Earnings Call Transcript
FASTENAL CO (FAST)
Earnings Call Transcript - FAST Q3 2021
Operator, Operator
Greetings, ladies and gentlemen, and welcome to the Fastenal 2021 Third 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 your host, Taylor Ranta. Thank you. Please go ahead.
Taylor Ranta, Host
Welcome to the Fastenal Company 2021 Third 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 being open question-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 December 1st, 2021, at midnight Central time.
Operator, Operator
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.
Dan Florness, CEO
Thank you, and good morning everyone. I appreciate you joining us for our Q3 2021 earnings call. I'll begin by discussing some insights from the quarter. Following that, Holden will share his perspectives on the latter part of the Flipbook, and we will conduct a Q&A at the end of this call. For this quarter, we achieved a sales growth of 10%, finishing the quarter with an 11% increase in business strength. It's important to note that, despite the usual year-on-year comparisons, if we look back to 2019, we present a clearer picture of our performance before the pandemic and how our current business stands. We all know the challenges Fastenal has faced in the past two years, including our contributions to society last year through our products, especially in the safety sector. What is noteworthy is our commitment to invest in our growth drivers, our people, and our market share. Our organization is now approximately 13% larger than it was two years ago. While our growth drivers have a different gross profit profile, our gross margin is about 90 basis points lower than it was two years ago. However, these growth drivers give us a competitive edge and allow us to scale effectively while managing operating expenses. In fact, despite the gross margin decline, our operating income as a percentage of sales is currently 10 basis points higher than it was two years ago. Over the past two years, we've successfully served our employees, customers, and society while also benefiting our shareholders. Regarding our operating and administrative expenses, we've seen increases primarily on the people side, which account for about $28 million, with 14% attributed to new hires and compensation adjustments. A significant portion, 61%, is related to incentive compensation. This reflects our philosophy of sharing our organizational success with our team. Our remaining operating expenses have increased by about $4.5 million over two years, with major contributions from FMI vending, distribution centers, and IT equipment investments. We've deployed mobile devices to enhance productivity and customer service. Fuel prices have risen as well, but we've managed to offset the impact through various cost-saving measures. Looking ahead, we've expanded our Fastenal Managed Inventory (FMI) program. A year ago, we had 705 machine equivalent units, which increased to 2,600 in Q3 2021, accounting for about 1% of our sales. Additionally, our mobility technology now manages 11% of our revenue, up from 6% last year. The inflation in product and shipping costs is significantly higher, impacting our industry. However, our entrepreneurial culture helps us find solutions amidst these challenges. In terms of on-sites, we signed 75 new locations this quarter, a 10.5% increase. Our sales through these on-sites rose over 20% in the past year, demonstrating their value to our customers. Our e-commerce now represents 14% of sales, having grown by 43%. Combined with FMI, our digital footprint now makes up 45% of total sales, a substantial increase from earlier this year. Moreover, in the past eight years, we've strategically reduced our network by 938 locations while focusing on growing on-site services, without the disruptive effects that such changes might usually entail. During the third quarter, we faced challenges with COVID-19 cases among our staff, but I’m proud of our team for managing through it effectively. Lastly, we conducted a pulse survey among employees, and feedback indicated a strong sense of care and support among team members, although there are areas for improvement in internal communication. Overall, we have many positive developments despite the challenges, and with that, I'll turn it over to Holden.
