Fastenal Company F2Q08 (Qtr End 06/30/08) Earnings Call Transcript

Jul.11.08 | About: Fastenal Company (FAST)

Fastenal Company (NASDAQ:FAST)

F2Q08 Earnings Call

July 11, 2008 10:00 am ET

Executives

Willard D. Oberton – President and Chief Executive Officer

Daniel L. Florness – Executive Vice President and Chief Financial Officer

Nicholas J. Lundquist – Executive Vice President Sales

Analysts

Holden Lewis – BB&T Capital Markets

Adam Uhlman – Cleveland Research Company

John Baliotti – FTN Midwest Research Securities Corp.

Brent Rakers – Morgan Keegan & Company, Inc.

Michael Cox – Piper Jaffray

David Manthey – Robert W. Baird & Co.

Jeffrey Germanotta – William Blair & Company

Operator

Welcome to the Fastenal Company fiscal second quarter 2008 earnings conference call. (Operator Instructions) The call will be hosted by Will Oberton, Chief Executive Officer, and Dan Florness, Chief Financial Officer. The call will start with a general overview by our sessional hosts Mr. Oberton and Mr. Florness. The remainder of the time will be open for questions and answers.

As a reminder, certain statements contained in this presentation are not historical facts or forward-looking statements and thus perspective. These forward-looking statements are subject to risks, uncertainties, and other factors which could cause actual results to differ materially from future results expressed or implied by such forward-looking results. More information regarding such risks can be found in Fastenal’s quarter and annual SEC filings.

Willard D. Oberton

I’d like to start by saying that I believe we had a very good quarter and I think the people in the Fastenal team did a great job producing profits and growing our business. I want to thank all of our Fastenal people that may be listening today.

Starting out with sales growth, I would categorize our sales growth as okay for the quarter. We came in just over 16%. June came in just about almost exactly where May was. The trend in that mid to upper teens number and, as I said, that’s okay. The reason I’m not real excited about it is that we’re investing at a slightly higher level and we would expect a little more.

I am very happy though with the older store growth. Our older stores grew 11.2% in June. They’re actually doing very well. I think the reason why our stores are doing well is because of our investment in outside sales people.

We have noticed a trend though in our large account business has slowed down. If you look in the supplemental information the strategic account only grew 12%, down from 14% in the first quarter. We think that’s mainly economic, the headwind just a little stronger with the big accounts, but we made that up with the small accounts with our outside sales program.

We’re very happy with the results that we’ve had with the outside sales program. Looking at information, actually, this is not the June information. It’s from earlier in the quarter. I did not have all the June information in. But the outside sales people, we looked at the group that have been with us since the beginning of the year. They were employed in 2007 and before. About 1,762 people. That group of sales people is growing at about 28% year over year.

They’re growing much faster than the company. They’re producing about 28% to 30% of our revenue in any given month. When you look at that they’re actually producing about more than half of our sales growth with only 1,800 people. You back up and you say what is going on there? We’re calling in the small accounts that we don’t have. We’re adding customers at a faster rate.

Another very positive thing about the outside sales program is that the margin that this group is producing is about 300 to 350 basis points higher than the company average. Again, because they’re calling on the small accounts. The big accounts are slower, typically lower margin. Small accounts are growing faster, typically higher margin. That’s probably the biggest difference in our gross margin, one of the biggest differences in the improvement in our gross margin. So very happy with the outside sales program.

We’re starting to track some of our problems with the under performers. I think our people in the field are doing a great job of that trying to sort through and see what works and what doesn’t. And also developing our tools that the outside sales people use. We just upgraded our software on the handheld computers again making it faster, making it more efficient, and getting a higher adoption rate of that technology.

So overall, sales growth okay, but a lot of bright spots in there.

The margin, we’re very happy with the margin. As I said, the outside sales program is probably the biggest reason our margin has grown. The second reason is discipline. Third I would say is we’re keeping up with the prices increases. I’ll talk about inflation a little later in the call, but I think our group is doing a good job of keeping up. I don’t think we’re really getting ahead. I don’t think the market will allow us to get ahead because it’s in competitive times and when you go to raise prices you get questioned. I’ve been on a lot of those calls myself and they’re not very much fun, but that’s business.

I think one other reason our margin is improving is our [Fastco] trading continues to find new products, better sources throughout the world. Our freight initiative, even in the times of fuel where it is, we continue to make improvement and Dan’s going to cover that a little more on his part. And the NRI expansion. So a lot small things that are making a big difference in the profitability of Fastenal.

Expense control, I think we did a good job in expense control. We did not leverage our expenses and it’s really two reasons. The formula I put down, high margin plus profit growth equals high commissions, bonus, and profit sharing. That’s really the first one is that we talk about our programs heavily levered to gross margin, sales growth, gross margin, and profit growth. Sales growth wasn’t really a factor here at 16%. It doesn’t lever up hard. But the gross margin in the profit growth really drives bonuses. It’s a very high grade problem. It’s good for our employees and usually what’s good for our employees is good for our shareholders.

