Fastenal $FAST
A deep dive on a classic boring compounder
Intro:
Fastenal has been operating since its initial branch opened in 1967 in small town of Winona, Minnesota. They started and are best known even today for selling threaded and other types of fasteners.
Since then, they have expanded the product line significantly to include all kinds of fasteners and into other lines of related products to supply their manufacturing, construction and other customers.
Fastenal trades on the Nasdaq exchange with the aptly named FAST 0.00%↑ ticker. As of June 2021, it has a market cap and an enterprise value of just under 30 billion USD. While not a mega cap company, it is now not a small one either. It has slowly and surely grown steadily over the history of the past 50 years. In some ways, it has become a better business as it has grown due to some scale/network advantages. It has been well over a 100 bagger for long term holders… if you bought in 1992, you’d have over a 100X return today (not including dividends).
The Business Model:
The company has a few ways to serve its customers. It has distribution centers, branches and onsite locations. It has expanded dramatically over the years. Initially in the U.S. but then to Canada, Mexico and now to Europe and across the globe. As of 2021, it has 12 distribution centers in the U.S., 2 in Canada and 1 in Mexico and 1 in Europe servicing its branches and onsite locations. It currently has approximately 3,200 in-market locations in 25 countries globally. This has expanded in the past decade from 2,600 and the mix of traditional branches to onsite locations has shifted to the latter in the past several years.
The business works well because it has established a focus on being a reliable, convenient supplier of its products for its customers. Fastenal focuses on ensuring it is physically in close proximity to its customer base. Because these parts are often heavy compared to the price, shipping is not something that makes sense for a lot of its customers. More on this in the moat section later.
The product lines that Fastenal offers can be broken down into 3 broad categories:
Fasteners - a wide variety of common and specialty applications
Safety Supplies - PPE and related items for manufacturing/construction
Other - small and commonly used parts and supplies
Over the past few years, fasteners continued to make up about 30% of the revenues while the safety supplies category has grown to almost 20% and the other category has grown to be almost 50%. These are rough numbers, but you get the idea.
The company continues to look to add to the product lines that it offers to its customers as a way of adding value.
Fastenal has many suppliers and because it acts as an intermediary to its customers and suppliers, with a network that has a strong foothold, it has some reasonably strong bargaining power with suppliers. At the same time, enjoys some pricing power over its clients when it strategically makes sense. This is a strong competitive advantage that should not be overlooked.
Even though the products that Fastenal provides its customers are not generally proprietary or big purchases on their own, fasteners and other small intricate items are critical to their customers. In many cases, only certain types of fasteners will do for these applications. Also, because these parts are not generally a large percentage of the cost of capital/maintenance on their own, a competitive bid is often not undertaken. Once a reliable supplier of these small, inexpensive and critical parts has been found, it tends to be sticky repetitive business. This is obvious once you consider what an onsite location means. Most suppliers, even critical ones, do not have sales channels physically on the site of their customers.
This is a good and perhaps great business. The gross margins have been around 45-50% over the past decade and more. The operating margins have been fairly reliable and stands around 20%. The business continually produces free cash flows and these free cash flow margins have improved over the past 5 years.
Capital expenditure has been significant in the past but now it is a lower portion of cash flows. It has been fairly steady around 150—200 million per year where free cash flows have grown steadily to over 600 million in 2019 (2020 number was in at 900 million, probably higher than it will be with a normal year). I would expect the cap-ex to continue to increase slowly over time but with the scale that the company now enjoys and more focus on capital light onsite/vending/bins and other models compared to traditional branches, expect the business to be less capital intensive in the future on a relative basis. Only time will tell if this model will scale as well as the traditional branches of the past.
The Management:
Capitol Allocation
Management has grown dividends consistently. In 2006, a share paid $0.10 per share. In 2020, it paid $1.00. As the business matures, it is likely that this trend continues as it may not always have amazing returns to put its cash towards. It has also taken on debt since 2013, taking advantage of low interest rates. As long as rates stay low, this predictable business should have no trouble servicing this debt.
Share buybacks have been small and not consistent (small and relatively frequent). This is a good sign that management is willing to do share buybacks but it is not set on autopilot. The management team has been able to continue to reinvest at high rates of return. The ROIC has been around 25% over the past decade and the ROE has been similar. Small amount of leverage has helped the ROE be consistently and predictably over 20% for many years.
