MSM - Fastenal Out-Executing A Sluggish Market

2023-10-23 15:27:23 ET

Summary

• Fastenal had a better-than-expected quarter, with revenue and gross margin beating expectations, as volume/share-driving initiatives like vending, onsite, and e-commerce continue to deliver outsized growth.
• Heavy manufacturing has held up well so far, but uncertainties remain heading into 2024 with industrial production roughly flat recently and non-residential getting weaker.
• Management is targeting more than three points of volume outperformance over the longer term; that may be difficult in a flat IP environment, but is attainable longer term.
• Fastenal rarely looks undervalued but has nevertheless delivered strong returns over the years; multiple contraction is an ongoing risk, but Fastenal remains well-levered to share gains and U.S. manufacturing growth.

These aren’t necessarily the easiest times for Fastenal (FAST), as industrial production remains sluggish, and industrial outlooks for the remainder of 2023 and 2024 are still cautious. Even so, the company continues to demonstrate its superior execution capabilities, as management consistently executes growth-driving initiatives like vending, onsite, e-commerce, and product line expansion, not to mention operational efficiency.

It’s hard to talk about Fastenal’s share price prospects and valuation without sounding like a broken record at times. Is it expensive? Yes, but it has almost always looked expensive by conventional approaches, and that hasn’t prevented it from outgrowing most peers/rivals and its served markets by a wide margin over the years.

Fastenal had mostly been tracking the industrial sector lower since my last update until third-quarter earnings provided a nice pop on above-market volumes and solid margins. While I don’t question the bull thesis that Fastenal will continue to gain share over the years and outgrow underlying production volumes, even with a premium multiple that accounts for the company’s superiority the shares look no better than fairly valued.

A Better Quarter Soothes Some Jitters

I believe the market was worried about miss-and-lower quarterly reports coming out of the industrial sector in this third-quarter earnings reporting cycle, and Fastenal’s modest beat was likely reassuring to many investors. That said, I’d be cautious about extrapolating – Fastenal is a superior company and just because they’re doing better, it’s not necessarily a sign that the overall sector is doing better than expected (or feared).

Revenue rose 2% as reported and 4% in average daily sales terms, with fastener sales down 2%, safety up more than 9%, and “other” up nearly 7%. National accounts were notably strong, with daily sales up almost 9%, while smaller accounts saw an almost 2% contraction. Price was a “modestly positive” contributor to the quarter, suggesting something on the order of 2% to 3% volume growth against flat industrial production. Sales were very slightly weaker than Street expectations.

Gross margin was flat from the prior year at 45.9%, good for a 40bp beat. The company carried some of this through the operating earnings line, with operating income up 2%, margin down 10bp to 20.9% and about 20bp better than expected, driving a $0.01/share beat versus the Street. Lower taxes contributed to the rest of the outperformance.

Familiar drivers all came through this quarter. Daily sales from vending were up 13% and onsite was up low-teens (from high-teens in Q2), while e-commerce sales grew 41% after 45% growth in the second quarter.

Sales turned up in the September months – up 5% after two months of sub-4% growth. Fastener sales returned to growth (barely), but non-residential sales remain weak.

Execution Versus Underlying Strength

I’m still cautious about the overall health of most industrial markets at this point in the cycle, and commentary from companies like ABB (ABBNY) and PPG (PPG) has supported the notion of weakness in multiple short-cycle markets. At the same time, though, some markets like auto, heavy machinery, and aerospace are certainly healthier, and I think that shows up in the splits between Fastenal’s heavy manufacturing revenue growth (up 9%) and “other manufacturing” (up 2.5%), as well as that spread between national accounts (larger companies) and smaller accounts.

I’m not as concerned about a recession as I was earlier in the year; while I think it’s possible that the U.S. could still see a recession in technical/literal terms, I think it will be relatively mild and short-lived, and I’m expecting a “bump along the bottom” trend for a few quarters before more evidence of stronger activity toward the end of 2024.

That doesn’t mean that Fastenal can’t or won’t grow at a better rate. Ventures like vending and onsite are long-standing growth drivers that are far from exhausted, and e-commerce is likewise a strong growth driver now. On top of that, Fastenal has a relatively newer high-touch sales effort (Consumer Solution Consulting) that should help drive increased sales at mid-sized customers – it reminds me to some extent of the pivot that MSC Industrial (MSM) has made toward higher-touch service offerings, and it has worked there too.

Management is underperforming its own target of 300bp-600bp volume growth above industrial production, and that may continue for a few more quarters, but overall I think the company has strategies in place that can drive solid volume outperformance and share growth across a still-fragmented industry where customers (larger customers in particular) have shown consistently that they will pay for service and will take a holistic view of their sourcing costs (not necessarily evaluating suppliers on a cents-per-bolt basis).

How much more the company can hope to achieve on operational efficiency is a good question, but a hard one to answer. Fastenal has consistently turned over all the rocks in its search for operating leverage, and with ongoing pressure on gross margin (gross margins used to be consistently above 50%’s years back) that has been crucial to minimizing operating margin erosion.

Further moves away from store-based sales should help some, allowing for a smaller footprint, and there are likely still some opportunities “here and there” in areas like logistics, but I expect a lot more of incremental operating leverage to be volume/scale-dependent in the future. In other words, hitting those industrial production volume outperformance targets is important to more than just top-line growth.

The Outlook

I’ve made some adjustments to my model, but not a lot in terms of wholescale changes. My 2023-2025 revenue estimates are all within a percent of where they were when I last wrote about the company. I do still see some risk to FY’24 expectations, but that’s from macro risk, not company execution. Long term, I still expect around 6% annualized revenue growth as the company takes share and further embeds itself with major customers (literally, in the case of vending and onsite).

On the margin side, I still think mid-to-high teens FCF margins are about as good as Fastenal can reasonably expect to do, and that still supports double-digit annualized growth across the next 10 years.

As far as valuation goes, you pretty much have to go to growth stock valuation approaches to get an attractive fair value for the shares. The stock trades well ahead of what I’d consider an attractive FCF-based fair value, and even awarding a 19x-20x EBITDA multiple (consistent with some of the best value-creators in the industrial sector) only gets me to around $60.

The Bottom Line

Fastenal shares have outperformed for years despite robust multiples. That probably isn’t sustainable, but I’m not so confident in that reversal happening over a predictable time period that I’d short the shares. Instead, I look at Fastenal as a leveraged way to play underlying industrial activity in the U.S. and as prospects for IP improve, Fastenal will probably do well. Given my caution on the economy, though, I won’t be jumping into shares myself at this point, though another 10% pullback would certainly make for a more interesting case.

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