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Fastenal Company (NASDAQ:FAST)

Q3 2010 Earnings Call

October 12, 2010 10:00 am ET

Executives

Ellen Trester - Internal Audit Manager

Will Oberton - President and CEO

Dan Florness - EVP and CFO

Analysts

David Manthey - Robert W. Baird

Jeff Germanotta - William Blair

Sam Darkatsh - Raymond James

Brent Rakers - Morgan Keegan

Dan Garofalo - Piper Jaffray

Holden Lewis - BB&T

Adam Uhlman - Cleveland Research

Steven Gregory [ph] – Mandalay Research [ph]

Operator

Good day ladies and gentlemen and welcome to the Fastenal quarterly earnings call. At this time, all participants are in a listen-only mode. Later, we will conduct the question-and-answer session and instructions will follow at that time. (Operator Instructions). As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference Ellen Trester.

Ellen Trester

Welcome to the Fastenal company 2010 third quarter and earnings conference call. This call will be hosted by Will Oberton, our Chief Executive Officer, and Dan Florness, our Chief Financial Officer. The call will last for 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 being audio simulcast on the internet via the Fastenal Investor Relations home page, investor.fastenal.com. A replay of the webcast will be available on the website until December 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 may often be 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 material from those anticipated. Information on factors that could cause actual results to differ material from these forward-looking statements are contained in the company's periodic filings with the Securities and Exchange Commission, and we encourage you to review those carefully.

The investors are cautioned not to place undue reliance on such forward-looking statements as there is no assurance that the matter contained in such statements will occur. Forward-looking statements are made as 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, Mr. Oberton.

Will Oberton

Thank you, Ellen. I would also like to thank everyone for joining us this morning. I am very proud of the results that we produced in the third quarter of 2010. Overall, I think we did a very good job. We continue to see strength in our top line revenue in all areas of our business. Geographically in the United States, we really don't see any weak spots at this time, we only have stores in small areas that maybe be not be doing as well. But overall we are seeing strength in all parts of the country which is very encouraging.

It's been a long time since we've seen that. Even back in 2008 when we were doing well, there were certain areas that were very slow. We had a particularly strong September and when you look at September year-over-year the number was good at 23.5%. But the good numbers from September show a sequential growth, because September is really the most difficult comp that we had from last year, because we had a very good September, August-September last year and we improved upon that in 2010. So we are very happy with those results.

Both our Canadian and Mexican businesses are growing above the company average and they are both becoming larger and actually meaningful part of our growth number at this point. The other international businesses mainly Asia and Europe are both doing very well and are also growing above the company average. So outside of the United States our business is very strong, and the profitability of those businesses continues to improve as we become better at running the businesses and have greater sales revenue.

At this time, the real strength in our business is being driven by our manufacturing customers. And if you broke down the manufacturing customers, it's mainly the large ones. We are doing well with all sections and sizes and types of manufacturing businesses. But the large customers are driving our business; we're seeing the best growth out of that group of customers. But because of this we're also seeing pressure on our margin.

Traditionally the large manufacturing customers are also our lowest margin customers. So although our margin did go backwards in the second quarter we're pretty comfortable with where we are, and we're still very comfortable with that 52% margin range that we stated over the last year or two. We're going to have to work hard for it, but we also believe that over time our smaller customers and our construction business will pick back up, and the mix will change more positively for our growth going forward.

The entire Fastenal team did a really nice job in expense control, not only in the third quarter but throughout the entire year. The only area of expenses that really outgrew or was disproportionate to our sales growth was the commission and bonuses which is, as we say, a very good problem.

But even that will normalize in 2011 because in 2009, the commission and bonuses were at basically all time low levels as a percentage of revenue. 2010 is almost at all time high levels. So in 2011, that will normalize, and they should be able to show very good growth over those numbers from an earnings standpoint. We continued to add new stores in the third quarter. We added 45 new stores. We plan to end the year at somewhere between 125 and 130 new stores for the year which would give us about 35 to 40 stores for the rest of the year and we're comfortable that we can get that done mainly in the next two months, in the beginning of December.

