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Fastenal Company (NASDAQ:FAST)

Q4 2009 Earnings Call

January 19, 2010 10:00 am ET

Executives

Darin Pellegrino - Controller

Will Oberton - Chief Executive Officer

Dan Florness - Chief Financial Officer

Analysts

David Manthey - Robert W. Baird

Adam Uhlman - Cleveland Research

Holden Lewis - BB&T

Brent Rakers - Morgan Keegan

Hamzah Mazari - Credit Suisse

John Baliotti - FTN Equity Capital Markets

Operator

Good day and welcome to the Fastenal Company fourth quarter and fiscal year 2009 earnings results conference call. Today’s conference is being recorded. At this time I would like to turn the conference over to Darin Pellegrino. Please go ahead, sir.

Darin Pellegrino

Good morning and welcome to Fastenal Company’s 2009 fourth quarter and year end earnings conference call. This call will be hosted by Will Oberton, Chief Executive Officer and Dan Florness, our Chief Financial Officer. The call will last up to 45 minutes. The call will start with a general overview of our quarterly results and operations by Will and Dan with the remainder of the time being open for questions and answers. Today’s conference call is a proprietary Fastenal presentation and is being recorded by Fastenal.

No recording, reproduction, transmission or distribution of today’s call is permitted without Fastenal’s consent. This call is also being audio simulcast on the internet via the Fastenal’s Investor Relations home page at www.investor.fastenal.com. A replay of this webcast will be available on this website until March 1, 2010, at midnight Central Time.

As a reminder today’s conference call includes statements regarding the company’s anticipated financial and operating results as well as other forward-looking statements based on current expectations as defined by the Private Securities Litigation Reform Act of 1995. Forward-looking statements maybe often are identified with words such as we expect, we anticipate, upcoming or similar indications of future expectations. It is important to note that the company’s actual results may differ materially from those anticipated.

Information on factors that could cause actual results to differ materially from these forward-looking statements is contained in the company’s periodic filings with the Securities and Exchange Commission, and we encourage you to review those carefully. Investors are cautioned not to place undue reliance on such forward-looking statements as there’s no assurance that the matter contained in such statements will occur. Forward-looking statements are made of today’s date only and we undertake no duty to update the information provided on this call.

I would now like to turn the call over to Will Oberton. Go ahead Will.

Will Oberton

Thanks Darin. Thanks everyone for joining us today for our fourth quarter 2009 conference call. Start right out with the sales. Sales for the quarter were pretty much on plan. We had a very good November, it was a little weaker in December, but you average it out, and look at the numbers from where we thought we would be starting the quarter. We really came right on plan and we stayed on our sequential trend pattern that we really started back in July.

So we’re pretty optimistic about numbers. Looking at our January numbers month-to-date at this point it appears when we report numbers in January, we will report a positive number, not a lot of growth, but right now it appears that we will have growth and any amount would be a real positive for our team here at Fastenal.

Jumping to the margin, we are a little disappointed with the margin where it came in at 49.9. Not really surprised because we did make a decision on the rebates to pullback. We understand where we are with that and that will be coming back in the first quarter, or starting to come back in the first quarter in throughout 2010.

There’s really three pieces to margin. The first one as I mentioned the rebates understood what happened there we just made a conscious decision to reduce our purchasing, and just basically work towards 2010 and growth in 2010. We’re comfortable that will come back.

Second one that hit was in 2010 was the deflation in the steel products, primarily the Fastenal products. We have seen the steel price is pretty much flat and down in summer and they’ve actually started rising through the last four months of the year. We anticipate continue in a little bit of inflation in steel is really hard to tell it has a lot to do with what happens with the economy and the world or mainly China right now, but right now we’re anticipating some inflation in steel and inflation or pricing as a year ago, but that won’t kick in until probably the second or third quarter as the product sells through, but that’s a positive for our margin.

In the third part of our margin is the POS, what the customers or what the stores use to charge and price their customers, that bottomed out in August we have seen positive trends in the POS margin every month since August we’re very optimistic. When you look at the margin, rebates, deflation, positive in POS positive, we’re still very optimistic we’ll see improvement in each of the next three quarters.

