Greetings and welcome to the Fastenal 2020 Second Quarter Earnings Results Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce to your host, Ms. Ellen Stolts. Thank you, ma'am. You may now begin.

Welcome to the Fastenal Company 2020 second quarter earnings conference call. This call will be hosted by Dan Florness, our President and Chief Executive Officer; and Holden Lewis, our Chief Financial Officer. The call will last for up to one hour and will start with a general overview of our quarterly results and operations, with the remainder of the time open for questions-and-answers. Today’s conference call is the proprietary Fastenal presentation and is being recorded by Fastenal. No recording, reproduction, transmission, or distribution of today’s call is permitted without Fastenal’s consent. This call is being audio-simulcast on the Internet via the Fastenal Investor Relations' home page. A replay of the webcast will be available on the website until September 1, 2020, at midnight Central Time. As a reminder, today’s conference call may include statements regarding the company’s future plans and prospects. These statements are based on our current expectations and we undertake no duty to update them. It is important to note that the company’s actual results may differ materially from those anticipated. Factors that could cause actual results to differ from anticipated results are contained in the company’s latest earnings release and periodic filings with the Securities and Exchange Commission and we encourage you to review those factors carefully. I would now like to turn the call over to Mr. Dan Florness.

Thanks, Ellen, and good morning, everybody. Thank you for taking time this morning to listen in on the Fastenal earnings call. Before I start, I'd like to mention two milestones in Fastenal this week, and I want to do that just to make sure I don’t miss it. Dave Donahue today celebrates 40 years with Fastenal. Dave, I want to say thank you and congratulations. Not far behind Dave is Lee Hein, who will celebrate 35 years with Fastenal tomorrow. Hey, Rodney, if you're listening, I would mention you as well, but you're only at 20 years. So in 10 years, I'll mention you on the call. Surround yourself with great people, people better than yourself. Be willing to learn to change and be comfortable with trusting others, and you will find success. I'm pleased and really proud of the Fastenal team for what we accomplished this quarter. First off, the team was successful in sourcing hard-to-find safety products and bringing this product to our existing customers, but of equal importance—maybe greater importance—to new customers; customers we don't traditionally do much business with, and I'm thinking of hospitals and first responders when I talk about that group. The team was also successful in lowering our cost structure. It's really a combination of our model simply working the way it works. One item that assisted us this quarter is we've enjoyed great growth over the years. We are a promote-from-within organization, which means we're finding new talent every day in the organization. And the best way to do that is to have constant relationships with four-year state colleges and two-year technical schools, finding folks every day to come work for us part-time. We had a fair number of full-time students working for us part-time. As you can appreciate, in the spring of 2020, with all the schools closing, we lost some employees. We fully expect, and we are maintaining contact with that group, because we want them back when they're back in school. But in the short term, that helped us a little on managing the P&L, and you see that shine through on our FTE numbers. Again, that's the model working, as it should work in an environment like this. The final piece is that if you truly believe in a decentralized decision-making structure, you can move faster than anybody else in the marketplace. I think that was demonstrated this quarter in our ability to quickly rein in expenses and also to find critically needed safety products. If there's anything to take away from this quarter when we think back, trusting others is probably the most important lesson, and it’s probably one of the greatest legacies that Bob Kierlin has given to this organization. I'm going to be redundant here for a second. Our five priorities to the quarter included trust and fairness. Trust each other, be fair with each other, and support each other. If somebody needs to be home with a child today or a parent, be flexible with that person’s schedule. If somebody has a person in their household who is particularly susceptible to the negative aspects of COVID-19, be mindful of that and conduct yourself accordingly in our brands and support area, wherever you are within the organization. And maintain a safe environment for our people. That includes our people's family and for customers and their families. Customers allow us to come into their business every day to fill vending machines, to stock product on a production floor, or in a bin stock. We have an obligation to them as well to maintain a safe environment. Support the people directly involved in the pandemic. They're the heroes here. Be there to support them and make sure you're reaching out to them to see what they