From a headcount standpoint, we continue to add people in our stores. We're not really aggressive with that. We do continue to add people in our stores mainly to support our existing and growing business but also some additional sales people. On the support side we've been really pretty tight. We've added if you do a comparison we're looking back at the numbers, if you look back to the start of our pathway to profit which was in the first quarter of 2007, we actually, if you take out the 90 people we added to the Holo-Krome acquisition, we have fewer people in support today than we did in the first quarter of 2007 and I don't think we are squeezing it too hard. I think we are just working really hard at becoming more efficient with how we run our business and finding things that we maybe didn't have to do or we can't do in the future.

But overall the business seems to be running well. We are seeing very low turnover with our support help side. I don't think we are driving them out the door by driving them too hard. So we are very comfortable with where we are on the support help and we believe we can continue to see that trend going forward. We will have to add some additional people but the trend is becoming more efficient, should stay with us for a long time. Just changing to a more of an overview or some thoughts on the business, I had a Fastenal Board meeting yesterday and I was talking to our board members and the one thing that I pointed out at the end of the meeting that I think is helping us to do as well as we are and it's really the strength of our team.

If you look at everywhere from starting with the store managers, district managers, warehouse managers, RVPs and all the way to the top, our turnover has continued to go down and especially at the district regional and hub manager levels, really the core people running our business and we continue to get stronger in those positions and I believe that trend and the work that the people are doing there should bode well for the company and the shareholders for a long time going forward there.

I really pounded that point yesterday with the Board and I want to make that point with our shareholders because it really is important because all the numbers don't mean anything if you don't have the team on the field that really wants to win and it wants to work here and that part of our business I think we are doing very well.

With that I am going to turn it over to Dan. Dan will give you a lot more color and granularity to the numbers. Thank you.

Dan Florness

Thank you Will and good morning everybody. And again thank you for participating in our call today. As you saw, our sales trends continued to improve. If I look at the information that we break out on page 2 of our earnings release, we talk about the sequential patterns. In the first quarter, if you look at what our sequential patterns are doing relative to our benchmark period, we were beating those numbers on a sequential basis on average about 1%. So our sequential change, the delta was about 1% above. In the second quarter that moderated slightly down to about four-tenths of a percent. We are still beating it but it moderated slightly.

And in the third quarter, to be honest with you I was surprised by this, we continued to see, we saw that turnaround and we were beating that sequential pattern by about 1.4% and as Will mentioned a lot of that could be attributed to strength in our large account business which is growing quite well right now, our largest account business, our key comp business is growing closer to low 30% neighborhood versus the overall business and giving us a nice surge in top line and gross profit dollars. And while that business as Will mentioned might carry a lower gross margin, the operating margin in that business is very attractive because overtime there is no volume going there that you can manage in your operating expenses quiet effectively and garner a very attractive operating margin on the business.

In addition to the sequential patterns if you look at the chart here on page three, you can see that we now for the year every month except for February, I mean February was really hurt a little bit because of weather. Every other month of the year has been at or above our trend line so we feel some comfort and sustainability of these trends. Therefore I touch on a little later, we allowed our inventory dollar to grow a little bit to support that business. I will touch on that in a few minutes.

From an end market perspective and we added a couple of new graphs to our earnings release manufacturing business continue the positive trends and we continue to see some up-ticks in our non-res construction business that we started to see in June-July timeframe.

If I look at where our daily average was in January and I fast forward that to September, our manufacturing business year-to-date is up 17% fairly average, our construction business is actually up 24.4% from what was in January to September. Now most of that is normal seasonality, obviously especially in the Northern State, January is not exactly the best month to be doing outside construction work, September is a much better month but that is a stronger number than we've seen in recent years.

When I look a the active account growth, active accounts up 2.8% in the month of September, that's the weaker number we'd like to see, whenever you do get to look at it. If you look at our business and look under the hood of our business, we actually have more non-residential customers than we do manufacturing customers.

We have a lot of small non-residential customers that do nominal amounts with us. The non-res construction segment, the active account sales is actually down year-over-year. There is a lot of 2%, 3%, 4%, 5%, 10% firms that have kind of disappearance that would work over the last 18 months and probably 18 months and that's really hurting that number. And but overall, our manufacturing business is active account growth is in the mid-single digits.

