FAST - Fastenal: A Softer Manufacturing Environment Is Weighing On DSR Growth

2023-04-18 11:25:12 ET

Summary

• Fastenal Company sells a variety of industrial and construction supplies on primarily a business-to-business basis at both their branch and Onsite locations.
• The company's results closely mirror the overall strength in the manufacturing environment.
• While results have continued to exhibit a positive trend, the rate of growth in their daily sales rate has been impeded by the softer macroeconomic environment.
• At current trading levels, I am maintaining a neutral position on the shares until there is a more marked reversal in their daily sales trends.

Fastenal Company (FAST) is a leader in the wholesale distribution of industrial and construction supplies.

They offer a broad variety of products to customers primarily through their branch and Onsite locations. Both locations exist close to their customer base, though Onsite is most often within or immediately proximate to their customers' physical locations.

Over the years, the company has made substantial investments in their Onsite model, and the growth of these sites is viewed as a key growth driver. The sales mix at these locations does operate at lower gross margins, but this is offset by overall revenue gains with the customer, as well as the lower overall costs to serve them.

Recent results indicate the company is continuing to make strides in their targets. In addition, margins are holding steady on improved expense control and favorable contributions from freight. A more normalized environment in the supply chain is also contributing to a stronger cash flow position than in prior years. But these positive notes are offset by headwinds in daily sales growth due to the slowing manufacturing environment. And at current valuations, I don't see shares tracking materially higher until there is greater improvement in their daily sales rate ("DSR"). I, therefore, maintain a neutral view on the stock.

Higher Net Sales But Weak Growth In DSR

Total net sales increased 9.1% in Q1 of fiscal 2023 to +$1.9B. Contributing to the increase was higher unit sales on favorable demand drivers in industrial goods and commodities. Product pricing contributed between 290 to 320 basis points ("bps") to total sales growth.

This was offset in part by a contraction in construction supplies. In addition, foreign exchange and adverse weather negatively impacted quarterly sales by about 100 basis points ("bps").

Within individual product categories, Fasteners and Safety Supplies represented about 55% of their total quarterly sales, consistent with prior periods. The DSR continued to decline in their Fasteners product line, to 7%, with a 2.3% decline noted in March.

This most likely relates to lower manufacturing activity . The U.S. industrial production index ("PMI") in March, for example, was 46.3, which was below the 47.1% average for Q1FY23.

Among National and Non-National accounts, daily sales rose 13.6% in their National account, with over 80% of their top 100 customers growing.

Steady Margins On Adequate Expense Control

Gross profit percentage slipped to 45.7% in Q1 from 46.6% in the same period last year. One factor driving the decrease was their customer and product mix, which tilted heavily towards Onsite customers and non-fastener product lines, respectively, both of whom generate lower margins.

During the quarter, FAST had 89 Onsite signings, bringing their total active sites to nearly 1,700, up about 16% from last year.

Partially offsetting the gross margin pressure was favorable freight performance. The DSR in freight, for example, was up 13.8%. In addition, both the volume of products and the number of containers being imported from overseas suppliers was below prior year levels, resulting in lower overall container costs.

Though gross margins were down, operating margins were up 20bps to 21.2% due to improved operating expense leverage. As a percentage of sales, operating and administrative ("O&A") expenses declined 90bps from the prior year to 24.6%. This was due in part to lower incentive compensation.

While incentive compensation was down, overall employee base pay was up during the period due to a combination of a higher employee count and average wages. This in turn pushed employee-related expenses, which represents about 70% of total O&A expenses, up 4.4% during the first quarter of 2023.

Positive Earnings Growth And Strong Overall Operating Position

Overall, FAST reported total earnings per share ("EPS") of $0.52/share during the quarter. This was up 10.4% YOY due primarily to daily sales growth of 9.1%, expense control, and a lower share count resulting from last year's more aggressive repurchases.

At quarter end, the balance sheet held steady, while total cash flows exhibited significant YOY improvement due primarily to a more normalized environment within the supply chain, which has reduced the company's working capital needs to support their operations. Inventory, for example, was up 3.2%. Though higher, the pace of growth is slower than their sales growth during the period.

Total net capital spending ("CAPEX") during the quarter came in at +$31M, which is a lower rate of spending in relation to prior periods. But this relates primarily to the timing of their expenditures. In total, management expects to spend +$220M in CAPEX in 2023, with higher outlays expected on hub investments, fleet equipment, and IT equipment.

Post-Earnings Insights

FAST reported a mixed Q1, though largely in-line with expectations . Total revenues, for instance, missed estimates by +$10M but earnings landed a penny ahead of consensus on a combination of growth in their DSR of 9.1% and prudent expense control.

Though their DSR continues to exhibit growth, the trend remains negative. Following a peak of 18.4% in Q1 of fiscal 2022, DSR has decreased every quarter thereafter. In addition, management noted particularly softer growth in March. This is suspected to be due to more tightened conditions for manufacturers.

The company also made further progress on their Onsite signings, a key growth driver, but the pace of their quarterly signings tracked below their expectations. The slower pace, however, was offset by favorable progress in their weighted FMI device signings and installations, as well as their percentage of sales through their digital footprint, which increased to 54.1% during the quarter from 47% in the same period last year.

Margins held steady. Some softness, however, was noted due to their product and customer mix. Pricing tailwinds also figured less into overall growth. But looking ahead, FAST could experience some margin expansion relating to pricing actions taken on less frequently sold, non-standard products. Continued improvements in freight-related expenses should also benefit the company in later periods.

At the upper end of their 52-week range with a near 27x multiple, I don't believe shares ring of value in this market environment. By assessed measures, the manufacturing environment is cooling, as evidenced by recently reported PMI figures. This is negatively impacting their DSR, especially in their Fastener product line, their largest by net sales. Their cash flow strength and balance sheet foundation do mitigate their exposure risk to a slowing market environment, but the strengths here don't provide much of a catalyst for the share price. While the stock can serve as a good benchmark for the state of the manufacturing environment, I am neutral on new or further positioning on the stock.

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