Then the other expense area would be fuel. Fuel added incrementally about $2 million more than it would have had the price per gallon been about the same. That doesn’t include energy costs. I did not pull out the utility energy costs. We know they’ve grown tremendously just because of the cost of gas and electricity due to again the higher energy costs.

Overall I think we did a very nice job in expense control. Even without being able to leverage we did a lot of things well.

Earnings growth, driven by the sales in profitability, or sales margin, excuse me. Twenty-point-five-percent pre-tax. I went back and you have to go all the way back to 1995 to find a quarter when Fastenal was able to report pre-tax earnings at 20.5%. I think there’s only one or two quarters in our history that we are over 20.5% and they are both in 1995. I’m very proud of what everyone did. Hard work, but we knew we would get there if we worked hard.

Earnings growth of 26%, also a very good number. We picked up 170 basis points improvement year over year. That goes to our pathway to profit discussion or the discussions we’ve been having over the last year. Our internal goal is 100 basis points. We got a little bit of a run on it here. We’re very excited about that.

The pathway to profit, a little bit of a recap. Average store size grew 7.8%. We’re happy with that, but we really need about 9% or 10% to hit our long-term goal. We’re going to have to push and hopefully push our top line revenue up as the economy picks up a little bit or as maybe we can execute at a slightly higher level. We’re not real disappointed, but slightly disappointed with that.

Our pre-tax profit growth, as I just said, 170 basis points far exceeded our goal. Our return on assets, one of the other things we stated would be improved. Looking at a mid-year snapshot, it’s a little difficult because it’s not year end, but second quarter rose 7% over second quarter 2008 went from 20.4% to 22.1%. Very nice improvement on the return on our assets.

The other one that probably not quite as good is we’re a little bit behind on our store openings. Very confident that we’ll get caught up. All of our people have their plans in place to get the stores open in the third and very early in the fourth quarter. We’re going to hit our numbers for the year. We’re not worried about that. But as we stated in the past, it works better the earlier we can open the stores in the year the better off we are. So a little work to do there, but generally a very positive report on pathway to profit and, as I said earlier in my comments, the outside sales program is starting to gain more traction internally.

The last thing I want to talk about before I turn it over to Dan are some of the inflationary pressures that we’re seeing. It almost all hinges around our steel product. We break out our products, as you see, 50% of our revenue is driven by fasteners. But it’s really about half of that or 25% of our overall product that’s greatly affected by steel. It’s the commodity fastener. It’s the nuts, the bolts, the washers that are the heavy steel parts that have a very high component of their cost driven by steel.

I’ll give you a little bit of history of how it came through. Back in July of 2007 the Chinese government repealed the VAT tax. That was 13% tax, they brought it down to 5%. There was an 8% increase in our product. That hit about 10% of our cost of goods and added about 80 basis points to our costs. Now, when you think about this, it’s about a nine-month cycle from the time we place an order till we sell the product. It takes 90 to 120 days to receive the product and then we turn the product just over two times a year, so there’s another six months. The product that went up that we purchased, say the middle of July of last year, would have sold through at the end of the first quarter or something like that. That 80 basis points is fully baked in.

Later in the fall, September or October, they started revaluing the RMV or the Yuan in China and another about 10% increase added another 1.1% on 10% of our spend, added 1%, that’s pretty much fully loaded into the second quarter.

The real inflation started in January of this year when steel just went on fire. It’s right after the Asian steel companies agreed to the 68%, 67%, 68% increase in ore and everything went crazy. That is just coming through right now as incrementally it’s a long path. As I said, nine months. Some comes through quickly because you buy it and sell it; some goes over a long period of time.

The other piece, and that part is a 20% to 40% increase on a select group of our products that will probably translate into 4% to 5.5% of gross or inflation by the end of this year. Now, some of that will be offset with the things we’re doing with Fastco with all the other initiatives we have going, but we will see more inflation later in the year as a product that we’re buying in the second quarter sells out in the fourth quarter and the first quarter. We’re just trying to give you a better understanding of that.

One other part that’s added to our inflation, and this is probably 20 to 30 basis points, is the fuel increase. Transportation both on the ground, on the water, on the rail. Transportation is up everywhere we look. It’s difficult to get an exact number because it’s thousands of purchasing transactions and millions of sales transactions put together. But both Dan and I have worked hard on this and our best estimate today is that we have between 3 and 3.5 percentage points of our growth coming from inflation based on all the things we’re seeing, all the price increases we’ve pushed. That’s our best estimate today with it going up a little bit, a couple more points later in the year.

With that, I’m going to turn it over to Dan. Dan’s going to give you some more colour on the balance sheet, which I want to thank Dan for doing a great job of managing our assets, especially on the inventory side. We did a really, I believe these people have done a really good job on that. Thank you.

Daniel L. Florness

Thanks, Will. Good morning, everybody, and again thanks for your time to listen in on our call today. I’m going to run through the press release and touch on some points in somewhat of a Paul Harvey fashion. I’ll start with page one.

Just a couple comments that I noted on the sales trends that we scheduled out. The five-plus, the two-plus, and the oil category, solid, consistent daily trends throughout the quarter, throughout the month. The one item that isn’t in our press release but is in our supplemental data, our 10-plus year old stores grew at 10.7% in the month of June on a daily basis. That’s a number that is off the chart. The same month a year ago that grew at 4.4% and that was the third highest month of the year in 2007. It wasn’t a case of it was an easy comparison by any means.

