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We’re now at that point in the cycle where earnings pre-announcements in the industrial space are skewing negative, and with rates shooting up and basic materials companies starting to warn, concerns are growing that the economy is going to slow more significantly in 2023, possibly even into a mild 1990’s-style recession. At the same time, data from the non-residential construction space is mixed at best.
None of this great for Fastenal (NASDAQ:FAST), as the company is a major supplier of fasteners, tools, and other components to manufacturing and non-residential customers. At the same time, price/cost seems to be turning, suggesting that gross margin leverage has peaked. It’s not so surprising, then, that the shares had been drifting lower since my last update until a better-than-feared third quarter earnings report.
This is a tough time to get really bullish on Fastenal given those macro/sector pressures. I have no concerns or issues with the quality of Fastenal, and I believe efforts like customer-located sales and an ongoing shift away from traditional stores will benefit the company, but I don’t think the Street is comfortable yet with the 2023-2024 outlook for manufacturing and non-residential construction. Given that, and the premium that the Street gives these shares, it’s a name that I’d keep up-to-date on to take advantage of more pronounced pullbacks, but not one I’d jump into aggressively now.
A Small Core Beat, But A Miss On Margins And Sales Are Decelerating
Fastenal’s third quarter earnings were okay, but I think the post-earnings reaction has been driven more by relief that it could have been worse, particularly with earnings warnings starting to add up.
Revenue rose 16%, more or less matching expectations. Sales decelerated throughout the quarter, with July daily sales up almost 19% (constant currency), August up less than 17%, and September up less than 15%. Manufacturing sales held up comparatively better (from up about 23% in July to up 23.5% in August to up 21.5% in September), but non-resi weakened noticeably (up 8.8% in July, up 5.8% in August, up 1.4% in September). Fastener sales rose about 20% for the first two months of the quarter, then decelerated to 15% in September.
Gross margin declined 40bp from the year-ago period to 45.9% (a 60bp qoq decline), missing by 40bp. There were impacts from weather and safety-related writedowns, but price/cost is starting to flip as customers are seeing improving product availability and shorter lead-times – meaning that they’re less willing to pay up for the superior product availability that companies like Fastenal and Grainger (GWW) offered over the last 12-18 months.
Fastenal continues to do well on the opex line, helped in part by ongoing growth in e-commerce sales (up 50%) and customer-located operations (vending and OnSite). Operating income rose 19%, with operating margin up 50bp yoy and down 60bp qoq to 21%. Incremental margin for the quarter was around 24.5%.
At the operating line, Fastenal beat by a little less than $0.01/share, with the remainder of the beat ($0.02/share total) driven by lower taxes and a lower share count.
Normalization Is Expected, But Further Deceleration Is A Risk
It shouldn’t surprise investors that between high inflation and rising interest rates the economy is starting to slow. Orders are still strong relative to historical norms, but companies have made significant progress working through backlogs, and many industrial sub-categories are getting back to more normal operating conditions.
With that, pressure from (and on) supply chains is easing, and that’s starting to impact distributors like Fastenal. This company stood out during the worst of the crunch on its ability to secure supply and maintain product availability for customers, and that helped support robust pricing and further growth in value-added services like vending and on-premises inventory management. I don’t expect those services to start contracting, and I do think they represent a strong base for future business (at better-than-average margins), but pricing power is starting to fade as sourcing becomes less of a competitive differentiator.
Above and beyond that are slowdowns in the end markets. Manufacturing still looks healthy on balance, with companies still talking about healthy order books (and bank corporate and industrial lending remains healthy), but the Fed’s rate hikes are having an impact and business confidence has been eroding as the year has gone on. Likewise, there’s been a more pronounced contraction in non-residential construction in recent months.
This is far from Fastenal’s first time through a business cycle, and I have no long-term concerns about management’s ability to navigate the cycle. I do think gross margins will continue to erode over time, but this is not a new phenomenon and it’s not an area where I think management has unrealistic expectations.
Fastenal has been shifting its business for years, deprioritizing its physical stores and in-store sales in favor of more online/e-commerce business and a growing percentage of business done on-premises with customers. The margin leverage from these new opportunities should help mitigate some of the long-term pressures on gross margin, and they also do support an ongoing expansion of the company’s product portfolio – giving the company an opportunity to pick up volume on increased share-of-wallet with existing companies.
The Outlook
At this point I’m not really making any meaningful changes to my model. I’ve cut back my expectations for FY’23 revenue a bit on reduced confidence in the non-resi outlook, but trends are otherwise tracking near my prior expectations, and I think the company could still have some opportunities to drive modest outperformance at the SG&A line.
Long-term, I’m still expecting core sales growth in the neighborhood of 6%, comfortably ahead of U.S. GDP and manufacturing growth. Greater onshoring/reshoring could perhaps drive some long-term upside, as could efforts to broaden the product portfolio. I don’t see the same upside on gross margin, but again I do think that operating efficiency can offset some of this pressure. I expect FCF margins to improve into the mid-teens over time, driving low double-digit core free cash flow growth, and I expect a continuation of high ROICs and ROAs in the years to come.
The Bottom Line
The “but” here will be familiar to my long-time readers – Fastenal’s valuation rarely gets into bargain territory and frankly seldom even gets to “growth at a reasonable price” territory, though I’ll note this is a company with a history of outperforming long-term growth expectations. I don’t think these shares are particularly cheap now, and I don’t think the market is finished pricing in the risk of a recession over the next 12-18 months.
Were Fastenal to slip into the low $40’s, I’d seriously consider adding shares, as I do think this is one of the best industrial (or industrial-adjacent) companies I know well. For now, though, I see more downside risks than upside opportunities and would be careful about buying in aggressively unless you have a much more robust outlook for the economy in 2023.
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