need, and be creative in finding solutions for them. Sustain our supply chain of critical products for our regular customers as well. They are the fabric of our society. If you think about the infrastructure of this nation or the planet, or consider the things you need in your day-to-day life, we supply the folks that make that product for you, and they need a safe and resilient source of supply. One suggestion I provided to the folks—and I apologize for this—was maybe to shut off the TV and get off social media. There's more garbage there than value, unfortunately. Talk to each other, talk to your customer, solve problems. That's the task of the day. The effects of this PPE surge, and Holden will touch on it in more detail, but the effects of this surge notably show up in our lower gross margin, as safety products do not carry a higher gross margin. Our task in the quarter was getting product to market quickly. Sometimes that required flying products that should be on a ship or using third-party transportation to move it in a different manner. It's not an inexpensive proposition, but it brought the product to market quickly, and that was more important in this environment. I believe that will recover as we move into the third quarter. You're seeing faster sales, daily sales, hub picks, and more vending expenses. Point two: we bottomed out in the environment we operated in April with improved trends in both May and June. I believe there’s nothing new for those looking at our monthly numbers, but just wanted to share that. We added two charts to this quarter's discussion. With 100,000 vending devices deployed across 25 countries, I think we have a good view into what's happening in real-time. Looking at product dispenses, I don't want to find myself in a situation where the analyst community is asking for numbers indefinitely. We indexed everything back to October at 100. It's really about looking at a machine or group of machines dispensing 100 items per day and analyzing the trends of that population. The reason we chose October as the cutoff is that it was well before COVID-19 started. The gold line you see is a combination of the last four years of history; you can see various points moving around. For example, typically, you see Thanksgiving drop-offs and holiday surges that correspond. You see drops around Christmas and New Year, treading water in January and February. History shows approximately 3% growth as we move into March, but this year, we began showing 5% just a couple of weeks later, before noticing the significant drop coinciding with Easter. The direct impact of COVID-19 was notable as that blue line drops, bottoming out in mid-April at 76 relative to the 100 dispenses from October. As we transitioned into June, we saw a recovery. If inflation warrants it, we would expect that our vending business could be growing about 14% a year. On the next page, we look at the unique users accessing machines. Using the same logic of indexing back to 100 unique users last October, we notice similar fluttering around Thanksgiving, drops during holiday periods, and historical expectations showing a minimum increase of 104 unique users by early March, indicating even more growth due to new devices. This year, we were at 106 or 107, with a dramatic drop resulting from COVID-19. We saw a similar recovery and are currently at about 101 through much of June. However, it trails behind historical expectations. Ultimately, we expect to peak at about 119 as we start a new cycle going into the new year. This information provides us with valuable insights regarding people and employment, and it's crucial for us to manage expenses tightly as we approach Q3 since the environment is still very weak. Fortunately, we found additional business in the second quarter and made lemonade out of lemons. Switching to page 6 in the flipbook, vending and onsite signings bottomed in April. I don't believe there's any surprise in that; they improved in both May and June. Vending and onsite signings are critical for us. Those are two of our principal growth drivers. While they may not have shown the same impact in the last 90 days or the next 30 or 60 days, vending does. However, onsite relationships are about building momentum for growth as we transition into the tail end of this year and into 2021. Our internal discussions are focused on how close we can get to 100 signings per quarter. I'm pleased to report that of the 40 we signed in the quarter, 20 of those were in June. We are exiting the quarter with positive momentum, but it still remains at a lower level. Looking at vending, our goal is to approach 100 signings per day. In previous years, we were in the 80s, moved into the 90s, and then eventually into the 100s. We experienced a drop in signings during March, and while April was low, we gained some traction in June, signing 69 per day. We’re nearly back to 70, highlighting our ability to engage with customers in this environment. The e-commerce sales grew approximately 13.5% in the second quarter and were climbing through May and June. One factor that impacted our e-commerce numbers was the strict allocation process we instituted for our COVID-19 products, which significantly affected the purchasing process to ensure a stable supply for our customers.