When I look at April, April was lifted a little bit by the Easter shift. May and June followed with nice, strong growth. Again, as Will touched on, with investment from (inaudible) we believe it should be better than that number, but solid growth nonetheless.

Some items on page two and three as related to the past profit. We are executing as expected from the store growth and head count growth standpoint. It could be a little bit higher on the store growth piece. To reiterate our stated goals, store growth 7% to 10%. Last year we targeted that 8% number. We’ll be similar to that this year. Store [SCE] growth looking at upper teens, DC and manufacturing [FTE] growth, upper single digits. And admin and sales support, lower single digits. That’s really where our thinking is at is where we probably should be growing and we are executing within that framework.

Some items on the store statistics that we break out on the top of page three. You’re starting to see what we talked about a year ago when we first talked about passing a profit. Really what we’re doing over a five-year period is we’re morphing the mix of stores such that the percentage of stores that are in the categories one and two will over time flip with categories four and five, which will drive our average store from the $75,000 to $80,000 a month neighbourhood it is today to about $125,000 at the end of five years would be our goal. You can see, especially in group one and group five, that shift is pointedly starting to occur as 17% of our stores are now in that first group versus over 20 a year ago and 11% in that fifth group versus 9% a year ago.

As Will mentioned, our average store size went from $74,300 to $80,100 a month. An increase of 7.8%.

Looking at pages three and four on fuel trends, fuel is taking its toll. Quantifying some of the figures in there again, about half of those dollars you see are included in cost of goods. It’s the diesel going into our transportation fleet. Our semi fleet. About half of those dollars going into the pickup trucks that we have for our store delivery vehicles. A few things to point out last year that we saw this year is the trend during the quarter was rising each month of the quarter similar to the trend we saw last year. What we saw last year was June and July really peaked and you saw some moderation of the gasoline prices in the August-September time frame.

The gross margin on the bottom of page four, I’m going to touch on a number of points there. The points we touch on increase the gross margin on business with a lower than a couple of margin. That’s really about discipline and where we want that lowest margin point to be on what is good business. We’re challenging that very hard and bringing up that bottom. That’s a meaningful piece of the improvement on our gross margin.

The fact that one that Will touched on staying ahead of the inflationary increases, in the first quarter we cited an estimate, and this is an estimate, it’s very difficult to perfectly pinpoint the impact of the gross margin expansion looking at our rightful costing of inventory because there’s so many pieces that come into play. The product, the shift that’s occurring because of Fastco, the product that’s sourced at the store level, the varying quantities at which we’re sourcing at can dramatically influence the price per pound of the product we’re buying. But we estimated in the first quarter about 50 basis points of our margin improvement was related to that. In the second quarter we feel that’s dropped about half to about 25 basis points of our gross margin is attributed to pure inflation. Again, that’s a rough estimate.

As Will touched on, improvements in our direct sourcing. The Fastco organization that we created some years ago continues to find new opportunities for sourcing our products and improving our gross margin overall.

Fourth item, our freight initiative. On a year-over-year basis, earlier I touched on the fuel costs and what they’re doing. On a year-over-year basis our overall freight number that’s in cost of goods we picked up 30 basis points of gross margin. Again, I repeat, our gross margin improved 30 basis points on a year-over-year basis looking at all freight components. Some years ago Bob Kierlin wrote the book The Power of Fastenal People. When I look at this quarter there’s two powers, there’s the power of Fastenal people and there’s the power of Fastenal trucking and logistics in general. They were a big part of our improvement year over year.

A lot of it is about what alternative we use to move product around North America. Are we sending it on one of Fastenal’s trucks? Are we using a third-party LPL shipper or are we using a third-party small parcel shipper? We’ve done a very nice job of continuing to challenge ourselves in our day-to-day thinking on sending more and more product on the Fastenal truck even though costs are going up on our fleet as well as external fleets. We still have a 10-to-1 cost advantage when we send it on one of our trucks. So even with added costs there, if we can migrate some stuff from the $10 category to the $1 category it doesn’t take a lot of math to figure out that’s a dramatic win.

I’ll throw out an example. If you look at the end of the second quarter. We had 2,272 stores. Now our average small parcel shipment that we do today is somewhere between $10 and $15. If I use the low end of that range, the $10, that means if we were able to reduce one shipment a day, one small parcel shipment a day, in each of our stores that would save us roughly $23,000 a day. With 64 business days in the month that would save us just under $1.5 million in the quarter. If we were able to accomplish that. That $1.5 million number is approximately 25 basis points. That’s the type of math you need to go through to understand how are we improving our gross margin when it comes to freight.

I applaud [Chris Stefenback], who’s been leading that charge in our logistics group, and his team that are really making that happen day in and day out. It’s just through sheer persistence. I think I get more emails in my inbox from Chris than I do anybody else in the organization throughout the month.

