With Quiver Quantitative’s recent institutional holdings data, we can see that hedge funds and asset managers have been increasing their holdings in Fastenal (NASDAQ: FAST). Firms such as Charles Schwab, Geode Capital Management, and Victory Capital Management have all recently added to their FAST positions. Most notably, Charles Schwab increased shares held by 3.16% (as filed on 9/30), bringing their total FAST holdings to 13,830,951 shares worth around $876.6 million dollars at current market prices. With this in mind, we took a closer look at some of the reasons why many investors may be bullish on Fastenal.
In October, Fastenal reported earnings results for the third quarter of FY23. Highlights of the quarter included net sales of $1.845 billion dollars (2.4% YoY increase), gross profit of $847.6 million dollars (2.6% YoY increase), EBIT of $386.7 million dollars (2% YoY increase), and net earnings (net income) of $295.5 million dollars (3.8% YoY increase). Fastenal's growth is primarily being driven by the expansion of its Onsite locations, with significant year-over-year growth and a substantial number of new signings, indicating increased dedicated sales and service delivery directly at customer facilities. Additionally, the company is experiencing growth through its FMI Technology offerings, particularly through FASTStock, FASTBin, and FASTVend, which are enhancing sales via more efficient, technology-driven stocking and fulfillment solutions, including the migration of products to digital stocking locations. With this earnings result in mind, we believe that Fastenal is a compelling investment opportunity trading at a fair valuation.
Fastenal, headquartered in Winona, Minnesota, is a leading distributor of industrial and construction supplies, originally founded as a partnership in 1967 and incorporated in 1968. The company's business model revolves around supplying a diverse range of products spanning over nine major lines, primarily through business-to-business transactions. Fastenal has significantly expanded its reach from its first branch in Winona to a global network of 3,306 in-market locations across 25 countries, supported by 16 distribution centers in North America and Europe. The company leverages advanced technologies such as vending devices, bin stock devices, and eCommerce to engage customers effectively. The strength of Fastenal lies in its proximity to customers and the ability to offer comprehensive products and services, thereby reducing the total procurement cost for businesses. With a workforce of 22,386, Fastenal's success is attributed to its high-quality employees and their commitment to customer service.
The industrial distribution industry, in which Fastenal operates, is highly competitive and features a mix of large national distributors dominant in densely populated areas and smaller regional or local distributors prevalent in smaller markets. The key competitive factors in this industry include customer service, price, convenience, product availability, and cost-saving solutions. The industry has seen a trend towards broad-line product offerings, though many distributors, particularly smaller ones, are still closely associated with specific product lines. Service delivery methods vary significantly, ranging from local branch-based presence to mobile sales, telemarketing, and increasingly, eCommerce platforms. This diversity reflects the varied needs of a customer base that typically utilizes multiple procurement channels. Fastenal differentiates itself through its physical selling and stocking presence close to customer locations, its broad network of branches facilitating efficient product distribution, and innovative FMI solutions, all of which contribute to its competitive advantage, particularly in its Onsite service model for larger customers.
Management is solid, and their capital allocation priorities do a great job of creating shareholder value for shareholders. Management likes to repurchase shares to return excess cash to shareholders, which not only decreases shares outstanding over time (effectively making investors positions in the business larger over time), but also reverses the dilutive effect of the business’ stock-based compensation. As of December 31st, 2022, management had the authority to repurchase 6,200,000 shares under the July 2022 repurchase authorization. With a history of repurchases, we believe that Fastenal will authorize additional repurchases going forward, creating lots of value for shareholders. In addition to share repurchases, management offers cash dividends on common stock. In FY22, Fastenal paid out $711.3 million dollars worth of cash dividends to shareholders. These dividends represented 65.4% of net earnings, which means that 65.4% of net income was paid out in the form of cash dividends. While management are great capital allocators, we believe that this payout ratio is potentially too high for a compounding business like Fastenal. We believe that it would be a better capital allocation strategy for Fastenal to reduce the payout ratio (let's say to 40%), which would give them additional cash for initiatives that create more value (in our opinion), such as cash reinvestments at high rates of return and additional share repurchases.
In terms of management incentives, management is incentivized well, with a compensation structure that does a great job of aligning shareholder and management interests, while also doing a great job of retaining executive talent over the long term. The executive compensation structure includes a base salary, quarterly incentives (paid out via cash), and long-term incentives (paid out via stock options). This unique short-term incentive compensation structure rewards the achievement of short-term profit growth, while aligning NEO compensation with Fastenal’s quarterly corporate financial performance. The long-term incentives, on the other hand, focus on long-term value creation, aligning compensation with shareholders. We believe that this is a solid incentive structure that ensures short-term and long-term excellence and growth in the business. It also allows management to build equity in the business, which not only aligns their pay with stock price performance (which aligns management and shareholder interests like mentioned above), but it also retains executive talent over the long-term as they are rewarded with stock options that vest over multi-year periods. It’s extremely hard to profitability run and grow a business with a revolving door at the top, and this incentive structure prevents this from happening.