From an expense standpoint, I think we did a really nice job. Our expenses were down 13.2%, in that somewhat of a kick in the health insurance. Our health insurance jumped and the problem with health insurance expense, it’s one of the expenses you can’t manage short term. You set a program up for your employees and we set up a good reprogram for our employees and then you basically just wait for the claims to come in or the experience rating in the claims.

In the last half of the year, we saw our claims go up, but we have also been reading that there are other companies seeing the same thing. We’re not sure if it’s people rushing to get things done before changes in health insurance we’re analyzing it as we speak and helpfully will better information, but we don’t foresee this problem going forward into the new year, so we’re very confident we can lower that a little bit as we go into the New Year, but otherwise our expenses, I think our team did a very good job managing at the point they are.

Earnings, a little disappointing, we came off one point, 1.0%, but that’s completely explain by the health insurance, that’s almost dollar for dollar there. A couple of other areas I want to touch on accounts receivable down 12.6% right where sales were. That’s one area and I said that in the last conference call, that I was worried going into the year with bankruptcies up and everything going on in the economy, but we did a nice job actually hanging on to our number, holding the days out flat to down a little bit in a difficult time and then the other one is inventory.

Our inventory is down 10% from the beginning of the year. If you take out the acquisition that we made in December, we’d actually be down almost exactly where sales were, so we did bring some inventory in with that acquisition and so they did a nice job on inventory. So overall that’s good.

So when I step back and I look at where we are as a company, starting out the New Year, starting out a new decade, how do I feel about our positioning. I feel very good about sales. We’re going to start out with a positive trend and the comps get a little easier as we go on, so I’m very comfortable that we’re going to have good sales trends, not only year-over-year, but also sequentially.

Our margin is lower than we want it to be, but we understand the pieces, and there’s a lot of positive in that. Our headcount is right inline, if you look at where our FTE came in we’re basically from a relative related to sales, we’re almost where we started the year out, so we’re positioned very well. The expense structure, the accounts receivable and the inventory are all in great shape.

So when we look at the business, I say, what do we need to work on? We need to work on margin. We need to continue to work hard on growth and we need to make sure the other things that I just mentioned stay inline. So, I think we near a very good position to move forward as a company and get back on to our strategic plan of pathway to profit, that’s why I’m looking at the year, that’s why I’m communicating to our people internally and that should be in a good position.

With that, I’m going to turn it over to Dan. Dan has more information and I kept my brief today. Thank you.

Dan Florness

Thanks, Will and thanks also to the shareholders on the call. I’m going to touch on a few items highlighted in our earnings release and then will turn over to Q-and-A after that. One item I want to tough is centered on page one discussion, about our end market, end full.

As we talked about our last call in the May timeframe, our manufacturing business appears to bottomed out and it has been improving sequentially every month since May, except for July and December, which we would expect a little bit of a drop off because of the holiday impact, but generally speaking the business has been improving mode since bottoming out in the May 2009 timeframe, manufacturing as you recall represents almost 50% of our sales.

On the construction piece, which is decide 25% of our sales that business has continued to weaken as we go through the year. Fortunately the manufacturing has been able to overshadow it through the second half of 2009. If I look at the remaining components of our end market, and I called them out individually on our press release this quarter, generally speaking those trends are all positive as we look through the second half of 2009 and I believe will remain positive as we go in to 2010.

A new piece that I added to the release this quarter, and hopefully for those of you who have had a chance to read it, it created more answers, a better understanding of our business, rather than a bunch of questions, but I’ll try to elaborate on what I’m really trying why I’m highlighting these point.

It really starts from the bottom of page one and continues on to page two, and what I laid out on page two is something that I have been looking at the entire year, as I try to understand really what was happening as we were going along through the year, because historically, when we talk internally at Fastenal, we always talk about kind of where we are in September, October timeframe, because the daily average in October, really sets us up in our mind for how the New Year is going to start, because historically, our daily average has been at or slightly positive to in January to the previous October,

So internally, we are setting our goals once we have the October numbers, because we really think we have the benchmark identified. And as you can see in the table I laid out, in 1998 to 2003 and I choose this timeframe is a benchmark, because I believe it’s a timeframe and extended period was an industrial recessionary environment and provides a good basis for comparison and in that timeframe we would see January was again slightly positive in the previous October and then we would start claiming stair way in the New Year.

