MSM - Fastenal: A Name To Watch As Short-Cycle Slows

Summary

• Fastenal's fourth quarter results were once again better than expected, though pricing likely played a bigger role in sales growth than formally acknowledged by management.
• Higher sustained pressures on gross margin is really no surprise to me, and I continue to believe that Fastenal has recourse to superior operating efficiency as an offset.
• I expect short-cycle demand to slow further, and if Fastenal shares were to retreat to the low-$40's, it would definitely be an opportunity to add shares of a top-notch industrial.

So far the great short-cycle slowdown really hasn’t been a thing. While the PMI has been easing off and companies remain nervous about the 2023 outlook (at least among those that have reported), short-cycle names like Kennametal ( KMT ), Lincoln Electric ( LECO ), and Rockwell ( ROK ) have been outperforming the broader industrial sector. That makes Fastenal ’s ( FAST ) relative underperformance since my last update (though still up about 5%) a little more interesting, particularly as I think there could be more downside for short-cycle names.

To be clear, I’m not really looking for Fastenal to get “cheap”. The best investors should realistically hope for here is “cheap for Fastenal”, as this company has shown it can consistently gain share in the fragmented industrial distribution market while posting strong margins and returns (return on assets, invested capital, et al). Were the shares to pull back into the low $40’s without a thesis-changing driver, it’s a name I’d definitely consider adding to my portfolio, even recognizing a challenging long-term outlook for margin leverage.

Business Is Slowing, But Fourth Quarter Results Still Beat

There was evidence of slowing end-market activity throughout Fastenal’s fourth quarter, but the company nevertheless executed well and delivered a top-line and operating-line beat.

Revenue rose 11% in the quarter, beating by 1%. Through the quarter management saw monthly sales slow from 15% growth in October to 9% growth in December, with a pronounced slowdown in non-residential spending, but more resilient activity in the manufacturing business (still up 13% in the last month of the quarter).

Gross margin declined 120bp yoy and 60bp qoq to 45.3%, missing by 30bp, and management signaled a long-term shift in gross margin headwinds going forward (more on this in a bit). Tight operating efficiency once again compensated, with operating income up 11% and operating margin flat year over year at 19.6%. Operating income was almost 4% better than expected, while operating margin beat by about half a point.

Growth Has Definitely Slowed

Management claimed around 350bp-380bp of pricing actions in the quarter, but this estimate only covers about 40% of the observable business, and I think underlying pricing was actually a lot stronger. Considering that fastener prices were up double-digits in the quarter (as per PPI data ) and most other product categories were up mid-single-digits to low double-digits, I suspect the real “apples to apples” impact of pricing was closer to the high single-digits, suggesting underlying volumes more in line with underlying industrial production of 2.5%.

Along those lines, management did acknowledge some headwinds that I’d mentioned as risk factors in earlier pieces. Namely, the company is seeing increased competition from smaller distributors as supply chains improve – large distributors like Fastenal, Grainger ( GWW ), and MSC Industrial ( MSM ) got a boost when supply chains were snarled on their elevated ability to source components that were unavailable elsewhere.

Looking ahead, I expect PMI to bottom out in the fall of this year (Sept/Oct of 2023), and I believe business will slow further. With commodity prices easing in some cases, increased competition, and higher normalized headwinds from mix shift, I do think Fastenal is going to see weaker quarterly results as 2023 goes on. I don’t think they’ll ever get “bad”, but a slowdown will be evident.

Speaking of gross margin headwinds, management acknowledged stiffer headwinds going forward from ongoing shifts in the business – including more branch closures, more on-site revenue, and more business done with large national clients (with more bargaining power). Where management had once expected 30-50bp of headwinds from these factors, it now looks like 50-70bp is the new normal.

I’d been expecting something like this, and it actually took longer for management to acknowledge it as the new reality, but it’s not at all bad. There are still opportunities for Fastenal to leverage more store-brand content, more customized content, and a broader array of products, all of which could help mitigate some of that margin pressure.

I’d also note that Fastenal remains masterful on the operational execution side of the business. The distribution fleet (trucks, et al) is exceptionally efficient, and management will be spending over $200M on capex in 2023 to add a new distribution hub as well as improve existing hubs (more automation, et al). Given that Fastenal has the wherewithal to invest in automation and distribution assets that small players can’t hope to match, I do think Fastenal can see ongoing gross margin headwinds and still emerge as a net winner due to its improved operating efficiency.

The Outlook

I’m still looking for around 5% to 6% long-term revenue growth from Fastenal; I believe Fastenal will continue to outgrow underlying U.S. industrial production on the back of expanded offerings (breadth and depth) and share gains driven by improved e-commerce and on-site sales (vending and on-site inventory management). As a reminder, industrial distribution is still exceptionally fragmented, and Fastenal probably has something around 6% share now, so there is plenty of room to gain at the expense of smaller, less-efficient players.

On the margin side, I do see a slow grind toward higher EBITDA margins, as well as higher free cash flow margins over time. I believe FCF margins can reach the mid-teens on a sustainable basis over the next decade, driving high single-digit FCF growth.

Valuation is always problematic when discussing Fastenal. On one hand, the shares rarely seem to offer much upside on discounted cash flow. On the other hand, the market has shown that it will consistently pay up for companies with sustainably strong margins, ROICs, and so on – the degree to which the market will pay up certainly varies with market sentiment, but I don’t have an issue with the general notion of a sustainable premium here.

The Bottom Line

If I use an 18x multiple on EBTIDA here, a multiple not out of line with what the market gives high-quality “compounders” (companies like Ametek ( AME ), Danaher ( DHR ), IDEX ( IEX ), and so on), a fair value just above $50 is plausible. While Fastenal is perhaps not a conventional compounder, I’m willing to let them in the club, but that still doesn’t suggest a lot of upside here. Were the shares to trade down to the low-$40’s, say on a broader pullback in short-cycle leveraged names, I think the investment opportunity would be a lot more exciting.

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