Fastenal: Relief Today, But Pressures Building

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.

 

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Fastenal: Relief Today, But Pressures Building

Fastenal Not Exactly Cheap As Tailwinds Start To Moderate

What inflation can give to industrial distributions like Fastenal (NASDAQ:FAST), pricing power namely, deflation can eventually take away, and that's a growing concern for industrial distributors as pricing is likely to become less of a benefit from here on. What's more, while underlying business activity and demand are still rather healthy, there is evidence that some of that strength is tapering off.

I'm not concerned about Fastenal from a long-term perspective; this is an uncommonly well-run company, and management's efforts to grow e-commerce, vending, vendor-managed inventory and the like will serve the company well in the coming years. That said, Fastenal still sports a premium multiple at a time when investors are increasingly skittish about industrial names, and I would be cautious about jumping in today - I do think a "buy the pullback" opportunity is forming, but I think it may be a little early to jump in today.

 

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Fastenal Not Exactly Cheap As Tailwinds Start To Moderate

Fastenal Operationally Sound, But Cycle Pressures May Be More Challenging

 

There is little to find fault with at Fastenal (FAST) from an operational perspective, and valuation is pretty binary – either you’re comfortable paying a hefty premium to buy/own a top-quality industrial supplier, or you’re not. That doesn’t mean that Fastenal is completely immune to larger cyclical concerns, as the shares have historically had a tougher time in periods where IP growth is slowing off recent peaks.

Fastenal shares are up a bit from my last update, outperforming MSC Industrial (MSM) and the broader industrial sector, but underperforming Grainger (GWW) and Applied Industrial (AIT). Little has changed with my basic thesis – I have no meaningful long-term operational concerns with Fastenal, but I remain concerned that the demanding valuation will make sustained outperformance more challenging in the future.

 

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 Fastenal Operationally Sound, But Cycle Pressures May Be More Challenging

Fastenal Seeing Better Results, But The Market Seems Less Interested In Short-Cycle Stories Now

 

Despite strengthening economic conditions, shorter-cycle industrials haven’t really been performing all that well, and Fastenal (NASDAQ:FAST) has been no exception. This industrial distributor did a little better than expected in the second quarter, and continued to show progress on long-term business-building initiatives, but it wasn’t thesis-changing outperformance and investors seem ready to call it a day with earlier-cycle plays.

Modest year-to-date underperformance versus the S&P 500 and the broader industrial sector certainly has to be kept in context – over the long term Fastenal has been a great stock, and there’s nothing wrong with the business. Valuation remains problematic for me, though, and unless you expect significant beat-and-raise quarters in the near-future or are a more value-insensitive investor who believes in just buying quality and holding through thick and thin, I don’t see much appeal right now.

 

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Fastenal Seeing Better Results, But The Market Seems Less Interested In Short-Cycle Stories Now

A Bumpy Initial Recovery Hasn't Really Hurt Fastenal

 

High-multiple stocks can often be more vulnerable to disappointments, but that hasn’t been the case for Fastenal (FAST). Despite three straight monthly misses on sales and a very slight negative downward trend in sell-side EPS expectations, the shares have held up well since my last article – appreciating another 10%-plus since then. That’s a little worse than the wider industrial sector, including the recovery star Parker-Hannifin (PH), and worse than Grainger (GWW) (which has risen more than 20% since the time of my last Fastenal article), but still better than the S&P 500.

The reopening/recovery of the U.S. manufacturing sector has been a little bumpy, and I wouldn’t be surprised if that is the case for the remainder of 2021, but I don’t see it as a major threat to Fastenal. The company continues to outgrow the underlying economy and there’s a potential path to better margins for at least the next year or two, as well as a growing revenue base as the company expands the reach of the business. Valuation is still problematic, but it’s tough to see how these shares would trade at conventionally cheap multiples without a serious market decline.

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A Bumpy Initial Recovery Hasn't Really Hurt Fastenal

Fastenal Seeing The Start Of A Rebound, And Bullish On Margins

While the recovery isn’t robust, and it’s not happening evenly across end-markets, there is ample evidence from recent reports, including Fastenal’s (NASDAQ:FAST) fourth quarter results and ongoing monthly sales numbers, that manufacturing end-markets are turning around. Guidance across the sector has been cautious, and I’m not looking for Fastenal’s growth to accelerate into the high single-digits in 2021, but fastener demand should improve throughout the year and help offset the headwinds that will come whenever the pandemic fades and drives lower demand for janitorial/safety equipment.