What you saw in 2009 is our January number wasn’t inline with the previous October. It dropped about 18.5% and what you saw was our sales when from positive to contraction in that timeframe as well. In February, March and April timeframe the erosion continue that a pretty steep clip and we were missing that sequential pattern that we enjoyed historically.

And then was the April timeframe things really started to change in our business in that while the sequential growth wasn’t as strong as we would like, it was starting to get closure to that historical pattern and really since July we have been in position what we have been consistently beating the historical trend and are slowly claiming out of the hole that the economy put us in, if you will, during the first part of this year.

I think its important trend to understand, because it really serves to guide us as we look into the New Year and being a Midwesterner and an accountant makes me a truly conservative person and so for me to come out and say something positive into the future is a pretty rare event, but when I look at the trends, as of last October, the trends would tell me and again, I’m looking in to 2010, based on where we are in October and I’m doing it based on these trend lines that I have laid out in our press release.

If I were to just plunk it down on a spreadsheet and say, okay if we’re 9/10 of a percent ahead of October. In January 2010, I would expect us to see positive growth and it would quantify to about 0.5% of positive growth and as Will mentioned earlier, we believe in the month of January we’ll see positive growth. So again we tend to be on that pattern which we really started on last July where our sequential numbers not only make sense but are making us more positive in our outlook to our future look in our business.

If I were to extend this out and look into 2010 and again, I’m merely taking the trend line based on our history, extending in to the future, I don’t know our visibility into the future is extremely limited due to the nature of our business, but I can look at history as a guide post. It would tell me, when we get in to the March, April timeframe. We are looking at double digit sales growth and if I were to truly anniversary the numbers, because of easing comps, as we get in deeper to the year.

When I look at out to July, if we were able to follow this past trend line, our sales growth in July, would just tip over would just eclipse 20%, 20.3%. I don’t honestly know if this will happen when I look at 2010, but it does makes me optimistic and bullish when I look at the years as far as our ability to continue to grow out of the pattern to grow out of the place we have been in when I look at 2009 and I believe for the year, this would provide us the ability to see growth that gets into the teens and only time will tell if these trends prove to be a good guide post to our future, or if they just prove to be just wrong, but I believe it gives us a positive bias as we enter the New Year.

Will touched on earlier our active account growth and there is something that I think is important also to understand when we you look at our active accounts. Our active account growth was weaker in 2009 than we would like to see. Historically, we like to see our active account growth in the low double digits. So in that 11%, 12%, maybe 13% neighborhood and this year we have been in the single digits, but when I look at the data from history and I look at, what we would expect for frequency of account base.

One thing I do see that’s very distinct in our 2009 numbers is our frequency of existing customers. In other words, what percentages of our customers buy in any given month, because we have some customers that buy daily or weekly? We have some customers that buy monthly. We have some customers that might buy sporadically, maybe they are buying every second, every third month.

We measure a lot of those statistics internally and provide that information to our store personnel, but when I look at the frequency factor of our customers, I see that in 2009, our frequency is off about 7%, so that dampens our active account number by about 7%, and, really serves to diminish what I believe is our true active account growth when I look at 2009, and again, what that does, it provides one more component to what gives me confidence when I look at our 2010 top line numbers.

Will touched earlier on gross margin, and I would echo his comment was tough for us to report 49.9% gross margin, because it was a barrier we really did not want to cross. That’s the negative news. The positive news is this, when you look at the decline, it was really when we looked at where we thought our vendor allowance and rebate programs would come in earlier in the year, they did come in weaker than we expected and track a little bit from the fourth quarter, when I look at gross margin, I really think of it in three distinct components.

One is structural, what is going on in the environment, internal and external, but primarily external that influences our number. The second one would be freight side, and the third would be just our transactional activity, in other words what’s happening at the point of sale level, what is happening from an importing level, or a direct purchase level.

On the structural side, I see two things that are generally speaking have a positive by as going in to 2010 versus 2009, one would be the vendor allowance program which tend to be linked to the calendar year, so the program reset, and starting in January, I would expect the rebate we’re earning would improve relative to where it was in 2009, that won’t necessarily flow in to the P&L in the first quarter, because that better purchasing activity will be sitting in ending inventory at the end of the first quarter.

I would expect us to start seeing that improvement in the second quarter, and that’s one of the components to improvement in gross margin when I look at 2010. The second is what the point Will touched on in the last several months of the Europe, about the last four months, we have seen some inflationary trends, and having a slight inflation trend versus a marked deflation trend has a significant impact on our gross margin, because of the nature of how fact our inventory turns.

