Fastenal's (FAST) CEO Will Oberton on Q2 2014 Results - Earnings Call Transcript

| About: Fastenal Company (FAST)

Fastenal Company (NASDAQ:FAST)

Q2 2014 Results Earnings Conference Call

July 11, 2014 10:00 AM ET

Executives

Ellen Trester - Investor Relations

Will Oberton - Chief Executive Officer

Dan Florness - Chief Financial Officer

Lee Hein - President

Analysts

Holden Lewis - BB&T

Adam Uhlman - Cleveland Research

Robert Barry - Susquehanna

Ryan Merkel - William Blair

Eli Lustgarten - Longbow Securities

David Manthey - Robert W. Baird

Operator

Good day, ladies and gentlemen. And welcome to the Fastenal Company Second Quarter 2014 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session, and instructions will follow at that time. (Operator Instructions)

As a reminder, this call is being recorded. I would now like to introduce your host for today’s conference, Ellen Trester, of Investor Relations. Please go ahead, ma’am.

Ellen Trester

Welcome to the Fastenal Company 2014 second quarter earnings conference call. This call will be hosted by Will Oberton, our Chief Executive Officer; and Dan Florness, our Chief Financial Officer. Also present for today’s call is Lee Hein, our President.

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' homepage, investor.fastenal.com. A replay of the webcast will be available on the website until September 1, 2014, 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 also 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 materially from those anticipated.

Information on factors that could cause results to differ materially 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.

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, and thank you for everybody who is joining us on the call today. Looking at the second quarter 2014, I would rate it as a good quarter, not a great quarter, but a good quarter. The most positive numbers being in the sales area, we had 12.1% sales growth for the quarter.

Some of the highlights as I see it, our older stores grew right at 10% and even stronger in last two months of the quarter. So, when our store historically, when our older stores are growing in the double-digit Fastenal does very well.

Our sequential pattern from January to June, which we follow the sequential pattern very closely was up 14.8% from January to June. Our fastener sequential growth was up 15.1% from January to June and our construction business was up more than 20%. To see those number -- to see number similar to that you would have to go back, all the way back to 2010, where we had similar results and you can see how it came out after that.

So, from a sales standpoint, we’re feeling very good about what we've done. We believe a lot has to do with us adding the people back at the end of or during 2013 and continuing to be committed to drive more sales [cost].

On the EPS side, we were somewhat disappointed, we thought we would do a better job or produce higher earnings per share and it's really a margin story. I think, Dan, did a nice job in the earnings release stating our margin and some of the pressures we’re having with larger accounts and things like that, and that we are not going to push the margins so hard internally that we make start -- put our people in a position to make bad business decisions.

A couple of things in the margin though that that were disappointing other than the net result, freight slipped just a little bit, which we have to work on that, that's really about pounding the drum and making sure that we make that work, and some of our measurements on pricing habits slipped slightly. So we are looking at that very hard, we are working very hard on the margin and I believe we will continue to do well there.

On the expense side, team did a nice job. We grew our SG&A by 10%. That was with 15% more FTEs. So we added the people, we got the sales results, we produced the sales results and we still maintained our expense level at a very well. So, we are happy about that.

Vending -- and also on the sales side, our vending performance remained strong. We had good signings. Our sales growth was good, it’s still about 20% and we saw improvement in the margin.

We have a tremendous upside on the margin with the vending. It will take time to do it, but with things we are doing with THUB and buying better packaging. There are a lot of initiatives going on with vending and so we are very excited about the vending opportunity and believe it's a big part of our future along with fasteners and many other things.

So to summarize, I am going to keep my comments short today. To summarize, as I see it, we have very good sales momentum. Our fastener sales are recovering. Our vending remains strong. We have -- we did -- done a very nice job on our expense control and we need to continue to work hard on our margin.

So as looking at our business, that's what you can expect from the future is continue to work hard in the sales, work on the margin, manage our expense and hopefully be a very good company for you to own.

With that, I am going to turn it over to, Dan, who will give you more color on all of the numbers. Thank you.