Of course, Fastenal’s valuation remains an issue. The shares typically trade above what would otherwise seem fair or normal, even allowing for Fastenal’s superior margin and ROIC profile. About the best that I can say is that the valuation isn’t so stretched on a relative basis (Fastenal’s forward PE and/or EV/EBITDA relative to the manufacturing/industrial sector), but I find relative valuation more useful for trading as opposed to longer-term investing.

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Fastenal Seeing The Start Of A Rebound, And Bullish On Margins

Full Valuation And A Timorous Recovery Aren't A Good Combo For Fastenal

While I liked short-cycle recovery plays earlier this year (and names like Parker Hannifin (PH) did pretty well), in recent months I’ve been getting more concerned that valuations were starting to overshoot the likely path of the recovery, setting the stage for potential disappointments and re-ratings. Fastenal’s (FAST) basically inline quarter and negative market reaction isn’t enough to claim “vindication” on that call, but with both Fastenal and Yaskawa (OTCPK:YASKY) seeing inconsistent recovery trends and large banks seeing soft C&I loan demand, I am concerned that shorter-cycle names could re-rate through the rest of the year.

Valuation is never an easy discussion with Fastenal, as a premier share-gaining company is worth a premium. So, I’m not surprised that the shares trade above a DCF-based fair value, though the implied long-term returns are worrisomely low. Looking at the typical premium Fastenal has enjoyed over the past three years, you can argue for a 17.5x multiple on forward EBITDA, but that only gets you to a fair value around $43.

 

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Full Valuation And A Timorous Recovery Aren't A Good Combo For Fastenal

Fastenal Riding Higher On Enthusiasm Over Shorter-Cycle Manufacturing

As investors start looking past Covid-19, this is a pretty good time to be leveraged to manufacturing, and Fastenal (FAST) shareholders are benefitting. Industrials have modestly outperformed the S&P over the past three months, and those names more leveraged to short-cycle manufacturing are doing even better, with Fastenal up more than 25% and Parker Hannifin (PH) and Rockwell (ROK) both up around 30%.

Given the rising expectations that have accompanied these stock moves (the Street has gone from expecting a mid-single-digit revenue decline for Fastenal in 2020 to low-to-mid single-digit growth), I’m not sure how much gas is in the tank. I’ve been consistently bullish on short-cycle industrial end-markets as the preferred way to play the post-Covid-19 recovery, but that’s looking more and more like the consensus view now. With valuation providing no safety net here, I’d be careful about pressing my luck, though I fully acknowledge that Fastenal is an incredibly well-run industrial name and still very well-leveraged to a short-cycle recovery in late 2020 and into 2021.

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Fastenal Riding Higher On Enthusiasm Over Shorter-Cycle Manufacturing

Fastenal's Results Suggest Manufacturing Is Hanging In There

Extrapolating from Fastenal’s (FAST) results should always carry the caveat that Fastenal is an exceptionally well-run company, proven capable of gaining share in good times and bad, and not necessarily reflective of everyone’s experience. On the other hand, Fastenal’s results do provide a pretty good read on the pulse of sectors like manufacturing and non-residential construction, and in that respect the company’s first quarter results are at least a little encouraging.

There’s no mistaking that 2020 will be a tough year for manufacturing companies and the U.S. economy, and I expect Fastenal’s revenue to decline 6% while experiencing weaker margins. Still, Fastenal’s results may support the idea that manufacturing companies will hold up relatively better through this outbreak-induced recession. Specific to Fastenal and its stock, while I do believe in paying up for quality, I don’t see any particular bargain here and I’d note the shares have been outperforming the broader industrial space by a significant margin (close to 20%).

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Fastenal's Results Suggest Manufacturing Is Hanging In There

Fastenal Will Be Fine, But Watch The Short-Cycle Recovery Story

It’s still very early in the reporting cycle, but these first few reports maybe ought to have investors reconsidering the popular second-half short-cycle rebound assumption. Fastenal (FAST) did okay relative to expectations, but the business has definitely slowed and management gave no indications that they see conditions improving soon. Add in similar reports from MSC Industrial (MSM), Sandvik (OTCPK:SDVKY), and Yaskawa (OTCPK:YASKY) and it’s too early too panic, but maybe the right time to start refreshing that “buy when a pullback happens” list.

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Fastenal Will Be Fine, But Watch The Short-Cycle Recovery Story

Fastenal Delivers Superior Execution In A Weakening Market

The argument over what constitutes a fair premium for Fastenal (FAST) has gone on for years, and it’s not about to be solved now. I will say, though, that strong execution in a tougher market is a solid argument for the bulls, particularly with Fastenal delivering better than expected results in a third quarter marked by a more noticeable slowdown in multiple key end-markets. Although industrial stocks in general have been about as sluggish as I expected, Fastenal shares managed to do a little better before spiking up after the strong third quarter results.

