Even when sluggish manufacturing activity weighs down growth in the industrial distribution/MRO space, Fastenal (Nasdaq:FAST) still manages to find the ways to outgrow most of its rivals. Quarter-to-quarter execution hasn't really ever been the issue here, nor the company's investments into aggressively growing the vending machine business. What the issue was, is, and likely will continue to be is what investors should pay for that growth – while Fastenal is clearly not as cyclical as some players in the space, even a 20% free cash flow CAGR estimate doesn't lead to a compelling price target.
Second Quarter Results – As Slowdowns Go, This Isn't So Bad
Manufacturing activity has clearly slowed in the U.S., and that's directly impacting sales growth for Fastenal – one of the 10 largest industrial distributors in the country and one of the very largest (if not the largest) distributor of fasteners.
Revenue rose more than 5% for the quarter, and average daily sales (a common metric in this sector) was up an identical amount. Sales to manufacturing customers were a bit stronger, up almost 6%, despite fastener sales growing only about 2%. To the extent that fasteners are a good proxy for manufacturing activity (and I'd argue they are, given how common they are across applications), there is the evidence of the slowdown in manufacturing.
Fastenal continues to do well with margins. Gross margin was basically flat sequentially, but improved more than half a point from last year. Operating income climbed 7%, with a half-point improvement in operating margin.
SEE: A Look At Corporate Profit Margins
Continuing To Invest In Growth
Fastenal isn't shy about allocating the capital the business needs to continue growing at an above-average rate into the future. The company added 17 stores (net) from the first quarter, bringing the total to 2,677. Fastenal also continues to grow its industrial vending machine business – adding more than 4,000 units (net) during the quarter, and bringing the total in sight of 30,000.
It's worth remembering that vending machines are a mixed-blessing in the short run. Margins tend to decline initially at vending customers (and often usage/sales as well), but performance improves over time and both Fastenal and rival MSC Industrial (NYSE:MSM) have seen pretty “sticky” growth from these customers.
And it's a good thing that Fastenal is investing for growth. Amazon's (Nasdaq:AMZN) foray into industrial supply has brought more attention to the possibilities of using e-commerce – an area where MSC is already quite stronger and Grainger (NYSE:GWW) has been getting more active. While there is still plenty of room for Fastenal to grow in this highly fragmented industry, its rivals are not standing still, so neither can Fastenal.
The Bottom Line
I don't claim any special insight as to when U.S. manufacturing activity will rebound, other than to say that industrial conglomerates like Illinois Tool Works (NYSE:ITW) (a big manufacturer of fasteners, by the way) have been talking down rebound expectations for 2013, but companies in sectors like machine tools are getting more optimistic about 2014. Luckily for Fasental, a lot of their business skews towards the low-price consumables as opposed to tools and such, and not only has monthly sales growth been improving, the company is looking to increase selling hours to boost sales.
My hang-up on Fastenal has long been valuation, and that's still true today. Even if you assume that the company can grow its free cash flow at a compound rate of 20% for the next decade, that only gets you into the low $40s with the target price. Said differently, I can't find a metric by which this stock is cheap, though I have no qualms with the company's growth nor its strategy to continue gaining share in the market. Accordingly, I'll continue to be on the sidelines with Fastenal in favor of owning the considerably cheaper (but more cyclical and less-”growthy”) MSC Industrial.
Disclosure – As of this writing, the author owns shares of MSC Industrial.