Thanks, Dan. I'll start on slide 7. Second quarter 2020 sales were up 10.3%. It was a quarter marked by two distinct trends, both stemming from the social and business efforts to manage the COVID-19 pandemic. The first trend was the weakening of the economy due to stay-at-home measures and steps taken by companies to protect their workforce. This caused customers to operate at greatly reduced utilization and even shut down during parts of the quarter, particularly impacting our Onsite signings. Conditions did improve throughout the quarter. This pattern was exemplified by our fastener daily sales, which declined 22.5% in April, 15.3% in May, and 11.4% in June. This pattern was likewise evident in vending data and our distribution center picks. We believe demand in our traditional business remains 10% to 15% below first quarter levels. We have seen some flattening in those trends in the last few weeks. The second trend was a surge in demand for certain products critical to governments, healthcare providers, and specific businesses in dealing with the pandemic. We estimate that the surge in sales of PPE, sanitizer, and other products contributed $350 million to $360 million or roughly 25 percentage points of growth in the quarter. These volumes drove 116% growth in our safety products and 260% growth in our government and healthcare business, more than offsetting the weak underlying conditions in our traditional business. We've mostly sold through our pipeline of surge orders at this time. The near-term outlook remains challenging to project. The reopening of industries is occurring in fits and starts as customers reconstitute their workforces and supply chains, and trends in our internal metrics and a June PMI of 52.6 are encouraging. While we do not expect a second quarter-style surge in PPE and sanitizer products due to the better-supplied marketplace, the recent increase in COVID-19 infections and an expanded customer list in key industries should maintain some level of safety growth. On the downside, it is less clear how this increase in infections will affect the pace of reopening. I would characterize the tone in the field to be one of cautious optimism for the third quarter of 2020. Now to slide eight, gross margin was 44.5% in the second quarter of 2020, down 240 basis points versus the second quarter of 2019. Roughly one-third of this decline related to mix, which was better than we expected at the start of the quarter. While the negative effects of product mix rose sharply, this was partially offset by customer mix, as closures in April and May caused our Onsites with lower gross margins to underperform total company sales. We expect these dynamics to reverse as conditions normalize. One-third of the decline in our gross margin was due to lower safety margins, a byproduct of quickly sourcing product from non-traditional channels. This should fully recover, though it might take a couple of quarters, especially as there is an oversupply of certain PPE, particularly masks, impacting margins for those products. The remaining decline in gross margin arises from cyclical and organizational factors like rebates and the deleveraging of certain fixed costs. With the exception of specific lines with unique supply/demand profiles, such as three-ply masks, the pricing environment remains stable. The decline in gross margin was more than offset by the leveraging of SG&A, which at 23.6% of sales was 320 basis points better than the second quarter of 2019. Most of our branch network did not have meaningful surge orders and reacted to the weakness in their traditional business by reducing FTE by 9.4%, mostly via a 15% reduction in part-time labor and 23% fewer hours worked. This resulted in 240 basis points of leverage over labor in the second quarter. The remaining leverage came from tight control over costs related to things like travel, training, and occupancy, producing an operating margin of 20.9%, up 80 basis points with an incremental margin of 29%. Given the ongoing challenging macro conditions, we will continue our tight control of discretionary operating costs in Q3 2020. Putting it all together, we reported second quarter 2020 EPS of $0.42, up 16.7% from $0.36 in the second quarter of 2019. Now turning to slide nine, operating cash flow for the second quarter of 2020 was $251 million, equating to 105% of net income. The increase in operating cash flow versus the second quarter of 2019 was due to $111 million in deferred taxes as part of the CARES Act and higher earnings. Of that, $104 million of the deferred taxes will be paid in the third quarter of 2020. Accounts receivable rose 7.5%, including approximately $75 million related to COVID, which we believe will mostly be settled in Q3 2020. Inventories rose 4.1%, including approximately $50 million related to COVID, which we aim to work down over the course of the year. We aggressively deployed our balance sheet throughout the second quarter of 2020 to retain customer inventories while shuttered or operating at severely depressed levels, as well as to quickly secure and move critical products. Net capital spending in Q2 2020 was $38 million, down from $67 million in Q2 2019, reflecting reduced needs for new hub capacity and capital expenditures for vending and trucks. Our capital spending range for 2020 remains $155 million to $180 million. We returned cash to shareholders in the quarter in the form of $143 million in dividends. From a liquidity standpoint, we finished Q2 2020 with debt at 12.7% of total capital, a rise versus Q4 2019 due to the March 2020 Apex asset acquisition but below the year-ago level of 16.6%. We converted our variable rate revolver debt to fixed debt under our Master Note Agreement, leaving us with about $660 million available on our existing credit lines. This provides ample capacity to pay deferred taxes and our dividend while supporting the reopening of our customers or any COVID-related needs that may yet emerge. That concludes our formal presentation. With that, operator, we'll take questions.

