Stock Analysis: Fastenal (FAST)

Company Description:

Fastenal Company (Fastenal), incorporated in 1968, sells industrial and construction supplies in a wholesale and retail fashion. As of December 31, 2006, the Company had 2,000 store sites located in 50 states, Puerto Rico, Canada, Mexico, Singapore, China and the Netherlands. As of December 31, 2006, Fastenal operated 12 distribution centers in North America, from which it distributed products to its store sites. Fastenal's offerings are grouped into 10 product lines: fasteners; tools and equipment; cutting tools and abrasives; hydraulics, pneumatics, plumbing, and heating, ventilating and air conditioning (HVAC); material handling, storage and packaging; janitorial supplies, chemicals and paints; electrical supplies; welding supplies; safety supplies, and metals, alloys and materials. Fastenal conducts business under various trademarks and service marks, including Fastenal with various designs or tag lines, FAS-N-IT, FNL, Blackstone and FNL G9.

Click here for a full description of the company’s operations (provided by Reuters).

Annual Report Highlights (latest report is for the period ending 12/30/06):

Business Overview

Fastenal Company was founded in 1967. As of December 31, 2006, we operated 2,000 store sites located in 50 states, Puerto Rico, Canada, Mexico, Singapore, China, and the Netherlands and employed 7,174 people at these sites. In addition, there were 3,241 people employed in various support positions.

We sell approximately 689,000 different types of industrial and construction supplies in ten product categories. These include (approximately): 306,000 different types of threaded fasteners and miscellaneous supplies (fasteners); 110,000 different types of tools and equipment (tools); 127,000 different types of cutting tool blades and abrasives (cutting tools); 47,000 different types of fluid transfer components and accessories for hydraulic power, pneumatic power, plumbing, and HVAC (hydraulics & pneumatics); 9,000 different types of material handling, storage, and packaging products (material handling); 12,000 different types of janitorial supplies, chemicals, and paint (janitorial supplies); 24,000 different types of electrical supplies; 26,000 different types of welding supplies (excluding welding gases); 19,000 different types of safety supplies; and 9,000 different types of metals, alloys, and materials (metals).

As of December 31, 2006, we operated twelve distribution centers located in Minnesota, Indiana, Ohio, Pennsylvania, Texas, Georgia, Washington, California, Utah, North Carolina, Kansas, and Ontario, Canada. Approximately 94.8% of our 2006 sales were attributable to products manufactured by others, and approximately 5.2% related to items manufactured, modified, or repaired by either our Manufacturing Division or one of our Support Services.

Stores

We have closed only ten stores in our history. Three of these locations were subsequently reopened when the expansion of our product line or the expansion of our distribution network improved the profitability of the locations.

We select new locations for our stores based on their proximity to our distribution network, population statistics, and employment data for manufacturing and construction. We intend to continue opening new store sites and currently expect the rate of new store openings to be approximately 13% to 18% per year (calculated on the ending number of stores in the previous year).

We believe, based on the demographics of the marketplace in North America, that there is sufficient potential in this geographic area to support at least 3,500 total stores. Many of the new store sites may be in cities in which we currently operate. Fastenal has not operated outside of North America long enough to assess the market potential of those markets.

We also operate “in-plant” sites. An “in-plant” site is a selling unit located in or near a customer’s facility that sells product solely to that customer. These sites are not included in the store count numbers as they represent a customer subset of a store.

We plan to open additional store sites outside of the United States in the future. The store sites located outside the United States contributed approximately 7% of our consolidated net sales in 2006 with approximately 78% of this amount attributable to our Canadian operations.

It has been our experience that near-term profitability has been adversely affected by the opening of new store sites. This adverse effect is due to the start-up costs and the time necessary to generate a customer base. A new store generates its sales from direct sales calls, a slow process involving repeated contacts. As a result of this process, sales volume builds slowly and it typically requires nine to 12 months for a new store to achieve its first profitable month. Of the 73 stores opened in the first quarter of 2006, 32 were profitable in the fourth quarter of 2006.

