Gross Margin Improvement Can Push Fastenal Upwards

Summary

• Changes in the product mix and a higher share of customers from the national accounts led to the sharp gross margin fall in Q2.
• The company plans to improve its gross margin by passing along higher costs through price hike.
• The long-term value drivers are strong.
• The stock is not relatively undervalued at the current level.

FAST Looks Good In The Medium To Long Term

Fastenal Company (NASDAQ:FAST) is a wholesale distributor of industrial and construction supplies in North America. Fastenal’s competitive advantage lies in its robust business model. The company’s legacy business model was branch-based, but it has gradually adopted more technology-based solutions and onsite locations. The long-term value drivers point towards a steady activity flow. As the company starts improving its margin, returns from the stock can increase in the medium-to-long-term. In the short-term, I expect FAST to maintain a stable top-line, while pressure on the margin is likely to keep returns limited.

Its current strategy involves adding to the onsite locations significantly while reducing the reliance on the public branches. It has also shifted away from fastener sales to other industrial product sales. The change in product mix along with a deceleration in the higher-margin non-National Account customer growth impacted gross margin adversely. Therefore, the primary focus of the company has been on improving the gross margin. It now has set a path to increase pricing and pass along the impact of the tariff hike on to the customers, which is likely to improve margin gradually up to Q4 2019.

Analyzing The Current Drivers

For FAST, typically, the larger customers produce a below-company average gross profit. This large-versus-small customer mix and fasteners versus non-fasteners product mix change have put pressure on the company’s gross profit. In the past year until Q2 2019, it fell further to ~47% from 48.7% a year earlier. The company’s gross profit margin was 50.8% in FY2014. Because large customers can leverage the company’s existing network, the company seeks to target this group. The other root cause for the margin fall was the deceleration in the higher-margin non-National Account customers, which grew less than 1% in Q2 2019.

In

Analyst’s Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.