Recent developments in the industrial distribution space haven't exactly dispelled the cliché that Grainger (NYSE:GWW) is the dependable leader, MSC Industrial (NYSE:MSM) the balanced growth story, and Fastenal (NASDAQ:FAST) the real growth dynamo of this triad. Although Fastenal did indeed post solid results in the fourth quarter, investors may want to ask if it makes sense to pay so much for a levered growth play on U.S. industrial activity.
A Solid Fourth Quarter
Analysts expected quite a lot from Fastenal in the fourth quarter, and the company largely delivered. Revenue rose almost 22%, as the company saw excellent growth throughout the fourth quarter. Monthly sales rose 21% in December (on top of a nearly 21% jump in the prior year) and stores open more than two years saw roughly 18% same-store sales growth in the quarter.
Distributors often find themselves squeezed on both sides by suppliers and customers, and Fastenal did absorb some gross margin pressure this quarter. Gross margin slid about 70 basis points sequentially and 80 basis points from last year. That compression was captured back through the operating results, though, as the company posted over 31% operating income growth and 150 basis points of operating margin improvement.
More Than Just Signs Of Life
Fastenal management gives investors a wealth of information with its earnings releases, and one of the takeaway points is that the business seemed to exit 2011 with increasing momentum. This corroborates well with recent earnings reports from rival MSC Industrial and Hurco (NASDAQ:HURC), a small manufacturer of machine tools, not to mention ongoing positive data on U.S. rail traffic.
Although Fastenal has traditionally looked to non-residential construction for a meaningful piece of its business, the company's sales growth is largely levered to overall economic activity in the U.S. Credit Suisse published a report back in 2010 showing that about 99% of Fastenal's growth could be explained by GDP numbers and 92% by industrial production data. Granted, this is hardly a Fastenal-specific phenomenon as Grainger, MSC, and WESCO (NYSE:WCC) show basically similar economic activity.
Leveraging The Store Model
Unlike MSC, which uses a store-free internet order model, Fastenal relies on a network of nearly 2,600 stores and industrial vending machines located on the premises of customers. Fastenal fills a niche that Home Depot (NYSE:HD) and Lowe's (NYSE:LOW) can't economically service and has been looking to expand beyond its core business in fasteners as rivals like Anixter (NYSE:AXE) enter the market. In recent years management has been looking to drive better performance by hiring additional sales staff and driving greater productivity. So far, so good -- Fastenal's incremental margins have improved as a result.
The Bottom Line
Certainly Fastenal has multiple avenues for ongoing growth; even industry giant Grainger has only single-digit market share of the MRO/distribution market. Moreover, a clean balance sheet allows the company to contemplate organic store expansion, international expansion, and incremental M&A as circumstances dictate.
Unfortunately, it's hard to see how Fastenal's valuation makes sense. While I do own shares in rival MSC Industrial, I don't think the conflicts of interest are all that pressing or relevant - MSC and Fastenal target different market segments, and the success of one does not preclude the success of the other.
A surprisingly healthy U.S. manufacturing sector has lifted valuations across this space, but it looks as though Fastenal will have to free cash flow at a hard-to-imagine compound annual growth rate above 20% over the next fifteen years just to live up to the current valuation. While Fastenal may appeal to growth/momentum-oriented investors looking to play the ongoing economic recovery, this is a very richly valued company.
Disclosure: I am long MSM, HURC.