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This Key Strategy Is Driving Fastenal's Growth

Reuben Gregg Brewer, The Motley Fool

On the surface, industrial parts supplier Fastenal (NASDAQ: FAST) is a boring, easy-to-understand business. As the economy waxes and wanes, so, too, will the cyclical company's top and bottom lines. Although that big-picture view is true, it misses a huge opportunity that Fastenal is working on today. One that has been and will continue to support its long-term growth. Here's the secret sauce that management is using today to spice up its business.

Nothing to write home about

Fastenal makes things like nuts and bolts. It is not a sexy business, but it is one that's pretty important to its customers. Without the often tiny parts that Fastenal makes, its customers' operations would grind to a halt. So being a reliable partner that makes quality parts is an important attribute, but not one that's going to get investors excited. It's more along the lines of table stakes in a highly fragmented and competitive business.   

A woman standing in front of a vending machine

Image source: Getty Images.

At the end of the first quarter Fastenal had just under 2,200 of the branches through which it sells its products. This has long been the core of the business, supporting its relationships with customers. That number, however, was down 6% year over year. Despite the decline in its branch count, first-quarter sales were up 10% and earnings per share advanced around 11%. If you simply looked at these numbers you might walk away thinking that Fastenal is doing more with less -- but that's not the big story. 

In fact, the company has been closing branches for a number of years now. At the end of 2013, Fastenal had roughly 2,680 branch locations. So over that roughly five-year span the company's store count has fallen around 18%. That's a huge decline. And yet sales have continued higher just the same, with trailing 12-month revenues and earnings per share higher by around 45% and 75%, respectively, over the past five years.

FAST Revenue (TTM) Chart

FAST Revenue (TTM) data by YCharts

Fastenal is good at what it does, but not good enough that it can shut 18% of its stores and still continue to expand like that. So what's going on? Fastenal has figured out a way to get even closer to its companies.

On-site

The main focus of a company like Fastenal is to become an indispensable supplier. Or, at the very least, really hard to get rid of. Historically it's done that by being reliable and providing high-quality parts. Now, however, Fastenal's growth is being driven by actually getting inside the companies with which it works.

With an on-site location, Fastenal basically operates a customer's parts inventory for it. At the end of the first quarter it had 945 on-site locations, up nearly 40% year over year. It has two primary methods here, managing an open inventory system at a customer location and some 83,400 vending machines that it maintains inside customer facilities. For reference, the vending machines contain parts, not candy and soda.   

Put the 40% year-over-year increase in on-site locations against the 6% decline in branches and it's pretty clear what's driving Fastenal's growth today. But don't stop there; the bigger picture here is more important. While Fastenal has, indeed, found a great way to continue expanding its business, it is doing so in a way that makes it even more vital to its customers' operations.

It's fairly easy to switch to a new supplier if the parts a customer gets come in a big box that the customer then deals with internally. The only thing that has to change is the box holding the parts. It's much more difficult to shift to a new supplier if your existing supplier is handling your internal parts processes. That includes keeping track of what parts are in need of replacement and ensuring that the parts go to the places where they are needed. Once a company outsources those two tasks it would need to either rebuild the processes and controls to exit a relationship with Fastenal or find some other company with the same capabilities as Fastenal. Neither would be an easy task.

On-site locations, then, are the real underlying story behind Fastenal's still-solid growth outlook. Yes, the company's sales and earnings will wax and wane with economic activity, but its business is getting even more sticky (for lack of a better term) as it further integrates itself into its customers' businesses. When you read about earnings, this is the story to keep an eye on.

FAST Chart

FAST data by YCharts

A wish-list stock

Fastenal is a very well-run company, a fact proven out by two decades of annual dividend increases (the annualized dividend increase over the past decade was roughly 20%, an impressive figure). And it has been getting even better by getting inside its customers' operations. But Fastenal stock is rarely cheap.

Today its price-to-earnings and price-to-cash-flow ratios are a little below their five-year averages, while price to sales and price to book value are a little above. The dividend yield at 2.4% doesn't really stand out (3% appears to be a more attractive entry point, historically speaking). For investors looking to add a good company at a reasonable price, Fastenal is worth a deep dive. But for most, this is one to put on your wish list for the next economic downturn. If you can hold out until Wall Street is frightened by a temporary economic malaise, you'll likely be able to buy Fastenal at a discount, knowing that its customers will have a hard time switching to a new supplier.   

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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.