Thank you. The floor is now open for questions. Our first question is coming from Josh Pokrzywinski of Morgan Stanley. Please go ahead.

Hey, thanks. I hope everybody is doing well?

Hi, Josh. Good morning.

Holden, just first question regarding a comment you made about flattening in the past few weeks. Depending on whether I look at the charts indexed to past points in time or just think about year-over-year, can you help me unpack what that means? Is business getting better in the last few weeks relative to how the quarter ended, or are you saying you've seen some tapering? It wasn't entirely clear. I apologize for being a bit slow on the uptake.

If you look at page 4, which is the product expenses through vending, you'll see it bottomed in April and recovered nicely through May. However, over the last three to four weeks, there has been flattening in the number of vending dispenses. That's what I was referring to. We've seen something similar in hub picks. This suggests that in the last few weeks we've shifted from consistent weekly increases to areas that have plateaued. It’s tough to pinpoint the reasons; it could be related to the timing of the 4th of July holiday or increased infections impacting behavior in certain regions. Currently, we don’t know, but that's what I meant.

Got it. If I had to look at it like a fastener-only version, stripping out some safety elements, would you think it would look similar, or would it show more steady increases, reflecting day-to-day business?

It would likely look the same, although it's worth noting we don't vend fasteners. More broadly, in hub picks, you see a similar pattern. However, the causes are difficult to ascertain. This flattening coincides with significant holidays, so timing plays a role here, making it hard to predict trends for July and the third quarter.

Got it. That’s helpful. I’ll jump back in the queue; I'm sure there are others with questions.

Sure. Thanks, Josh.

Thank you. Our next question is coming from David Manthey of Baird. Please go ahead.

Hey. Good morning, guys.

Hey, Dave. Good morning.

First off, I think that 2021 was supposed to be the year that Onsites would be gaining ground on operating margin as you're adding fewer to the bucket, and existing Onsites were improving profitability. Should we think about moving that timeline to the right a year due to the current downturn? Or do you still anticipate maybe 2022 as when we’d start to see Onsites improve in terms of profitability, thus helping the overall margin?

I’ll provide a thought and let Holden correct me if needed. You're correct about your 2021 comment, and our thinking remains consistent. However, let's consider a few competing factors. If our existing Onsites remain at a depressed level, that adversely impacts what you're suggesting. If we can recover from that depressed level, their operating margin improves along with volume absorption. New Onsites would also help us in 2021, though we may not see revenue growth. Initially, new Onsites typically hurt operating margin, so the mix change affects the outcome. I don’t believe it pushes things out necessarily, but Holden may have deeper insights.

Nothing has changed in our overall outlook over the timing. The overall dynamic remains strong; however, we face some new variables. As Dan shared, one key metric is the average size of an Onsite, which should begin to rise sustainably. Adjustments in that timeline could certainly play out because of the new variables. But the long-term secular picture on Onsites, improving profitability, and returns remains intact.

