Fastenal Not Exactly Cheap As Tailwinds Start To Moderate (NASDAQ:FAST)

What inflation can give to industrial distributions like Fastenal (NASDAQ:FAST), pricing power namely, deflation can eventually take away, and that’s a growing concern for industrial distributors as pricing is likely to become less of a benefit from here on. What’s more, while underlying business activity and demand are still rather healthy, there is evidence that some of that strength is tapering off.

I’m not concerned about Fastenal from a long-term perspective; this is an uncommonly well-run company, and management’s efforts to grow e-commerce, vending, vendor-managed inventory and the like will serve the company well in the coming years. That said, Fastenal still sports a premium multiple at a time when investors are increasingly skittish about industrial names, and I would be cautious about jumping in today – I do think a “buy the pullback” opportunity is forming, but I think it may be a little early to jump in today.

Inline Results For The Second Quarter

I believe the negative stock price reaction to Fastenal’s results had more to do with management acknowledging some signs of softening in its end-markets, but the reported results being “only” in-line with expectations likely didn’t help – particularly given the thesis that Fastenal is well-positioned to leverage strong manufacturing activity and healthy pricing power.

Revenue rose 18% in the quarter, coming in just shy of expectations. Fastenal sales were up 21%, while safety sales were up 14%. Sales to national accounts (large companies, typically) were up 23%, while sales to smaller customers were up a more modest (but still impressive) 12%. I’m not surprised that Fastenal outperformed MSC Industrial (MSM) on the national accounts line (where MSC grew “high teens”) given its stronger vending/OnSite presence, but the similar performance in smaller accounts (MSC grew “low teens”) is interesting.

Gross margin was flat from the year-ago period and basically flat with the prior quarter, as the company has been passing through higher costs. Gross margin was a bit better than expected (around 10bp-35bp depending upon which service you use for the “consensus” number). Operating income rose 21%, inline with expectations, with operating margin up 50bp to 21.6%, and operating costs were a bit higher than expected.

Fastenal Is Controlling What It Can, But Pricing Is A Watch Item

Management’s discussion/disclosure of pricing was interesting to me. While the company talked about 660bp-690bp of benefits from pricing, further discussion of the topic on the conference call indicated that was for the 40% or so of “like for like” business, with about 60% of the sales not having a direct year-ago comp to the customer. Management then went on to say that prices for that other 60% were still quite likely higher than they were a year ago.

I’m not entirely sure what to do with this information, other than to assume that pricing actually contributed more than the disclosed amount to sales growth. I don’t think it’s necessarily unreasonable to assume that pricing actions were broadly similar across product categories, and if you do so, that still suggests that Fastenal had something in the neighborhood of 6% volume growth – ahead of the recent Industrial Production (or IP) growth. It is also possible, though, that volume growth was stronger and there was some mixed impact from customers trading down to cheaper options.

In any case, I do still believe that pricing and inflation is an important watch item. Inflationary periods are about the only time that distributors like Fastenal see any real pricing power, but I expect we’ve seen the peak of this and the benefits are going to wane from here. I’m not too concerned about Fastenal being stuck with high-cost inventory, but I do think that gross margin pressures could emerge again as that pricing power fades.

Flagging demand is another watch-item for investors to consider. Average daily sales growth slowed from 20% at the start of the quarter to 16% at the end, and manufacturing-related demand has likewise been slowing. It is well worth noting that this slowdown still represents strong year-over-year growth, but as new orders continue to slow/decline across the broader industrial sector and companies catch up on their backlogs, I do expect demand to begin to slow more significantly.

I still believe that management is making sound decisions to reposition the business for longer-term success. The company’s efforts to aggressively market its managed inventory offerings (Fastenal Managed Inventory, or FMI) are paying off, and the company is seeing good growth in its vending and OnSite operations – both of which continue to generate sales growth above the company average (almost 2x for the vending operations).

Over time, I expect these expanded customer-located offerings to not only allow for more store closures and expense restructuring, but also allow the company to expand its offerings – including products (like power transmission) where gross margins have historically been too low to really make it worth the company’s trouble.

The Outlook

While I’ve made a few modeling adjustments, they aren’t all that meaningful on a long-term outlook basis. I’ve pulled some revenue from 2023 into 2022 and adjusted my working capital assumptions for 2022, but all in all, not much really changes. I’m looking for long-term revenue growth of over 6% and long-term FCF growth in the low double digits, as I expect Fastenal will continue to gain share on the strength of its sourcing, assortment, and multiple value-added go-to-market offerings (vending, et al).

I think gross margin leverage will be very difficult to maintain, but that’s an issue for all distributors, and I think Fastenal’s multi-channel strategy gives it options on the operating expense side to offset additional future gross margin pressure.

The Bottom Line

As is pretty much always the case with Fastenal, valuation is where things get squirrely. The shares have underperformed since my last update, but not to a dramatic degree, and Fastenal hasn’t seen the same magnitude of de-rating as other industrial darlings.

The shares don’t look cheap today on a discounted cash flow basis, but they do look a little more interesting on a margin/return-driven EV/EBITDA basis, provided you still think that Fastenal deserves a premium (around 20%, historically). Were the shares to move to the low $40s, I’d have to seriously consider the name, but given the number of quality industrial stocks “on sale” right now, I’m not in a hurry to grab these shares just yet, particularly as periods of contracting IP growth typically have led to a less robust performance.