We operate a central UNIX/terminal-based computer system allowing automatic data exchange between our stores and our distribution centers. This system consists of both customized and purchased software. The use of client/server technology allows our network of UNIX-based machines to serve networked personal computers and workstations and is provided to authorized users via a dedicated Wide Area Network (WAN). At the store level, we operate a proprietary point-of-sale (POS) system that operates on a Microsoft Windows operating system. The data exchange between the centrally located systems and POS is monitored and controlled centrally.

Products

Our original product offerings were fasteners and other industrial and construction supplies, many of which are sold under the Fastenal product name. This product line, which we refer to as the fastener product line, consists of two broad categories: threaded fasteners, such as bolts, nuts, screws, studs, and related washers; and miscellaneous supplies, such as paints, various pins and machinery keys, concrete anchors, batteries, sealants, metal framing systems, wire rope, strut, private-label stud anchors, rivets, and related accessories.

Threaded fasteners are used in most manufactured products and building projects, and in the maintenance and repair of machines and structures. Many aspects of the threaded fastener market are common to all cities. Variations from city to city that do exist typically relate to the types of businesses operating in a market or to the environmental conditions in a market. Therefore, we open each store with a broad selection of base stocks of inventory and then allow the local store and district leaders to tailor the additional inventory to the local market demand as it develops.

Threaded fasteners accounted for approximately 90% of the fastener product line sales in 2006, 2005, and 2004 and approximately 46%, 48%, and 50% of our consolidated net sales in 2006, 2005, and 2004, respectively. Concrete anchors make up the largest portion of the miscellaneous supply items included in the fastener product line. Most concrete anchors use threaded fasteners as part of the completed anchor assembly.

Since 1993, we have added additional product lines. These product lines are sold through the same distribution channel as the original fastener product line.

Inventory Control

Our inventory stocking levels are determined using our computer systems, our sales personnel at the store, district, and region levels, and our product managers. The data used for this determination is derived from sales activity from all of our stores, from individual stores, and from geographic areas. It is also derived from vendor information and from customer demographic information. The computer system monitors the inventory level for all stock items and triggers replenishment, or prompts a buyer to purchase, as necessary, based on an established minimum-maximum level. All stores stock a base inventory and may expand beyond preset inventory levels as deemed appropriate by their district managers. Inventories in distribution centers are established from computerized data for the stores served by the respective centers.

Manufacturing and Support Services Operations

In 2006, approximately 94.8% of our consolidated net sales were attributable to products manufactured by other companies to industry standards. The remaining 5.2% of our consolidated net sales for 2006 related to products manufactured, modified or repaired by our manufacturing division or our support services. The manufactured products consist primarily of non-standard sizes of threaded fasteners made to customers’ specifications. The services provided by the support services group include, but are not limited to, items such as tool repair, band saw blade welding, third-party logistics, and light manufacturing. We engage in these activities primarily as a service to our customers and expect these activities in the future to continue to contribute in the range of 4% to 10% of our consolidated net sales.

Sources of Supply

We use a large number of suppliers for the approximately 689,000 standard stock items we distribute. Most items distributed by our network can be purchased from several sources, although preferred sourcing is used for some stock items to facilitate quality control. No single supplier accounted for more than 5% of our purchases in 2006.

Customers and Marketing

We believe our success can be attributed to our ability to offer customers a full line of quality products at convenient locations, and to the superior service orientation and expertise of our employees. Most of our customers are in the construction and manufacturing markets. The construction market includes general, electrical, plumbing, sheet metal, and road contractors.

The manufacturing market includes both original equipment manufacturers and maintenance and repair operations. Other users of our products include farmers, truckers, railroads, mining companies, federal, state and local governmental entities, schools, and certain retail trades. As of December 31, 2006, our total number of active customer accounts (defined as accounts having purchase activity within the last 90 days) was approximately 275,000.

