MSM - Fastenal: Near-Term Slowdown In Growth Keeps Me On The Sidelines

2023-09-19 17:04:32 ET

Summary

• Fastenal Company's growth is expected to decelerate due to slowing macros, lower ticket size, and potential pricing deflation.
• Sales growth has slowed to high single digits in Q1 2023 and mid single digits in Q2 2023.
• Margins are also expected to remain under pressure.

Investment Thesis

Fastenal Company’s ( FAST ) growth should continue to decelerate as it is getting impact from slowing macros, lower ticket size and some pockets of pricing deflation in its SKUs. The company’s gross margins are also under pressure and, given slowing growth, SG&A leverage might not be enough to offset its impact resulting in lower operating margin as well. While the company has a good long-term track record of growth and continues to execute well, this is already reflected in its premium valuation versus peers and I prefer to remain on the sidelines and until the growth reaccelerates again. Hence, I have a neutral rating on the stock.

Revenue Analysis and Outlook

I previously covered Fastenal in April this year and, while I liked the company’s execution, I was worried about slowing macros and chose to remain on the sidelines. The company has reported its Q1 2023 and Q2 2023 results since then and its sales have continued to slow. Compared to mid-teens Y/Y growth seen in FY22, the company’s sales growth slowed to high single digits in Q1 2023 and then mid-single digits in Q2 2023.

In the second quarter of 2023, the company posted a 5.9% Y/Y increase in net sales to $1.88 billion. Daily sales of $29.4 million grew 5.8% Y/Y, mainly due to higher unit sales from onsite locations activated in 2022 and 2023 as well as continued growth from the older onsite locations. The pricing contributed 190 to 220 bps to sales growth. These positives were partially offset by lower revenues in the construction and reseller end markets and a 40 bps unfavorable impact of FX translation.

Looking forward, the company’s sales growth should continue to decelerate. Last quarter, on a monthly basis, daily sales growth was 7.8% Y/Y in April, 5.2% Y/Y in May, and 4.7% Y/Y in June. So, there was a meaningful slowdown in the growth rate. This has continued in Q3 2023. The company provides the data on daily sales monthly and daily sales in July was up 3.7% Y/Y and in August it was up 3.6% Y/Y. I am not optimistic about the trend in September given the strike at certain Ford ( F ), General Motors ( GM ) and Stellantis ( STLA ) plants which may impact the sentiment among U.S. manufacturers in the back half of September.

Further, if we look at the underlying reason behind the declining sales it's not the number of transactions but the average ticket size. The company's average ticket size was $258 in FY 2022. This dropped to $246 in January and then further to $222 in June. In addition to the economy slowing, there are two more factors impacting ticket size. First, last year there were supply chain constraints. So, it is likely that manufacturers were ordering more than they need last year just to make sure they have spare parts. This is not the case this year as supply chain conditions have improved meaningfully and there are expectations of continued improvement. Second, due to supply chain constraints last year, the company also saw prices increasing nicely which benefited sales. The pricing is not that big a benefit this year as the company has already started seeing pockets of deflation. I don't see these things changing in the near term. So, I expect sales to continue to remain under pressure.

That said, things are not all bad and the company continues to execute well gaining increasing traction in its onsite, Fastenal Managed Inventory ((FMI)) and e-commerce offerings.

The company had 86 onsite signings last quarter and had 1728 onsite locations at the end of Q2 2023 versus 1501 at the end of Q2 2022.

On the FMI Technology side, the company signed 106 new accounts per day last quarter while the company’s E-Commerce sales were up 45% Y/Y. The company’s digital sales, which includes both FMI and e-commerce , accounted for 55.3% of the Q2 2023 sales and management intends to continue growing this business.

I believe good execution on these initiatives should help the company gain market share in the long term. Further, the company should also benefit from increased reshoring of manufacturing facilities in the U.S thanks to government stimulus programs like CHIPS and Science Act and Inflation Reduction Act which are encouraging domestic manufacturing.

So, overall revenue outlook is mixed with some macro headwinds resulting in decelerating growth, but the company is executing well which should help long term growth.

Margin Analysis and Outlook

In Q2 2023, the company’s gross margin declined 100 bps Y/Y to 46.5% due to unfavorable customer and product mix, given the strong growth from onsite customers and non-fastener products which carry lower margins. Further, lower product margins in certain other product categories and higher organizational/overhead costs added to the margin decline. These negatives were somewhat offset by the lower freight expenses. The operating and administrative expenses, as a percentage of net sales, improved 70 bps Y/Y to 24.6% driven by a decrease in payroll-related expenses as a percentage of net sales. However, the lower gross margin more than offset the G&A leverage, resulting in a 60 bps Y/Y decline in the operating margin to 21%.

Looking forward, I expect the company's gross margin to continue to remain under pressure. Last year, the company was able to manage a difficult supply chain environment better than its smaller peers and the clients were also ready to pay a premium for their required MRO supplies because the availability was limited. So, the company benefited from higher pricing and lesser supply from competing distributors.

With the supply chain environment improving, this benefit is now gone. So, the gross margin is expected to remain under pressure in the near term. Further, with slowing sales growth, SG&A leverage may not be enough to offset the gross margin decline and the operating margin may also see some decrease.

Valuations and Conclusion

Fastenal is trading at 27.57x FY23 consensus EPS estimates and 25.83x FY24 consensus EPS estimates. Over the last five years the company has traded at an average forward P/E multiple of 28.22x.

I understand the company's good execution track record and history of gaining market share. However, given the slowing growth, I believe the stock deserves to trade at a discount versus its historical average P/E multiple. Further, at this valuation, the stock is still trading at a significant premium versus other listed distributors like MSC Direct ( MSM ) trading at 15.32x FY 23 P/E and W.W. Grainger ( GWW ) trading at 19.32x FY23 P/E.

The company's growth outlook is mixed with near term challenges from slowing growth and margin pressure, with a long term opportunity as the company continues to gain market share. I would prefer to wait on the sidelines for growth to reaccelerate before buying the stock. For now, I have a neutral rating on Fastenal.

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