The second category I talked about on freight when I look at where we are at the start of 2010 versus 2009 and 2008 and I’ll go back two years. I believe the momentum we had in both of those previous two years we have still today and we continue to identify opportunities to improve our freight margin and so I see that is the positive by as going to New Year.

The final piece the transactional; as Will mentioned that the margin we measure at our point to sale level, that margin bottomed out August ‘09 and we have been above that number since and we believe our day to day activities, our transactional activities we’ve been improve the pattern and since that low point in August.

That the second component of our transactional is really our direct sourcing margin that we measure and that really is the fact that we’re able to source in volume and that had a negative bias to it in 2009 because of deflation, and again, I believe will have a positive bias to it in 2010 if the inflation patterns that we have seen in the last four months continue.

Finally on the next couple of points, on cash flow. As you see in our cash flow statement, our cash flow for the year looks quite strong. The big drivers of the cash flow were the changes in working capital and accounts receivable and inventory that Will alluded to earlier, as a percentage of earnings, for every dollar of earnings we threw off $1.66 of operating cash.

Last year that number was $0.93 on the dollar. Our long term number that we really laid out when we started to past way to profit, we feel we could be in a position to be at or slightly exceed $0.85 on the dollar. So, we feel very good about our performance on that in the last several years, since that profit started. When I look at free cash flow again, a very strong number, our capital expenditures came in quite a bit less than they were a year ago, as we expected.

As I mentioned in the conference call, I would expect the capital expenditures to drop again in 2010, because we are complete with our projects in Denton, Texas, and Indianapolis, Indiana and now are in a position to reap the benefit of that hard work over the last several years. What this did is provided funding for two items that we did in the current year.

As in prior years, we were able to increase our regular dividend and our buyback, we did a buyback of some stock late in the year, we bought back about $41 million worth at $37 a share, so feel good about that at this point in time, and we’ll continue to look at buybacks in the future, and we’ll see how that plays out.

Finally, just to touch on a few things on the working capital identified on page nine of the release. As Will mentioned, accounts receivable we were down 12.5% inline with our sales, actually slightly better than our sales pattern and really what we did is identify a structural improvement and that structural improvement is, we have a lot of customers, and a lot of customers that buy relatively small amount and what happens, a lot of times with billing processes, is a lot of stuff gets caught in the chatter, and invoices.

Generally speaking our customers are really fair with us on paying their bills, and what happens is the stuff that usually falls through the cracks, that stuff is inadvertent and we made some structural changes to our billing in 2010. I think there was a great job of automating a lot of process, emailing more invoices, faxing more invoices, and we just improved the structural collection patterns in our business.

Despite the fact that we had some negatives from the standpoint of some customer bankruptcies during the year, that continue to hangover a little bit from the standpoint of increasing our days out, but the other stuff more than offset it.

On the inventory, as Will mentioned, were pleased with what we were able to accomplish in the year and it’s really an effort of everybody being on the same page and working to be smart about when we’re buying and constantly rebalancing our inventory, and really thinking about the components and challenging everybody, so very pleased with the team and what they were able to accomplish in 2009.

One last item I’ll touch on and then turn it over to the Q-and-A and that is as we disclosed we did a small acquisition late in the year. We acquired a business called Holo-Krome, we are very excited about this acquisition we think it fits in really well with our business, and quite frankly with our customers needs and we look forward to that business being a contributed to us in the future and we welcome the 92 employees in West Hartford, Connecticut to the Fastenal family.

With that I’ll turn it back over to the moderator for the Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from David Manthey - Robert W. Baird.

David Manthey - Robert W. Baird

Can you give us your thoughts on pathway to profit, do you have a new target for when you believe you can achieve the 23% EBIT margin, and then as you talking about growing stores 7% to 10%, is that should we expect that number for the full year or you expecting to hit that pace in the second half of this year?

Will Oberton

I’ll hit the second question first. We expect to hit that pace in the second half of the year, assuming we stay on our trends that Dan talked about. So, we’re going to start the year conservatively building back towards the pathway plan, with our plan for the goal of being on pace sometime in the second half of the year.