The fact that locations have been closing on net over the past decade but revenues continue to climb is a good sign that the business is navigating change well and is willing to let go of assets that are not meeting their hurdle for profit and reinvesting in other channels. Up to 2013, branch location openings were the source of the growth. Since then, on-site locations and other channels (vending, e-commerce, etc.) have been the source of growth in revenues.
Historically, management has had a great long term vision. They state in their 10-k that decisions are made regionally. Decisions on keeping locations opening, product lines, inventories and what type of location to use is made at the location/region. This is a great sign that top management understands the importance of decision making being made where the strategic insight lies. Incentives for sales, etc. also appear to be at the appropriate low level and there is a stock option/incentive structure available to employees.
Growth
As the company continues to evolve into integrating into the global market, we should expect continued growth in the long term. At 30 Billion market cap, it would be challenging for the business to be another 100 bagger from here. That being said, returns can still be great for the next 20 or 30 years. The good news is that the TAM for these products is enormous. Manufacturing and construction will not be slowing in the global markets and Fastenal will continue to try to get a toe-hold into many large customers and expand its network.
As other countries increase standards for manufacturing and safety, Fastenal will be a go-to for these low price products. They are a reliable source and once they are in a region/market/location, they will dominate as that customer grows. It would seem that in some ways, manufacturing will be more decentralized over the next 50 years and having a nearby supplier will be a huge advantage to supply on-demand fasteners, safety products and other niche products that support keeping manufacturing and construction projects going. Down time is a killer for any manufacturing facility. As these become more and more efficient, the parts to repair/fix/build will be more and more valuable.
Over the past decade, revenue and earnings growth has been around 10% a year. Free cash flow has grown at even higher rates thanks to improving free cash flow margins. I would expect that these rates can continue over the next decade and beyond as they continue to focus on good capital allocation and growth with minimal debt. Slow and steady has been the story so far and given the continued growth globally. It seems unlikely that the growth stops abruptly.
Simplification
Fastenal appears to understand the value of simplicity. Reading their 10-k document is easy. They explain things in normal everyday language and you don’t need an advanced degree in finance to understand how they make money.
Strategically, they focus on providing their customer whatever means of distribution that makes sense for them. They then adjust pricing, etc. to ensure they make a reasonable profit. Win-win. Lately, they have closed traditional branches that were not doing well and refocused on expanding to the markets that have demand. They have also pivoted to being closer and closer to their mid-large customers by being on site. They have vending machines, bins, whatever works.
Incentives
Compensation for employees and management is a base/bonus mix. Focus on simple and quantitative metrics that are aligned with success of whatever level the employee/management has control over is how management frames their compensation policy. The focus on simple and understandable and quantifiable goals is a good sign. Specifically, targets based on monthly sales growth, profitability targets and good management of working capital are stated. Other specific targets are developed for specific departments/projects depending on the nature of the work.
The company suggests that over 70% of their 20,000+ employees are customer facing and regularly interact with sales and customer relations frequently. I think the focus on making the incentives match the specifics of the role of the employee is a great sign. Also, ensuring that the bonuses come as soon as practical to the result ensures a good positive feedback loop for performance. Given the distributed nature of sales, having operational and small capital decisions near the floor level management is likely part of the success of the business.
Ownership
The executive board has been mostly Fastenal employees since the 90’s. The exception is the CFO who started in 2016. Many of these key players have made their way up in the company. This is a good sign for the culture and the view on valuing those who understand the details of how the company adds value to its customers.
Insider ownership is not tremendous as a percentage and currently sits at 0.3% of the outstanding shares. This is however, worth about 100 million dollars.
The Moat:
Scale
It is difficult to imagine a competitor building out the scale that Fastenal has. The scale allows Fastenal to have leverage over its suppliers as well as its customers.
With its suppliers, its scale’s size where its advantage lies. There are some exceptions but generally, these parts are not much more than a commodity on a unitized basis. This does not bode well for the suppliers to Fastenal.
With the customers, its the entrenchment and mission critical yet small per product pricing that makes the scale an advantage. For most customers, it is not going to make sense to negotiate new contracts all the time with a competitor once it has a relationship with Fastenal. Yet, these products are not generally optional (fastener products are required, safety equipment and other related products are generally requirements and not very flexible). The convenience of having a go-to provider for these parts/products is worth a lot to the customers. They allow business to flow without having to put strategic mindshare to source continuously for competitive bid processes, etc. It allows the supply chain departments to focus on larger, strategic sourcing of more expensive parts.
