Will Manufacturing Lead The Economy - And Fastenal - Again?

Jan.17.13 | About: Fastenal Company (FAST)

When the economy slows, particularly the manufacturing sector, there isn't much Fastenal (NASDAQ:FAST) can do about it. By the same token, when "disappointing" results mean that growth drops into the high single digits, you're still talking about a very strong company. The issue with Fastenal has never been about the strength of its growth, but rather the price investors pay for that growth. Nothing has really changed in that respect - while other MRO distributors like MSC Industrial (NYSE:MSM) and DXP Enterprises (NASDAQ:DXPE) may have claims to GARP ("growth at a reasonable price") status, Fastenal pretty much looks like a GAAP ("growth at ANY price") type of stock today.

Good Enough Will Do

Although Fastenal's December average daily sales growth was perhaps a little disappointing (many analysts expected a return to double-digits), overall performance for the fiscal fourth quarter was fine at least insofar as the income statement is concerned.

Revenue rose more than 8% this quarter, coming in in-line with a relatively tight range of expectations. Importantly, while fastener growth was less than 3% this quarter, the company's diversification efforts paid off as non-fastener products grew almost 14%. Metalworking was particularly strong (up 26%), and the company also posted strong 26% growth in its government business.

Gross margins were okay - up 40 basis points from last year, but flat for the third quarter in a row. Operating income rose 12% and the company continues to deliver strong operating margin leverage.

Vending - Pay Now To Prosper Later

While most large MRO companies (MSC Industrial, DXP, Grainger (NYSE:GWW)) have embraced the vending machine concept, I'd argue that Fastenal has pushed it like no other company. The company signed contracts for another 5,600 machines this quarter and installed almost 4,100 - bringing the total to just under 21,100.

These placements continue to pay off - more than a quarter of the company's sales went to customers with vending machines, and sales to these customers grew considerably faster than the non-vending customers.

This growth comes at a cost, though, and that's both good and bad news. The bad news is that it takes a real toll on near-term working capital; free cash flow improved 75% from last year, but missed sell-side estimates by about 20%. The good news is that small competitors simply cannot withstand this sort of capital investment. While these large companies are taking a hit to margins and working capital to install these vending machines, they're making it even harder for the small players to stay in the game, and I suspect that will translate into better growth and margins down the road.

Apparently, Fastenal Doesn't Need An OEM Recovery Quite So Badly

One of the problems for MSC Industrial in the past quarter was the tremendous uncertainty in the market, as management talked about sales crawling to a near-halt in December. That wasn't Fastenal's experience - sales growth improved sequentially throughout the quarter.

So, what's going on? I suspect at least some of it is due to the fact that MSC is significantly more leveraged to small OEM manufacturers, whereas that's about 30% of Fastenal's business. It could also be the case, though, that Fastenal is simply doing a better job of expanding its business into new areas (as witnessed by that 26% growth in metalworking, MSC's traditional stronghold).

It's a good reminder, though, that there's more to the MRO market than just "Fastenal is growth, Grainger is defensive, MSC is cyclical." While the December quarter did nothing to dismiss the idea that MSC is more cyclical than Fastenal, I think the difference in market exposures is important - Fastenal had less OEM exposure to hurt it (and more growth from new markets), while others like DXP can take advantage of focused businesses/markets like pumps/energy.

The Bottom Line

While I've long had issues with Fastenal's valuation, that didn't prevent it from outperforming MSC over the past year, nor matching Grainger (DXP outperformed them all, and by a wide margin). Along similar lines, I don't see any reason to assume that Fastenal is past the days of good growth.

Assuming that the underlying MRO market grows at 4% per year into the future (it's a cyclical market, so it won't be a straight line), Fastenal could grow at a CAGR of nearly 11% over the next decade and still have only about 4% share of the market. I also believe that the company will get past this point where vending installations compress free cash flow production, and that free cash flow margins will ultimately reach into the mid-teens (meaning a free cash flow CAGR of around 17%). Factor that all into a DCF model and a fair value of about $32 results - well below today's price on the shares.

Like I said, this is a stock where investors are willing to pay up significantly for growth. I'm not willing to join them, and would rather stick with holdings in MSC Industrial. Investors should certainly shop around, as there are many industrial sector stocks with attractive valuations, but Fastenal may still hold appeal for the growth/momentum crowd, particularly if manufacturing leads the U.S. economy higher again and improves fastener demand in 2013 and beyond.

Disclosure: I am long MSM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.