As far as the pathway to profit, it gets pushed back between 18 and 24 months and what we base that on is the growth we had in 2008 we gave back in 2009, so we’re really starting over again, so right now we’re looking at 2015. Go ahead, Dan has a comment.

Dan Florness

One item I would add on to that, one of the things that’s, influencing our thought process here, Dave, is when you look at the pathway to profit, it really is about overtime increasing the average store size, and letting the inherent profitability of Fastenal business model shine through, earlier in the call, I went through what I believe the trends could mean for our business in 2010 and trust me it was awkward for me to go out on that ledge, because I don’t normally talk about that that openly.

Even when I look out to the summer and I look at, what I believe will be a good year for Fastenal and our ability to move back in to the pathway to profit mode, our sales in the summer will still be down 7% or 8%, and that’s, if those trend lines play out from where they were in 2008 and for us to get back on the pathway to profit, we need to get the top line moving.

Will Oberton

Our projection for fourth quarter would put us right at fourth quarter of 2008. Those are the two years we gave up. One thing and I didn’t mention earlier, when you look at the pathway to profit, we have learned a lot of things in this slowdown about our expense structure about what we really need and what we don’t believe, that will improve, I believe, our chances of hitting our goals to pathway to profit, because we’re just smarter about controlling expenses.

Operator

Your next question comes from Adam Uhlman - Cleveland Research.

Adam Uhlman - Cleveland Research

You highlighted your high level view of how sales could shake out in 2010, some teens level in terms of growth, how should we think about operating expenses coming back on that level of sales growth, given the business is more variable in terms of costs instead of fixed previously?

Dan Florness

If you look at it, the real component that’s going to increase and I believe will increase, similar to our sales growth would be the payroll component and the real thing that drives that is if I look at 2009 versus 2008, what changed our commissions that went to our sales personnel fell off quite dramatically, because our sales fell off quite dramatically and that drop off was leveraged beat from the fact that our gross margin fell off, so it was kind of a double whammy.

The second piece, most of our employees in the company are paid on some type of bonus compensation and it’s really linked to our ability overtime to continually grow our earnings, and grow our return and so our compensation, our incentive compensation was off dramatically from what was year ago.

In the third piece, and quite frankly a smaller piece of the three I’m talking about, in 2008 and really, 2006, 2007, 2008, nice increases to the amount of dollars that we contributed to our employee’s retirement plan, 401(k), and it’s a set formula that we do and it’s based on a level of profitability.

We did not achieve that profitability in 2009, that target profitability, therefore, the payout on that was essentially eliminated and so when you look at 2010, that component of our cost structure will act in a very variable fashion. The other components of our cost structure want the fact that our sales growth, whether it strengthens or weakens, doesn’t influence things like occupancy. What influence these things like occupancy are, how many stores we open, what types of stores we open, what we agree to for rent and how do we manage that in the future for other expenses.

Will Oberton

I think Adam the way I’m looking at it is that the sales growth for the expenses will probably grow as sales. The real earnings leverage will come from the margin improvement and that’s where the real opportunity for 2010 earnings growth comes from, improving the margin as we grow the sales.

Operator

Your next question comes from Holden Lewis - BB&T.

Holden Lewis - BB&T

Can you talk about I guess about a couple elements of the gross margin. First, you talked about rebates and things like that, and there’s various cost that kind of spread through there over the course the year and they require some true ups. Were there any significant true ups in Q4 that might have been sort of a onetime drag on the gross margin and then can you also comment, you went through the details pretty specifically about what was in there? What about the change in the compensation instructed, do you feel like maybe that is having an adverse effect on sort of gross margin trends?

Will Oberton

I’ll take the second question. I really don’t think the change in compensation has made much affect on I mean, could there be some, yes, but we have broken it down and looked at where the lost margin dollars, what customers we lost them from, and it just doesn’t play in that the compensation change has made much of a difference, because it isn’t across the board. Some stores are doing better than others and so what we’re really looking at is that there is just a lot of market pressure out there on the POS side and some of our stores gave back more than others.

Dan Florness

On the first half of your question, Holden, about, components that, true ups and anything during that quarter that really influenced bringing that number down, there weren’t any.

Holden Lewis - BB&T

Just sort of on the follow up, in the past, your gross margin has always been sort of 50% to 52% in the recent past with the exception being a year where you were getting pretty significant pricing. Can you comment just sort of about what you are thinking about the future range?