Dan Florness

Thanks, Will, and good morning, everybody, and also thank you for joining us on our call today. I’ll just add a few noteworthy points on the patterns, primarily looking at the sequential patterns.

As Will touched on, since January our business is up about 15%, daily average and he touched on some of the components and he touched on the fasteners growing with the company. He touched on construction growing faster than the company.

Now, my guess is for the analytical folks listening to this, you look at them and saying, yeah, but you are comparing to a January that wasn’t that impressive, because the weather really dampened it. If you take four points, three or four points out of each of the numbers that Will cited, its still a number that nobody is coming close to and we haven’t come close to since 2010, 2011 timeframe. So we have great momentum going into the second half of the year.

And I think the real impressive part of that is, we talked a year ago about we’re investing in people at the store, we’re investing in selling energy at the store, that’s going to provide us the energy to ramp up our growth and that’s what you are seeing in the year-over-year numbers, but more importantly, that’s what you are seeing in the sequential patterns and I think that’s really strong statement going in.

There are some sacrifices that come along the way and right now one of those sacrifices is a weaker gross margin than we would prefer. With that an industry leading gross margin and when you start peeling back it's really about what’s happening in the business more so than what's happening our habits. Although, our habits like anything else in life we can tweak and make a moment better and we should have been in the range, now there is no question about that.

We’re less concern today about the noise in the range and more concern about whatever our patterns with sales growth. The -- but the sacrifice that comes with the hangover we have in gross margin, a hangover that I think everybody is aware of, that hangover changes dramatically as we transition now from Q2 to Q3.

Because what will the dynamics of our gross margin a year ago. And so, because of the short-term sacrifice we didn’t hit, we get frustrated internally when our incremental margin does not have a two -- at least a two in front of it.

We are in the mid teens. I believe looking into the second half of the year, we have incremental margin that we’ll be proud of. And it pushes us well as we approach 2015 and beyond.

Will touched on THUB. Our THUB facility is ramping up. You know, like any new business that’s taken us some time to work through the pains. Quite a few of the regions have now turned on. I was looking at our picking activity as it relates to our THUB facility and our vending replenishments and our picking activity from May to June went up 2.5 times.

So 2.5 times is the ramp-up. And we still have ton of opportunity. And what comes as that improves is it creates great efficiency at the store level. It helps us on working capital but it creates greater efficiency at the store level because we’re picking that product of replenishment for those machines as high frequency product.

We’re picking that in a more efficient manner. It also allows us to drive towards product consolidation of what’s in THUB. Efficiency is the win at the store. The gravy on top of that is as we drive consolidation, we improve the gross margin of our vending business because we’re consolidating the brand of skews that are going through the machines.

Finally, touching on our cash flow, we -- I missed one point, sorry. We did announce also in our release that we’re closing some stores in the second half of the year. And we’ve closed a number of stores over the last several years. And like -- and as we’ve said in the past, we’re always challenging ourselves of looking at our business today, based on how we go to market today and say what is the best thing for this local market. Because the key to our success long term is being the best distribution company we’re located.

If that’s Eau Claire, Wisconsin, we’re the best distribution business in Eau Claire, Wisconsin for serving the customers needs there and serving the growing opportunity of the marketplace. So we announced in the latter half of the year, we’re going to close about 45 stores. And the way we approach that internally is we reached out to our regional leaders with 20 plus regional leaders gathered around North America.

And we said to them, hey folks, if you could do a do over, if you could look at your business right now and identify where you want to open stores because there is still lot of stores for us to open. Where you want to open stores, where you would prefer to consolidate some businesses into fewer locations in this market because it makes more sense for our business today. It makes more sense because of our vending, because of our distribution capabilities, because of all the tools we have in place. What would you do and they identified 45 stores.

So during the second quarter, we accrued up some cost for the future leases related to those facilities and we’re moving on to our future. But I think that’s a good healthy thing for our organization to do.

Touching on the cash flow which I was getting to a second ago, I’m still proud of all the things we’re doing. As a growth company, we produce operating cash as a percentage of earnings, that’s in the 90s, was 92% in the first six months of this year, it was 93% in the first six months of the last year. That’s impressive number when you look at what our growth is doing today versus a year ago at this time because that takes cash to fund that growth.