As Will mentioned on the pathway to profit, our store headcount has been stabilized since last fall, we are starting to grow that number and I think we continue to do a nice job of managing the remaining piece of our headcounts, both the distribution and manufacturing group as well as the administrative support.

Our gross profit margin as we've touched on did slip a bit from Q2 to Q3, dropped about 35 basis points and again when you look again under the hood, really driven by the end market mix change where we slipped our transactional margins a bit about 25 basis points and our organizational profit is second for that slipped about 10 but its really driven by the end market change largely on customers, fewer non-res construction customers, smaller customers in the mix.

Operating and administrative expenses overall managed it well, the growth there is all centered on incentive compensation, store, commission, profitability balances throughout the organization, profit sharing contributions throughout the organization and if I look at that year-over-year, that number is up. Those three things combined are up over 100% for where they were a year ago. Sequentially though, they're up about 6.5%, which is much more in line with the 7.6% sequential growth in pre-tax.

From a working capital standpoint, we continue to manage our working capital, I believe well. Accounts receivable grew normally more than sales and that's really attributed to the fact that again, similar to our gross margin discussion large accounts, large customers drove a lot of our sales growth. And they often times have the ability to negotiate terms that maybe are slightly better than our overall average business.

Inventory, while we did, our goal was to hold it flat. We did allow it to grow, to support the added business because what we provide to our customers, we are their source of supply. They essentially outsource procurement of all these products to us, we will not betray their trust, we will stand ready to support their needs throughout their business cycle and therefore we allow the inventory to grow somewhat.

From a cash flow standpoint, when we started the pathway to profit, our stated goal consisted of really three numbers; an operating cash flow that would run somewhere between 80% and 90% of our net earnings. We would expand this somewhere in the neighborhood of 25% of that number, over time we felt on capital expenditures which I believe 55% to 65% of our net earnings available in the form of free cash.

Year-to-date, we generated 83.1% of earnings in operating cash flow. We spent about 20% of that in CapEx, infrastructure to support future growth, free cash flow which in our definition is operating cash flow less CapEx came in at 63.4%.

With that, I will turn it over to the narrator for Q&A and I will take your calls, thank you.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question comes from David Manthey from Robert W. Baird.

David Manthey - Robert W. Baird

I was wondering could you tell us on the large manufacturing customers growing faster on a same customer basis, or do you think you are gaining disproportionate market share there?

Dan Florness

Well first off, I do know when we look at not just 2010, but we look at 2009 and even quite frankly 2008, when I sit down with Reyne, Nick and Steve who head up our three business units, the one comment they have for me throughout 2009, and again in 2010 is the rate at which we were signing up our large account business is faster in that timeframe than it has been in '05 and '06.

And sometimes what happens is when companies are busy, sometimes they are less inclined to make changes to things because you're too busy to do it because changing a supplier or making changes to your business requires a tremendous amount of energy, and sometimes you just don't have that energy left over at the end of the day to make those changes. And so we saw, so I do know in 2008, 2009 and 2010, we have been gaining market share.

With that said when I look at it on a customer by customer basis, that business was mauled a year ago. That business was off dramatically. It wasn't uncommon to see a customer down 35%, 40%, 45%. And so a good chunk of this is sheer dollar per customer gain on a year-over-year basis, but we are taking market share.

David Manthey - Robert W. Baird

Okay, and then second, could you maybe discuss the pricing environment. I believe you are getting some positive movement earlier in the year and now it sounds as zero. Based on what you are buying today, what is your outlook over the next say three to six months for the pricing environment on fasteners?

Will Oberton

Based on what we are seeing today we don't see much change going over the next two to three or say the next two quarters. Steel had been going up. It went back down and it's kind of leveled out at the level it's been for quite some time. So right now there's almost nothing going on with pricing. We have had some of our suppliers coming in looking to push some pricing for the beginning of next year. Right now we are fighting that up, some will probably stick, most of it will get pushed back.

David Manthey - Robert W. Baird

The demand is still not great?

Will Oberton

Right

Operator

Our next question comes from the line of Jeff Germanotta from William Blair.

Jeff Germanotta - William Blair

Again, what you are gleaning from your larger manufacturing and construction customers regarding the 2011 outlook?