During each of the three years ended December 31, 2006, no one customer accounted for a significant portion of our sales. We believe that our large number of customers together with the varied markets that they represent, provide some protection to us from economic downturns in a particular market.

Store personnel generate a significant portion of our sales through direct calls on customers. Because of the nature of our business, we make limited use of the more expensive forms of mass media advertising such as television, radio, and newspapers. The forms of advertising we use include signs, catalogs, and direct mailings.

Competition

Our business is highly competitive. Competitors include both large distributors located primarily in large cities and smaller distributors located in many of the same cities in which we have stores. We believe that the principal competitive factors affecting the markets for our products are customer service and convenience.

Some competitors use vans to sell their products in markets away from their main warehouses, while others rely on mail order or telemarketing sales. We, however, believe that the convenience provided to customers by operating stores in small, medium, and large markets, each offering a wide variety of products, is a competitive selling advantage and that the large number of stores in a given area, taken together with our ability to provide frequent deliveries to such stores from centrally located distribution centers, makes possible the prompt and efficient distribution of products.

Employees

As of December 31, 2006, we employed a total of 10,415 full and part-time employees, 7,174 being store managers and store employees, and the balance being employed in our distribution centers, manufacturing operations, service operations, and home office.

We believe the quality of our employees is critical to our ability to compete successfully in the markets we currently serve and to our ability to open new stores in new markets. We foster the growth and education of skilled employees throughout the organization by operating training programs and by decentralizing decision-making. Wherever possible, promotions are from within our organization. For example, most new store managers are promoted from an outside sales position or from an assistant manager’s position, and district managers (who supervise a number of stores) are usually former store managers.

The Fastenal School of Business develops and delivers a comprehensive array of industry and company specific education and training programs that are offered to all Fastenal employees.

Risk Factors

• The industrial, construction, and maintenance supply industry is consolidating, which could cause it to become more competitive and could negatively impact our business.
  

• Our revenues and net income may be adversely affected by economic conditions, political situations, and changing laws and regulations in foreign countries, over which we have no control.
  

• We may not be able to compete effectively against our competitors, which could harm our business and operating results.
  

• We are exposed to foreign currency exchange rate risk, and changes in foreign exchange rates could increase our costs to procure products and our foreign sales.
  

• Inclement weather and other disruptions to the transportation network could impact our distribution system.
  

• Our ability to successfully attract and retain qualified personnel to staff our stores could impact labor costs, sales at existing stores, and the rate of new store openings.
  

• Increases in energy costs and the cost of raw materials used in our products could impact our cost of goods and distribution and occupancy expenses, which may result in lower operating margins.
  

• The ability to identify new products and products lines, and integrate them into our store and distribution network, may impact our ability to compete and our sales and margins.
  

• New store openings may negatively impact our operating results.
  

• Opening stores in new markets presents increased risks that may prevent us from being profitable in these new locations.
  

• Lower volume orders and changes in our customers and product mix could cause our gross margin percentage to fluctuate or decline in the future.
  

• Neither our current business strategy that focuses on stores with an industrial-leaning retail look and feel nor our new business strategy of opening certain stores with additional product selection has been proven successful on a long-term basis.
  

• We may be unable to meet our goals regarding new store openings.

• Our current estimate for total store market potential in North America could be incorrect.
  

• A downturn in the economy and other factors may affect customer spending, which could harm our operating results.

Management’s Discussion & Analysis of Financial Condition & Results of Operations

Financial Overview

During 2006, 2005, and 2004, the strength of the global industrial environment positively impacted our performance. During the first half of 2003, the recession in the global industrial environment, which had begun several years earlier, negatively impacted our performance, and that of the industry as a whole.

The 2006, 2005, and 2004 net sales growth rate percentages reflect the strengthening of the North American market in the period since July 2003. The increase in net sales in 2006, 2005, and 2004 came primarily from unit sales growth in existing stores more than two years old, growth in the newer product lines, and new site openings. The 2004 growth was increased by 3.0% to 4.0% due to an inflationary increase in pricing during the year.

