On July 7th, Fastenal Company's (NASDAQ:FAST) stock dropped over 4% after reporting adjusted earnings of $130.5 million, or $0.44 per share, with revenue of $950 million. These earnings were in line with analysts' estimates but revenue was slightly below expectations. However, what raised concerns among analysts, and likely led to the decline in the stock price, was that its gross margin of 50.8% was below levels observed both last quarter and last year. Over the last five years, Fastenal's gross margins have mostly stayed between 51% and 52%. Although this quarter's gross margin only declined slightly, it raises concerns that if margins continue to shrink, Fastenal will not be able to meet future earnings predictions. Despite this slight decline in its gross margin, Fastenal remains an appealing buy with a long history of consistent growth, potential for increased overseas expansion, negligible debt, and a 2% dividend.
Fastenal is one of the largest American sellers of industrial and construction supplies. It was founded in 1967 as a retailer and distributor of fasteners. Fasteners are still its main line of business, but in 1993, it expanded into tools, and now offers many other industrial supplies. Among its many product lines, Fastenal offers 1,448,000 stock items as of 2013, and it continues to work to grow this number. It manufactures a small number of its own products, although almost all of what it sells still comes from suppliers. After the second quarter of 2014, Fastenal operated 2,684 stores. About 2,400 of these stores are in the U.S. and about 200 are in Canada.
Fastenal has many different types of stores and other selling locations. Its main type of store caters to all customers and offers a wide variety of products. Fastenal also operates strategic account stores and strategic account sites which are designed to sell to a small group of large customers in an area.
Fastenal also markets its Fastenal Automated Supply Technology Solutions (FAST Solutions), the most prominent of which are its industrial vending machines. These industrial vending machines are installed at the facilities of customers and provide convenient access to supplies, tools and fasteners that might be needed. Each vending machine's stock can be tailored to a specific customer's potential needs with a variety of products. Locker systems can be installed along with vending machines to store larger products. According to Fastenal, these industrial vending machines provide economic and environmental benefits. Having parts available on-site reduces downtime and waste from unnecessary purchases. Products can be acquired as needed and as soon as they are needed. Fastenal's industrial vending machines are rapidly gaining popularity, and over 43,000 have been installed across North America.
Despite limited product differentiation in the industries in which Fastenal operates, it has managed to achieve a substantial economic moat solidifying its position in the industry. Fastenal's motto is "Growth through Customer Service." Its emphasis on customer service has led to Fastenal's remarkable success. Fastenal carries a remarkably wide range of products, and finds it important to make sure no products are out of stock through its inventory management system. Even Fastenal's industrial vending machines reflect its motto, since they were designed to provide maximum convenience to customers.
Fastenal's recent decision to increase "selling energy" shows its commitment to customer service. Over the last year, Fastenal has increased its employee count by 15% to over 18,000. This increase in employees has already lead to a 12.1% increase in sales from the second quarter of 2013 to the second quarter of 2014. As part of Fastenal's commitment to customer service, it strives to have employees who are educated on fastener strength, function and composition, as well as industry and regulatory standards. As its new employees gain more experience working at Fastenal, they will be able to serve customers better, which will hopefully lead to increased customer loyalty and sales.
In addition, Fastenal has created an extensive network of both suppliers and customers. It is able to bring over a million products from its 3,000 suppliers to its 400,000 customers. This protects Fastenal from future competition, since potential competitors would have to establish a supply network of equal size in order to match Fastenal in product offerings.
Over the last 10 years, Fastenal has opened over 1,100 new stores and over the last year, it added 7,309 FAST Solutions machines, bringing its total machine count to 43,761 machines. These vending machines have proven to be very popular and successful, and their success and rapid growth rate will likely continue in the coming years. Fastenal has consciously slowed the signing of new industrial vending contracts out of concern that meeting the high demand will impact quality. This shows that the demand already exists that will allow Fastenal to expand its FAST Solutions business.
At the end of 2013, Fastenal planned 50-70 store openings for the next year, but due to store closings, the total number of Fastenal stores has decrease by three over the last six months to 2,684. Fastenal believes that it can expand to 3,500 stores in North America before the market is fully saturated. However, recent store closings and slowing growth suggest this number might be lower.
Although continued store growth in the U.S. and Canada appears to be more difficult, Fastenal has strong growth potential in other countries. At the end of 2013, Fastenal had 89 stores outside of the U.S. and Canada, representing about 3.3% of its total stores. These stores accounted for 4.3% of total sales, which shows that on average, these stores had higher sales than Fastenal's stores in the U.S. and Canada. These foreign stores' high revenue is even more noteworthy, because 45 of the stores were opened in the last five years. Traditionally, Fastenal's stores start off with low sales which grow as the individual stores are able to establish relationships with customers. In 2013, average monthly sales for stores less than five years old was $73,600 compared to its average monthly sales of approximately $90,000 for all stores. With only 40 stores in Central America, South America, Asia, and Europe, there are definitely opportunities to open many new stores in the these markets.