Will Oberton

Jeff, do me a favor, the first part of your question didn't come through, could you restate it please?

Jeff Germanotta - William Blair

Regarding your larger accounts, can you share any insights into what you are hearing from them regarding their 2011 outlook for manufacturing and non-residential construction?

Will Oberton

I can't comment on the non-residential construction Jeff because I haven't been out with many of large construction customers, but I have visited with several large manufacturing customers and pretty much I can't think of any that we are not positive for 2011, at least the first half of 2011 and many of them are basing it on their order backlogs that they continue to see a certain amount of strength that it's not like on fire, but they are seeing strength in the backlogs. They are looking at adding people and they are actually looking for a very good 2011. And that has been a broad group of customers, I spoke with over the last probably eight weeks. So we are feeling very good about that from what we are hearing from those customers.

Jeff Germanotta - William Blair

And as you look to next year and assuming we are in a moderate economic growth environment, do you think that incremental operating profit margins which have been running upper 30s, 40% can still be sustained above the 30% level in 2011?

Will Oberton

Yes we do. The one thing I will add there Jeff, the reason we believe we can is because we are not going to have that unusual growth and the bonuses and commissions.

Jeff Germanotta - William Blair

All the variable expenses should pretty much be back at this point. So we are going to have a flat or more level year-over-year comparison.

Will Oberton

Yes and an easier comparison to understand and model.

Operator

Our next question comes from the line of Sam Darkatsh with Raymond James

Sam Darkatsh - Raymond James

Can you give us an early read as to your store opening plans for 2011? Do you still anticipate this 14 to 15 stores per month level or would that accelerate a little bit based on what you are seeing now from a comp standpoint?

Will Oberton

Right now if our sales continued strong, if we see the trends that we are seeing today, with nice sequential pattern at or above the line we would envision going back to a more normalized rate about 7% to 9% or 6% to 10% range of new store openings in 2011. And we are feeling pretty good about that sticking way after September and what we are seeing today. So I guess I have to do a little math in my head, but it would something like a 150 to 170 stores.

Sam Darkatsh - Raymond James

So I guess, would there be a mile post in terms of the comparisons get more difficult I suppose by yearend or November, December or so. It is that when the decision for the store opening plans for next year get made or what should we look at from that standpoint?

Dan Florness

Sam, I don't think it's so much about the year-over-year growth numbers. I think it's more about what's the sequential pattern. When you look at the dramatic fluctuations you've had over the last 18, 24 months. Sometime it's the only sanity you can get or clarity you can get to your business as looking at the sequential patterns because again when your comparisons are changing so wildly that become less meaningful.

So it is really about us, when we look out to historically September, October is our high watermark of the year as far as daily sales average. From October to January you pick up maybe 90 basis points in additional daily sales and then you start that stairway for the next year of where do we get to by September-October. You know providing we continue to see things we are seeing today which are positive to that historical trend line, that's what really builds confidence in your business and which is where we are today.

And the only wildcard that comes into play in my mind is when you look at things that are going on, for example lot of the investments we are making internationally that we touched on earlier, doesn't necessarily translate into always so many stores because we are going into new markets and sometimes the footprints of that market give you to manifest differently. But generally speaking we were fairly optimistic to look up 2011. And we are Midwestern conservative almost on the verge of being boring.

Will Oberton

And maybe beyond the verge but one other thing I will clarify is our accounts don't really get a lot more difficult Sam, because on a sequential basis we started seeing our improvement in August of 2009 and we have very good sequential trends like I said September, August to September last year was very strong. So, the counsel won't get any more difficult as long as we keep hitting our monthly numbers.

Sam Darkatsh - Raymond James

The second question I have, the share repurchase activity, you have the authorization is that a matter of a price sensitive, is it a matter of you pay the dividend twice a year so you're here free cash flow will be better next quarter than this. What are your thoughts Dan in terms of incremental repurchase from here?

Dan Florness

We have been pretty quite on it, we have bought some late in 2009 and the thing is trouble with on it is, and we had this issue even late in 2008, we decided to make a supplemental dividend payment because we looked at it at that time and we said, is our evaluation low from in a struggle standpoint? Absolutely, but you could say that about virtually every company that was out there.