The fifth item, product availability in network. That really touches on the master stocking hub concept we talked about several years ago. That does two things for us. It allows us to source the product more efficiently rather than when we do it one at a time at the store level. It also allows us to move that product more efficiently. So some of our freight improvement is occurring because of what we’re doing in Indianapolis. But that’s having a very nice improvement.

The second half of that product availability is Fastenal becoming much more effective, much more efficient at moving and making all product available to all customers at all stores. And that’s through our store-to-store transfer program we call Inventory Redistribution. It’s really about having great visibility and efficient means to move that inventory around. Today our average store transfers three items a day to another store in the company, which in the month of June translated into about $140,000 picks that occurred and transfers that occurred that were at the store level on top of what we’re doing at the distribution centre level.

A few other items to note, Will touched on it. Our OSP program. That in and of itself has a positive bias over time to our gross margin. The fact that the large comp business is running a little bit slower, that is a positive bias as well.

One item I would point out, if you’re looking at year-over-year numbers. The gross margin last year was unusually low by about 60 basis points because of the implementation of our ERP system and a true-up we had in the second quarter of 2007 which lowered the gross margin about 60 basis points to 50.6.

Looking at the operating expense side of the equation, pleased to see another quarter where we’re leveraging our occupancy. That’s one of the key points within our pathway to profit. In the first quarter our occupancy went up about 10.9%. In the second quarter about 9%. Year to date about 10%. Our personnel in the field, our district managers, our regional VPs, our regional finance manager is doing a great job managing that expense and being very careful about store relocations and what we’re paying for the new stores we’re going into.

One program that we’re doing on the energy side of the equation is we’re doing what we call our top end opportunities. That’s looking at stores with the highest 10% occupancy cost per square feet in a given region and going and affecting that and making change in that store. We’re making nice headway on that to lower our energy consumption costs.

Payroll, as Will mentioned, we did have a negative leverage in payroll, as we saw in the first quarter. That’s one of those good problem situations. Payroll really is linked to our ability to grow our gross profit dollars and our ability to grow our pre-tax dollars. We’re doing a nice job with both. It’s causing our payroll to increase quite dramatically in the short term because of the added profitability that we’re enjoying as an organization.

Again, occupancy is about 20% of our SG&A. Payroll is about 70%. The other 10% is dominated by the vehicles in our fleet and the insurance we leverage nicely. The fuel, as we touched on, that had negative leverage within our operating expenses. All other expenses with operating expenses I feel we did a really nice job of managing when looking at data on a sequential basis and year over year.

Working capital on the bottom of page five. AR and inventory leveraged quite nicely. I’m very pleased to see that happening. There’s two inherent negative bias points that are in play right now. One, when it comes to accounts receivable. Again, we continue to lower our days to collect improve our overall AR in general. That’s in the face of a weaker economy, which would tend to in many cases slow payment patterns down a little bit and increase your exposure. We have not seen either. Our team is doing a great job with maintaining our progress on the accounts receivable growth.

The inventory, the natural bias that we have in there that’s negative is the inflation that we touched on. Most of our increase on a year-over-year basis is really to inflation. We’ve done a nice job of managing that asset through our distribution centres and in our store level. I believe we have ample opportunity to continue to improve that going forward. We have great momentum there and I feel that will continue to improve as we go through the year and into next.

Looking at our cash flow statement, very nice performance year to date. Operating cash flow as a percentage of earnings came in at 79.5%. Now, our stated goal is to be in that 80% to 90% category on an annual basis. The first six months is usually difficult because of the working capital growth and the tax payments that occur in the first half of the year. But close to an 8% number for six months is very good. Historically that number $0.50 to $0.70 on the dollar. Again, that’s looking at operating cash flow as a percentage of net earnings.

Will touched on the return on assets for the trailing 12 months. This year, 22.1% versus 20.4%. Our average total assets measured at the June, December and June snapshots, increased 13% year over year, whereas our profits on a trailing 12-month basis are up 22.4%.

One item I’d also point out, at the end of last year in our year-end report we cited our CapEx for the year would be about $77 million. I now anticipate that number to be closer to $85 million to $86 million. The drivers of that change would include two primary components: one, the distribution expansion that’s going on at Indianapolis and Dallas, some of the steel that’s going into the ASR systems come a little bit higher than our original estimate, as well as we bought some adjoining land in Indianapolis. The second piece relates to our smart store program, our vending, and the CapEx that’s going into that program this year. That’s vending where we’re putting it in customer locations. It’s a very attractive return.

A couple items of note from our press releases last night, we announced our second half dividend of $0.27 per share versus the $0.25 per share we paid out in the first half of this year. In the for what it’s worth department, since we went public in 1987 we’ve paid out about $315 million in dividends. Forty-six percent of that number has been paid out in the last two years. Just in the for what it’s worth.

Finally, we did increase our share buy-back authorization. We had $800,000 authorization. We bumped that up to $1.8 million that we currently are authorized to buy back in the open market.

With that, I’ll turn it back over to Anthony for the Q&A session.

Question-And-Answer Session

Operator

(Operator Instructions)Your first question comes from Jeffrey Germanotta – William Blair & Company.