Are you kind of thinking that 50% to 52% remains what you would expect to see over the course of a cycle because that is what you have done or is your visibility on pricing so significant at this point that you would expect to be able do better than that or operationally better just a little bit of perspective and where you have been and where you see that going?

Will Oberton

I think we can do operationally better going forward. I would say it’s more of a range of 51% to 53% and we should stay to the high end of that range and a lot of that has to do with our sourcing. We just continue to find better sourcing for a lot of product and we should be able to retain most of that within the company and not have to pass it along to the customers.

The customer mix hasn’t changed a lot, the market hasn’t changed dramatically, so if we’re able to buy better, we should be able to retain that and stay, really, within the 52 plus, but in certain times it could drop below that. In 2009 was so unusual with the rebates incentives, because we just never planned and I ran that for a long time, that was my job running operations. I never planned for a down year, and we didn’t build into our programs, we kind of gambled for the high side and it worked out well and last year it hit us hard.

Dan Florness

It works out 40 years, and doesn’t look one you look at it and say, I think my asked are better than 40.

Will Oberton

I have told our people that because may we should plan, let’s not plan for our right now, lets plan for growth going forward and I’ll take it when I can get it. It’s better overall.

Operator

Your next question comes from Brent Rakers - Morgan Keegan.

Brent Rakers - Morgan Keegan

Just following up on some of the earlier question about the SG&A outlook for 2010, there’s some comments in the release about payroll being 60% to 65% of SG&A in 2009. Wondered if maybe at that kind of mid teens, top line growth rate next year, what sort of target do you think we’ve see for 2010?

Dan Florness

I think you would get a little bit leverage on it, but, it would be in just shy mid teens.

Brent Rakers - Morgan Keegan

Mid-teens increase Dan, just to clarify?

Dan Florness

Yes, it will increase, I guarantee that, yes, Sorry.

Brent Rakers - Morgan Keegan

Just again, if I’m looking at 60% to 65% of overall operating costs in 2009 and I think it was 65% in 2008, can it creep back to that 65% number it was in 2008?

Dan Florness

Yes.

Brent Rakers - Morgan Keegan

One, I guess somewhat related question, just again, revisiting the pathway to profit, you have given a good outline of what you are expecting in terms of branch opening strategy for the year, but I want to say back in 2007, 2008, you added about 1,000 additional sales people as part of pathway to profit in those years, any kind of sense what the plans for might be for sales force additions in 2010 over and above the branch openings?

Will Oberton

What we planned to do our plan today as far headcount additions at the store level, as they’ll probably be close to what our sales growth is lagging a little bit. What you have to understand is we have about a 1,000 stores now, unfortunately many that are 50,000 and below. Those stores we don’t have to add much too, because they’re properly staffed to create growth at least 10% to 20% higher than they are.

It’s the larger stores when they start growing, we’re going to have start adding staff to not only grow the business, but also support the business coming in. Most of the headcount reduction that we saw in 2009 at the store level came out of part time heads…

Brent Rakers - Morgan Keegan

FTE in general.

Will Oberton

Right, FTE in general came out of part time hours and part time heads, so we’re really pretty well staffed with the sales and full time people, it will be adding part time hours and part time people to support the revenue.

Brent Rakers - Morgan Keegan

Jut to clarify on that, the premise it goes along with the same thinking as with the branch openings, as you’re still waiting on an inflection point in the economy to push forward a lot more aggressively with the sales as well; is that correct?

Will Oberton

There’s pieces to it. We believe we’ve seen the inflection point, only the future will tell us if we’re right or if we’re full of it, but if you look at, where the staffing is, and the inflection point, part of it is we stabilized on the October call, we really talked about we were stabilizing our store headcount, and we were preparing for where we were going to be in 2010.

Because every time I open a store, I’m pulling a very valuable resource out of an existing store, as you need to balance those two, so it’s really stabilizing and growing the headcount, in connection with the store openings, but not letting one get too far ahead of the other.

Operator

Your next question comes from Hamzah Mazari - Credit Suisse.

Hamzah Mazari - Credit Suisse

Just a question, is it fair to say that your inventory levels are now where they need to be given the demand environment you’re seeing out there? How should we think about that? Could you quantify if possible, the negative gross margin impact you saw this quarter from further deterioration in your vendor rebates, which you talk about reversing as you get into sort of the third quarter?