We continue to invest heavily in both the vending side as well as our distribution infrastructure. And if you look at the numbers, we have published in our annual report looking at CapEx for the year and you will apply that to our patterns of business. Historically, our investing activities are just shy of 30% of earnings. Last year, we were in the mid-40s so we invested a lot of cash into the infrastructure of the business.

This year we anticipate being in the mid 30s. That number is working back down to a more normal number. And we think that infrastructure investments that we've made positions us well for the years to come.

With that, I will turn it over to Q&A.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) And our first question comes from Holden Lewis from BB&T. Your line is now open. Please go ahead.

Holden Lewis - BB&T

Great. Thank you very much. Good morning guys.

Will Oberton

Hey Holden.

Holden Lewis - BB&T

I just sort of want to get a sense of, on one hand, you’re kind of talking about working hard on sort of the margin, but I think in the sort of in the transcript you talked about how you definitely have a sort of a focus now on perhaps more growth than margin? So I’m trying to reconcile in terms of trying to get a sense of when we could start to see margins getting better? How do you reconcile those two comments that caring about margin but on the other hand really caring about growth perhaps more so than margin at this time?

Will Oberton

Well, we care about both of them equally, but what we have discovered as if we push margin too hard that we make bad business decisions and we’re walking away from very -- what might be very profitable business.

So we have to do is from a margin standpoint, work more on the mechanical side of it of what the pricing should be versus just standing up and saying, hey, we need to be at 52% or we need to be at 53%, talk about good decisions, talk about what the opportunities are, talk about how we buy product and so it’s more of a mechanical discussion piece by piece than it is about getting every penny for on every sale.

So it’s about creating better habits at the store level and building it into the culture and as we get there whether that gets us to 51.5 or 52.5, whatever that is, we still want to be able to grow our business at 18, 15 to 20 plus percent as we do that. We’ve done a lot of sole searching on the margin and we found as if we push it too hard it throws breaks on sales. I don’t know if that helps yet, it’s a fine line.

Holden Lewis - BB&T

Yeah. Okay. And then just on the follow-up, fewest number of heads I think that you added this quarter since the Q1 of ’13. Are we sort of seeing one of this plateaus or floors in the headcount adds, do you feel like you sort of over added, you want to grow into it or is it sort of a temporary random noise? How should we think about your strategy about heads going forward?

Will Oberton

Well, our headcount growth goal is to stay at 15% right now on the brand side of it. But last year we are very flat in the second quarter, so we didn’t have to add a lot. You look at that we ended up right at the number of 15% growth rate, we actually…

Dan Florness

Yeah. We’re north of 16…

Will Oberton

Yeah.

Dan Florness

… stores.

Will Oberton

I’d say, overall, so at the store we’re above our number. But we’ll continue to add through the third quarter the adds won’t be real great because we didn’t have again a lot last year, as fourth quarter comes that number will start to ramp up. So if you just pull out last years number and add 15%, 16% to that, that’s pretty close to where we are going to be.

But that, again, we’ve been working very hard with our regionals, we had a mall in this week, talking about folks, get your numbers, we’re not going to give you exact headcounts, run your businesses like CEOs. And we have 20 of them doing that. There’s a little fluctuation in the numbers, some of we will had and some of we will not, but overall our goal is to add about 15% to our stores.

Dan Florness

Only thing I will add to that is, back in both our January and April call we did a talk about that that we wanted to end the year in that 15% neighborhood and we were slowing down. We weren’t pushing as hard on the adds, because we’re also very conscious of the fact that we want to manage our operating expenses through all this. We want to invest for growth, manage our operating expenses and I think that’s what you saw in the quarter.

Holden Lewis - BB&T

Okay. Thank you, guys.

Operator

Thank you. And our next question comes from Sam Darkatsh from Raymond James. Your line is now open. Please go ahead.

Unidentified Analyst

Good morning. This is Josh filling in for Sam. Thanks for taking my questions.

Will Oberton

Hi, Josh.

Unidentified Analyst

In light of the store closings coming in the second half, could you give us an update on the potential number of stores you think you could have in the U.S. or North America, like what the potential store count could be years down the road?

