Contents
Fastenal Company (FAST) released Q2 2019 results July 11, 2019 in which management indicated that while activity has clearly slowed and there is no panic in the market, sentiment has become more cautious.
Summary
- A $9,000 investment in FAST on the date of its August 20, 1987 IPO would now be worth in excess of $5.8 million.
- The latest Duke University/CFO Global Business Outlook survey shows company executives are getting more nervous about the state of the U.S. economy, with nearly half now expecting a recession within a year.
- Over recent years FAST has stretched its payables by 5 – 6 days but the days in which it collects its receivables has stretched by ~8 days.
- FAST’s current valuation is superior to that in 2009 – 2017 but the macro outlook is such that I think its valuation will become more attractive within the next few months.
Introduction
In my January 19, 2018 Fastenal Company (FAST) article I indicated that I viewed FAST as an extremely shareholder friendly company.
With FAST having released Q2 2019 results on July 11th I now take this opportunity to revisit FAST to determine whether I should initiate a position.
Business Overview
Over the years, FAST’s mandate has been expanded to a broader range of industrial and construction supplies which are broken into twelve product lines; more details on FAST’s business can be found in my January 19, 2018 article.
The following image extracted from the 2018 Annual Report provides a very high level overview of FAST.
Should you be interested in learning how an investment in FAST would have fared over time you may wish to access the investment calculator. This calculator factors in the 8 stock splits subsequent to FAST becoming a public company; January 1, 1994 is the earliest start date which can be plugged into the investment calculator.
The following information on the impressive returns generated from a long-term investment in FAST are found in the FAST’s 2018 Annual Report.
Initial Public Offering (IPO)
On August 20, 1987 (date of IPO), 1,000 shares of our stock sold for $9,000. Approximately 31 years later, on December 31, 2018, those 1,000 shares, having split seven times, were 96,000 shares worth $5,019,840, for a gain of approximately 22.6% compounded annually. (In addition, the holder of these shares would have received $1,054,944 in dividends since August 20, 1987, for a total gain of approximately 23.4% compounded annually.)
10 Years
On December 31, 2008, 1,000 shares of our stock sold for $34,840. Ten years later, on December 31, 2018, those 1,000 shares, having split once, were 2,000 shares worth $104,580, for a gain of approximately 11.6% compounded annually. (In addition, the holder of these shares would have received $19,620 in dividends since December 2008, for a total gain of approximately 13.6% compounded annually.)
5 Years
On December 31, 2013, 1,000 shares of our stock sold for $47,510. Five years later, on December 31, 2018, those 1,000 shares were worth $52,290, for a gain of approximately 1.9% compounded annually. (In addition, the holder of these shares would have received $6,140 in dividends since December 2013, for a total gain of approximately 4.2% compounded annually.
Subsequent to the issuance of the 2018 Annual Report, FAST initiated another 2 for 1 stock split May 22, 2019. The 96,000 shares as at December 31, 2018 would now be 192,000 shares. With FAST currently trading at $30.37, the 192,000 shares are worth in excess of $5.8 million. Not a bad return on investment for a company that began as a partnership in 1967 with a marketing strategy of supplying threaded fasteners to customers in small, medium-sized, and, in subsequent years, large cities.
Macro Outlook
I have been relatively cautious over the past several months and have been hesitant when it comes to deploying new money. I am of the opinion that an economic downturn is a very real possibility within the next few quarters and think upcoming earnings announcements, for the most part, may fall short of the expectations of many investors.
It would appear that my cautious outlook is shared by many corporate executives. The latest Duke University/CFO Global Business Outlook survey shows company executives are getting more nervous about the state of the U.S. economy, with nearly half now expecting a recession within a year. Roughly 48.1% now see negative growth by Q2 2020 and 69% figure a recession will start before the end of next year, which is roughly consistent with the previous survey in April that showed 67% were anticipating a downturn by the Q3 2020.
CFOs believe the economy is weakening and the prospects for their businesses are declining. Reasons for their concerns vary, with some citing tariffs and others listing strong competition, freight costs and credit risks, among other issues.
Given this macro outlook I am cautiously optimistic we will experience a broad market pullback within the next couple of quarters. If this does occur then patient investors should be able to step in to acquire shares in high quality companies at valuations that are more favorable than current levels.
Q2 2019 Financial Results
Turning to FAST and its performance in Q2 2019 for which results were released July 11, 2019, we see that Gross Profit and Operating Margins deteriorated relative to the corresponding periods in the prior fiscal year; overall activity in the end markets FAST serves slowed as the company entered Q2.