Dan Florness

Yes, the deterioration we saw was about 15 basis points during the quarter. If you look at it in total, we’re down 70, 75 basis points from where I would have expected us to be in a normal environment. As far as the inventory level, we will add inventory in 2010, because we’re opening stores, and because we’re beefing up some of our spending patterns, and really those beefing ups started in November and December.

In fact, I wouldn’t be surprised to see some inventory growth in the first quarter. However, when I look at the inventory we need to add in 2010, I’m a firm believer that we’ve identified in excess of that amount of still surplus inventory that we can continue to rebalance out of our inventory as I look at 2010.

So I feel for the year, there’s a reasonable chance we can operate the year with very modest growth, and my goal is to hold it flat, and to me the only wild card in it is depending on how the inflation plays our and what that influence of the steel component, but if there’s a little bit of inflation and influences feel component, we’ll take that issue, as long as it’s mandible for us and our customers.

Operator

Your next question comes from Holden Lewis - BB&T.

Holden Lewis - BB&T

Can you also perhaps touch on some of the pricing versus cost? We all know what’s kind of happening to steel I would think that probably going to be flowing through in the year cost of purchasing here very soon, but when you think about the cost relationship. If you can just talk about maybe the upcoming few quarters, I mean, where does the price cost should be cost relationship become positive, negative? How should we look at both sides of the ledger there?

Will Oberton

I would say right now, the price cost relationship is about neutral, flat about middle of the year, inventory flows through. Prices have gone up and we should start seeing the inflation coming through in the March through May timeframe, depending on when the important product hits, we always lag it, because our customers most are steel or fastener customers are savy, they understand the market.

So we watch the steel indexes, if steel continues to increase, we should inflation in our fastener and steel products late first quarter and through the second quarter. The other products, the non-fastener products, we have not being seeing nearly as many vendors showing up, or suppliers with price increases this year, and I think most of it is people are just basically happy to have what they hang on to what they have. Normally, they’re not timid, but it appears that they’re a little bit timid with price increases for the first time in long time.

Holden Lewis - BB&T

So that’s the cost to you, what about when you start to institute price increases that try to offset that?

Will Oberton

On the steel, last time this happened we were very successful with most of our large customers, we have an index put into our contracts so it steel goes up, we pass it on, if steel goes down, we pass it on also in a decrease. We’ve been quite successful. I’m confident that we can pass that along in an increase in sales because of it.

Holden Lewis - BB&T

Knowing what’s coming down the pike on the raw materials side, I mean, are you planning on perhaps putting through price increases as early as sort of the March timeframe, in which case you probably get a little bit ahead of the actual inflation? I’m just trying to get a sense of how the timings in play out on how the price will fall?

Will Oberton

Well, what really place out is we have to see what the master distributors in the market do. We don’t determine that for the most part. We can work to stay ahead of it, but it really depends on what’s going on in the market. History shows that we’re able to get some timing out of inflation, and that we lose timing on the down side, I would anticipate it happens the same way this time.

We’re watching it very closely. The difference today, Holden is it’s not an abrupt change like last time steel swanked up in August or September of 2007, it just shot up. Right now it’s moving up, but it’s a little bumpier on the way up.

Operator

Your final question comes from John Baliotti - FTN Equity Capital Markets.

John Baliotti - FTN Equity Capital Markets

Just following on Holden’s question earlier about gross margins; Will, you had mentioned that with some inflation that should help, and I’m trying to go back historically to see the patterns that played out, and I think the last time gross margins were in this range, they kind of stayed in the 50%, 51% range for up until 2008, and the sourcing sounds like a good opportunity, but are you also hampered by the fact that back then, 60%, 65% of your sales were fasteners? That’s down to 50%-ish. How does that mix play out as you tried your backup into the 52% range?

Dan Florness

I’ll touch on a piece of that, and then turn it over to Will if he wants to add it to. When you look at our fasteners as a percentage of sales, you have to go quite a few years back to get in to the 60s. That number has been in the low 50s, for quite a few years. In fact, it picked up a little bit in the mid part of this decade from a couple of things. One, I think what we referred to at the time as our CSP initiative, where we put more products in our stores.