Got it. And it's been a while since I asked this question, but regarding Fastenal’s business today, particularly in manufacturing verticals compared to industrial production, what areas do you see the company as being slightly overweight or underweight? Can you provide insights on the top one or two?

We're still heavily involved in the manufacturing sector, particularly with heavy machinery. While this is a natural byproduct of the products we serve and our history, I wouldn't say we're overweight. However, we would ideally like to grow our construction mix as well as our government and education mix. We have seen progress, but we'd like to accelerate it. Looking forward, will manufacturing likely be smaller relative to other markets like government, education, and construction? Probably. That’s just a reflection of our movement into additional markets and opportunities.

Approximately half of our manufacturing business is tied to heavy manufacturing, particularly heavy equipment. As you've noted, we observed a slight weakening in manufacturing in June, gaining some strength in May after being down 24% in April, down 10% in May, and down 14% in June. The overall weakness in June could relate to year-over-year comps, but I can't verify that at this moment. About 40% of our manufacturing business is broadly classified as media manufacturing, which was marginally negative in June. The remaining 10% likely includes food production, which is growing double digits in April, May, and June compared to a 9% growth rate in March.

Thank you. Our next question is coming from Hamzah Mazari of Jefferies. Please go ahead.

Good morning, thank you. I wanted to ask about your captive trucking network. I believe you mentioned using third-party transport. Can you share your thoughts on freight? Additionally, what kind of competitive advantage does your trucking network have, particularly considering you’ve historically talked about optimizing that?

Our thought process regarding freight, particularly with our own captive network, remains unchanged. We reduced our lowest shipment day—Tuesday—effectively canceling those shipments in April, resulting in branches receiving fewer trucks. We challenged those branches to coordinate with customers around inventory stocking without resorting to canceling trucks and trading unnecessarily. While we see savings through labor and fuel, we cannot drastically reduce trucks; we can only park them as they rotate out of service. Additionally, we relied on third-party transport due to the nature of surge orders; we were moving truckloads or container loads rather than smaller boxes, requiring flexibility.

Underutilizing our fleet has fallen out of the norm, given the circumstances. We likely moved between six to seven percentage points more product via third-party carriers than in recent quarters, which also raises costs. However, it reflects the nature of the product we’ve been moving in this period.

Thank you. Following up, what visibility do you need before beginning to reinstate costs, specifically headcount? I know you mentioned cautiously optimistic conditions currently, but any specific thoughts on that?

I receive updates on vending stats every Wednesday, which are very telling because we run a $1 billion business that affects our operations daily across 25 countries. It offers an accurate reflection of our performance. When I observe those trends improving, we’ll feel more comfortable taking action.

Got it. Thank you for your insights. I'll turn it over.

Sure. As for expenses, do expect some return. We saw movement in travel and food expenses, down about 60% in Q2. I doubt it will remain this low in Q3, but it will likely be significantly reduced. According to our RVPs, they're still cautious about labor additions, likely starting by adjusting hours before adding heads or bodies. Overall, we plan to operate well below pre-COVID levels of expenses, which seems appropriate for the market, but some increase is expected as conditions evolve.

Hi, guys. I have a few questions about safety. Firstly, any insights on why safety sales in June only tapered slightly? Holden, I believe you expected a more significant drop-off, yet one of your peers mentioned that their customers already bought heavily, resulting in a meaningful decline in safety by June.

The surge business remained robust in June, which surprised me positively. Both May and June saw stronger surge orders than expected, which is beneficial for our organization and the marketplace. However, I still anticipate tapering off in the second half of the year, which I think is likely.

I'd add that some noise remains in the environment. Our government team has effectively built trust, helping us maintain a reliable supply source. Even in June, we saw results not anticipated, and I have received feedback that new customers from April and May are interested in long-term arrangements.

