Greetings, and welcome to the Fastenal 2022 Annual and Fourth Quarter Earnings Results Conference Call. As a reminder, this conference is being recorded. I would now like to turn the call over to Taylor Ranta of Fastenal Company. Thank you. You may begin.

Welcome to the Fastenal Company 2022 annual and fourth 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 we'll start with a general overview of our annual and quarterly results and operations, with the remainder of the time being open for questions and answers. Today's conference call is a 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 homepage. A replay of the webcast will be available on the website until March 1, 2023, at midnight Central Time. As a reminder, today's conference call may include statements regarding the company's future plans and products. 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.

Thank you, and good morning, everybody, and welcome to our fourth quarter earnings call, and Happy New Year. Some highlights on the quarter. I'm on Page 3 of the flipbook. Our daily sales grew 10.7% in the quarter, eased a bit from what we've seen in recent quarters, primarily because of tougher comparisons to what we were seeing in the fourth quarter last year, but also some moderating demand. I'm pleased to say that our fourth quarter operating margin remained stable at 19.6% and our ability to generate cash has returned to historic levels. This is really a sign of moderation in the level of inflation that we're seeing in the marketplace. Also, a more stable supply chain enables us not to need to expand our stocking levels to ensure a reliable supply line for our customers, giving us some flexibility as we go into 2023. We're very pleased to see that. 2022 was a year of milestones, all centered around $1 billion. In October, our e-commerce revenues surpassed $1 billion for the first time ever. Our international sales exceeded $1 billion and we hit that milestone in November. As noted in the release this morning, our company-wide net earnings topped $1 billion for the first time ever for calendar 2022. When looking at the chart on the upper left, it's hard to decide where to start explaining all the noise over the last three years, as we went through COVID, emerged from it, faced supply chain disruptions, and inflationary periods. Therefore, I chose to compare to 2019 to tell a more stable story about what we've built. In the first quarter of 2022, we were 28.1% larger than we were in the first quarter of 2019. This expanded to 30% in the second quarter, around 31% in the third quarter, and in the fourth quarter, we were about 35% larger than we were in the fourth quarter of 2019. It should not be concluded that we expanded by 7 points from Q1 to Q4. In full disclosure, 2019 was weakening as we moved through the year. Ignoring COVID, supply chain issues, and inflation, we are 30% bigger than we were three years ago, which is a testament to our business model and the team's execution. I believe we're exiting the pandemic stronger than we entered. We experienced margin pressure in the fourth quarter, and Holden will touch on that in more detail later in the call. Fasteners were challenging, but we understood what was going on there and knew what was coming. Safety faced similar challenges we managed through effectively. We did add a few more people in the fourth quarter than preferred, likely due to easing hiring difficulties throughout the year. Overall, we've done a good job managing headcount. On Page 4, we signed 62 Onsites in the fourth quarter, finishing with 1,623 active sites, up about 15% from a year ago. If we ignore sales that transfer over when we opened an Onsite with an existing customer, our revenue grew in the high teens, with a goal for 2023 to sign 375 to 400 Onsites. Participation inside the organization is crucial; just over 80% of our district managers signed an Onsite back in 2019, and participation dropped dramatically during 2020 and 2021. However, in 2022, 80% of our district managers signed at least one Onsite, as we aim to restore that figure and preferably increase it to 85% or 90%. Regarding the FMI Technology, we signed 4,730 weighted devices in the fourth quarter—an increase to 76 per day compared to 64 per day a year ago. Our activity through the FMI Technology platform represented almost 39% of sales in the fourth quarter, up from 35% a year ago. For 2023, our goal is to sign between 23,000 and 25,000 MEU devices, whether through FASTBin or FASTVend. E-commerce also saw daily sales rise by 48% in the fourth quarter, demonstrating incredible traction partly due to COVID and our improved execution. EDI, punched-out catalogs, and large customer-oriented e-commerce were up by 45%, along with web sales nearly increasing by 60%. Our digital footprint, consisting of FMI and non-FMI e-commerce, accounted for 52.6% of sales in the fourth quarter, an increase from 46.5% last year. Our goal is 65% of net sales to come from our digital footprint next year. Admittedly, that’s an aggressive goal. Looking at Page 5, our network has evolved over time. In 2013, we had 30-minute access to about 95% of the U.S. manufacturing base. We believe that number will drop to about 93.5% as we rationalize our branch count. Despite 567 fewer people in the branch and Onsite network since 2019, our sales headcount has actually increased, as we have realigned our resources. The expected ratio tends to lean toward Onsites outnumbering branches in the near future; in 2022, that delta narrowed from 377 to just 60. Another initiative, our LIFT program, ended the year with over 17,000 vending machines being resupplied from our LIFT facility, enhancing our operational efficiency. The final piece I want to highlight is our headcount trend as part of our ongoing improvement. We've been proactive in managing our support labor; while we have added distribution staff because of LIFT, we've maintained strong management over our overall headcount. As a result, 51% of our headcount increase in the last three years has focused on IT, which supports our technologies like FMI and LIFT. I hope this highlights the positive investments Fastenal is making. In early January, we added around 100 people to our support infrastructure without raising concerns about headcount management; it represents our investments in technology resources. With that, I'll turn it over to Holden.