Fastenal is a very efficient business. The business currently operates at a LTM ROE of 34.2% and a LTM ROIC of 36.9%. With a WACC of 8.8%, Fastenal operates at a ROIC to WACC ratio of 4.2x. This high ROIC to WACC ratio showcases the business’ ability to generate excess returns on capital relative to the business’ weighted average cost of capital. Businesses that operate with strong returns on capital are compounders, businesses that are able to rapidly compound earnings and intrinsic value over the long-term, much to the delight of long-term passive shareholders. Looking further, we can see that Fastenal has had stellar sustained growth in operating income (EBIT), with flat EBIT margins (EBIT margins have hovered around 20-21% over the last decade), over the last ten years. Looking at operating income is important, as it shows the profitability of a business’ core operations. Since 2013, Fastenal has grown EBIT at a CAGR of 7.4%, showcasing the business’ operational efficiency improvements over that time frame.
Analyzing Fastenal’s income statement, we can see some stellar sustained growth in revenue, gross profit, and earnings within the last decade. Since 2013, Fastenal has grown revenue at a CAGR of 7.7%, with gross profit growing at a CAGR of 6.5% during that same time frame. The growth deficiency of gross profit relative to revenue can largely be attributed to slightly contracting gross profit margins over the last ten years. In 2013, Fastenal operated at a gross margin of 51.7% of revenue, compared to today where the business operates at a gross margin of 45.6% (LTM gross margin). This contraction in gross margin can signal increased competition, rising COGS (cost of goods sold), or changes in the product mix, among others. While this may be a sign of concern for some investors, we don’t think it should be, since flat EBIT margins over the last ten years (while gross margins have fallen during that time frame) show that this gross margin degradation is largely due to rising COGS (cost of goods sold). With high tariffs placed on Chinese imports during the Trump Administration (which Biden hasn’t reversed), Fastenal suffers from higher COGS as they source products from China (tariffs increase the cost of importing these goods). In terms of earnings, Fastenal has grown EBITDA at a CAGR of 7.7% since 2013, with EPS growing at a CAGR of 9.5% in that same time period. This growth in EPS can largely be attributed to light share repurchases over the last ten years. Since 2013, Fastenal has decreased shares outstanding by 3.7% through share repurchases.
Looking at Fastenal’s balance sheet, we can see that the business operates in sound financial health. The business currently holds $297.5 million dollars worth of cash and equivalents on the balance sheet, paired with no short term borrowings and $200 million dollars of long-term debt. With a net debt of only $241.4 million dollars and a LTM Net Debt/EBITDA of 0.13x, we can see that the business has plenty of runway to cover its debt obligations and a deleveraged balance sheet. Adding credence to this point, Fastenal operates at an interest coverage ratio of 108.47x, meaning that the business generates $108.47 dollars worth of EBIT for every dollar of interest expense that the business incurs. This low debt burden is a great characteristic of a compounding business like Fastenal. With debt not being an issue, the business can put money towards initiatives that create value for shareholders and the business in general, like share repurchases and reinvestments back into the business at high rates of return.
Analyzing Fastenal’s cash flow statement, we can see some stellar sustained growth in net income and free cash flow over the last ten years, showcasing the business’ operational improvements and increased efficiency over that time period. Since 2013, Fastenal has grown net income at a CAGR of 9.5%, with free cash flow growing at a CAGR of 13.9% in that same time period. This growth in free cash flow over the last ten years can largely be attributed to expanding free cash flow margins. In 2013, Fastenal operated at a free cash flow margin of 6.3% of revenue, compared to today where the business operates at a free cash flow margin of 16.5% (LTM free cash flow margin). This free cash flow margin expansion acts as a catalyst for future free cash flow generation, as the business is able to generate more and more free cash flow from revenue (this is exacerbated by Fasental’s MSD top-line revenue growth, which further catalyzes free cash flow generation). As mentioned, this revenue growth and free cash flow margin expansion act hand-in-hand, creating a flywheel of free cash flow growth, allowing a compounder like Fastenal to continue to rapidly expand earnings and intrinsic value over time. With the business generating more and more cash flow over time, management can put that money to work with initiatives like share repurchases, reinvestments back into the business at high rates of return, and dividend increases, which all create value for shareholders and allows Fastenal to continue to compound earnings.
After conducting a reverse discounted cash flow analysis, we can see that Fastenal is trading at share prices that imply a 11% growth rate (CAGR) in free cash flow over the next ten years, using a perpetuity growth rate of 3% (largely in line with US GDP growth) and a discount rate of 8.8% (Fastenal’s WACC). As discussed above, we believe that Fastenal is a very high quality compounding business, and we further believe that this market valuation of Fastenal is a fair value for the business. While past performance is not indicative of future results, Fastenal has grown free cash flow at a CAGR of 13.9% over the last ten years, which is slightly above the market valuation of Fastenal’s future free cash flow growth rate currently. This gives investors a margin of safety of 290 basis points, which we believe is ample given free cash flow margin expansion. Investors with a smaller risk appetite might enter into a position at a margin of safety of 420 basis points (around a 30% margin of safety), which implies a FCF growth rate of 9.7% and an intrinsic share value of $58.11/share (-8.6% implied downside). Oftentimes, high quality compounding businesses like Fastenal trade at high valuations due to incredible future earnings potential, and we believe that Fastenal is a compelling investment given the fair value of share prices currently, offering a rare opportunity to enter into a position in a high quality business at a relatively cheap valuation. Please note that these projections and valuations are based entirely on our proprietary models, and we encourage all investors to do their own due diligence.
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