On the July 11th Q2 earnings call with analysts, FAST’s President and CEO specifically mentioned that FAST has been unable to increase its prices to fully offset the tariffs and general inflation the company is encountering.
The direct impact of tariffs has been a drag on FAST’s results as it has yet to be able to fully pass along increased costs. Going into Q3, however, FAST expects to be able to recover some of these increased costs.
FAST’s EVP and CFO mentioned on the earnings call that activity has clearly slowed and while there is no panic in the market, sentiment has become more cautious.
Looking at FAST’s Q2 2019 Earnings Presentation we see on page 6 of 13 that the Gross Margin of 46.9% in Q2 was 180 bps lower than in Q2 2018; this decline was larger than expected.
The 2 primary factors behind the decline were the customer and product mix. First, FAST witnessed a higher than expected deceleration in its higher-margin non-National Account customers. Secondly, the price/cost deficit was 40 – 60 bps. Initial steps were taken to raise prices to offset tariffs but the price increases did not cover a sufficiently broad range of products.
FAST continues to pursue a range of actions to mitigate the effect of tariffs/inflation including a broader price increase (already instituted in Q3).
FAST’s Q2 20.1% operating margin was 100 bps lower than Q2 2018. While operating expenses were reduced the reduction was insufficient to overcome the lower gross margin.
From a cashflow perspective, FAST generated $0.128B in operating cash in Q2 which was 63% of net income; cash generation is seasonal and Q2 is typically a low quarter.
The 62.6% Q2 2019 operating cash flow conversion rate fell short of Q2 2018’s 72% but Q2 2018’s rate would have been closer to 66% absent one-time benefits derived from the Tax Cut and Jobs Act. Management views Q2 2019’s conversion rate to be consistent with the typical Q2 conversion rate.
Net capital spending in Q2 of $67 million was up from $25 million in Q2 2018 but was consistent with expectations since FAST invested in hub property, equipment, and vehicles that are necessary to support high levels of service. In addition, investments were made in vending equipment to support growth in FAST installed vending equipment base.
FY2019 has reiterated its $0.195B - $0.225B total net capital spend guidance.
Q2’s dividend of $0.123B increased ~16% from Q2 2018.
Q2 2019 debt represented ~16.6% of total capital which exceeds the previous year’s ~16% level. FAST is satisfied this level provides ample liquidity to invest in the business and to support the dividend.
Working capital remains a challenge with inventory of $1.3457B as at June 30, 2019 being ~15.7% higher than the $1,163.4 level as at June 30, 2018; ~ 40% of this increase relates to inventory added to support additional onsites.
Management is of the opinion overall inventory can be reduced even while making additional investments in vending equipment to support growth in the FAST installed vending equipment base. In fact, FAST began to reduce overseas purchasing in Q4 2018 but because there is a lag between such an action and there was slower sales growth in Q2, a noticeable change in inventory levels will only become more visible through the second half of 2019.
On the Q2 conference call with analysts, management raised the topic about the 11.7% growth in accounts receivable. FAST’s customers continue to aggressively push payments out past quarter end, and as a result, there was a 2.9 day increase in receivables days outstanding. The rate of increase, however, has moderated versus 2018 and FAST is reacting more effectively to customers' actions. As a result, there has not been any meaningful change in hard-to-collect balances.
FY2019 Guidance
FAST does not provide guidance but projected FY2019 diluted adjusted EPS from 16 brokers ranges from $1.36 to $1.40 with the mean being $1.38.
Efficiency
As noted above, FAST’s customers continue to aggressively push payments out past quarter end. When I look at FAST’s accounts receivable turnover over the past decade I see that receivables turned over in excess of 9 times/year in 2010 – 2011 (~41 days). In 2018, however, the turnover level had dropped to 7.51 times/year (~49 days).
Looking at FAST’s accounts payable turnover I see that the number of days in which payables were outstanding in 2010 – 2012 was between 18 and 19 days. In 2018, this had jumped to more than 24 days.
So, FAST’s receivables now take ~8 days longer to collect but FAST has only stretched its payables by 5 – 6 days. This is not an encouraging trend and I can see why the issue of receivable turnover was raised on the Q2 analysts call.
While there has been a moderation in the rate of increase in the number of days in which receivables are outstanding relative to 2018, this is very different from a reduction in the number of days in which receivables are outstanding. I will be looking closely at the change in the payables and receivables turnover when Q3 results are released in October.
