by the slower sales growth environment.

Third, the Blue Team did not adjust spending quickly enough to the slower macro environment with the variable cost for meals, travel, supplies, all increasing double digits. Also, while lower incentive compensation produced leverage in the second quarter, we continue to have growth in headcount and part-time hours that exceeds sales growth. I would expect us to tighten this spending appreciably in the third quarter of 2023. Putting everything together, we reported second quarter 2023 EPS of $0.52, up 4.6% from $0.50 in the second quarter of 2022. Turning to Slide 7. We generated $302 million in operating cash in the second quarter of 2023 or approximately 101% of net income in the period. Traditionally, normal second quarters have a conversion rate in the 60% to 70% range.

So this is a strong cash performance relating to a reduction in the use of cash for working capital versus the prior period. This allowed us to reduce debt with debt ending at 9.4% of total capital in the second quarter of 2023, down from 13.7% in the first quarter of 2022 and from 10.9% in the first quarter of 2023 -- I apologize, 13.7% in the second quarter of 2022. Year-over-year accounts receivable was up 6.1%, largely tracking sales growth with the impact of mix due to faster growth from larger customers which tend to have longer terms being offset by improved receivables quality. Inventories fell 6%. This is a function of normalized supply chains, allowing us to unwind inventory layers we had built up in late 2021 and early 2022 to manage that period's product bottlenecks.

That process will likely continue, though likely to a lesser degree, throughout 2023. It is also notable that our days on hand fell to 138.5, a level not seen since 2002 which reflects improved velocity of inventory through our internal network, a reduction of retail stock in branches and improvements in stocking processes. We have significant strategic flexibility in inventory at this point. We have retained our range for net capital spending in 2023 of $210 million to $230 million, reflecting higher spending on hub investments, fleet equipment and IT equipment. At the same time, we have deferred certain projects related to slowing demand that suggest our capital spending will be at the low end of the range. The second quarter of 2023 was obviously challenging.

We expect to have better cost comparisons and to more tightly control those costs that we can affect in the second half of 2023. Obviously, we have little control over end market demand. Whatever direction that takes over the next 6 months will influence our profitability. However, these shorter-term issues shouldn't cloud the structural improvements to our business. The second quarter saw record labor productivity they create some significant strategic flexibility in our inventory and further improvement in our return on capital, as reflected on Page 9 of the investor presentation. We believe we are positioned to strongly outgrow the market, particularly as the industrial cycle stabilizes and improves. With that, operator, we'll turn it over to begin the Q&A.

Operator: [Operator Instructions] Our first questions come from the line of David Manthey with Baird.

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