Holden Lewis, CFO
Great. Thanks, Dan, for turning over to Slide 6. As indicated, our sales were up 10% in the third quarter of 2021, which includes an increase of 11.1% in September. The period still had some difficult COVID-related comparisons with government customers down 40.4% and safety and janitorial products being down 2.9% and 15.4% respectively in the third quarter of 2021. As a result, we believe that total growth for the quarter understates the strength we are experiencing in our traditional manufacturing and construction customers, as the chart on the page illustrates. On the product side, this is also well demonstrated by our 20.2% growth in fasteners, with sales in our other product segments, excluding janitorial, also up 16.8%. In safety, sales of vented safety products, which removes from both periods direct shipped, typically COVID-related, products, were up 28.5%. National accounts sales were up 16.8%. While our smaller accounts were only up 2.2%, if we adjust for the government, our remaining customers would have been up 11.7%. So bottom line, we continue to experience broad strength in our traditional markets, consistent with macro data points such as PMI and industrial production. Pricing contributed 230 to 260 basis points to growth in the third quarter of 2021, up from 80-110 basis points in the second quarter. This reflects actions year-to-date to mitigate the increases we're seeing in the products, particularly steel and transportation. Inflation continued to rise over the course of the third quarter of 2021, particularly for overseas containers and shipping services. While we have a range of efforts underway to mitigate the impact of inflation on our customers' costs, further price actions may also be necessary for the fourth quarter of 2021. Aside from inflation, as Dan discussed, our marketplace continues to experience tight supply chains and labor shortages. These disruptions impacted customer production more in the third quarter of 2021 than the previous quarter, and an increase in COVID infections exacerbated these challenges. These trends seem likely to persist in the near term. To address these, we will continue to lean on technology and branch initiatives to improve productivity and an organizational culture that empowers local leaders to sustain high service levels. While the supply chain remains elongated, we do expect an inflow of imported products in the fourth quarter of 2021 and the first quarter of 2022, which should sustain our high product availability and reduce the impact of fill-in buys. Now to slide 7. The operating margin in the third quarter of 2021 was 20.5%, flat versus the third quarter of 2020. The gross margin was 46.3% in the third quarter of 2021, up 100 basis points versus the third quarter of 2020. This relates to two items: First, we experienced good leverage of overhead and organizational expenses due to strong product demand and growth. Second, we had a better product margin primarily in safety products. Lower-margin COVID affected PPE was a smaller proportion of total safety sales versus last year, and the margin on those COVID-affected products increased. Product and customer mix did not impact gross margins in the third quarter of 2021 versus the prior year, in contrast to the favorable impact experienced in the second quarter of 2021. Relatively strong fastener growth allowed positive product mix to offset the negative impact of strong on-site growth on customer mix, but the gap was narrower sequentially, a trend that is likely to persist. While the impact of pricing in the third quarter of 2021 exceeded our original expectations, inflation and shipping costs similarly exceeded our expectations. As a result, price cost continued to be largely neutral on our gross margins in the third quarter of 2021. The increase in gross margin was offset by operating expenses growing faster than sales. Part of this is due to the comparison as third-quarter 2020 operating expense leverage still reflected COVID-related low labor-intensity sales versus current sales being generated in a more traditional high-touch manner. Just as relevant, however, is the role of cost resets. In the first year of a manufacturing recovery, it is typical for various operating expenses to have an outsized recovery. We're experiencing that in 2021, including in the third quarter, but also believe that the breadth of resets is unusually wide. For instance, we are seeing a 40% increase in incentive pay, but we're also seeing a 50% increase in fuel costs, a 165% increase in travel expenses, and a 45% increase in healthcare costs. The nature of past downturns and recoveries would not have necessarily led to such a dramatic rise, particularly in the latter two items. As with last quarter, deleveraging operating expenses in the third quarter of 2021 is a function of the anniversary of the first periods of pandemic-related cost-savings measures, combined with a strongly recovering marketplace. Similar dynamics are likely to play out in the fourth quarter of 2021, although not likely on the same order of magnitude. We anticipate being able to leverage 2022 for a comparable level of growth. Putting it all together, we reported third quarter 2021 EPS of $0.42, up from $0.38 in the third quarter of 2020. Turning to slide 8, operating cash flow was $168 million in the third quarter of 2021, down 32% annually and 68.8% of net income. We paid roughly $30 million in payroll taxes which were deferred from 2020 as part of pandemic-related legislation. The bigger impact on our conversion, however, was an increase in working capital. Year-over-year accounts receivable was up 13.8%. This reflects strong customer demand and a shift away from PPE surge buyers last year and towards traditional customers this year, which slightly blended up days outstanding. Inventory was up 4.4%. We did see a meaningful reduction in our 3-ply mask inventory in the third quarter of 2021 and anticipate clearing out this inventory in the fourth quarter. Adjusting for this, inventory would've been up 6.2%. We continue to clean out the slow-moving hub and branch inventory, close branches, and shift our stocking focus in the field. We believe these represent improvements in our working capital that will be sustained, that is being offset by product installation and, to a lesser degree, product flowing into our network. We have a significant amount of imported products in transit and we expect to see product availability in our hubs improve over the next couple of quarters. In the current environment, this is how we are utilizing our balance sheet to support customer service and growth. Net capital spending in the third quarter of 2021 was $47 million, up from $34 million in the third quarter of 2020, reflecting spending on a non-hub construction project in Winona. We have lowered our 2021 net capital spending range to $155 to $175 million, down from $170-200 million. Our supply chain difficulties are limiting our purchases of vehicles, branch supplies, and other products. From a liquidity standpoint, we finished the third quarter of 2021 with debt at 11% of total capital and net debt at 3.4% of total capital. Net debt is up from 2.2% in the year-ago period and 5.1% versus the fourth quarter of 2020. Essentially, all of our revolvers remain available for use. That's all for our formal presentation, so with that operator, we will take questions.