My issue with Fastenal shares is pretty simple – I’m not willing to pay around 16x forward EBITDA, nor buy into a valuation that seems to require mid-teens annualized long-term FCF growth to deliver an acceptable annualized return. I do expect key end-markets to slow further, and I’m concerned about the non-residential pipeline once large projects finish up. That said, I do expect Fastenal to remain a “best of breed” in the industrial distribution sector for the foreseeable future, and investors holding Fastenal today have likely long since made their peace with the valuation issues.

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Fastenal Delivers Superior Execution In A Weakening Market

Fastenal Still The Best House On The Block, But The Neighborhood Isn't Looking So Good

Without having seen Grainger's (GWW) results yet, I feel pretty confident in assuming that Fastenal (FAST) will come out of this quarter with the best set of results among the large industrial distributors. Although Fastenal is seeing worse gross margin pressure than MSC Industrial (MSM), they're growing their business more effectively and offsetting gross margin pressures with strong execution on operating expense items - something MSC has long promised, but that Fastenal actually delivers.

I don't think there's much argument now that industrial end-markets are slowing, and so too is non-residential construction. That still leaves plenty of debate for how much worse things will get, as Fastenal management maintains that the broad "general industrial" category is still holding up well. Either way, I'm not inclined to pay the premium valuation that Fastenal shares carry today; I do think Fastenal is an exceptionally well-run company (and exceptional companies deserve premiums), but I don't like paying up for companies with deteriorating end-markets.

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Fastenal Still The Best House On The Block, But The Neighborhood Isn't Looking So Good

Fastenal's Execution Remains Beyond Fault, But The Valuation And Macro Picture Are More Debatable

With investors feeling noticeably better about industrials over the last three months (the Industrial Select Sector SPDR (XLI) is up about 14%), I'm not altogether surprised that the shares of Fastenal (FAST) are up even more, though the 26% move is still exceptional. When industrials do well, Fastenal almost always does well, and at least, some investors certainly seem to be counting on a stronger second half in that sector.

I remain more cautious. I'm more cautious on the macro outlook for the U.S. economy going into this quarter, though I'd be more than happy to be proven wrong by strong beat-and-raise reports from the sector. I'm also cautious on what looks like a "take no prisoners" valuation that leaves no room for company-specific or more generalized headwinds for Fastenal, even though I do believe there are still growth opportunities in place that can drive above-sector mid-single-digit long-term revenue growth.

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Fastenal's Execution Remains Beyond Fault, But The Valuation And Macro Picture Are More Debatable

Standing Up For MSC Industrial Getting Harder And Harder

I’ve been waiting for MSC Industrial (MSM) to show some meaningful signs of internal momentum for some time… and the wait just keeps going on. While management continues to tell a story of becoming a more integrated, mission-critical partner for customers and points to future benefits from pricing actions and sales force restructuring, the fact remains that this company has established a worrisome trend of underperformance and excuse-making.

I do still own MSC and I do still believe the shares are undervalued, but I now regard this position as a future source of funds if/when a better idea presents itself, and I’m not especially comfortable holding the shares in an underperforming manufacturing distributor going into what I believe is a slowdown.

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Standing Up For MSC Industrial Getting Harder And Harder

Grainger Looks For A Soft Landing As Industrial Headwinds Build

It was a very mixed year for Grainger (GWW) in 2018, as the company did well in the first half as the company reaped the benefits of a significant pricing adjustment, but the shares significantly underperformed rivals like Fastenal (FAST) and MSC Industrial (MSM) in the second half as worries mounted about the durability of the U.S. economic cycle, whether Grainger had meaningful levers to drive growth beyond price, and whether the company could drive margin leverage.

Unfortunately, fourth quarter results don’t offer easy answers. Grainger’s guidance for 2019 looks quite rational insofar as expecting modest market growth and little price leverage, but expectations of almost 4% relative outperformance in sales could be too bullish. Grainger’s profitability is solid, but I believe distributors are going to have a more challenging time in 2019 and it’s hard to get really excited about these shares.

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Grainger Looks For A Soft Landing As Industrial Headwinds Build

Fastenal Pitting Operational Excellence Against A More Challenging Macro

Long a margin leader in the industrial MRO distribution space, not to mention a growth leader, Fastenal (FAST) has been reporting incremental margins north of 20% coupled with double-digit sales growth. A downturn in manufacturing PMI doesn’t bode as well for near-term revenue growth, and tariffs could still challenge the price/cost balance in 2019, though the company still has some opportunities with pricing and operational efficiency moves.