Jeffrey Germanotta – William Blair & Company

One of the comments I was curious about was on page three of your press release where you show the pre-tax margin by size and age of store. Generally speaking you’ve done really, really well there, but there’s one small anomaly in some of the younger stores that seems you have contracted the margin year over year. Any insight into what’s going on there?

Willard D. Oberton

What’s going on there, Jeff, is that’s where we’ve added outside sales people into those stores. Both Dan and I had the same question, what happened? We’re investing more in the smaller stores to grow the business faster.

Jeffrey Germanotta – William Blair & Company

It’s because we have more resources in there it’s taking slightly longer to ramp up or we have many younger sales people that are still ramping up. Is that the conclusion?

Willard D. Oberton

No, the conclusion is we have more people. Remember, we’re putting part time people in all of our stores. We use to start with two, now we have three people in every store. We’re putting more resources in the stores earlier to grow them faster.

Daniel L. Florness

Jeff, one item I’d add into that. If you recall last year when we were first talking about the pathway to profit, I think the zero to 50 category, which was the sweet spot of our inventory, had an operating margin at that point just north of 24%. We are getting a company number of 23%.

Willard D. Oberton

Not zero to 50, above.

Daniel L. Florness

The 100 to 150, we were targeting a 23% number and the thought process was that all groups, because we’re adding people at a faster clip, there would be a slight dampening in all five groups or really groups two through five because of that added labour cost we’re introducing. What’s really offset it, if you look at year over year as our gross margin expansion has offset it in all the groups, but in that group that you talk about, the issue there is if you add a part time person or a full time person a store it just swings the needle too much as a percentage of sales.

Willard D. Oberton

It doesn’t take a big expense on a $30,000 store to $100,000 for the quarter. You add $3,000 labour you lose three points of operating profit.

Jeffrey Germanotta – William Blair & Company

Does it cause you to think about how you allocate that labour to newer or more staff?

Willard D. Oberton

Absolutely not, we want those stores to grow. That one point on that group of stores is nothing. If you look at the top group of stores, I think we added about 55 stores into the over 150. If you look at those stores and say they do $2 million. Say it’s $150,000 a month, roughly $2 million. At 28% operating profit every store going in there is worth about 20 of those ones that lost a point or 30 or 40. The faster we get them to the top the better we are. If anything, we’ll invest more and if we lose a little bit more on the bottom or lose a little ground on the bottom we’ll make it up in spades for years to come.

.

Operator

Your next question comes from Michael Cox – Piper Jaffray.

Michael Cox – Piper Jaffray

During the first half of the year you were up about 150 basis points on the operating margin. I know you’ve stayed at a 100 basis point target for the full year. What are some of the factors that would lead to exceeding that 100 basis points or what would be some of the factors that would be a drag in the second half of the year to pull it down to your target for the year?

Willard D. Oberton

We’re not working to pull it down to our target.

Daniel L. Florness

I think the biggest factor is the gross margin expansion. That’s caused it to accelerate. Because if you really, we’re off the map of just slowing morphing the stores and getting some leverage on occupancy. Getting some leverage on labour and other costs. It would naturally happen there. But the gross margin is really what’s leveraged it up even faster.

Willard D. Oberton

Also, because of the higher gross margin we’ve been willing to add more outside or continue to add people into the stores. At 16% top line revenue, if we had not seen the gross margin expansion we would have added fewer sales people. We’ve been a little more liberal with our additional sales people because we can.

Michael Cox – Piper Jaffray

You mentioned the 3% to 3.5% inflation impact to sales in the first or I believe in the second quarter. I was wondering if you could give us that figure for the month of June, if you could.

Willard D. Oberton

I think it’s probably about the same, Mike. We really looked at the core, but it doesn’t change rapidly because somebody’s anniversarying product coming in. We didn’t break it out that way, but I think it’s pretty accurate for the month of June also.

Operator

Your next question comes from Adam Uhlman – Cleveland Research Company.

Adam Uhlman – Cleveland Research Company

Dan, just a follow up on the gross margin question, earlier in the discussion it was pointed out that costs are going to be accelerating even further in the back half of the year. I would expect that FIFO accounting eventually starts to work against gross margin. How should we think about the gross margin rate in the back half of the year?

Daniel L. Florness

Well, when I look at the components that make up the gross margin we have today and the permits we have today, the piece at risk is that 25 basis points. Rough number. That is inflation that is going to be waning. The added costs that we’re seeing and that we saw the first of this year, you’ll really be seeing those costs late in the third quarter and they’ll be baked in by start of the fourth. And then the real challenge for us is, and the market place in general, staying with that wave as it comes through. But again, that last increase worked out to about 40 to 50 basis points of inflation. When you factor it down to the inflation on steel and how that translates into impact on our cost of goods.

Adam Uhlman – Cleveland Research Company

Now, have you seen any change in the competitive environment at all?

Willard D. Oberton

We really haven’t seen a lot of change in the competitive environment. Whenever there are price increases people are shopping. It goes in both directions. It creates opportunities for Fastenal and it creates challenges when you’re out pushing price increases. But our competitors are doing the same thing. So far we’ve been able to pass our price increases along. But because we run each one of our store as an independent business we charge them the actual cost of the product.