Operator, Operator
Our first question is coming from Jacob Levinson of Melius Research. Please go ahead.
Jacob Levinson, Analyst
Good morning everybody.
Dan Florness, CEO
Good morning.
Holden Lewis, CFO
Morning.
Jacob Levinson, Analyst
Some of us were positively surprised by the growth rates, particularly as you closed out the quarter. Didn't seem, at least, that you had a lot of maybe product availability issues, but maybe I'm reading into that wrong. Were there any particular areas that you guys are really struggling to procure products? I am just thinking about your fastener supply chain and stuff being stuck off the coast of California. So, maybe any commentary you can provide there.
Holden Lewis, CFO
We have various supply chain partners, including domestic ones that might sell us branded products, which can be manufactured domestically, in North America, or globally. Some of the items, especially in makeup and fasteners, are more commodity-based and are typically produced offshore, which has been the case for decades. We've increased our safety stock and have a solid inventory of domestically sourced products. Our supply chain and distribution centers are performing well in terms of fulfilling our branch network's needs. However, we face significant challenges with products that must go through ports, and while we are not exempt from these issues, we have more local resourcefulness compared to many peers. Some business models depend heavily on scale, leading to difficulties when challenges arise, but our model allows local teams to step in and make things work, although it requires a lot of effort. Feedback from our regional vice presidents indicates we've been effective at sourcing products locally when imports are hindered, particularly with fasteners, though we still face challenges in finding domestic products. Despite the difficulties with imported goods entering our supply chain, we are discovering solutions outside traditional channels to maintain high service levels for our customers.
Jacob Levinson, Analyst
Okay. That's helpful. And just as a quick follow-up, I'd have to imagine your smaller competitors are probably struggling right now, maybe not able to maintain that same service level and you've got a clean balance sheet. So, is there maybe a comment on the pipeline? Is there an opportunity to maybe pick up some of your smaller competitors that are struggling?
Dan Florness, CEO
I believe there are a few aspects to consider. In my view, there is indeed a challenge in the marketplace for companies that lack a robust supply chain and access to various alternatives like us. Our trucking network allows us to manage logistics in ways our competitors cannot because our products are costly to ship; while it's also expensive for us, our efficiency reduces those costs. The significant risk for smaller companies with shallower supply chains is becoming apparent now as I notice a decrease in fill-in purchasing of imported goods, which is indicative of dwindling availability in the market. This situation places us in a favorable position to serve our customers without the need for excessive effort. When assessing future opportunities, our focus is on strategic evaluations rather than solely acquiring struggling competitors for consolidation. Our primary aim is strategic growth. Therefore, at this time, we believe that a more effective use of our financial resources lies in investing in the working capital needed to maintain high service levels, which will ultimately exert pressure on smaller rivals and enable us to increase our market share without incurring excess costs.
Jacob Levinson, Analyst
Thank you, guys. I'll pass it on.
Dan Florness, CEO
Thank you.
Operator, Operator
Thank you. Our next question is coming from David Manthey of Baird. Please go ahead.
David Manthey, Analyst
Thank you, hi, guys. Good morning.
Dan Florness, CEO
Morning.
Holden Lewis, CFO
Morning.
David Manthey, Analyst
First question on operating expenses. Now when you look sequentially in most years, there's either the same number of selling days or sometimes there's a minus one from the third quarter to the fourth quarter. This year, if my math is right, you're losing two selling days and offsetting that, I know you have costs up on some of these resets and inflation and things, but given that day's situation, is there any thoughts you can give us relative to the roughly $400 million SG&A you reported in the third quarter? How we should be thinking about the fourth quarter SG&A?
Holden Lewis, CFO
You're correct about the count of selling days. On a sequential basis, yes, we will lose a couple of selling days. This contributes to the leverage you miss out on alongside the seasonal factors. The fourth quarter typically isn't as active as the third quarter, and this trend is consistent each year. Looking at historical data, you might expect a flat to a decline of around 3%, which primarily hinges on compensation costs. Whether we are flat or see a decline of 3% is largely influenced by these costs, given that they account for 70% of our operating expenses. While we face a challenging comparison in terms of selling days, we also have a slightly easier comparison regarding wages since some wages were deferred into the fourth quarter last year, which we won't duplicate this year. Overall, considering everything, I believe that a result within the normal range still seems reasonable.