Will Oberton

Our published number has always been around 3,500. As far as what we’ve talked about internally and externally, and we don’t frankly know that number is right or wrong. What we do know is the market opportunity, depending on whose set of numbers I’m going to look at is maybe its $160 billion, maybe its $140 billion, maybe its $110 billion. At $3.5 billion, we have a tremendous opportunity to go out to take market share for years into the future.

I’m 50 years old. I’m confident. When I’m long gone from being around here, this organization will be growing. Maybe at that point in time a good chunk of that growth is coming from outside of North America, who knows, depends on how successful we are in the next 10, 15 years.

But that -- but it’s really about what’s the opportunity? I don’t know how many stores we will have. I don’t know how many vending machines we will have. I don’t know how many bin stock programs we will have. I know that we will be doing business with more customers in more locations, doing more dollars and I look forward to seeing how that evolves. But our stated number right now is 3,500 and we -- it’s a little bit of a napkin calculation, but we think it’s a reasonable way to look at the future.

Dan Florness

We are also spending time trying to understand the changing customer habits with internet, with -- more terrific, with where people want to travel, and that’s going to determine a lot of where that number eventually falls, what the customers expect out of us as a distributor or supplier.

Unidentified Analyst

Thanks for the color. And then specifically on the pick up in fastener growth, could you discuss in a little bit more detail, what was driving that and specially what the -- whether pricing was positive or negative?

Will Oberton

Pricing is pretty neutral, if anything, it’s challenging because, one thing you had to keep perspective, if you look at the economic improvements we have had, which have been meager over last five years. But if you look at that them, they are heavily skewed to larger companies than they are to smaller companies, at least that’s my perception when I read in the paper, what I see in the media, what I see in connections I have with friends in my hometown of, their own businesses, that employing where from five to 25 employees or 50 employees, of where the recovery, albeit, meager has been achieved.

The other thing as we raised our fastener business, we have talked a bit about 20% of our business today is heavy equipment manufacturing and that pummeled us in 2013. In 2012, we were seeing very attractive growth in that business. As we went through 2013 that we growth weakened.

We bottomed out in the third quarter with low single digits growth, we had a month there, but we actually went slightly negative and the only growth that we were seeing in the months around it, were the facts we were adding market share, but our core business was down.

That business has been improving as we have entered into 2014. We saw mid, kind of mid single-digit growth in that business in the first quarter. That improved a few percentage points in the second quarter. We were at about 8% to growth in that business and from a sequential pattern that’s given legs to our fastener business as well.

Unidentified Analyst

Thank you. I will get back in queue.

Operator

Our next question comes from Adam Uhlman from Cleveland Research. Your line is now open. Please go ahead.

Adam Uhlman - Cleveland Research

Hi, guys. Good morning.

Will Oberton

Good morning, Adam.

Dan Florness

Hey, Adam.

Adam Uhlman - Cleveland Research

Just to clarify, Dan, you mentioned earlier that the second half of the year, you are looking for an improvement in the incremental margins, you think you can still hit that mid to high 20% range that we were talking about a couple months ago?

Dan Florness

Well, if I look out the fourth quarter, I am very comfortable with that, because that the hangover has gone in gross margin. The wildcard for third quarter is topline and gross margin. I -- come end of the quarter, I personally will be disappointed and this is a dangerous place me to go, but since you asked the question. I personally will be disappointed if its not a two in front of the incremental margin and I don’t think, I am going on and live with that comment, because when you look at where our expectations are and where our expectations should be.

And that’s, we just had all of our regional leaders in on Wednesday and Thursday of this week and those are the discussions we had with them and I believe the selling momentum we have in the business, went itself to having that type of belief in the future and I don’t think I am smoking something and saying it.

Adam Uhlman - Cleveland Research

Okay. Got you. And then, unrelated to that, percent of sales to vending customers fell for the first time, I think ever, what exactly is unfolding there?

Dan Florness

Similar to the, what you saw in assessing our stores and our stores that we have today, we have a business that’s gone from zero to $350 million, $400 million in sales annual run rate, plus in a handful of years and in 2012 and 2013 we signed a tremendous amount of vending machines.