Stores sites opened in 2006 contributed approximately $32.9 (or 1.8%) to 2006 net sales. Store sites opened in 2005 contributed approximately $109.1 (or 6.0%) to 2006 net sales and approximately $35.5 (or 2.3%) to 2005 net sales. The rate of growth in sales of store sites generally levels off after they have been open for five years, and, as stated earlier, the sales of older store sites typically vary more with the economy than do the sales of younger store sites.

Impact of Current Initiatives

During 2006 and 2005, we have been actively pursuing several initiatives to improve our operational performance. These include: (1) a new freight model, (2) tactical changes to our working capital model, and (3) an expanded store model called CSP2.

The freight model represents a focused effort to haul a higher percentage of our products utilizing our trucking network (which operates at a substantial savings to external service providers because of our ability to leverage our existing routes) and to charge freight more consistently in our various operating units. This initiative positively impacted the latter two-thirds of 2005 and all of 2006 despite the fact we experienced year-over-year increases of approximately 31.7% and 5.3%, respectively, in per gallon diesel fuel costs during those periods.

The diesel fuel cost per gallon did soften in the last four months of 2006 as our average price per gallon dropped below $2.90. Given the nature of our distribution business, if the lower fuel prices continue, it will translate into cost savings in our business during 2007.

The tactical changes to our working capital model include the establishment of a central call center for accounts receivable collection and the establishment of financial business rules for the purchasing of products outside the standard stocking model (formerly referred to as CSP) at the store. The balance sheet impacts of these changes are described below in the working capital discussion.

The CSP2 store model represents an expansion of the core stocking items and sales personnel in an existing store with the goal of driving additional product sales to existing customers, target customers, and specific geographic areas within established markets. During 2006, 163 stores were converted to the CSP2 format (an additional, five new stores opened with the CSP2 format). This resulted in 193 stores converted to the CSP2 format since the third quarter of 2005, plus the six new stores opened with the CSP2 format. The balance sheet impacts of the CSP2 locations are described below in the working capital discussion.

Impact of Fuel Prices

Rising fuel prices did take a toll on the year ended December 31, 2006, but there was some relief in the final four months. During 2005, our total vehicle fuel costs averaged approximately $1.2, $1.5, $1.7, and $1.8 per month in the first, second, third, and fourth quarters, respectively. During 2006, total vehicle fuel costs averaged approximately $1.9, $2.1, $2.2, and $1.9 per month in the first, second, third, and fourth quarters, respectively. These changes result from variations in fuel costs, the freight initiative discussed earlier, and the increase in sales and store locations. These fuel costs include the fuel utilized in our distribution vehicles (semi-tractors, straight trucks, and sprinter trucks) which is recorded in cost of goods and the fuel utilized in our store delivery vehicles which is included in operating and administrative expenses.

Gross Profit Margins

Gross profit margins for 2006 increased over 2005. The improvement was driven by our freight initiative (discussed earlier) and by improvements in our direct sourcing operations.

Gross profit margins for 2005 and 2004 were similar. The gross margin in 2005 was reduced by the greater inflation cost in steel-based products flowing through cost of sales. This impact was expected, and reflects product costs in the last three to six month ‘turn period’ of inventory in a ‘first-in, first-out’ inventory costing model. This impact was more than offset by an improvement in the gross profit associated with net freight revenue since May 2005 and a reduction in outside freight costs in the fourth quarter of 2005 due to the freight initiatives discussed earlier.

Dividends and Stock Repurchases

We have paid dividends in every year since 1991. In June 2006, we issued a press release announcing our board of directors had authorized purchases by us of up to an additional 500,000 shares of its common stock (over and above previously authorized amounts). We purchased 474,000 shares of our outstanding stock at an average price of approximately $36.49 per share since the beginning of this repurchase plan.

On January 18, 2007, we issued a press release announcing our board of directors had authorized us to purchase up to an additional 1,000,000 shares of our common stock (over and above previously authorized amounts). With this new authorization, we have remaining authority to purchase up to 1,086,000 shares of our common stock.