Great. Thanks, Dan. Starting on Slide 6. Total and daily sales increased 10.7% in the fourth quarter of 2022, which included an 8% reading in December and represented further deceleration from prior quarters. We attribute this deceleration to slower industrial production, which shouldn't surprise anyone tracking the purchasing manager index and more difficult growth and pricing comparisons. However, significant elements of our business continue to perform well. Manufacturing, which was roughly 73% of our sales in Q4 2022, grew 16% and slightly exceeded normal quarterly sequential growth. Our largest customers, which approximated 59% of our sales, grew 15%. These metrics reflect our investments in Onsite and changes to our branch structure. The outlook for 2023 remains constructive but shows some incremental weaknesses among large retailer customers tightening budgets and non-North American sales being affected by a strong dollar and geopolitical events. Construction revenues have also softened due to our focus on larger key accounts, contributing to better labor leverage. Collectively, these areas represent over 15% of sales and have declined from double-digit growth in Q1 2022 to a decline by Q4 2022. While we have limited visibility on future demand, we anticipate that our sales initiatives will continue gaining momentum. Now onto Slide 7. The operating margin in Q4 2022 remained stable at 19.6%, flat from the prior year. We managed operating expenses effectively, producing a 120 basis points of SG&A leverage in Q4. Occupancy costs are restrained due to strategic branch closures, while initiatives like our digital footprint and LIFT program significantly contributed to improved labor leverage. As Dan mentioned, we were more aggressive with headcount adds than may be prudent given market uncertainties heading into 2023. However, we believe we can adjust quickly, and expect annual FTE growth peaked in December or will peak in January before slowing down in the first half of 2023. While future marketplace conditions are uncertain, we do believe we can continue to leverage operating expenses in future periods. Our SG&A leverage was offset by a 120 basis points decline in gross margin, which was more than anticipated. Certain familiar factors influenced this decline: the product and customer mix pressure widened as non-fastener growth began outpacing fastener growth. There was also a slightly more significant price-cost drag than expected, reflecting improvements on the fastener side but challenges in other products. We experienced broader product margin pressure outside of fastener and safety categories. These categories tend to have less centralized supply chains, and with slower demand, greater unplanned spend resulted in more discounting. We believe our proper actions have contributed to these issues. On the bright side of the margin equation, we observed healthy freight revenues and narrower losses, maintaining our captive fleets. Higher tax rates reflected the absence of certain favorable reserve adjustments from 2021 and higher non-deductible expenses in the fourth quarter of 2022. Our fully diluted share count dropped by 0.8% due to share buybacks over the last two quarters. To summarize, we reported fourth quarter 2022 EPS of $0.43, representing a 7.1% increase from $0.40 in Q4 2021. Moving on to Slide 8, we generated $302 million in operating cash during Q4 2022, approximately 123% of net income for the period. This reflects a typical fourth quarter conversion rate contrary to the previous five quarters, where we lagged in conversion rates. Increased working capital financing in the second half of 2021 was needed due to supply chain constraints and inflation, but we do not expect similar investments in 2023, which should improve cash flow. Year-over-year, accounts receivable grew 12.6% in line with customer demand and an increase in larger key account customers, which typically have longer payment terms. Inventories rose 12.1%, but with the supply chain normalizing and inflation moderating, our inventory growth aligns more closely with revenue growth. Our days on hand improved to 161.5, over 4 days better than Q4 2021 and more than 13 days below Q4 2019, despite challenges over the past 18 months. We're continuously identifying sustainable efficiencies in inventory management. Net capital spending in 2022 totaled $162.4 million, slightly below the forecast of $170 million to $190 million due to deferrals. Anticipating a spending range for 2023 from $210 million to $230 million, we ended Q4 2022 with a debt ratio of 14.9%, up from 11.4% in Q4 2021. Overall, we've been more aggressive in returning cash to shareholders, with $177 million in dividends and $93 million in share buybacks. We've increased our quarterly dividend from $0.31 to $0.35 for the first quarter of 2023. One final note before questions, this week, we released our inaugural ESG report, available on fastenal.com. It highlights how strongly aligned Fastenal's culture and mission are with environmental and human capital objectives of our stakeholders. Thanks to everyone who contributed to this report. Now, I'll turn it over to Q&A.