Fastenal’s margin superiority has never translated into significant free cash flow superiority over peers like MSC Industrial (MSM) or Grainger (GWW), but the shares have never been held back by DCF-based valuation. Strong margins and ROIC should support a forward EBITDA multiple a little above 14x, but that doesn’t leave much upside from here unless Fastenal can drive some outperformance on margins and/or revenue.

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Fastenal Pitting Operational Excellence Against A More Challenging Macro

MSC Industrial Has To Offer More Than Lackluster Growth And No Margin Leverage

MSC Industrial (MSM) has continued to test the patience of its shareholders, as the company’s shares have continued to lag not only the broader industrial sector since the company’s fiscal fourth quarter earnings report, but also fellow distributors like Fastenal (FAST) and Grainger (GWW). I believe the primary issue is a familiar and long-standing one – not only is MSC lagging in terms of organic growth, it’s not showing the hoped-for margin leverage that has been a centerpiece of many bull theses. On top of that, MSC’s exposure to manufacturing is a potential vulnerability has uncertainties build ahead of the upcoming wave of guidance from industrial companies with their calendar fourth quarter reports.

I believe MSC Industrial can be better than this, which is a large part of why I continue to own the shares, but “can” and “will” are not synonyms, and investors have to consider the risk that between internal missteps and a changing competitive environment, MSC will never live up to its growth and margin potential. The shares do appear undervalued on both a DCF and margin-driven EV/EBITDA basis, though, and I believe the potential returns are worthwhile if the company truly does, at last, have its ducks in a row.

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MSC Industrial Has To Offer More Than Lackluster Growth And No Margin Leverage

MSC Industrial Looking To A Restructured Sales Effort To Drive Better Results

As I've discussed (and lamented) on more than one occasion, MSC Industrial's (MSM) track record over the past couple of years has not been up to snuff, with the company underperforming other distributors like Fastenal (FAST) and Grainger (GWW) in both operational and stock performance terms. Although MSC's fiscal fourth-quarter results weren't all that great, expectations had ratcheted down going into the quarter, and it looks as though a long and surprisingly disruptive sales force restructuring/retraining process should start leading to better results in the coming quarters.

Valuation on these shares is mixed, and I don't think they're a screaming bargain, though I can support an argument that the company's profitability and return on capital (and assets) justify a price into the mid-to-high $90s. The biggest issue for the stock, though, is whether MSC can start delivering better organic sales growth and drive some of the long-awaited incremental operating leverage that investors have been waiting on for some time now.

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MSC Industrial Looking To A Restructured Sales Effort To Drive Better Results

Grainger's Pricing Reset Continues To Drive Exceptional Volume Growth

I’ve been critical of several of W.W. Grainger’s (GWW) strategic moves over the years, particularly its overseas business decisions, but the decision to cut prices has proven so far to be a very good move for this company. Against a very healthy backdrop for manufacturing and construction, Grainger has managed to dramatically outperform smaller rival MSC Industrial (MSM) on volume and outperform Fastenal (FAST) on pricing, allowing the company to outperform both on margin and earnings leverage.

Grainger has done a great job of clawing back the mid-sized customers that it lost in years past when its pricing got too high, but what happens when it exhausts that supply remains an open question. There’s still room for distributors to run as the industrial cycle ages, and Grainger’s valuation isn’t unreasonable on an EV/EBITDA basis, but I do think it’s harder to make the long-term valuation case with the shares up roughly 100% over the past year.

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Grainger's Pricing Reset Continues To Drive Exceptional Volume Growth

Fastenal's Familiar 'Strong Growth / High Expectations' Profile

Fastenal (FAST) has long been an interesting case study in the question of just how much investors should pay for growth, as this company has long been a growth leader in the industrial distribution space, and the shares have typically sported a hefty valuation. Arguing for the case of “valuation always matters sooner or later”, Fastenal’s long-term returns (10 to 15 years) aren’t that exceptional relative to the S&P 500, though the company has more or less kept pace with Grainger (GWW) and outperformed MSC Industrial (MSM).

I don’t really have too many doubts about Fastenal’s ability to continue to grow by expanding into adjacent product markets and growing its vending and onsite operations. I also don’t think that the shares are all that unreasonably priced relative to the market’s prevailing willingness to pay for given levels of margin and returns in the industrial sector. Still, given the changing competitive dynamic in the industrial distribution sector and the mediocre long-term returns implied by discounted cash flow, this isn’t a compelling idea for me now.

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Fastenal's Familiar 'Strong Growth / High Expectations' Profile