Since listing on August 20th 1987, Fastenal (NASDAQ:FAST) has been one of the true success stories of the US stock market. In capital terms alone, it has delivered in excess of 50,000% equating to a CAGR of more than 27% (share price of $50.69 as at February 10th 2013). This has been achieved by operating a simple business model in as lean a manner as possible. This then generates a high cash flow return on invested capital, which is used to reinvest back into the business in a methodical and sustainable way.
Where are we?
Fastenal started out in 1967 as a supplier of threaded fasteners to the construction and manufacturing sectors, but has since expanded its product range to include a large range of products related to construction and manufacturing. These are spread across at least 20 different categories including abrasives, paint, military spec hardware and janitorial equipment. It has a mature business in the US with almost 2,400 stores, as well as significant operations in Canada (195) and Mexico (36) and nascent businesses in Brazil, Panama, the UK, the Netherlands, China, Taiwan and Singapore amongst others, which ought to provide avenues for further growth.
How did we get here?
There have been four identifiable engines for growth since listing.
1. The company generates an ex-growth free cash flow return on capital employed of between 20% and 30%, but typically in the mid-20s, where ex-growth free cash flow is defined as working capital adjusted cash flow from operations minus maintenance capex add back tax adjusted finance costs. This is achieved through a mixture of brand value and a super-lean business model. Eschewing the use of debt, a significant portion of this free cash flow is reinvested into the business. Historically, this took the form of building new sites in locations that are serviceable by the existing distribution network, are not in competition with other Fastenal sites and for which there is a sufficiently large population working in construction and manufacturing. Up to the mid-90s, the expansion of capital was at around 25% per annum, suggesting that virtually all of the free cash was being reinvested into the business in the pursuit of increased space. Throughout the period from 1985 to 1995, the number of stores grew 12-fold from 35 to 412. From 1996 to 2007, openings continued at a rapid pace at between 13% and 18%, but as a listed company, the demands for shareholder returns via dividends reduced the cash available for expansion. Additionally, in the mid-90s, the company introduced a great deal of new product ranges so that the period between 1993 and 1997 saw the introduction of around half of all products sold today. This meant that there was, for a time, a source of relatively cheap growth whilst the new ranges were added to the existing store network. In 2007, the company enacted a new growth strategy; 'pathway to profit'. From now on the number of stores will increase by between 3% and 8% per annum (average 4.8% since the onset of the 'pathway to profit' program).
2. The second source of growth is through the expansion of capacity in the existing stores, though not physically, rather an increase in the range available per store and the number of account executives per store. The first major push in this strategy began in the mid-90s when the range of goods supplied increased from just fasteners to a larger array of products. The effects of this can be seen by the high rate of in-store growth during the mid-90s (see chart below). The second push began in 2007 with the 'pathway to profit' plan. This entails growing sales per store per annum from around $950k to $1,500k over the five year period to the end of 2012. Simultaneously, the aim was to increase the pre-tax margin from 18% to 23%. In 2009, during the Great Recession, these targets were pushed out by 24 to 30 months. However, the advantage of the recession was that it forced the company to become leaner. Consequently, management now believes that it will achieve sales per store per annum of between $1,200k and $1,320k by the year ending 2013. But at that level, because of the leaner operation, the pre-tax profit margin is still expected to have risen to 23%. The margin improvement, if achieved, will generate 7% PBT growth in 2013 (23% from 21.5% currently) whilst sales growth will add another 2% to 11%.
3. The third source of growth comes about through inflation and store maturity. This can be a double-edged sword because it can be difficult to pass on cost increases. The key to passing on these increases comes about through brand value and inflation being fairly stable and not too high. It might be tempting to assume that, as with typical retail-type operations, Fastenal's stores take around 3 years to mature. However, typically the older the store, the greater the sales. Stores that are 2 years old typically generate around $600k of sales per annum, by 8 years old it is $930k of sales per annum, and by 16 years it has increased to as much as $1,920. This should provide a further source of unquantifiable growth.
4. Finally, vending machines, which were introduced in 2009 and are growing at a fast pace from a small base, are providing a fourth avenue for growth. These machines provide a small targeted range of goods to clients in satellite locations and are believed by management to provide a significant source of future growth. The question is will this cannibalize any of the existing business? Probably not given the limited range of products, but a risk worth monitoring. Presently, vending machines are adding approximately 3% to revenue, but this could increase if the rate of expansion remains high whilst the vending business grows into a larger portion of the overall business.