Before we start Q&A, I want to echo Holden's sentiments regarding the ESG report and encourage everyone to read it. It’s a well-written story on how Fastenal addresses these topics throughout our history while being conscious of societal formatting and structure. Also, I want to highlight the announcement from last night regarding our international team surpassing $1 billion in revenue for the first time during 2022. My congratulations to everyone on the international team spanning the Americas, Europe, and Asia. To our team in China, Happy Chinese New Year. I sincerely hope you can visit family as society opens up more. Now, let's open the floor to questions.

Our first question comes from Ryan Merkel with William Blair.

Holden, as you might imagine, I'm getting a few questions on gross margin this morning. Should we think about, for '23 a typical 30 basis points to 50 basis points of pressure from mix? Or could it be a little bit greater, just given this price-cost dynamic, lower rebates, and any other pressures?

From a mix standpoint, 30 to 50 basis points is a low number now versus where it was in the past due to our strategy of prioritizing key and larger accounts. I think that you've seen a widening in the expected mix impact on gross margin. While the labor leverage we've enjoyed recently has been a positive offset, I wouldn't be surprised to see the mix impact range be closer to 50 to 70 basis points.

Right. Got it. Okay. And then next, moving to incremental margins, your exit in Q4 at about 20%. Is this a level you think you can achieve in '23 with mid-single-digit sales growth? It sounds like FTEs will be down and you'll have the incentive comp that’s down. Anything you can add there would be helpful.

You're right to anticipate good leverage there. Wage inflation has moderated, and while I'd love to see higher incentive pay, that won't be the case if the market slows. We plan to control headcount, and the mix will shift towards more part-time positions as we rebuild. Ultimately, the question remains on gross margin impact. If we manage to limit the decline in gross margin due to mix, I’m confident we can grow our operating margin year-over-year, exceeding 20% incrementally.

Our next question comes from David Manthey with Baird.

I have one two-part question on OpEx. The first part is related to labor. Your initiatives have clearly driven better labor efficiency overall. But is the Fastenal cost structure more or less variable today than it has been in the past due to these structural changes? And the second question is on branch rationalization. By the chart you provided, it appears you're mostly complete with that transition. Are there any costs related to that transition that you've incurred over the past few years that will disappear in 2023?

Regarding your first question, we do anticipate additional closures this year as we work towards that target, and I believe those will taper off after this year. Closing branches has introduced some expenses, including lease buyouts for closed locations, but they have been within our overall costs for the last 5 to 6 years. It’s not a significant amount, and I wouldn’t read too much into it. As for the underlying leverage, yes, over time, we have seen variability tighten.

If I think of 2022, a significant part of our compensation is linked to growth in pre-tax profits. In 2022, we saw a major increase in incentive comp compared to previous years, supporting our efficiencies. For 2023, with expected lower earnings growth, variable costs may be higher than it has been over the last few years. We've changed our model to enable better management of the P&L—no longer do we add fixed layers that add expenses without generating revenue. So, in 2023, we expect more variability, and our ability to manage headcount effectively compared to before will aid that.

But looking over the cycle, I don't think our variability has changed much. We’ve lowered the level that our SG&A as a percentage of sales can decline to without impeding our service or growth capabilities.