They’re raising prices when the pressure comes to them. It’s a very natural process as if they were independent owners. It basically eliminates most of our opportunities for inventory timing in an expanding margin, but at the same time it flows through very well. They’re not going to go out and raise prices if their margins aren’t under pressure because they want to be competitive within the market place. They’re business people

Operator

Your next question comes from David Manthey – Robert W. Baird & Co.

David Manthey – Robert W. Baird & Co.

Could you talk about your sales trends in construction end markets specifically and then your outlook for that vertical? And also one of your competitors discussed longer and broader summer shutdowns than normal. Are you hearing anything like that? It seems like you’ve seen that trend among your larger customers, but do you think that’s what’s behind it?

Nicholas J. Lundquist

A lot of our larger customers, as you’d indicated earlier from some of your other previous communications with some of our competitors, the larger customers are seeing some impact. However, we see a lot of opportunity with the small to medium contractors with our outside sales initiative. As a percentage of the market, we have a very small percentage of the overall construction market. We’re still seeing opportunity there to continue to grow from a construction standpoint. But there is pressure for the large commercial contract6ors right now and they’re not as busy as they’d like to be.

Willard D. Oberton

Although we did have a record month with our largest contractors in June. I just got the email two days ago. The people who call on those sent me an email basically patting themselves on the back, very, very nice month in June. It’s almost all being driven by energy of some sort, either power plants or oil refining.

Daniel L. Florness

There’s a lot of power plant stuff.

Willard D. Oberton

And also there’s a lot of mining going on right now. There’s a tremendous amount of activity around energy and because we’re located in a lot of these small towns like Central Wyoming and all these places we get a big opportunity at that. We’re really not being hurt by construction at this point.

David Manthey – Robert W. Baird & Co.

Did you have a comment on the summer shutdowns, the turnarounds?

Daniel L. Florness

I have not heard anything. But to be honest I haven’t been in the field a lot in the last month or so. Have you, Nick? Have you heard anything on shut downs?

Nicholas J. Lundquist

I don’t see any difference in what’s been historically happening when it comes to shut down. I’ve not seen or heard anything different.

Operator

Your next question comes from Brent Rakers – Morgan Keegan & Company, Inc.

Brent Rakers – Morgan Keegan & Company, Inc.

I’m just trying to get a little clarity on the additional price increases that might happen during the second half of the year. Will, I think you mentioned earlier, you estimated about four to five percentage points.

Willard D. Oberton

I think by the end of the year what we’re seeing with steel right now that we could have between four and five percentage points of our growth attributable to inflation in steel. That’s because it’s coming, it came through really hot and heavy in the March-April time frame. We’ll be selling that product out. What it really comes through is about 25% of our product saw a 20% to 25% increase and it’s the basic commodity nuts and bolts. Now, the price increases that we saw last year are going to anniversary, so that drops it back down a little bit, but by the last half of this year I think that’s probably where we’ll be.

It will be interesting to see what the overall economic picture does. If we can use that to accelerate our sales growth or if the bottom erodes a little bit and we use that to maintain our sales growth. We’re working hard to accelerate, but right now we don’t know what’s going on.

We believe that that’s probably pretty much the same for all of the industrial distributors because pretty much all of us sell steel products. That the inflationary picture is very similar no matter who you look at out there in the industry. Whether you’re an electrical supplier or other products.

Brent Rakers – Morgan Keegan & Company, Inc.

Will, just again to clarify for me, if you’re getting 3 to 3.5 essentially in the second quarter you’re only looking at the equivalent of a new 1% or 1.5% on top of what you’ve already realized.

Willard D. Oberton

Yes. Part of that is because some of the old stuff falls off from a year-over-year basis. You know what I mean. It’s a moving target.

Brent Rakers – Morgan Keegan & Company, Inc.

The bottom keeps rising.

Willard D. Oberton

The bottom keeps rising, correct. There’s two lines, the top line and the bottom line.

Operator

Your next question comes from Holden Lewis – BB&T Capital Markets.

Holden Lewis – BB&T Capital Markets

Could your comments earlier about seeing the smaller or larger accounts slowing down somewhat and that being related to the economy, but making it up with the smaller accounts. I would tend to think that the smaller accounts would be more volatile and more economically sensitive the larger accounts. I’m confused by the way that you’re putting out there. Can you maybe just give a little bit more colour?

Nicholas J. Lundquist

One thing that you have to keep in mind, and you’re correct in some regards that there is volatility there, but it’s the sheer number of accounts that we’re adding. We’re adding accounts on an active basis twice as fast as we’re growing our stores. Better than twice as fast. Almost three times as fast right now. Yes, there’s a lot of volatility there, but our account base is growing Interjection he mid teens right now, so that wipes out a lot of the volatility.

Willard D. Oberton

It’s not that our existing small accounts are buying more; we’re just adding more small accounts because we have this army of sales people out there actively knocking on doors and bringing them in new business.

Nicholas J. Lundquist

The other thing I’d throw into that is when you look at just the volatility of the existing customer base. With 200,000-plus active customers that volatility really gets smoothed out because it’s such a wide dispersion of customers.

