Sentiment has very definitely turned on the American industrial economy, and investors have been fleeing the stocks of industrial distributors and supplies like Fastenal (FAST), MSC Industrial (MSM), and Grainger (GWW). Fastenal once again delivered a good quarter of growth in an absolute sense, but the high valuation and competitive threats make this a less perfect stock.
A Sigh Of Relief After Q2
With the reported monthly sales figures at Fastenal and Grainger showing declining growth (but still double-digit growth in the case of Fastenal), analysts have been paring back their estimates here for a couple of months. Consequently, the company's basically in-line performance and the steady tone of management on the call seems to be giving investors some relief.
Revenue rose almost 15%, basically matching the average Wall Street guess. Sales were driven by 11.1% comp-store sales growth (which Fastenal defines as stores open two years or more), and ongoing expansion of the vending machine program. While June sales did show a break in the downward trend (five straight months of shrinking sales growth to start the year), the year-to-date daily sales trend is definitely lagging the past couple of years.
Management didn't seem overly bothered by the 60 basis point decline in gross margin, as it is still within the 51% to 53% range they deem normal and some of the weakness was due to forex movements. The company also continues to do a good job of leveraging its own infrastructure and driving further operating leverage - operating income rose 22% and operating margin expanded almost a full point.
Vending - Some Bad, But Mostly Good
Fastenal continues to put a significant amount of emphasis on growing its business through vending operations. The company now has over 13,000 machines in place, with over 3,000 net installations this quarter.
In the past, I've been worried about the vending concept as I think it may drive greater worker efficiency and reduce the amount of supplies used and repurchased. And it turns out that I'm right, but only partly - while there is indeed an initial drop in usage (and reorders) when a vending machine is installed, it appears to be a transitory phenomenon and sales per site actually increase at a faster than rate than non-vending customers.
No wonder, then, that Grainger and MSC are both going the vending route as well.
The Push-Pull Of Competition
As I've mentioned many times before in writing on industrial suppliers, most of the major names in this huge (and still very fragmented) market focus on their own particular niche strategies. In the case of Fastenal, that has historically been a small-scale store model heavily based on manufacturing and non-residential construction and centered around all manner of fasteners.
But that doesn't mean that Fastenal is standing pat. Fastenal is trying to grow its government business, and pitching the angle that government agencies should buy from local Fastenal stores instead of a delivery-based supplier like MSC as it is better for the local community/economy. Fastenal is also trying to get into MSC's wheelhouse by building up its metalworking business, including stocking tools from longtime MSC ally Kennametal (KMT).
But for every action, there are reactions. MSC is getting more aggressive with vending, while Anixter (AXE) is pushing into the fastener market (a core strength of Fastenal). Amazon (AMZN) is also getting more attention for its Amazon Supply business these days, but the commentary of most management teams in the sector suggests that Amazon Supply is more popular with sell-side analysts than manufacturing customers. What's more, Home Depot (HD) had a go at this market once and ended up surrendering pretty quickly.
The Bottom Line
Fastenal has never been cheap and it's not cheap now … and it probably won't be for a long, long time. It's a perennial favored growth story in industrial supply, and a favored name for those looking to leverage bullish views on the manufacturing sector. In other words, if and when the Street feels good about American Widget, Inc. Fastenal does well.
I do actually really like this company, and I think the company's detailed disclosure of all manner of financial data is proof positive that you can be open with shareholders without compromising your business. In any case, I still think the shares are too pricey for me – a decade of 20% compound free cash flow growth won't come close to justifying today's price. In fact, you have to project around 25% free cash flow growth and a lower-than-average discount rate just to get 10% undervaluation at today's levels. Accordingly, I'm sticking with MSC - not the cheapest stock, either, but another high-quality company with similar exposures and a more reasonable valuation.
Disclosure: I am long MSM.