And everybody looked at it at the time and we continue take this way and look at it and say that the cash that is sitting on our balance sheet belongs to shareholder that hold 150 million shares of Fastenal stock and try to understand what's the best way to utilize that cash for them. In 2008 we saw it as additional dividend, we increased our dividend meaningfully in each of the last two years. However, we in 2010 have chosen not to be in the market because we still waiver between what is the best value, what is the best return for our shareholders.

And we are also consciously paying attention to what's going on in the marketplace as far as tax rates on different types of activities and where that might go in the future, and not to get too far ahead of myself, but long way of saying we don't have a definitive plan on where do we step in and buy, where do we not. But we continue to make the problem worse for ourselves by throwing off one heck of a lot of cash for their business. That's a big problem.

But for a company our size to have a couple of hundred million dollars in cash is not an unusually high number. We're pretty comfortable with that going forward.

Operator

Our next question comes from the line of Brent Rakers from Morgan Keegan.

Brent Rakers - Morgan Keegan

Just wanted to follow-up with I think an earlier question on the compensation, the pay roll growth numbers, was hoping you could maybe give us a little bit, you've talked about how much the bonus comp and some of the incentive comp was up year-over-year, but maybe if you could maybe dissect a little bit more. Your FTE numbers companywide has been up about 700 year-to-date. I was hoping you'd give us a sense for how much contribution the employee additions, the new employee additions were actually contributing to that number?

Dan Florness

About 6%-7%.

Will Oberton

It will actually be a little lower. In fact they did come in below the company average.

Dan Florness

Our non-incentive compensation is up greater than that number, but the delta between that 6 percent point or whatever in the actual number is really because as we've gotten busier our hours work per employee have gone up as well. So that's driven a piece of the increase, probably 40% of the increase.

Brent Rakers - Morgan Keegan

And then well it's somewhat related to that you're doing a good job holding down the support employee numbers, but I think in this quarter sequentially the support employee growth actually I think exceeded the store based employee growth, and just wondered if you can give us a better sense for direction, where do you think those two classes will go in the future?

Will Oberton

The support employee growth will go down. A lot of what drove it in the third quarter was hours in the warehouses.

Dan Florness

And we added a few support people into a few subsets of business. In the manufacturing we added some sales reps and we added some people in the regional business units to support some of our larger comp business. And then we added some additional government personnel.

Will Oberton

And so at some level support versus sales is really not correct because all of our outside sales people that are working in national accounts in those areas fall into the support side. So a lot of the support side is actually sales.

But anyway going forward, we believe that most of our growth will be coming on the store side of the group of people, and the support side with the exception of adding some sales specialists will be very flat.

Brent Rakers - Morgan Keegan

Last question, on the occupancy costs in the quarter, a bigger jump than we have been seeing recently. We had a record summer heat wave I think nationally, just wondered how much if utility costs were a significant component of that?

Dan Florness

Utility cost was a very meaningful piece of that sequential increase. And a couple of things in there, one obviously the cooling costs were quite a bit higher than they were a year ago. Another piece that falls into our occupancy that is new is our new Holo-Krome business. And their business is ramping up nicely and there's some additional cost there on the heat treatment cost.

Will Oberton

It's a big energy consumer, heat treating of steel fasteners.

Operator

Our next question comes from Dan Garofalo with Piper Jaffray

Dan Garofalo - Piper Jaffray

Hi guys, its Dan for Tom Hayes today. Just wondering if anything other than the mix that you brought up in your comments, perhaps something from a promotional standpoint contributed to kind of a sequential easing in gross margins that we saw.

Will Oberton

No, I think it was pretty much driven by customer mix. We do have a big promotion or we have big promotions twice a year, once in March and once in August-September. I suppose that has a little effect but it's pretty minimal. It would be hard to measure that but the way we slice it up, we sold more product, the large metal manufacturers and they traditionally carry a lower gross margins.

Dan Garofalo - Piper Jaffray

So, you had mentioned in your prepared comments, with the non-res segment likely coming back slow, but you mentioned the 24.4% January to September delta was above kind of the historic norm. How has that matched up with your expectations? And heading into 2011, would you say that trajectory seems sustainable?