Willard D. Oberton

I think what happens with the large customers, Holden, is they’re just more sophisticated buyers. They’re very, very tight with what they need. When they can reduce inventories they have better visibility to their business than the guy who runs in this morning because the job is starting and he needs $500 worth of concrete anchors or whatever it happens to be. It’s a different type of business. We’re not saying the bottom’s falling out on our big business. It grew at 12%, we’re disappointed with that, but we have a lot, we’re working very hard to improve that.

Nicholas J. Lundquist

I’ll add a little bit to the larger customers as well and that is if somewhat the same thing is happening in that group. That is we are, because of the volatility of the marketplace we have a lot of customers that are buying more product from us or weren’t buying from us in the past because of the services we can provide. Lowering their inventory, lowering their labour. The net-net result is, yes, they’re not growing very fast, they’re not growing as fast as we’d like them, they’re about in that 12 range.

What is happening is some of our existing large customers might be slowing down, but we also have existing customers that are buying more from us because of the services we provide. We’re adding larger customers out there that are looking for the type of services we can provide because they’re in a situation where they basically have to lower operating expenses, which is primarily labour, which we can come in and take care of some of those services. The net-net result is they’re not growing as fast as we think they should. Most of that is a result of some of our existing large customers being slow, but they’re not going away.

Holden Lewis – BB&T Capital Markets

You’ve always come at the breakeven level in terms of growth was in the 11% to 12% range. You think you’re down there. Over the last six quarters, so going out even before the recent gross margin spike, over the last six quarters you’ve achieved revenue growth between 14% and 15% and you’ve had SG&A leverage, stripping out the D&A component, up about 30 basis points. Essentially breaking even in terms of SG&A leverage at a mid teens growth rate, which seems like it’s a little bit higher than you would normally suggest. Can you give some colour as to why that may be?

Daniel L. Florness

It’s all about the fact that 70% of our SG&A is levering up like crazy because of the gross margin expansion.

Willard D. Oberton

Gross margin expansion, profit growth, and addition of outside sales people.

Holden Lewis – BB&T Capital Markets

The gross margin expansion is like the last two quarters, but not necessarily the four preceding it, right, the 2007 year.

Willard D. Oberton

The 2007 was really about adding outside sales people. If you look at the additional sales people that we added in 2007 drove almost all of our expense. And then we have had this conversation before, Holden; as long as we can afford it we’re going to keep pushing on growth because long term that is our best bet right now. We look at it and we say we’re doing things we need to with the gross margin, we have the money, we can get our 100 basis points growth and profitability; let’s add the sales people because in the future when the economy picks up we should be really well positioned.

Daniel L. Florness

Yes, just like we were well positioned earlier in this decade and in the mid-90s. Early to mid-90s.

Holden Lewis – BB&T Capital Markets

The fast rate of profit is a relatively new effect. At what point do you think that you begin to leverage the revenue that’s being driven off of that investment? Is that something in this environment that we can expect or in the environment that exists today it’s going to be difficult to envision leveraging those personnel ads?

Willard D. Oberton

You mean from an expense standpoint? You mean operating? We’re really not focused on just leveraging that. We’re focused on growing our operating profit and investing as much as we possibly can and hitting our profit goal. If it’s going out in high bonuses in commissions because we have great gross margin we’ll take the profit wherever it comes. Whether it comes from gross margin or lower operating expense. If our margin drops or our profit drops we’re going to react very quickly and lower our operating expense.

Daniel L. Florness

And part of that reaction will naturally occur because of the profit bonus component.

Willard D. Oberton

If you look at the executive bonuses, they are more than triple from last year in the second quarter. The group that works for me.

Holden Lewis – BB&T Capital Markets

You’re not getting the leverage because you’re adding the expense. And that’s deliberate. You’re maybe accelerating that because of the gross profits.

Willard D. Oberton

Because we know we can.

Nicholas J. Lundquist

One of the key pieces to this, though, is the average size of the store continuing to grow. That’s the basis from the strategy and that’s what you have to remember. If we can continue to grow the average size of our store and use our historical data as reference, which we can, we should be able to drive up our earnings. And all of the other stuff is a lot of detail, which is important.

Willard D. Oberton

If you take the, I believe it’s 54 stores that we added into the top category, the 150-plus, and do the math that adds about $8 million in operating profit year over year. Just that group of stores. If you take it from the bottom and roll it up to the top. Take them out of the bottom, take them to the top. It adds over $8 million in operating profit in a small group of stores. And that’s what Nick’s pointing out.

Operator

Your next question comes from John Baliotti – FTN Midwest Research Securities Corp.

John Baliotti – FTN Midwest Research Securities Corp.

Could you maybe give us some colour end market wise? If you look at the overall average and maybe give us some colour on end markets that might have been growing above and below how you grew for the quarter. And if you could remind us of the percent of your sales that are more non-res construction versus other.

Willard D. Oberton

Well, basically we have very small exposure to non-res construction, or excuse me, residential construction very small exposure. Non-res construction is about 20% to 22% of our business. The products for construction are greater than that with the actual contractors. We don’t state specific growth numbers in each category, but we haven’t seen a lot of change. Probably the biggest one is the large OEM customers are dropped and that’s reflected in that strategic account number.

