GWW - Why We See 30% Upside Potential In Fastenal's Stock

Summary

• Fastenal has innovated in a historically staid industry.
• We think the company's price has broken through an important price-to-EBITDA metric without good cause.
• Fastenal has executed with great efficiency in its store count and inventory levels.

Quietly Printing Money

The famous fund manager Peter Lynch once expounded on the virtues of investing in businesses that were inherently boring. Flashy business, he said (we are paraphrasing here), tended to attract a lot of hype and very little substance, while boring businesses and industries with stellar financials were often ignored by market participants and therefore can prove to be fertile hunting grounds for value-oriented investors.

Industrial supply is, perhaps, the prime example of such a boring--but financially lucrative--industry.

Most organizations have the need for routine repair items from time to time. When they do, repairmen will head to a Grainger ( GWW ) or Fastenal ( FAST ) store, or consult their tome-like McMaster-Carr catalog. Similarly, manufacturers in need of components (screws, flanges, o-rings, straps, nuts, bolts, etc.) also call on these companies when it's time to ramp up production. These organizations dominate an otherwise fragmented market, and Grainger and Fastenal make up the lion's share of the revenue, with Grainger in the lead in terms of sheer size.

In other words, these companies are selling the pickaxes (repair and manufacturing components) to miners (virtually any company that builds something or may need physical repairs of equipment). Those who regularly read Ironside Research's work will know that these are exactly the kinds of businesses we seek out.

In this article, we will focus on why we believe Fastenal is trading at a price that investors may find quite attractive.

The Business

Industrial supply is rather straightforward. Companies supply two main types of customers, which were briefly described above--original equipment manufacturers [OEM] which are utilizing Fastenal's products to build something, and maintenance and repair operations [MRO], which represents customers utilizing Fastenal's services when something has gone wrong and needs to be fixed.

The real trick of having an enduring industrial supply business is to find the sweet spot between these two business segments. If a company finds itself too intoxicated with the regular, lucrative orders of the OEM community, it may find itself in a pinch when the economy turns and those regular orders dry up. MRO business is typically much more economically resilient, but it unfortunately lacks the predictability of contract manufacturing (it's hard to predict how regularly things will break).

Theoretically, then, the old-school nature of the business lends itself to analytical simplicity. Inventory that is held rarely falls into obsolescence (unlike software, they are not consistently developing new screws), and revenue recognition is relatively straightforward. Large players like Fastenal are able to leverage their size with suppliers to negotiate favorable prices, which can then be turned into lucrative manufacturing sales on a contracted, spread-above-cost basis, or sold in an MRO situation for a substantially higher price.

It's against this industry backdrop that Fastenal operates. Customers can either order from Fastenal online or in person at one of their 3,306 in-market locations.

Efficiency Is King

As you may have guessed, operators in this business live and die by efficiency. Since the products at issue are largely commoditized (it hardly matters whether a handyman buys a repair part from Fastenal or Grainger), convenience, price, and availability are the key drivers for customers.

Fastenal utilizes a process which is known internally as Fastenal Managed Inventory [FMI] to ensure that inventory management remains as lean as possible. Investors can check in on this by examining the company's days outstanding inventory, which measures inventory levels relative to sales to measure inventory management efficiency.

Inventory levels rising relative to sales indicates that either efficiencies are being lost in the inventory management process or that sales trends are weakening. Over the past ten years, Fastenal has managed to increase its inventory efficiency dramatically, with even the most recent Q4 bump in days outstanding inventory remaining well below historical averages.

To this end, companies in the industrial supply space obsess over how to get product to the end user faster than the competition. Recently, Fastenal has come up with a novel solution--an industrial vending machine known as FASTVend. FASTVend is just what it sounds like: bins filled with frequently used parts placed in contracted locations with certain customers where commonly needed items can be retrieved when needed rather than being ordered online or requiring a trip to a Fastenal location.

When a FASTVend bin is emptied of its parts, a customer simply places the RFID-equipped bin on top of the machine, and Fastenal is alerted that a refill is needed. For those unfamiliar with the industry, this may seem trivial. But those with knowledge of the staid, steady world of industrial supply recognize that innovations like these can be crucial in claiming market share and driving profits.

Valuation

Unfortunately for investors today, Peter Lynch's advice about finding boring businesses is much more mainstream than it was in his day. Fastenal is hardly an unknown quantity, but that doesn't stop the market from offering up buying opportunities.

After trading at a 10-year high of near 24x forward EV/EBITDA at the start of 2022, Fastenal now trades at 16x, much closer to its 10-year average of 16.2x.

Of course, this doesn't represent a discount. However, in a world where analysts are slashing profit estimates across the board, Fastenal remains steady.

In fact, 1-year and 2-year forward EPS estimates by analysts are actually on the upswing overall.

Furthermore, Fastenal's stock price has largely traded at a relative parity when overlaid against forward EBITDA. Recently, however, that trend has broken down.

In early 2022, Fastenal's stock price fell along with the rest of the market, declining to a point well out of bounds from the stock's historical relationship with EBITDA. We would also like to point out that EBITDA estimates in this case (unlike many other stocks) did not decline by a significant margin. In fact, it seems to us that Fastenal's price decline was largely the result of the overall market shift to the downside in 2022 rather than anything specific to the company.

Just a visual check of the chart shows how wide the disparity of the historical relationship is. We also would like to reiterate that we have not detected any underlying weakness in Fastenal's inventory management or accounts receivable--both of which can be killers in this space.

We believe, then, that it's only a matter of time before the historic relationship recovers.

The Bottom Line

We believe that Fastenal has a solid core business that will continue to provide excellent returns for investors over the long run.

The company has innovated in a historically stale industry via its FASTVend offerings, and has adroitly managed its inventory even through the uncertainty of the COVID pandemic. Further, we believe that a historic price/EBITDA discrepancy exists, and that the stock could extend up to 30% to restore that relationship in the absence of underlying business weakness.

With all that said, we think investors should give Fastenal stock serious consideration for their portfolios.

Thank you for reading our article. Please comment below with any questions you may have and we'll be happy to respond!

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