Dan Florness

Well, I guess from our standpoint, it matches up reasonably well with what we expected earlier in the year, maybe at 24%, to be honest with you. If you had asked in January, I'd looked at a 22-ish number, because so much of that is about seasonality. What it demonstrates for me, and we really started seeing that 20 guidance about the May timeframe, April timeframe, is that last August, we believe was the bottom month for the non-res construction business in our business as far as from a trend standpoint. And that's really what caused August of 2009 to be our bottom month as far as overall business because that last piece stopped killing us.

You don't feel real comfortable in getting too excited about it when you're looking at trend numbers in October, November, and December because it's seasonally such a weak period for construction. You don't know if you're reading it wrong. When you get into April and May and you see the trends continuing to be positive, what you know is normal seasonality has kicked in and yes, indeed that business is not getting worse, it's getting slightly better. But it's not like it's on fire. It’s hasn't gotten worse, it's gotten slightly better.

Will Oberton

The areas of non-res construction that we will need to see improvement in or continue to do well would be power generation, all the energy areas because we're just not going to see a lot of the non-res construction in building shopping centers and residential areas that we did five and six, seven years ago. They are putting up Home Depots and Targets by the hundreds today. That was a great part of our business. But it has to come in energy infrastructure and highway and bridge has to do well.

Dan Garofalo - Piper Jaffray

So it sounds like you're maybe cautiously optimistic for the seasonal ramp-up in 2011 at this point, right?

Will Oberton

Yes.

Dan Garofalo - Piper Jaffray

Okay. And just one last quick one. What's the mix look like in the new store openings? Are a lot of those non-res manufacturing or can you give us any color on the mix of the new openings?

Dan Florness

You mean who the end markets are?

Dan Garofalo - Piper Jaffray

Yes.

Dan Florness

There really won't be an appreciable difference. If there is any difference, it'd be because of what geography it's in. It's in this state or that state. They might have a bias because that state has a bias. But short of that, a new store we opened should mirror a store that's two hours away or an hour away.

Will Oberton

I think if you check the growth, if you checked our 90 stores we've opened this year, blended their business, they would look very similar to the company numbers statistically.

Operator

Our next question comes from the line of Holden Lewis with BB&T.

Holden Lewis - BB&T

You sort of alluded I think to the fact that your cost structure right now is in the process or has largely normalized, and so I guess being aware that you're still close to historical peak margins at this point, I guess I'm sort of curious when you look forward without necessarily getting into the exact date, what pieces of the margin pie do you think that there is good progress to be made on? Because obviously vendor rebates are kind of flattening out and the price cost piece looks like its flattening out. I don't know how much more you have in terms of the transportation this year, there were I think some more occupancy but when you think about all your margins pieces, what pieces do you think that you have meaningful margin opportunity in the next 12 months or the next 24 months to continue to drive the margin tired [ph], and keep those incremental margins above 30?

Will Oberton

You mean the operating margins higher or the gross margins?

Holden Lewis - BB&T

Well, I mean pieces that might affect you know one or both.

Will Oberton

Well on the gross margin, which will drive to the bottom, I think importing and private label we still have a lot of opportunity there. That got slowed down a little bit because we weren't growing our business a year ago. So it's hard to introduce new products when you don't have the growth.

Dan Florness

And we're in an inventory contraction mode.

Will Oberton

Yes, So we have a nice opportunity there. Other things, one is support labor. Support labor makes up something like 7%, 7.5% of sales. If we grow our business by say 20% next year, not saying we will, but if we were to and that only grows by 5% to 10%, there is a nice incremental improvement. Occupancy is another one if we were to grow our business well above our 6% to 10% store opening rate, another very big improvement because occupancy is our second largest expense behind labor.

Dan Florness

Out of that, a piece of occupancy, when we started the pathway to profit, when we talked about the 500 basis point increase improvement in our operating margin, it was largely an operating expense discussion. About 60% of that was going to come from labor efficiencies over time because we didn't need to add as much support infrastructure to support that sales growth, so about 300 basis points of labor efficiency and about 200 basis points of occupancy efficiency

And that efficiency and occupancy was all about growing our average store size because the occupancy expense on a per store basis doesn't change when you go from 50 to 100,000 appreciably. And when I look at the third quarter number as an example, of that 200 basis points of operating margin expansion that we are getting from occupancy alone, 160 is still on the table. But what needs to happen to get that is our average store size needs to continue to grow and run away from if you will that occupancy, that fixed occupancy expense.

