With investors feeling noticeably better about industrials over the last three months (the Industrial Select Sector SPDR (XLI) is up about 14%), I'm not altogether surprised that the shares of Fastenal (FAST) are up even more, though the 26% move is still exceptional. When industrials do well, Fastenal almost always does well, and at least, some investors certainly seem to be counting on a stronger second half in that sector.
I remain more cautious. I'm more cautious on the macro outlook for the U.S. economy going into this quarter, though I'd be more than happy to be proven wrong by strong beat-and-raise reports from the sector. I'm also cautious on what looks like a "take no prisoners" valuation that leaves no room for company-specific or more generalized headwinds for Fastenal, even though I do believe there are still growth opportunities in place that can drive above-sector mid-single-digit long-term revenue growth.
It Seems That Good Enough Was Good Enough
Given Fastenal's valuation going into first quarter earnings, I was concerned that just meeting numbers might not be enough. Apparently, I needn't have worried, as the shares have traded up since reporting despite an in-line EPS number and a trivial top-line miss.
Revenue rose more than 10% as reported, with 12% growth in average daily sales. Fastener sales were slightly below trend, and non-fastener sales were up almost 13%. Both manufacturing and non-residential construction remained strong growth markets for Fastenal throughout the quarter, but there was a more noticeable divergence between national and non-national accounts, with national accounts outperforming.
Gross margin declined a point from the year-ago level. MSC Industrial (MSM) saw broadly similar erosion (120bp GAAP, 80bp adjusted), and this is not a new phenomenon for Fastenal - the company has not reported a year-over-year improvement in gross margin since the second quarter of 2017 and hasn't reported back-to-back quarters of year-over-year gross margin improvement since the third quarter of 2013. Given the increased visibility that buyers now have into manufacturer prices, rebates, and so on, and the overall increase in price transparency (and online sales), it has gotten progressively harder for distributors to hold the line on gross margin without losing volume.
That said, operating performance continues to be strong, and Fastenal leveraged 10% revenue growth into 11% operating income growth and a 20bp improvement in operating margin (MSC's operating margin declined 90bp on an adjusted basis).
"What Now?" Is Still A Valid Question
In my opinion, the tone of Fastenal's call was more positive than MSC's, as subjective as a metric as that may be. Fastenal did point to weakness in oil & gas (like MSC), but manufacturing was up over 13%, and management said that "most sub-verticals" are healthy, presumably including autos, which has been an area of concern (and an area where MSC noted weakness in its fastener business). Interestingly, Fastenal did point to moderating growth in safety - I'm curious to see what, if anything, presages about the safety businesses at Honeywell (HON) and 3M (MMM) and to what extent Fastenal's exceptional growth here in recent years has been from share gains versus riding strong underlying demand.
Fastenal is also continuing to do well with its organic growth drivers. Vending machines continue to grow above trend, with a 13% year-over-year increase in machine placements. The company's Onsite program is still in its early days, but sequential location additions grew over 12% (and up 39% yoy). I'd also note that while EPS were in line with expectations this quarter, incremental margin was better than expected at 22%.
While what Fastenal can control is doing well, I'm more concerned about what lies outside that circle. March daily sales were up from February and still very healthy (nearly 13% like-for-like), but below the expected 14%. As I said before, I'm concerned that there are emerging signs of a slowdown that are still being overlooked in the hopes of a stronger second half to 2019. Maybe I'm too bearish, and industrial earnings reports will support a stronger outlook, but time will tell. If economic activity does indeed slow, Fastenal will face increasing headwinds - I believe the company's internal growth efforts will offset that some, but a lot of growth is already priced in.
My basic outlook for Fastenal hasn't really changed much; I've raised my expectations for 2019 slightly, but I'm still looking for long-term revenue growth of a little more than 6% and long-term FCF growth of around 10% (against a long-term growth rate of 10%). Unfortunately, those estimates don't get me close to an attractive fair value on a discounted cash flow basis, so you either need to assume meaningfully above-trend growth or use a low discount rate (or some combination).
Valuation through margin/return-driven EV/EBITDA is more forgiving, but with the big run over the past three months, even that is now stretched. A mid-teens EBITDA multiple is arguably fair, given what investors have historically paid for similar levels of margin, ROIC, and so on, but the shares are now at over 16x forward EBITDA.
The Bottom Line
I don't believe in arguing with success, and Fastenal has been both a good company and a good stock over the long term. Still, I also don't believe in just ignoring valuation, and while I am bullish on Fastenal's plans for generating revenue growth and margin leverage, I can't get comfortable with the valuation, given what I see in the macro environment.
Disclosure: I am/we are long MSM, MMM. 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.