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Some Thoughts on Fastenal

Fastenal (NASDAQ:FAST) is a leader in the distribution of industrial and construction supplies, primarily operating in the United States (roughly 90% of its revenues and income). The company's legacy business was in fasteners (screws, nuts, bolts, etc), which now accounts for roughly one-third of its revenues. These products were inexpensive, ranging from a few pennies to a few dollars per unit. Part of the value-add Fastenal brought to the table was it enabled customers to access product when it was needed quickly or unexpectedly; if a business can't operate without a critical part, availability may trump price. In addition, the cost and time to manage product procurement across suppliers can be meaningful. For these reasons, Fastenal added a lot of value in the eyes of customers.


Beginning in the 1990s, Fastenal expanded beyond fasteners into product lines like safety equipment, which account for the remaining two-thirds of the business. As shown below, growth in non-fasteners has been meaningful over the past 10-plus years (with a notable example being safety, where revenues have increased from $150 million to $850 million over the past decade).

Historically, the company met its customers' needs with local branches. As noted in the 2016 annual report, it was a straightforward operation: "The strategy was pretty basic: place products and people close to the customer and empower everyone in the organization to make decisions, take risks, and share the success of their company." However, as shown below, the growth in the branch network started to slow (beginning with the "Pathway-To-Profit" strategy in the mid-2000s) - and has since declined somewhat precipitously over the past five years.

The decline in the number of branches reflects a strategic shift for Fastenal. It has built out its onsite and vending offerings, both of which get them even closer to the customer (revenues for each of those offerings increased more than 20% in 2018). As noted in the 2005 shareholder letter, "The key is to stay focused on the best model to serve our customers and grow." As shown below, the shift to onsite and vending has been significant.

The numbers suggest this shift has been effective (and as Fastenal notes, this is an "effective means of providing differentiated and 'sticky' service that is very difficult for competitors to replicate"). Vending will contribute roughly $1.1 billion in revenues this year, compared to less than $500 million five years ago. Onsite should also account for more than $1 billion in sales for Fastenal in 2019. In other words, two verticals that were basically immaterial to Fastenal a decade ago now account for more than 40% of its annual revenues. Fortunately, there's a lot of room for these verticals to grow.

"We believe the market could support approximately 1.7 million industrial vending machines. We have also identified 15,000 customer locations with potential to implement the onsite model," CEO Dan Florness said at the 2018 Investor Day event. "We think we're so early with the onsite initiative and even vending that we have a lot of runway ahead."

However, the shift to vending and onsite, as well as the mixed shift to national accounts and non-fastener product lines, has been a gross margin headwind for Fastenal: over the past five years, gross margins have contracted by roughly 350 basis points. The headwind on gross margins has been offset by an increasingly efficient cost structure - a trend that has been at play at Fastenal for decades - with the net result being relatively stable operating margins. (Note that the operating expenses associated with an onsite offering are 40% - 50% lower than the comparable spending for a branch, with the average onsite location generating $1.4 million in sales. There's reason to believe that, at maturity, onsite could be an operating margin tailwind for Fastenal.)

Conclusion

As shown below, Fastenal has delivered mid-to-high single-digit revenue growth over the past five to 10 years, with a comparable increase in operating income. Net income and diluted earnings per share have grown 11% per annum, with the lift above the increase in operating income attributable to a lower effective tax rate. (Note that Fastenal has delivered these results while returning roughly 60% of net income to shareholders in the form of dividends.)

Personally, I'm comfortable assuming a comparable level of revenue and earnings growth over the long run (hopefully that operating margin assumption proves conservative). Given those assumptions, I believe that Fastenal can earn more than $2 per share in the next five years. While I'm not too intrigued with the prospect of buying the stock at current levels, that would change if it fell by 20% or so. For now, I'll wait and see if Mr. Market is willing to accommodate my wishes (hopefully he'll do so if we see sustained weakness in the industrial marketplace).

I'll close with something CEO Dan Florness said at the most recent Investor Day event:

"And I believe, every day, that the moat around our business continues to widen."

If you agree with that statement, as I do, Fastenal is a name worth keeping on the radar.

Disclosure: None

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This article first appeared on GuruFocus.