Financial Highlights:

Revenue Growth (1-yr): 18.8%
Revenue Growth (9-yr average): 18.5%

Net Income Growth (1-yr): 19.2%
Net Income Growth (9-yr average): 20.8%

Earnings-Per-Share Growth (1-yr): 20.0%
Earnings-Per-Share (9-yr average): 20.5%

Net Profit Margin (current): 11.0%
Net Profit Margin (10-yr average): 10.0%

Return On Equity (current): 23.3%
Return On Equity (10-yr average): 24.4%

Debt Ratio (current): 0.11
Current Ratio (current): 7.38

Financial analysis:

• Company’s debt ratio has stayed consistent throughout the past decade and currently stands at 0.11. This low level of leverage will allow the company to expand through acquisition if need to.
  

• ROA has also been fairly consistent throughout the past ten years, hovering in the mid-teens and low twenties. Currently it stands at 20.6% and 10-yr average is 21.0%.
  

• ROE has also shown consistently impressive results. Currently it’s at 23.3% and 10-yr average is 24.4%.
  

• Profit margin has stayed at roughly the same level throughout the past decade. It is currently at 11.0% and company posted a 10.0% 10-yr average.
  

• Revenue growth has not been very consistent in the past nine years, but it did stay positive and mostly in the double digits. Company posted growth of 18.8% in the 2006 fiscal year and averaged 18.5% over the past nine years.
  

• Net income growth is as inconsistent as the revenue growth, but unlike revenue growth, it has been in the negative territory (in 2001). Most recent annual net income growth was 19.2% and 9-yr average is 20.8%.
  

• Free Cash Flow figures have got to be the least impressive such figures I’ve seen so far. FCF margin has historically been very low and was negative in 1997. For the 2006 fiscal year, FCF margin stands at 1.1%. FCF growth was negative in six of the past nine years and varied between single and four (!) digit growth (or decline). So, saying that it was rocky and inconsistent isn’t saying anything. Most recent FCF growth was negative again at (-64.3%) for the 2006 fiscal year.
  

• Fastenal’s Current Ratio is rather impressive at 7.38. This shows that company is currently holding a lot of cash on hand, enough to pay for the current expenses seven times over. Such high Current Ratio may suggest that company has transferred some of its assets into a more liquid form to be able to act fast on potential acquisition targets. Or, the company is simply inefficient at using its cash reserves. The latter theory seems to be more plausible given that the Current Ratio has consistently increased over the past decade from 3.79 (which is already pretty high) to the current 7.38.
  

• Inventory Turnover has decreased from 2.76 nine year ago to the current 2.21. This seemingly slight change increases the time inventory spends sitting at the company’s warehouses by 34 days (from 132 days nine years ago go 166 days now). This change may indicate that as the company is growing it is losing inventory management efficiency.

Discounted Cash Flow (DCF) Analysis:

I was unable to use DCF analysis to come up with any kind of meaningful valuation. Even if I were to use the highest free cash flow figures from the past nine years, the stock still wouldn’t reach over $20/share. Considering that market price is about $38/share and Morningstar’s valuating the company at about 150% the current price, I must be missing something here.

Pros:

• Fastenal has a well-established network of stores with a proved earning potential.

• The company has brand recognition, which provide it with the needed leverage when lending national and government accounts.

• Fastenal plans on increasing the repurchase of its common shares, which will boost EPS.

Cons:

• Company’s growth depends on the construction industry, which is currently in a slump.

• Fastenal’s free cash flow margins and growth are abysmal, which make it difficult for me to value this company and doesn’t instill confidence in the future free cash flow growth.

Final Decision:

Fastenal seems to be a good company with a significant competitive advantage, but I’m not impressed by its free cash flow margin and growth, which are the best indicators of the financial quality. This company is definitely worth a look and other investors might find it quite suitable for their portfolios and a good fit for their investing styles. As for me, I will pass on this company and keep looking for companies I’m significantly confident about, which is not how I feel about Fastenal.