The Short Case For Fastenal

| About: Fastenal Company (FAST)
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Fastenal Company (NASDAQ:FAST) is a wholesaler and retailer of industrial and construction supplies. The company serves the construction and manufacturing markets, as well as maintenance and repair operations for a variety of industries.

Fastenal has taken advantage of the growth in these industries, and the company's stock has been one of the best performers over the past couple of years. Earlier this year, the stock peaked just over $53, but then fell below $38 over the summer. After trading in the $41-$44 range from August through October, the shares recently broke out above $48 as we approach Q4 earnings.

Fastenal Is Priced For Significant Growth

With FY13 earnings projected at $1.65 per share, Fastenal currently trades at a 29 P/E. Over the past two years, the company's revenues had been growing at over 20% on a year/year basis. This performance is consistent with the significant growth in manufacturing construction during the same time period. According to the construction spending data from the Census Bureau, manufacturing spending started to grow in the middle of 2011 and peaked at over 50% year/year growth in the beginning of 2012 (note that these calculations are based on data that has not been seasonally adjusted).

Fastenal has been able to capitalize on the growth in the industry by increasing its sales per store, by opening new stores, and by rapidly growing its vending machine business. According to Fastenal's earnings releases, the number of installed vending machines has grown by over 30% each quarter throughout 2011 and 2012. During that same period, the number of stores grew at an average of 4% each year. Given this type of performance, it is not surprising that investors are willing to pay such a high multiple.

Fastenal Cannot Maintain This Growth

So what makes Fastenal a good short candidate? It is the fact that Fastenal will not be able to sustain these growth rates to justify a near 30 multiple. The monthly sales data released by Fastenal is showing that there are major cracks in the armor.

The chart below shows the year/year growth in net sales reported by Fastenal each month. In early 2010, Fastenal's net sales started growing at a 20% clip and maintained that level until around May 2012. That's when the first weakness in growth appeared--and caused the stock to drop about $15 in price over the next two months.

Because of the varying number of business days per month from year to year, the net sales numbers can be a bit choppy. The chart below shows the year/year growth of Fastenal's average daily sales. This chart more clearly shows the decline that started in May. It also shows the continued decline in average daily sales through the end of this year.

These two charts illustrate the decline in the growth of Fastenal's sales. Another growth driver--new stores--is also on the decline. Fastenal opened 121 and 95 new stores in 2010 and 2011, respectively. During the FY11 Q4 conference call, the company projected that it would add 4% to 6% to its total stores (or around 100-150 stores) in FY12. The company has come up short of that target. Through November, Fastenal opened only 77 new stores. During the FY12 Q3 conference call, the company projected opening 50-100 stores in FY13. As a result, the addition of new stores will not be a growth driver in the near term like it had been in the past.

As for vending machines, there is no sign yet of a drop in growth. In FY12 Q3, Fastenal installed around 4,000 machines and signed contracts for an additional 5,000. But with over 17,000 installed machines at this point, it will not be long before the company fails to increase its vending machine count by 30% each quarter. The decline in growth should start early next year.

The Trade

Fastenal's top-line revenue growth will drop below 10% on a year-over-year basis after it reports Q4 earnings. And the trend down will likely continue. If the P/E multiple were to drop to around the 20 level, that would mean a $15 drop in the shares (9 x $1.65 projected FY13 earnings).

The jump in price from $40 to $48 in the past month has provided a good opportunity to enter a short position in the shares. If you are not comfortable shorting the shares, you could buy a deep-in-the-money put as an alternative. Keep in mind there is a cost for doing so. For example, the $49.50 puts for the May strike are priced with about $2.50 of extrinsic value. In other words, FAST would have to move down $2.50 by May just to break even on the trade.

If you are inclined to play the short trade with options, consider a vertical bear spread. Looking at the May expiration, you can buy the $54.50 puts and sell the $41.50 puts for around $6.50. With a $13.00 difference between the strikes, your maximum loss will be $6.50 (what you paid for the spread) and your maximum gain will also be $6.50 ($13.00 difference between the strikes less your entry price). The net effect of this option position is that it will behave just as if you shorted the shares except your maximum gain and loss are capped at $6.50.

Disclosure: I am short FAST. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.