Integrated With the Customer
Fastenal is well known in the markets it serves. The fact that its network of sales teams interfaces with customers regularly and is incentivized to grow sales, manage working capital and profits means that they will focus on what is important and maintain good relationships with their end customers. The frequent, repetitive business that these customers have means that this is generally a relationship that is hard to break and is long lasting. This is an incredible advantage for Fastenal.
Given the nature of the weight to value of the products, shipping long distances on an as-needed basis from a competitor like Amazon (for example only) is not likely to be a worthwhile venture. The fact that Fastenal’s network of having distribution near or even at the customer locations is a moat that will take an incredible effort to disrupt.
Culture
It appears that there is a culture of simplicity and allowing employees and lower level managers to make the important decisions. It also seems like there is a very focused effort on keeping costs at bay. The CEO letter to shareholders specifically calls this out as a way to ensure the capital to grow/maintain operations in the future will be available.
Culture is a difficult thing to measure, especially as an outsider. Good signs include the aligned incentives for employee bonuses and the recognition for the benefits of allowing making decisions as close to the locations as possible.
The employee reviews generally appear to be pretty good and there is certainly good things to be said of the current CEO based on a 87% approval rate on Glassdoor.
The Future:
On the surface, it would be easy to say that the growth of the business is mostly in the past here. If you peel the onion a little more, it is likely that the runway will continue for the foreseeable future for Fastenal. That is not to say that the stock will continue its long term trajectory as it is possible that margins will contract, more competition will enter, the market may not value this business as highly in the future, etc.
There are several good signs for the future of Fastenal:
Total Addressable Market Growth (TAM) - The manufacturing and construction markets should continue to grow globally as other regions outside the US are modernized, become richer and standards increase. Coupled with a potential significant investment in upgrading infrastructure and manufacturing capability in the western world, there is no situation in which the global TAM grows less than GDP growth on average.
Flexible Business Model - Fastenal has been very open to trying new models to best meet the needs of its customers. It has changed with the times. It understands the network value of its role in the supply chain of its customers. It has closed traditional branches and focused on getting closer to key customers where that makes sense. It is constantly trying new models to fulfill inventory and the CEO talks to this in the most recent letter.
Efficiencies in capital deployed - The move away from more capital intense branch locations makes it more nimble to changing customer needs and locations. Should a customer move locations, it is much easier to move vending, bins, etc. than a traditional branch location. It also enables the growth to happen as needed whereas before, it would only make sense to open a new branch when there was enough demand to meet the upfront large fixed cost. The downside to this shift is that the fixed cost is less but the variable costs increase, so there is less operating leverage with this model compared to the past where one branch strategically located could serve multiple customers with little change to its costs.
International Growth - Outside the U.S. there are plenty of markets to expand into and many of these markets will grow. Currently, North America accounts for roughly half of all sales. This number will likely shrink as the business expands internationally. As standards for safety increase in international manufacturing and construction, it will be hard to imagine no opportunities for Fastenal to offer their product lineup.
The Valuation:
Starting with some key quantitative metrics:
P/E - currently sits just above 30. Compared to its own history, this is on the high end
P/S - currently above 5… again, this is somewhat high compared to its own history although somewhat justified given the better than historical free cash margins in the last few years.
EV/EBIT - stands at around 25 times. With very little debt, this is neither a sign of an incredible value nor is it extreme for a predictable compounder.
Revenue growth - revenue growth over the past decade has clocked in around 10% per share. For a somewhat mature predictable business, this is a decent growth rate. The real question will be is it sustainable years into the future?
Earnings growth - similar to revenue growth. Expect that it will continue higher in the future. The direction is fairly certain to continue higher in the future, the magnitude will depend on successfully transitioning business models, new products and new markets as well as macro-economic factors (unknowable).
In summary, the valuation appears fair for this long term compounder. There is likely no get rich quick type of returns to be had here. If you believe the lower rates for longer economic theory, then there could be some further expansion of the valuation in the short term. Over the long term, there is some potential for mean reversion of the margins and valuations which would cut the performance slightly (a 20-30% valuation compression would take it back to normal levels). That being said, it is very likely that dividends, some share buybacks and the continued success of the fundamentals of the business will compensate for any compression of the valuation over the long term.
The business has consistently had good ROE around 20% and reinvested what it can at ROIC of even higher rates. It has managed to get these returns at fairly low levels of risk. Given that you are basically paying somewhere around a market type multiple, it doesn’t seem like valuation will be your downfall here.
Let me know what you think on twitter@MoS_Investing
FULL DISCLOSURE: I own a small amount of shares of Fastenal at the time of writing. Do your own due diligence as this is not intended to be financial advice.