Fastenal's management works to keep its gross margin between 51% and 53%, so it raised concerns when it reported a gross margin of 50.8% last quarter. Fastenal has also had a slight decline in operating margins and net margins over the last six months. One cause of these decreasing margins is that the 15% increase in employees has driven up selling, general and administrative expenses, but the full benefit of these new employees has likely not yet been realized. In the coming years, these new employees through experience and growing familiarity with Fastenal's business will become able to generate more sales, leading to a rise in operating margins.
Another factor that is driving Fastenal's margins down is its expansion outside of the fastener industry. Fastenal's sales of products other than fasteners grew consistently faster that its sales of fasteners. Nonfasteners products now account for over 50% of sales. In the past year, nonfastener sales grew 17% while fastener sales only grew 6%.
As its name suggests, Fastenal's specialty is fasteners. Over its almost 50 year history, it has established a reputation for its fasteners and developed many crucial relationships with suppliers and customers. Fastenal now offers over 600,000 fasteners. These factors help generate the value to customers that allows for Fastenal to achieve high margins from its fastener sales. The rest of Fastenal's product lines are less than 20 years old and have lower margins. However, as Fastenal gains experience in its nonfastener businesses comparable to its fastener business, its margins on these products will likely rise.
Fastenal has also began offering private label brands in order to keep its margins high. These private label products typically have 20%-30% higher margins than Fastenal's other products. Currently, they only account for around 10% of Fastenal's total sales. If Fastenal continues to expand its sales of private label offerings, this too will drive up margins.
Fastenal reported earnings for the fiscal year of 2013 of $449 million, up 140% from 2009, on revenue of $3.33 billion, up 72% from 2009. Fastenal's revenue and earnings dropped after the start of the Great Recession but recovered quickly since then. This is not surprising, because many of Fastenal's customers are industrial and construction companies which are closely tied to the strength of the overall economy. Margins have declined slightly in the last few quarters, with an operating margin of 21.1% and a net margin of 13.29% for the last twelve months. Over the last five years, these margins have risen about 30% each.
Remarkably, Fastenal has no short-term or long-term debt and liabilities of only $300 million. Because Fastenal does not have to worry about its solvency, it is able to hold only a very small fraction of its assets in cash, especially with $414 million in current receivables at the end of 2013. Fastenal can instead put more money into assets beneficial to growth like property and inventory. At the end of 2013, Fastenal had $784 million of inventory and $655 million in property, plant, and equipment, after accounting for accumulated depreciation, with only $59 million in cash.
Fastenal's sales are closely tied to the success of the industrial and non-residential construction industries in the U.S. If a downturn in the overall U.S. economy occurs, it will hurt these two industries and in turn, hurt Fastenal's sales.
Even if North America has enough demand for 3,500 stores, Fastenal is approaching this number, capping its store growth in this region. As it approaches 3,500 stores, it will become more difficult to find locations to expand.
After releasing its second quarter earnings, Fastenal is priced at a market cap of about $13.7 billion or $46 per share. At this price, Fastenal has a P/E of just over 30 and a forward P/E of 23.5. Two of Fastenal's competitors, W W Grainger (NYSE:GWW) and MSC Industrial Direct Co (NYSE:MSM), have P/E ratios of 21.5 and 24.2 respectively. Although Fastenal's P/E is much higher than these two companies, it has historically higher revenue growth rates and operating margins, both of which it is working to increase in the future. This potential for increased sales and operating margins growth justifies Fastenal's lofty P/E compared to its peers.
In 2011, Fastenal began paying a consistent quarterly dividend which totaled 1.5% yearly. Its projected dividend for 2014 is over 2%. Comparatively, W W Grainger pays a 1.6% dividend and MSC Industrial Direct pays a 1.5% dividend.
Fastenal has suffered from slowing growth in the past few quarters, which has been reflected its relatively flat stock price. It is currently trading around the price it was a year ago. However, earnings are projected to grow about 15%-20% a year for the next several years. The increased sales force, growth overseas, and a large increase in contracts for vending machines should help increase revenues. At the same time, private label brands and Fastenal's growing expertise and relationships with suppliers for its tools and supplies should help boost margins. Currently, Fastenal estimates that it only has a 2% market share despite being one of the largest companies in the industry, so there is plenty of room for it to use its scale to gain market share. All of these factors will drive growth, providing those who invest in Fastenal with a substantial upside.
Disclosure: The author is long FAST. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.