Where are we going?
Taken together, the growth rate should be around 5% for investment in new stores, around 7% as the company reaches its margin target of 23% by the end of 2013, between 2% and 11% as it reaches its per store sales targets, a small amount through inflation and maturity (which we will assume is a nominal 3% for no other reason than it seems a fairly conservative, yet realistic, number) and 3% for vending machines. This implies growth of between 23% and 32% next year.
However, at least a portion of this is not sustainable growth, specifically the 9.1% to 18.8% related to margin improvements and increases in sales density. Removing this from the equation, the long-term sustainable growth rate ought to be around 13.5% per annum. This compares to the long-term CAGR of earnings of 17.7% that has been achieved since 1995. But interestingly, the average growth in capital employed over the same period was 13.4%, which with a free cash flow return on capital employed of c. 25%, seems perfectly achievable in the future. Therefore, we ought to feel justified in projecting forwards the long-term CAGR of 17.7% in EPS and free cash flow, in order to determine its likely path up until 2020. Below is a chart showing the EPS since 1993 with a trend earnings chart overlaid, which smooths out the growth to assume that it is constant throughout the period. This is then projected forwards to 2020. This implies EPS of around $5.68 by 2020, which assumes that the management team can continue to generate a comparable growth rate in the future. Certainly, our analysis shows that it ought to be possible if not probable.
How much does it cost?
At >30x earnings, Fastenal superficially seems rather expensive. But this has been the case since listing and that fact has not stopped the owners of the equity generating extremely high returns. Below is a chart showing the PE rating of the company since 1993 where the year end price is compared to the EPS 12 months hence. This assumes that the market looks ahead by 12 months typically. Additionally, the dotted line shows PE ratio using the same share price but trend EPS instead of reported EPS. It is fairly clear that the company has de-rated somewhat. This is justified since the current growth rate is lower than the early-90s. The chart shows that by the current PE (February 10th 2013) the shares are highly rated as compared to both the linear line and the rating the company has sat on for most of its listed existence.
In addition to the EPS data, below is similar data but for free cash flow against enterprise value. The first one is similar to the PE chart above and shows the effective discount rate on which the company has traded, based on the year end enterprise value and the ex-growth free cash flow to the firm. This shows that at the current share price, the implied discount rate is approximately 3.8%. The second one shows the FCFF and EV plotted against each other since 1993. Both of these charts show the general de-rating that the company has seen, whilst the first one in particular shows that, as with the PE chart, the company seems a little expensive at present.
Should I buy it today?
Fastenal is a quality business run by a capable and experienced management team; however, with the shares up 25% since November, a quality business can run the risk of being a lousy investment. For current holders, they should continue to do so since temporarily high prices can seem like bargains with the mere passing of time as the fundamentals catch up with the market. For those with time horizons that extend beyond the end of 2014, the shares ought to be a decent investment, as by merely hitting the trend earnings over the next few years the PE will fall to around 22x and the discount rate rise to almost 5%, which history has shown us to be good value for Fastenal. 2014 is also the point in time when the company's valuation breaches the linear projection of the de-rating. For short-term investors however, the valuation looks high and whilst we cannot predict how the shares will perform, the margin of safety is insufficient on time horizons of less than 3 years. Personally, I would hope for a pull-back in the market and try to pick the shares up at closer to $42.
Fastenal is the kind of stock we all wish we had bought back when it had its IPO. But does that mean you'd want to own it now? The fundamentals continue to stack for a business that ought to be able to grow at the mid-teens percentage per annum. The management team is talented and experienced and the balance sheet is exemplary. The cash flow return on capital employed is very good and, with such a large number of immature markets in which to expand, the company ought to have ample room for expansion. It's very unlikely that it will return 50,000% over the next 25 years, but for the patient, long-term investor, Fastenal remains a very compelling investment case.
The source for all data is 10-Ks found on the Fastenal website and my own model built in excel.
Additional disclosure: I work as an equity analyst but do not cover Fastenal in my job. The views are my own and not of my employer.