It's an unfortunate reality of financial writing today that you can't express concern about a stock's valuation and/or investor expectations without reaping a whirlwind of angry readers claiming you hate the company (while in secret many are shorting the stock). Be that as it may, only a fool wouldn't appreciate the business that Fastenal (Nasdaq:FAST) has built in the industrial distribution market, but that doesn't mean that the shares are cheap – particularly with growth becoming more of a concern than at any time before in this latest post-recession recovery.
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Q1 Sales Show Better Margins But Troubling Growth Trends
However much of it is due to sequestration or other economic factors, Fastenal and other industrial supply companies are definitely seeing some signs of lagging industrial growth and manufacturing activity. Perhaps this is just a pause before the recovery, but that second half recovery is looking increasingly V-shaped as we go deeper into 2013.
Revenue was up just 5% this quarter, or 6.5% on a daily sales basis (that adjusts for more/fewer days in a quarter). However, sales came in short of Wall Street expectations, and it sounds as though a surprisingly weak March was the cause. Perhaps the damage was from industrial/manufacturing companies planning for sequestration.
Slicing and dicing a little more, fastener sales (a good proxy for manufacturing) rose less than 2%, while non-fastener sales rose almost 11%. Sales to non-residential construction customers increased just 3%, and sales to vending machine customers continue to slow (though were still up 24% on a daily sales basis).
While revenue was a bit soft, margins helped keep the quarter on track. Gross margin improved by a full point, while operating income increased nearly 9%. It's worth noting, though, that Fastenal did lose a little margin leverage through the operating lines, as the operating margin expansion was 80bp.
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Continuing To Build From A Position Of Strength
With 2,660 stores at the end of the quarter, few of Fastenal's industrial supply rivals can even come close to the company's store coverage. Frankly, many don't even try as rivals like MSC Industrial (NYSE:MSM) and AmazonSupply (owned by Amazon.com (Nasdaq:AMZN)) pursue a delivery model instead.
Likewise, while industrial vending is no longer a novel concept, Fastenal is still running strong with the concept. Even with rivals like MSC and Grainger (NYSE:GWW) pushing their own vending offerings, Fastenal signed up another 5,700-plus vending machine contracts this quarter, installed another 4,300-plus, and ended the quarter with almost 25,500 in place.
Better still, there's a lot more left for the company to do. Depending on the definitions used, this is a market with over $150 billion in addressable revenue each year, and Fastenal has a tiny fraction of that. Some of that is effectively “off limits”, as Fastenal does not yet compete much in segments like electrical supplies (where WESCO (NYSE:WCC) is a strong player), and certainly other rivals like Anixter (NYSE:AXE), Lawson (Nasdaq:LAWS), and MSC are trying to penetrate Fastenal's core fasteners market.
But it's nevertheless true that there are still many avenues for growth. Fastenal has been expanding its metalworking business (going right at MSC), and there's a world of opportunity should the company look to replicate its model in other countries like Germany or Mexico.
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The Bottom Line
Fastenal has long been prized (and priced) for its exceptional growth and its relatively uncommon status as a high ROIC, cash-generating, dividend-paying industrial growth stock. To that end, I don't expect the company's returns to decline, nor do I expect a sharp fall-off in growth.
Unfortunately, Fastenal's growth is so highly priced that even 17% long-term free cash flow (FCF) growth doesn't imply an attractive fair value today – meaning that investors are likely going to have to settle for annual returns in the mid-single digits unless growth really accelerates again. While I'd definitely consider these shares on a pullback (say if the markets abandon the notion of second half economic recovery), I'd be nervous about paying such a high multiple today.
Disclosure: Stephen Simpson owned shares of MSC Industrial at the time of writing.