As we become smarter about the business we see vending machines that are performing unbelievably. We see vending machines that are performing damn well, excuse my choice of words. We see vending machines that are disappointing. And we take a good hard look at them and we pull some machines out. And when we pull it, the way we report the number is we count -- if we have a customer that has 30 locations that we sell to and we’re vending in 20 of those. We only count the business in those 20 when we’re reporting our numbers.

So if we pull vending machines out of one location and we scratch our head and say this location just doesn’t have enough employees, want to pull it out of this one. That might be a location that spends a fair amount of dollars on something but vending machine did make sense. And it pulled out a little bit.

To me the number that really matters is the 21% or 22% growth with the customers that have vending because that’s what’s going to drive our business long term. The other thing you had to keep in perspective some of the things that are raising our numbers right now, improving our growth of 15% Fastenal improvement, the 20% construction.

Some of those customers don’t have vending yet. And so one thing that’s happening, we pulled some machines up. What is really happening is the tide is rising.

Dan Florness

Better business mix.

Will Oberton

Yeah. But you know essentially, you look at 37 or 38, it’s a little bit noisy.

Adam Uhlman - Cleveland Research

Got it. Thank you.

Operator

And our next question comes from Robert Barry from Susquehanna. Your line is now open. Please go ahead.

Robert Barry - Susquehanna

Hey guys. Good morning.

Will Oberton

Good morning Rob.

Robert Barry - Susquehanna

I had a question, follow-up question on the gross margin outlook. So in the release you alluded to it being near or just below the low end of the range for the short term. I’m curious what gives you confidence. This pressure on gross margin will only be a short-term phenomenon?

Dan Florness

Well, the real reason I put it in there to be honest with you. You guys wore me out in the last three months. The number of questions I got about, we would be here, be here, it almost wore me out and it’s really more of a statement to everybody, hey let’s manage growing the business. We’re going to work really hard on the gross margin. There is a whole bunch of things mechanically that I can look at that we’re doing today, tomorrow, next week. I touched on a few with THUB that we’re doing to structurally improve the gross margin.

But we’ll mention it earlier. What we don’t want to do is play the music so darn loud that we have a store somewhere in Fastenal tomorrow that turns down a 28% margin sale or 22% margin sale because of the noise they heard from us. And we want to say to them, grow your business and grow it properly. One thing, Bob Kierlin taught us years ago that we can never forget, at the end of the day, it’s about returns. At the end of the day, it’s about your operating margin. Are you generating cash to support your growth in terms of the business? And if you do that everyday and you service your customer well, you’ll grow your business. And you’ll build a better business tomorrow than you have today.

Will Oberton

I think also staying on what we learnt from Bob is that our biggest factor we believe in margin isn’t markets and isn’t products, it’s pay programs. And I have been saying that for a long time when we are all Fastenal’s, we are margins at 52. We’re now 40% Fastenal’s, our margins at 51.8. So not a lot of variance over 20 years the way we got, excuse me, 50.8. So it has not moved a lot.

We have the pay programs in place to motivate these people to make the good decisions. And those decisions just aren’t all about margin, they are about growth versus margin and that’s what we want to let -- we want to let that work but we haven’t lowered our programs to allow lower margins and pay it.

So I think the systems are in place at the store level, at the district, at the regional and the top level and that’s why I have confidence that the margin is not going to move a lot. And going down, we’ll keep our hand down.

Dan Florness

To be honest, I’d rather report second quarter with 12% growth and 50.8 gross margin than 8% growth and we’re at 51.8.

Robert Barry - Susquehanna

Yeah. I mean, I guess, it all normalizes out on the earnings line, right. And I think that there is a big picture concern that it’s becoming more expensive to grow in industrial distribution. And so I guess the follow-up question is, if you want to shift the conversation to operating margin that’s fine or even earnings growth help us see how you get back to your kind of target growth range of 15% to 20% without it costing so much that you’re not really seeing as much or greater leverage on the earnings line.