Credit Ratings
As at June 30, 2019 FAST had long-term debt of $497 Million versus total shareholders’ equity of $2,503.7B (19.8% long-term debt/shareholders’ equity). FAST’s debt is not rated by any of the ratings agencies.
The current portion of LTD is $3 Million with LTD due as follows:
- 2020 – 2021: $0.04B
- 2022 – 2023: $0.397B
- After 2023: $0.06B
As a relatively conservative investor I appreciate FAST’s conservative use of leverage.
Free Cash Flow (FCF)
I view FCF as a critical metric. In FY2014 – 2018 FAST generated $0.31B, $0.395B, $0.33B, $0.465B, and $0.498B in FCF. I am confident FAST will continue to generate positive FCF going forward…even during a challenging business environment.
Dividend and Dividend Yield
FAST’s dividend history can be accessed here.
The dividend was recently increased to $0.22/share and the first quarterly dividend at this level will be distributed August 22nd to shareholders of record as at July 25th.
With shares trading hands at $30.37 and a $0.88/year dividend, FAST provides investors with a ~2.9% dividend yield. This compares favorably to the 1.73%, 1.37%, 1.49%, 1.59%, 1.68%, 2.10%, 2.74%, 2.55%, and 2.34% dividend yields of 2009 – 2017; the dividend yield in 2018 was 2.95%.
FAST’s $0.88 annual dividend is ~65% of my projection for FAST’s FY2019 earnings (see below).
The repurchase of issued and outstanding shares is another method in which shareholders are rewarded. In FY2009, the diluted weighted average shares outstanding amounted to 593.4 million shares; this figure has been reduced to 573.4 million shares as at June 30, 2019 (these figures reflect the 2-for-1 stock split in 2011 and the 2-for-1 stock split in May 2019).
Valuation
At the time of my January 19, 2018 article, FAST had reported diluted EPS of $2.01 for FY2017 and shares had closed at ~$53.30 on January 18, 2018. When we account for the 2 for 1 stock split in May 2019 FAST generated diluted EPS of ~$1.01 and the share price is adjusted to $26.65 giving us a diluted PE of ~26.4.
At the time of my previous article, 18 analysts had projected FY2018 adjusted diluted EPS of $2.30 ($1.15 post split). Using the $26.65 post split January 18th closing stock price, the forward adjusted diluted PE was ~23.17.
We now see that FAST has generated diluted EPS of $0.69 for the first half of FY2019. Should it generate similar results in the second half of the year then projected diluted FY2019 EPS should be around $1.38. With shares currently trading at $30.37 we get a forward diluted PE of ~22.
With the mean adjusted EPS guidance from 16 brokers being $1.38 we get a forward adjusted diluted PE of ~22 which compares favorably to PE levels in 2009 – 2017 which were 33.58, 33.28, 38.59, 32.85, 31.46, 29.73, 22.93, 27.31, and 29.09.
As much as FAST’s current valuation is more favorable than recent historical levels, I don’t think it would take much for FAST’s share price to retrace to the mid $20 range as we witnessed in October and December 2018; a $4 drop in FAST’s share price from the current $30.37 level is only a ~13% pullback.
Were FAST’s share price to retrace to ~$26 - $27 then we would have a forward diluted PE level of ~18.8 - ~19.6 and the dividend yield would be ~3.34%...well above historical levels.
Final Thoughts
I do not envision the US/China trade war coming to an end anytime soon. In addition, corporate earnings growth appears to have stalled and the political divide in Washington only appears to be getting wider. Although there is talk of a Fed interest-rate cut I don’t know if this is a ‘done’ deal and I don’t think an interest rate cut will resolve all issues.
As much as FAST is taking steps to improve its results I think conditions are ripe for a broad market pullback which could very realistically result in FAST’s share price falling at least $3 - $4/share from the current $30.37 level.
I like FAST’s long-term prospects but I think there are sufficient short-term headwinds that continuing to be patient is a prudent strategy. It is currently not my intent to initiate a FAST position but should shares pull back below $27 I will revisit initiating a position but much will depend on the valuation of other companies which are on my ‘watchlist’.
I hope you found this article helpful and wish you much success on your journey to financial freedom.
Thanks for reading!
Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to [email protected].
Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.
Disclosure: I do not currently hold a position in FAST and do not intend to initiate a position within the next 3 business days.
I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.