Will Oberton

One thing I'll point out talking about pathway to profit that I was very happy with when I started, if you look at the report where we show the profitability by store size, the group that shows 60 to 100,000 in monthly revenue was at 22.7% pre-tax which is only 30 basis points off our pathway to profit goal, but these stores are about only 60% the size. So we've really done a nice job that our release tells me is that we don't need to get to the $125,000 because of all the things we are doing. And so the goal of pathway to profit 23% is not as far away as we once thought it was.

So those are very encouraging numbers and we still have a lot of opportunity. One other thing that I was going to touch on is, we also have opportunity in distribution for next year because we don't plan to open any large distribution centers.

In the last couple of years, we have invested very heavily in Indianapolis and some of our other distribution centers, Dallas. To mention the other one. That's pretty much behind us. So we are going to start leveraging that fixed cost as we go forward with higher revenue base.

Holden Lewis - BB&T

So it's really not a lot of internal initiatives that you are working on. It's mostly just limiting the cost creep as the revenues go up a bit; you're kind of farming those?

Will Oberton

No, I think we're continuing to work on the same things, transportation, support. I mean there's only so many pieces to our business, so we can't go out and create new things to save. But just looking at the business we believe that we have a lot of headroom on all of the things we mentioned to improve those areas of the business as a percentage of revenue.

You know we have no new initiatives like we did when we started our transportation initiative.

Operator

Our next question comes from the line of Adam Uhlman with Cleveland Research.

Adam Uhlman - Cleveland Research

Just a couple of quick clarifications, first of all for the fourth quarter store opening, is it correct to say you are looking at the lower end of the second half target of 80 to 95 stores. Did I hear you correctly, or you are looking at 35 to 40, is that right?

Dan Florness

Yes, it was 80 to 95, and about mid point of that range.

Adam Uhlman - Cleveland Research

Dan, you mentioned that non-res active accounts are a greater percent of the customer base than the revenue from those customers. Could you flush that out with some data behind it? Is it actually like half of the actives, or what would that look like?

Dan Florness

It is not quite half the actives. I mean if you look at all of our customers we have a lot of active customers in the respective groups, but if I looked at it relative to our manufacturing group of customers it's about 20% bigger. Sometimes the data gets a little dizzying because there are different pieces that we identify in different ways.

Sufficed as to say non-res construction is our largest customer group by number of customers, but clearly not our largest revenue group. Because if you think about our business model and what we bring to the table you know a lot of those subcontractors that are working on these jobs, we are a great supplier to them because we provide them the ability to be unbelievably flexible in their day-to-day business plans.

Adam Uhlman - Cleveland Research

And then the last question, the new stores that are under two years old seem to be generating a bit more revenue per location than they did in the past, and I am wondering if the new stores that are being opened up are larger format, or if you are just having better success with location planning? Could you just talk through that dynamic a little bit?

Dan Florness

Well I guess when I look at it, over, really I think that's been something that's been, the comment you made has been true for a number of years now. And I attribute the good part of that to our CSP initiative we did earlier in the decade. When we open a store, we are putting in a better offering of inventory. We are going into a better location, but this isn't something we're doing over the last two years, this is something that's really been going on for four or five years. We just have a better business and we spread out. Will?

Will Oberton

And I think at some level when you open fewer stores you pick the best locations, the best managers, everything affecting the top quartile in this because that's all you have to do in the top half. So we should expect a little better results when we open fewer stores. Especially from a personnel standpoint, we have more qualified people because we pick the best ones ever lined up.

Operator

Our next question comes from Steven Gregory [ph] at Mandalay Research [ph].

Steven Gregory – Mandalay Research

A couple of questions, Will. A couple of months ago in the Wall Street Journal they talked about how in 2011 e-commerce is going to be the driving initiative for outcome this year for that. Hitting on the leverage even at the bottom line or the top line. What are you guys doing in terms of, can you provide some color as to what some of your e-commerce visions are going forward and how do you plan to take the company there?