Looking at safety volumes thus far in July, they constitute approximately 24% of revenues compared to 34% in the second quarter and around 17-19% last year. This indicates that July will likely differ from June unless the trend reverses.

That’s helpful. In a broader sense, in a post-COVID world, do you think your value proposition to customers increases? Also, will there be any impact on your go-to-market approach?

I believe our value proposition has expanded, especially for those outside our historical customer base; e.g., those who were unaware of the full extent of our offerings. We've also learned that we can execute things we didn’t realize were possible regarding safety as a business.

From our standpoint, we prioritize the total cost of ownership savings in our relationships. E-commerce raises customer involvement, while our approach aims to remove them from routine procurement processes. If customers see value in our Onsite and vending solutions, we believe it will continue to strengthen despite an increase in e-commerce reliance from other sectors.

Good morning, guys. I wanted to continue on the topic Ryan mentioned. In retail, we’ve seen a marked shift from physical to e-commerce. Do you foresee a similar acceleration for e-commerce at the expense of physical store sales?

When evaluating our business, we operate primarily in a B2B environment centered around planned spend. Our e-commerce effectiveness isn't reflected compared to traditional retail; our model remains focused on ensuring customer reliability through social distancing tools like vending machines. Thus, I don't foresee a substantial shift away from our approach, even in post-COVID.

I believe our fundamental value proposition is one of total cost of ownership savings. Our ability to act as a supply chain partner sets us apart. E-commerce inherently involves customer participation, while our models aim at minimizing their procurement activities, which is the premise of our offering. Therefore, I don't believe we'll see a significant change in customer preferences.

Understood. Thank you for that insight. The other aspect I wanted to clarify was regarding the market being well-supplied now, particularly in the non-traditional customer base. Is that due to traditional distributors catching up on inventory or customers stockpiling themselves?

It’s likely a combination of both. Initially, when the pandemic struck, supply chains were disrupted; however, they have recovered admirably. Many customers purchased in anticipation, and their inventory levels have subsequently increased, leading to a well-supplied situation now.

Many people engaged in panic buying early in the pandemic, which contributed to the chaos. We implemented an allocation process early on to help regulate supply, which enhanced customer trust and understanding. The marketplace remains stable, so our commercial partners have learned to purchase more rationally moving forward.

Very clear. Thank you.

Hi. Holden, do we have time for one more question, or would you prefer to wrap it up?

Yes, go ahead.

I'll answer it, as I tend to talk too much.

Thanks, guys. Regarding the non-traditional customers, how many have expressed interest in building a larger relationship? Is it merely a short-term response to support government and healthcare workers, or can these relationships extend into 2021 and beyond?

Our safety teams believe that approximately a quarter of these non-traditional relationships have the potential to evolve into long-term partnerships. Some transactions were purely one-off due to supply shortages, while others may establish a recurring business connection.

We expect that awareness will play a significant role in this evolution. New clients might negotiate their suppliers through consortiums, potentially bringing Fastenal into their preferred vendor category based on satisfaction throughout the pandemic.

Perfect. It’s encouraging to hear there’s tangible potential there. In terms of your deal with newer suppliers, how might that impact your margins? Can you reasonably anticipate that established rebate relationships might help offset the gross margin strain you expressed earlier this year?

The decline in safety margins we experienced was likely 250 to 350 basis points lower than expected, primarily due to sourcing dynamics. Should our new suppliers prove worthwhile, we may stabilize pricing through negotiated agreements in the future. However, as we approach Q3, I can't assure that will happen due to current inventory conditions.

Got it. Appreciate the color, guys. Take care.

Thank you to everyone for participating in today's call. My thanks to the Blue team at Fastenal for setting aside personal fears to address the strong conservative balance sheet. The last few months have demonstrated the importance of reliable supply chains, and I'm proud of our team's response and commitment.

Thank you.

Ladies and gentlemen, thank you for your participation. This concludes today's event. You may disconnect your lines at this time and have a wonderful day.