Dan Florness

If we grew, we grew our expense at 10%. So we had leverage on the growth. Our problem was on the sales growth versus expense. Our problem is we had a tough margin comparison from last year. So if we roll it forward, if we maintain our margin at 51% range and hopefully we move it up on that’s given guidance I’m saying, we should -- we will have earnings leverage. So we’re controlling our expenses well. We have great sales momentum. Again we’re up 14% from January and so we think we’re in a good spot. It’s -- we just have to continue to do well.

Robert Barry - Susquehanna

Okay. Thank you.

Operator

And our next question comes from Ryan Merkel from William Blair. Your line is now open. Please go ahead.

Ryan Merkel - William Blair

Thanks. First question on pathway to profit, I noticed you changed the 23% EBIT margin target. You now needing a 110,000 per month for the average store from 100,000. Just wondering if you can expand on that a bit?

Dan Florness

The language we had in there was the range of 100 to 110. We’re at a base. We had a $100,000 average store this quarter. And our gross margin slipped at 50.8. We need to be closer to 110 to hit 23. At 51.5, it would be a different discussion.

Ryan Merkel - William Blair

Right. Okay. And then on vending, what is the average gross margin today on those products and where do you think it could go, is 50% achievable at some point or is that too optimistic?

Dan Florness

If I look at our vending where it’s running right now, a few years ago when we were talking about vending and a lot of questions about the weaker gross margins in it and we take a step back and say, the customers that have vending are larger customers and their gross margin is around X and our gross margin in vending is very much in line.

And when we look at our customers before vending and after vending, the gross margins didn’t really change and they were in that neighborhood of 40%. If you look at our vending today, we've improved it meaningfully from where it was two years ago. And if we hadn’t, we would have more drag from it because it’s roughly 12% of our sales right now vending, 12% to 13%. I don’t have the exact number in front of me.

Will Oberton

Its north of 13

Dan Florness

It’s north of 13. And so -- and we’ve move that margin up more in that 43.5 to 44 range. And right now if I look at the concentrations of products going through vending and that’s why I touched on the THUB comment earlier. Our concentrating effect isn’t that strong yet. And so I really see no reason why that the gross margin in our vending can't normalize to the gross margin of the company allowing for the products. And what I mean by that is our fastener’s gross margins are 51%.

Our non-fastener margins aren’t 51%. Fasteners are above that number, non-fasteners are little bit below that number. But there is plenty of room for us to improve gross margin over time and it’s really about being smarter about the products that go into a machine. A machine that we know a lot more about today than we did two years ago and that’s why our margin is improved by 3.5 points.

Ryan Merkel - William Blair

Right. And I would assume private label more than the machine is only going to help as well.

Dan Florness

It’s private label, it’s brands. Its really about the scale and efficiency that comes from -- if I can say to my supplier, we would like to buy this product and we’re selling so many of this product, whether it’s a private label or a brand, we’re selling so much of this through our vending machines that we want to buy it this way. Its not even pallete pricing, its container pricing. By this way we’re going to bring in the THUB and we’re going to push it out through our machines.

It allows you to source so much better and the margin improves and it isn’t just because you’re putting your brands in it, it’s because you’re putting -- you’re even getting the business. And you are improving the economics of the business and improving the labor efficiency at the store unbelievably and it gives you more selling energy.

Will Oberton

I’m still completely convince looking at the numbers that vending will be our most efficient and most profitable business overall or on period, not very shortly but for a long period of time, for years to come because of all the things we built in. And in the second quarter for the first time, we had a run rate to actually be over a $0.5 billion going through the machines.

Ryan Merkel - William Blair

Yeah.

Will Oberton

So it is become a big business that’s growing well above the company, so if we continue any, even similar growth rates, our profit picture for the future looks great.

Ryan Merkel - William Blair

Thank you.

Operator

And next question comes from Eli Lustgarten from Longbow Securities. Your line is now open. Please go ahead.

Eli Lustgarten - Longbow Securities

Thank you very much. Good morning, everyone.

Will Oberton

Good morning.

Eli Lustgarten - Longbow Securities

Well, I hate to go back to the margin question, which is really the focus we are seeing from clients.

