Generally, when investing in stocks we look for companies with strong brand power, differentiation and significant barriers to entry. This is not the case with Fastenal Co. (NASDAQ:FAST). As the company operates in the industrial supplies distribution sector, there is little differentiation and a low barrier to entry.
The company makes up for this, however, by being very efficient in executing its business model, offering diversified solutions, inventory solutions and has a large distribution network, which guarantees it some moats.
As a result, Fastenal has an enviable track record, gradually improving its financials and consequently the distribution of shareholder value.
Despite being a very solid and attractive company, though, there are two main risks that need to be monitored. First, the cyclicality of its market. And second, its valuation, which is only reasonable in a base case scenario.
Strategic evolution drives consistent growth and operational efficiencyFastenal is a distributor of wide-ranging industrial and construction products, including safety materials, screws and other tools and equipment. It also helps its customers with stock management, cost reduction and more.
One of the interesting strategies that Fastenal has been expanding in recent years is its onsite participation, through initiatives such as FastBin and FastVEnd. This practice turns out to be good for both sides. For Fastenal, it expands and builds customer loyalty (improving relationships), increases operational efficiency with automatic sales and better logistics and also makes revenue more recurrent. On the customer's side, it optimizes inventory costs and makes management simpler and more efficient, as well as gives them quick access to the materials they need.
Source: Fastenal's investor relations
In recent years, the company has been reducing its branch locations and expanding its onsite locations. In 2014, the company had 214 onsite locations with onsite revenue of $387.70 million, which represented close to 10% of total net revenue. In 2023, the number of onsite locations grew to 1,822 (1,934 in the second quarter) with around 40% of revenue.
Source: Fastenal's IR
Note that this business model combined with good execution translates into good financials for the company. Even in industries that are cyclical, good management has allowed for a consistent advancement in net revenue as well as an evolution in net margin. Focusing only on the last few quarters, a slightly slower growth rate and greater difficulties in margins have been observed. Management mentioned customer sentiment was still challenging, along with other data such as the U.S. Purchasing Managers' Index at 48.80 in the second quarter, but this was partly mitigated by better customer acquisitions and contract growth.
Thus, even with the greater representation of onsite operations, the challenging scenario, together with other factors such as short-term inefficiencies in the supply chain, caused the gross margin to shrink by 0.40 percentage points year over year to 45.10%, while the operating income margin fell from 21% to 20.20%, impacted by the advance in selling, general and administrative costs. Despite this, Fastenal stressed it remains prudent and for the third quarter, it intends to remain tight with costs.
From a long-term perspective, this slightly more challenging moment is almost unnoticeable, especially if we focus on the dividend per share, which continues to increase gradually and consistently, as well as being very well supported by the growth in earnings per share. On the other hand, we can already see a certain stagnation caused by the factors mentioned in the diluted earnings per share.
In general, these earnings are converted into cash generation and consequently sustain this good return to shareholders, both in terms of dividend growth and any buybacks. Note that in relation to the amount of cash generated, there is no great need for capital expenditures, which also makes the distribution to shareholders healthier and more predictable.
Source: Fastenal's investor relations
Finally, its capital structure is quite comfortable. In addition to generating consistent cash, its debt is low at just over $500 million, while cash and equivalents are just over $250 million. Since its leverage is very low, there is no need for large principal payments or interest expenses.
In summary, Fastenal has a solid track record of execution. Its good management with efficient strategies and cost reduction have proven capable of making a cyclical company in a market with no apparent barriers to entry able to present a consistent and sustainable return.
Valuation concernsThe main problem with the thesis is the market already rewards the stock. This premium is even higher at an unfavorable time for Fastenal since, despite the rate cuts and some statements about the resilience of the economy, there is still some cloudiness about the growth of economic activity in the short term and, consequently, uncertainty about its growth in the coming quarters.
Breaking down Fastenal's valuation multiples a little, the forward price-earnings ratio is 33.30, while the forward enterprise value-to-Ebitda ratio is 23.20 and the price-to-operating cash flow ratio is 29.80. All of these multiples are considerably above their medians.
However, multiples are always relative. For a company with high quality and predictable accelerated growth in its fundamentals, 33 times forward earnings may not be enough. But I do not think this is exactly the case with Fastenal. As I explained earlier, its business model and track record of execution are very good, but analysts' forecast for the next few years do not predict such strong growth. By 2026, the consensus expectation is that Fastenal will reach earnings per share of $2.40 - a sustainable and reasonable growth based on 2023's earnings of $2.02 - but even so, this figure implies a price-earnings of more than 29 by 2026.
Paying this premium compromises shareholder returns since the dividend yield ends up being low compared to the higher payout. With the estimated earnings per share for 2026, if the company distributes 80%, the yield based on the current stock price would be 2.70%, still below its average of the last 10 years, which is a dividend yield of 3.15%, and that's thinking of something that will still take two years to obtain.
Source: GuruFocus
As the company is not in a favorable cycle, it is normal for earnings to be a little more pressured and a resumption in this cycle could benefit it, especially if combined with some internal cost optimization initiatives, a better mix of revenue with more onsite operations, which could lead not only to a resumption of revenue growth, but also to the net income margin continuing to gradually advance.
Even in this scenario, you still have to believe the company will advance its free cash flow at an accelerated pace and discount this cash flow at a very low rate. In a discounted cash flow model, we find a fair price of just $60 for Fastenal when we consider growth of 11% for the next two decades and discount it at a rate of 7%. In other words, this valuation is reasonable, but I don't consider it attractive. As much as I believe the outlook for the company is positive and reliable, the 11% per year already incorporates this optimism well, eroding the margin of safety.
Final thoughtsFastenal is an excellent company that is worth keeping on the radar as it is a solid option for compounding. Its efficient management allows it to generate good shareholder value, with good prospects of maintaining sustainable growth in cash generation and being a good dividend payer, ideal for those investors looking for alternative companies with quality income.
On the other hand, the current share price is a little stretched, even with the company's more timid results, which is why, in my opinion, a more cautious approach is needed in order to enter stocks or increase positions when there is a greater margin of safety.
This content was originally published on Gurufocus.com