Our next questions come from Josh Pokrzywinski with Morgan Stanley.

This is actually Gustavo for Josh. Earlier, regarding gross margin, can you quantify the margin impact from pricing costs based on the improving supply chain? How do you expect that to trend compared to Q4?

In Q4, stronger pricing was expected to have a lesser impact. We anticipated about a 30 basis point impact last quarter, which has widened to around 40 basis points this quarter, reflecting a greater decline than anticipated due to the broader product issues, though fasteners have shown improvement.

Got it. That's helpful. On fasteners, with steel deflation coming into play, how should we consider the P&L impact from fastener deflation over the next couple of quarters?

Historically, during inflation and deflation periods, our product categories will impact gross margins. The current price reductions on fasteners tied to steel costs will need to be orchestrated alongside lower costs reflected in our P&L. The dialogue with our customers will be key in managing those adjustments effectively to keep gross margins neutral in 2023.

Historically speaking, the late 2000s period of inflation followed by economic downturn demonstrated the impact on gross margins during both upward and downward turns. Our current environment has evolved, and while we retain a better understanding of the price dynamics with our customers, executing adjustments effectively will be crucial as we transition through these changes.

Our next questions come from Tommy Moll with Stephens.

I wanted to start off with some end market commentary around continued strength in manufacturing. Yet, Holden, your word for the outlook was 'cloudy' with PMI now sub-50. Have you seen any softening or could you characterize that market as strong?

The feedback from our regional leadership holds up. The consensus is still constructive about manufacturing. While the PMI signals suggest softening, overall activity and customer sentiment has remained relatively strong month-to-month.

Talking with our district managers regularly gives me insights into manufacturing. The backlog from 2022 has been healthy, even if the current status shows some decline. The anxiety stemming from reduced backlogs might affect PMI, but overall demand activity remains steady. Our concerns are there, but we're also optimistic about our customer traction heading into 2023 as we have significant new Onsite contracts.

As a follow-up, could you provide context on expectations for gross margin transitions from Q4 into Q1, and should we be alarmed over discounting developments in non-core product categories?

Typically, gross margins tend to be seasonally weaker in the first half of the year, improving later. The discounting seen in categories and the softness in planned products can be mitigated through proper actions over the next quarter. There is a belief that the operational adjustments needed will be executed correctly, affecting our gross margins positively in the latter half of 2023.

Our next questions come from Jake Levinson with Melius Research.

The milestone of reaching $1 billion in international revenue is impressive. I want to understand your long-term aspirations and whether there's a path for further expansion beyond the traditional model.

That growth is primarily organic and reflects how strong our regional teams are adapting to their landscapes. Despite challenges from geopolitical tensions and lockdowns, our international capabilities are maturing. What's exciting is finding new partnerships and markets beyond just leveraging our North American model. We're strategically aiming to invest in markets that grow and excel in our unique decentralized organization framework. We're confident about long-term growth prospects outside of North America and remain committed to expanding our international presence.

Our next questions come from Chris Snyder with UBS.

I wanted to discuss the ability to drive operating leverage as Onsite activations ramp. How long should we expect it to take for Onsites to reach full maturity and how does that dynamic play into 2023 with the ramp in activations?

Maturity depends on scale rather than time. A certain level of revenue needs to be reached for Onsites to drive margin accretion. Our historical performance indicates that when Onsites reach around $1.8 million to $2 million annually, we see margins over 20%. During COVID, existing Onsites matured faster than expected, resulting in improved overall operating margins. We expect to see growth in the number of signed Onsites in 2023 and while new units may dilute margins in the short term, the trend should ultimately lead to larger average revenues per site as we continue to optimize our approach.

The maturity of Onsites contributes effectively to net operating margins as the network continues to evolve. As we grow, the focus should be on leveraging revenue growth across our expanding branches. I believe we can utilize our Onsite strategy to drive efficiencies in the organization and improve operating margins, even with a mix shift present.

I believe we will see an increase in profitability at the Onsite level as they ramp up. We might see variability in newer units’ performance, but the overall operating margin trajectory should remain positive as we continue our focus on larger accounts.

Thank you. This does conclude today's teleconference. We appreciate your participation. You may disconnect your lines at this time. Enjoy the rest of your day.