I believe that helped our fastener business, because we went from being I think, a really, really good fastener distributor to a great fastener distributor from the standpoint, we had great availability of product, a wide range of products at the local site, and we got better at it as the percentage of sales picked up a little bit. It was also a little bit of inflation that helped it a little bit, because we measure it at a dollar level, and so those two things influenced it, but you have to go back, as I mentioned, quite a few years in to the history to see our fasteners as percentage in the 60s.

Will Oberton

One the other hurdles that we have, we are doing a lot more importing in fasteners, so I think that’s a big thing that a lot of people don’t understand, I think , that we’re only importing fasteners. We’ve developed lots of other products. One thing that everybody has to understand that’s a huge motivator for our troops is, we had a tough year in 2009 from a bonus standpoint, District Managers, Store Managers, Regional Vice Presidents, and we’ve made it very clear to everybody, because I met with all of our districts, all of our regional and lot of managers.

If you want to get your payback in 2010, it’s going to require that we improve our margin, and living in the environment we live in; motivation like that really does work. We’ve been doing it for a long time, when we have about 3000 people out there say “Hey, I need to do this.” It’s not about just going out and raising prices on everybody. It’s about making a lot of transactional decisions to a little bit smarter.

I can make an extra dollar here. I can negotiate a deal with our supplier here and it all works to together where we have a large team of people trying to make an extra dollar, two or three in every transaction, with a number of transactions, that adds up very quickly. So I think probably the biggest thing is the motivated team of trained people. They had a pretty touch year in 2009 and we’ll guess we soon have a good year in 2010 on a margin standpoint.

John Baliotti - FTN Equity Capital Markets

Regarding store openings, Dan it sounds pretty optimistic about, I mean obviously you did mention cost that were help, but getting back to nice positive growth rate. Given the balance sheet, you talked about, given your size, waiting to the second half of the year to add stores at seven or 10. I think like kind of puts pressures on the number of stores per month that kind of close to 20 to 30 per month range.

Just thinking, if non-RES construction starts to get better, wouldn’t it be to your advantage to maybe add more now when those cost would be lower rentals and real estate costs would be lower now and take advantage of that, and put much less pressure on having to add so many stores in the back half of the year to get that rate?

Dan Florness

We said our run rate of 7% to 10%, the back half. We’re not saying we’re going to open 7% to 10% more stores in 2010. So we wouldn’t have to double down in the second half, that’s not our plan.

John Baliotti - FTN Equity Capital Markets

If you did that in the second half, that’s like 165 stores, divided by six months is like over 20 stores a month?

Dan Florness

Yes, we can do that. We’ve done that for years, what we’re really looking at the business and saying, “Where do we think is the best place to put our investment?” Also understand that we have a lot of stores out there that were 20% and 30% larger a year ago. Those stores have the built in customers, the capacity to grow very rapidly. We’re going to invest aggressively to grow. We really believe at this point, we want to get our average store size up a little bit before we go aggressively after new stores.

John Baliotti - FTN Equity Capital Markets

You mentioned that the fourth quarter, your non-RES construction business was down below the average for the year. Do you expect that to cover in the second half and does that affect what you expect for leasing costs?

Will Oberton

When we look at 2010, we don’t give a lot of thought. I’m just being bluntly honest, so a lot of thought to what construction we do in the second half of the year, and the biggest reason is because we don’t frankly know. What we do know is we believe we’re optimists as a group. We believe the worst is behind us, and time will tell if that is correct. We think, when we look into 2010, we have a reasonable basis for why we’re doing, what we’re doing and if construction were to comeback in the second half of the year.

Keep in mind that the store openings in a given year represent a relatively small piece of our sales in that year, and we have 2300 stores that have business that’s down. So we want to turn back on the energy of the Fastenal profit. We want to turn back on the ability for our folks to have a good 2010, a great 2011 and ‘12, and we believe these are the pieces and we believe in that scenario our shareholders will do quite well.

Operator

That does conclude today’s question-and-answer session. At that time, I’ll turn the conference back over to you gentlemen for any closing remarks.

Dan Florness

This is Dan. I just want to again thank everybody for participating on our call today. I hope you find it informative and thank you again for your support in the Fastenal organization. Have a good week.

Will Oberton

Thank you.

Operator

That does conclude today’s conference. Thank you for your participation.

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Source: Fastenal Company Q4 2009 Earnings Call Transcript
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