Will Oberton

From an e-commerce standpoint, we've pushed very hard internally to grow. We see e-commerce a little different than others because we have the brick and mortar out there. So our plan for ecommerce and it seems to be working well although its small, it's small is to get our customers in a local market to place orders off the web, using it as an order, our search method and an order placing mechanism through our local place of business. If they want to buy just like people from Amazon and have it shipped in, we're happy to do that. But most customers would rather have the product delivered locally if they can.

So what we need to do as an organization, we need to go out to our existing customers and all the customers in the area, introduce them to fastenal.com which is a very good website, has a very good search engine. Show them what we're capable of doing and change their habits from picking up the telephone and calling us to turning around their keyboard and placing an order with us electronically.

The benefit to us, one is, they see a lot broader product offering; two is, we can download their customized pricing to them so we don't have to look it up every time they call and three is, if the order comes in electronically, it does save us time and energy in processing the order because it's already in the system. They entered it instead of one of our people entering it. So we recognize the benefits of it. We have a very strong initiative internally. Nevertheless, well, basically throughout 2010 we've seen a tremendous increase in the activity. But we have a long ways to go. The first one to admit; that's one area where Fastenal is probably not the leader in industrial distribution. We plan to catch up and pass people as time goes on and we're going to do it fast.

Steven Gregory – Mandalay Research

What is your percentage of revenue that you're actually getting from the Fastenal site? Now where would you like that to be?

Will Oberton

We don't actually put those numbers out, but the number is low.

Steven Gregory – Mandalay Research

And so you like, it's obviously, it really got transacting more people have tried to improve that revenue stream?

Dan Florness

Matt, could you repeat it? We're really having a difficult time understanding your questions.

Will Oberton

We can't hear you.

Steven Gregory – Mandalay Research

You're looking to guide more people to the site. That definitely improve revenue stream that's probably your top initiative this year?

Will Oberton

Our top initiative is introducing the site to our customers and driving revenue so that we have more customers familiar with it. We'll never be more than 50% because it doesn't really work well for our bin-stock business, our vending business and our line stock business. And so it's really about the MRO unplanned spend part of our business. I mean it should realistically, it could grow to 20% or 30% of our revenue someday but that's far into the future.

Steven Gregory – Mandalay Research

I saw you guys are doing a lot on the social media in terms of like Facebook and Twitter. What are you guys doing in terms of mobile? Is that something you've already done or looking to where customers can download an app and then go directly to your store and order from their iPhone?

Will Oberton

I know they're working. I'm probably the wrong guy to be talking about it. But I'd be happy to put you in touch with the person who runs that for us. I can barely run my own cell phone. It's not that bad.

Steven Gregory – Mandalay Research

Final question. Going forward for 2011, what would you like to say to everyone on the call, to share, what is your top goal to really take the company in the next level and how would you like to get there?

Will Oberton

What is our top goal to take the company to the next level?

Steven Gregory – Mandalay Research

Yes.

Will Oberton

Continue to drive the pathway to profit and basically the revenue and the pathway to profit. So we're working very, very hard at making our business more efficient. I'm a very strong believer in the company that wins in the long run is the one that has the most efficient machine for delivering product to the customers simple, efficient. And so we're going to continue to work on pathway to profit and just improve our model from a manufacturer somewhere in the world to a customer somewhere else, and the one who can do in a most efficient way is the one who is going to give the greatest return to their employees and their shareholders.

Dan Florness

With that, we are at 9.47 Central Time. So we've hit the limit of our call. Again, thank you for your interest in Fastenal and your support of Fastenal. I would hope this call was informative as well as the earnings release we put out early this morning.

Typical at the end of a call it's not uncommon for me to get a couple of calls from our analyst community; I would ask that you hold those calls off for about an hour this morning. A few minutes before the call I got word that my 90 year old uncle passed away, I'm going to give my cousin a call and share some memories with him.

I was blessed from the standpoint of having an uncle that he lived 90 years, was a pilot in World War II in North Africa, and I have a ton of respect for him. And I want to make sure my cousin knows that. Thank you.

Operator

Ladies and gentlemen thank you for your participation in today's conference. This concludes the program, you may all disconnect, everyone have a great day.

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