Dan Florness

That’s okay.

Eli Lustgarten - Longbow Securities

… from clients.

Dan Florness

We’ve heard it before Eli, go on…

Eli Lustgarten - Longbow Securities

I know, but, you’ve articulate a stronger incremental in the second half, the mix is sort of trending little bit better, you are controlling your expenses to a slower add. So the question becomes, why our gross margins hanging around the same level and so as you look out? And there is got to be something else affecting it whether its lack of supplier rebates or changes, something else is affecting the market that you shouldn’t show some leverage from 50.8%, that's meaningful basically with last year based on the current trends? So can you help me get some idea what -- why it was at the same levels?

Dan Florness

We are not saying we’re not. What we’re saying is, if our growth, like I said, in part of my commentary it was, the focus, the spotlight of every question that comes in is about gross margin here, here or there. And we are not going to jump out the window. If we report a quarter with 51 or 50.9 or 51.1 gross margin, we are seeing a tremendous amount of growth in our business right now, from non-fasteners, we are seeing improvements in fasteners, we see great trends in fasteners, but the year over numbers are what they are and it’s disproportionate to large account business.

If the small customer was growing as fast with us and we had that that mix in our numbers, we are being challenged by mix in a massive way, all these things that are under the hood that we talked about, the vending -- improvements in vending gross margin, the improvements in our sourcing, the things we do everyday, the improvements over the years in our freight, all these things are structural changes we are making to combat the massive change in customer and product mix that occur in our business.

When I joined Fastenal in 1996, 4% of our business was national account, today its 44%. If I add large reasonable accounts more than 50% of our business today is a large multi-location customer.

When I joined Fastenal in 1996, I think at that time fasteners were about 80%, 85% of our business, today they dropped in half to low 40s, but during that timeframe, we've managed all the structural components within the respective product categories and end market categories and we’ve basically had a gross margin that has been unchanged. There has been periods of turmoil, but, yes, you have a business that goes from $220 million a year to $3.5 billion a year in 17 years that comes to the [third-party].

Will Oberton

Here is our internal thinking on it. If we had a point of growth to our business where we are right now, we had just about $10 million in quarterly revenue and $5 million in gross margin. If we give up 20 basis points, which everybody's freaked out about, we give up $2 million, so do I want a point of growth or do I want the 20 basis points, I like them both, but on balance, a point or 2 of growth is worth a lot of margin and we have to find that balance within our company and keep the street in and the know at the same chart to keep, Dan, is checking his calculator here, if I got it right.

Dan Florness

No. I am not.

Will Oberton

Oh! I do have a right. So at a $1 billion you had a point of growth, you pick up $10 million and so that’s trying to find that balance, where do you get the return on, the extra $5 million in gross margin.

Eli Lustgarten - Longbow Securities

All right. Thank you. And one follow-up question on a completely different topic? One of these, I am surprised that I don’t hear much is that, the company is undertaking sort of a metalworking initiative, more venture into cutting tools, I know, you have the deal with the Kennametal? So, we are not hearing very much about what's going on in that business, how its growing, whether or not it's still a main focus and cutting tools or right to vending machine would add a lot to margins still at the same time? So if you can give some idea of should I not expect much in next couple of years or is that a real focus area outside of what we had discussed?

Will Oberton

No. We are continuing to work very hard at a metalworking, it’s continuing to outgrow the overall company revenue, not by the amount that we had expected but we are growing well above. We see our public peers that are working in that area. Our metal working sales are growing well above any one else that we can get public data on. We’ve just -- we haven’t been talking as much about the different product lines. What Dan and I have learned over long period of time is the more we talk about it, the more we have to support it. And it’s easier for us to give more general information, continue to work harder on the macro numbers, growth, margin, headcount and -- but when people ask we do talk about this. So, we’re very excited about the metal working opportunity just as we’re about Fastenal’s safety, vending and many other areas.

Eli Lustgarten - Longbow Securities

All right. Thank you very much.

Operator

And our next question comes from David Manthey from Robert W. Baird. Your line is now open. Please go ahead.

David Manthey - Robert W. Baird

Thanks. Hi guys. Good morning.

