FAST - Fastenal Is Not Fazed By Slowing Manufacturing Activity

2023-07-06 07:30:00 ET

Summary

• Fastenal's stock price is near its 52-week high despite a contraction in the manufacturing sector, consistent with the company's past resilience in challenging market conditions.
• The company is expected to report Q2 earnings on July 13, with a projected $1.89bn in quarterly sales, representing a 6% year-over-year growth. Gross margins will likely be weaker.
• Despite weakening trends in C&I lending and a potential recession, Fastenal's expansion of its offerings and growth in on-premise and e-commerce businesses could mitigate potential impacts.
• Fastenal shares are seldom cheap, and today is no exception, but a shortfall in Q2 and/or weaker 2H'23 guidance could be an opportunity for investors.

Strong organic growth and market share gains through good times and bad has long been a key differentiator for Fastenal ( FAST ) and limited its cyclical vulnerability, but that divergence has become even pronounced lately. While manufacturing sector contracted for the eight straight month in June (as measured by the Institute for Supply Management's (or ISM) manufacturing PMI), Fastenal's stock price is within a dollar of its 52-week high as of this writing and within 10% of its all-time high.

Although I'm not concerned about Fastenal's future, and the stock has long traded at a robust multiple, I have to admit being surprised at the lack of concern the Street seems to be showing over relatively uninspiring volumes and the ongoing slowdown in its manufacturing business. While I don't expect this industrial downturn to be steep nor long-lasting, the shares already seem to be looking forward to a robust recovering and ongoing share gains, and that may be a more demanding set-up for upcoming earnings.

Looking Forward To Q2 Earnings

Fastenal is scheduled to report fiscal second quarter earnings on the morning of July 13, with a conference call before market open. Expectations have pulled in slightly since the last quarterly report, and given that Fastenal reports monthly sales figures there usually aren't too many large top-line surprises when the company does report.

The Street is currently looking for $1.89B in quarterly sales, or about 6% year-over-year growth, and that seems reasonable given the 8%-plus growth in April sales and 5%-plus growth in May sales. While MSC Industrial ( MSM ) indicated that its June sales were trending up 7%-8% when it reported in late June, there are some company-specific drivers at MSC that could drive better results than what Fastenal sees (MSC's May and April sales growth numbers were better).

Specific to Fastenal, sales have been decelerating for a while now, with manufacturing sales growth falling into the high single-digits (from low double-digits) in May, led by fastener sales during negative. Non-residential construction sales have been increasingly weak of late (down almost 10% in the month of May), as the company sees weaker non-residential demand trends and continues to restructure the business (away from smaller customers, which exacerbates the macro trends).

Given mix (weaker sales of higher-margin fastener products, and more Onsite sales), I expect another quarter of weaker gross margin. I think the year-over-year decline could be something in the order of a point, and I think there could be up to a half-point of downside risk here relative to sell-side expectations if fastener sales really softened in June.

On the positive side, Fastenal management has shown time and time again that they can offset gross margin pressures through excellence in operating cost management. I would expect more of the same, and while I think operating margin will be down a few tenths of a point from the year-ago level, I don't see major downside risk here, and I think an EPS number of around $0.54 is doable (as of this writing, the average sell-side estimate is $0.53 per share).

The Trends Are Not Friends, But May Not Matter That Much

To be sure, the macro environment is not particularly constructive right now. Companies have been warning of slowing momentum and the potential for a modest recession starting later this year. Along similar lines, we now have eight straight sub-50 readings for the manufacturing PMI, suggesting a prolonged period of moderate contraction (the latest reading, a 46, is the worst so far, but still not that bad).

I'm also concerned about weakening trends in C&I lending. In the past, downturns in C&I lending have led to downturns in industrial production by about a quarter and although year-to-date C&I lending is still up year over year, the numbers are getting weaker (up less than 3% yoy in the last reading). The buzz now is that while investment in process industries (oil/gas and renewable energy especially) is still healthy, discrete manufacturing companies are starting to postpone capex projects while also undertaking a "controlled" inventory destocking process as supply chain snags unravel.

How much this will impact Fastenal is debatable. Fasteners are the most cyclical part of the business, and I do expect to see a further step down in sales growth in the second half (to around 3% yoy growth), but I expect a downturn to be relatively brief, and I think mid-single-digit revenue growth is attainable in 2024. Likewise, while the fastener business will be under pressure from reduced industrial activity, Fastenal is still underway with efforts to grow its overall share of industrial distribution by widening its offerings and growing its on-premise (Onsite, vending) and e-commerce businesses. In other words, even if core sales volumes erode more than I currently expect, growth in other areas will help mitigate the impact.

The Outlook

As I said, I'm looking for growth to decelerate further in the second half of 2023 before rebounding in the second half of 2024. Ongoing expansion of its offerings and its on-premise and e-commerce businesses should continue to drive several years of growth well ahead of the underlying industrial economy, and I also see Fastenal as benefiting from increased domestic manufacturing (on-/reshoring). Net-net, I expect long-term revenue growth in the neighborhood of 6% against a trailing growth rate a bit below 9%.

On the margin side, I expect long-term deterioration in gross margin. That's the nature of distribution now, and it's exacerbated by the growth of lower-margin on-premise offerings. I do still see opportunities to optimize SG&A, though, and while on-premise business carries lower gross margins, it offers better long-term operating margins. With that, I still believe that Fastenal can attain long-term free cash flow margins in the mid-teens, helping drive low double-digit FCF growth.

None of this means that Fastenal is conventionally cheap, but that's the norm here. A high-teens (18x-19x) forward EBITDA is not out of line with other high-quality industrial companies, but that doesn't get me to a fair value much above today's price based on my 12-month EBITDA expectation.

The Bottom Line

As I said in my prior article , Fastenal is a name to watch for a rare sell-off. I do find the recent share price performance to be a little optimistic relative to what I see is fundamental deterioration in the company's served markets, but then Fastenal has shown over and over again that it can grow through cyclical downturns and continue to gain share. Should the company miss and/or offer a more cautious guide, a sell-off could create a window of opportunity, but investors shouldn't expect Fastenal to get conventionally cheap so long as the company can continue to grow well in excess of underlying industrial production over the longer term.

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