Maintenance continues to be strong. The energy industry is very strong. Agriculture is very strong. And anyone who’s exporting product because of the weak dollar seems to be doing very well. Where we’re getting beat up is any manufacturer that sells their product into the residential construction – windows, doors, equipment – one of our largest customers or a very large customer just announced a 40% layoff because their products they make are used in building homes.

John Baliotti – FTN Midwest Research Securities Corp.

Will, earlier you said in your prepared remarks that smaller counts were higher in gross margin, which makes sense because of how they buy. I was curious, could you characterize that from an overall profitability and operating margin and if you characterize the small.

Willard D. Oberton

We don’t because we look at the store as a business. The store manager has to maintain a 50% margin to be fully, or mix to be fully comped. We don’t break it out by customer size. On the very big customers we do. On the very large customers. But we don’t do it on the small customers. We look at it that they are a business manager. We trust them to manage their business profitably. And when we do so we pay them fairly or hopefully better than fairly.

John Baliotti – FTN Midwest Research Securities Corp.

Academically, would a smaller customer require more service than a large customer because they’re maybe buying more frequently?

Willard D. Oberton

It’s all over the board. Some are very needy and others walk in and buy product. There just is no exact customer type we sell to. More than 225,000 customers a month. Some of our largest customers are the most needy customers that we have because they can be. And then others are not and we have to balance the profitability on the large ones. But on the small ones you run your business and you understand the customer needs.

Nicholas J. Lundquist

And two things I’d add to that. One is you need to talk about the concept of need is the case of we’re a local distributor of that customer. We have the ability to provide them a high level of service and they compensate us for that service. It’s a great win-win scenario.

The second thing I’d put out, especially on the smaller customer base, the CSP initiative that we started back in 2002 where we really laid out the products in a more efficient fashion in our store lends itself to servicing a wide range of customers, especially smaller customers, much more efficiently than we could have, say, five or 10 years ago because it used to be a lot of our stores had a sign on the front, “Minimum Order $20,” “Minimum Order $25.” Those signs are gone because we can make money on transactions, but we don’t have labour in the transaction at the store.

Willard D. Oberton

And also because we let our managers, we give our managers a lot of decision making or discretion. They have a customer that’s very needy they might have to slowly raise the price until it balances between opportunity and energy going in like any business person would do in managing their business to profitability. Because they do have a limited number of resources to use to grow their business. We work very hard in training them to be independent business people whenever and wherever possible.

John Baliotti – FTN Midwest Research Securities Corp.

On the pricing side you’re talking about how steel prices; you’re starting to see in the beginning of the year 67% rise in pricing.

Willard D. Oberton

No, no. It was 67% rise in iron-ore pricing.

John Baliotti – FTN Midwest Research Securities Corp.

Did that transition as it works into the product itself; is that something that you can start to convey to your customer in terms of your pricing? Do you do that right away or do you start to see that in the headlines? How do you –

Willard D. Oberton

Well, what we do is we have to wait for the market to start reacting because we can’t run out there right away. If they haven’t seen it they’re not going to accept it and we risk the business. What we do is we raise our prices as it comes through. Our wholesale price and all of our prices. We go out to our managers. We explain it to them. And they raise prices as soon as they can, but they really have to wait.

Normally they will wait until their margins start being affected. If they’re margin is moving down they go raise their prices. If we’re doing a good job that’s about the same time as our competitor’s probably raising their prices and it becomes a market condition. We’ve become pretty good at that. For the 20 years before 2004 we never had to do it. In 2004 we learned a little bit. In 2007 and 2008 we’ve learned a lot about raising prices and understanding what the customers will accept.

I have been more involved in that in the last year than I was in the previous 20 years. Mainly always big customers. It’s a challenge, but we get paid to do a job and right now the job we have includes price increases.

Daniel L. Florness

I wanted to reiterate one item within our conference call and that is the whole gross margin area. One way you’ll often times hear us talking at conferences or just internally, we’re straightening out the lines. Our direct sourcing operation is really straightening out the line between the manufacturers of the product and the customer that’s buying it. Where we can straighten out the line of where that product flows, everybody knows the shortest distance is a straight line. We can lower our costs and have a competitive advantage and improve our margin and improve the value we provide to our customer.

The second half of that is over the years a lot of times I’ve been questioned about the wisdom of having this large internal trucking fleet. It’s a large fixed-cost component of gross margin. This is a quarter, this is a period of time when I look at the last three months, six months, 12 months, where I’m very thankful in my role of the wisdom we had 20 years ago when we started creating this trucking network of what a competitive advantage we’ve built, the proverbial moat we’ve put around the business to enhance gross margin over time, to provide a great level of service.

Because when you get down to it we’re hauling a gob of steel at relatively low value per pound product around a very large continent and we can do it more cost effectively than anybody. Getting back to that whole concept of alternative A or alternative B, alternative B, which is Fastenal trucking, has a 10-to-1 cost advantage. I can’t make that point enough.

Again, thanks to everybody for taking an hour out of your morning today to listen to our call. Have a good weekend.

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