Will Oberton

Good morning.

David Manthey - Robert W. Baird

First off, Dan, you mentioned is there is a lot of things that you’ve got going on that if you call them mechanical factors that will structurally improve gross margin and not to dwell on this too much. But could you just tick up a few examples of those things just so we can have a [longer] list?

Dan Florness

Sure. The first one is what we touched on was THUB.

David Manthey - Robert W. Baird

Right.

Dan Florness

The consolidate -- the aggregation of our spend whether that’s going to one of our brands that we support in our THUB facility or private label that we support in our THUB facility. It’s identifying all the opportunities we have and communicating that to the field and communicating that to our district managers and our regional leaders. So here’s the gross margin opportunity for this, this and this. And we’re always doing that for the business in total but there is tremendous opportunity.

I always think of the vending machine as an end cap if you want to use a retail analogy. And on the end cap, as our retailer yield lot of choice, but what goes on to that end cap. We have a lot of influence while that goes into the vending machine. We need to exercise that influence and we need to go to our customer everyday with cost savings ideas and this is one of them.

We can -- you can do a sharing, a gain sharing components of that and it’s a win-win scenario for our customer, for our business and for our suppliers. And so because it’s a more efficient supply chain, the freight one is another component of that, that we always talk about. And then the third one is being really good on the sourcing side at the store and at the company level on commodity pieces, the branded pieces and challenging ourselves on the exclusive brand pieces. And again that relates to our business everyday and I challenge our product managers and our sourcing folks on that everyday about what we’re stocking in the store, about how we’re sourcing, how we’re expanding our capability to source and how we’re helping our stores do a better job too.

Will Oberton

David, I would throw in a fourth there and that is the education of our stores to charge for the value that they provide our customers. That is -- I know that’s an intangible but I’ll tell you we were adding 16% to 17% more hours in the store. They are inexperienced people. As they gain experience and they gain confidence, things will change but that goes right back to the habits of pricing our customer or a sale appropriately. And that is an ongoing item for us too.

Dan Florness

As long as I have a list, I’ll throw in a fifth.

Will Oberton

There you ago.

Dan Florness

And that is that Lee has promoted a gentleman to work for, I am working on pricing but he is really working on, he is trying to identify the current systems that are available, software, trends and study the science of pricing and understanding the opportunity of the products we sell into the market. And we’ve always been pretty good at that but we think there is upside. So he is and it’s really -- that is really more focus on larger customers understanding what the needs are. And so I had all these things put together give us some help and at the same time, everyone is pushing you for the other direction. So it’s going to be a tug of war forever. We just hope to win a little more on the rope.

David Manthey - Robert W. Baird

Right. Okay. And then just to follow-up, dragging that down the P&L to where it matters at the EBIT line. Historically, you’re changing EBIT, divide about change in GP dollars has been, let’s call it around 50%. And I guess, the theory is that if -- let's say your customers are getting bigger, the mix is changing and so forth but the cost to serve goes down. Should that number not be as good or maybe even better than it has been historically, meaning you get better leverage on your cost structure because of the cost to serve these bigger customers is lower.

Will Oberton

That’s really inherent in pathway to profit, that’s kind of what we identified bigger customers, bigger stores, lower cost to serve.

Dan Florness

It’s about volume

Will Oberton

Yes. It’s -- and we see -- we have lots of data points with the number of stores. We have and we can see where it is and as long as we continue to grow our average store size, this quarter is difficult because we had tremendous drop in the margin, I mean 140 basis points, everything looks skewed in the wrong direction. But in more normal quarter, you would have seen that come through.

David Manthey - Robert W. Baird

Yes. Okay. All right, thanks very much.

Will Oberton

Thanks, Dave.

Dan Florness

Thanks, Dave.

Operator

And that is all the time we have for questions. I would like to turn our call back to Will and Dan.

Will Oberton

Once again, I want to thank you for your continued interested in Fastenal. Hopefully, the combination of our earning release and the commentary in this call helps you understand our business and how we’re working to grow the business into the future. Thank you and have a good day.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today’s program. You may all disconnect. Everyone have a great day.

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