David Manthey, Analyst
Yeah, okay. That's helpful thanks. And then just quickly on Slide 7, you said you expect to more effectively leverage at a similar growth in 2022. Was the similar growth part of that statement any kind of outlook, or is that just a placeholder for the leverage comment?
Holden Lewis, CFO
It was not an outlook; it was simply a way of saying that all other factors being the same, but it wasn't a prediction. As you know, my ability to foresee trends primarily relies on the PMI, and that doesn't extend far beyond the beginning of Q1, so it wasn't a prediction.
David Manthey, Analyst
Yeah. I had to ask. Thanks a lot, Holden. Appreciate it.
Holden Lewis, CFO
Sure thing.
Operator, Operator
Thank you. Our next question is coming from Chris Dankert of Loop Capital. Please go ahead.
Chris Dankert, Analyst
Good morning everyone. Thanks for taking the question, guys. First off, any update here? Third-quarter now, 2020, we added a lot of new customers, count on retention in the past, but any update on what that retention looks like today?
Holden Lewis, CFO
In the quarter, we defined retention as customers who had not made any purchases from us before Q2 of last year, when the pandemic began to settle in. We understand this definition. We recognized just over $50 million in revenue from those customers in the third quarter, which is slightly down from the Q2 period. However, it still represents a significant investment and opportunity within the healthcare sector that has resulted from the conditions we've been navigating for the past 18 months.
Chris Dankert, Analyst
Got it. Got it. Okay. That's helpful. I guess. My apologies if I missed it in the prepared materials, but very dynamic pricing environment, obviously. Any comment on what you're expecting, the top-line impact to be into the fourth quarter here? I mean, subject to change so then just kind of a snapshot of what you're seeing today would be great.
Dan Florness, CEO
Yeah, I always feel I need to also plan to a very dynamic cost environment. But I would say that our exit rate was perhaps a little stronger than our entrance rate for the Q3. And so I do believe that you'll probably have some continued edging up from the range that we experienced in Q3, in Q4. It wouldn't surprise me if that number is a little higher. But we also keep a pretty good tab on when we expect to see container cost and things like that begin to flow to the model, and I think you're going to see that head jump in Q4 as well. So you could see incremental pricing in Q4 relative to Q3, but I think you're going to see incremental costs. I think we're currently expecting that, for all intents and purposes that, that price costs will remain neutral.
Chris Dankert, Analyst
Got it. Thanks so much for the help. And again, congrats to the team on being able to maintain that price-cost neutrality so far. So thanks again and best of luck.
Dan Florness, CEO
Thank you. Before we take the next question, I want to add some commentary on the inquiry about new customers that are now purchasing from us. Holden mentioned the statistics. I’ll share a bit of an anecdote. Looking back three to four years ago, when I traveled, the only place I frequently learned about our noteworthy projects in government or healthcare was in Florida, where Bob Hopper would tell me about the K-12 school district we were working with or that had expanded. Sometimes I'd visit a site, and we had many on-sites in K-12 school districts in the Southeast, particularly in Florida early on. Bob would talk about it, and soon others began to explore and find success there. We then expanded into higher education and signed on-sights. In the last nine months, I’ve started hearing, not just from Bob, about healthcare facilities we’ve recently signed up as on-sites. Most of these are associated with a university. While the numbers are still quite small in the grand scheme, it’s encouraging to hear about this growth, which I didn’t note 15 to 20 months ago, but I'm now hearing about it each quarter of 2021. I view this as a positive development because it broadens our potential customer base. Another point that stands out is that Holden and I regularly discuss our approach to metropolitan areas, and we recently talked about our strategy for the Minneapolis and St. Paul area. All of those discussions have included the traction we're gaining on the government and educational sectors and healthcare fronts regarding business activity and on-sites. Previously, such insights had to be drawn out, but now they’re shared as growth opportunities in specific markets. With that, we’ll take the next question.
Operator, Operator
Your next question is coming from Ryan Merkel of William Blair. Please go ahead.
Ryan Merkel, Analyst
Hey guys, nice job on gross margins this quarter. My first question is, is there anything to call out on gross margins as we think about the fourth quarter? Should we expect normal seasonal declines?
Holden Lewis, CFO
Historically, you would generally expect to see a decline of about 20 to 40 basis points from the third quarter to the fourth quarter. I feel fairly positive about this expectation. There may be a slight upward trend within that range, but considering price costs are relatively stable compared to where we are, I believe the historical data is quite informative. So, I would characterize my expectations for the quarter along those lines.
Ryan Merkel, Analyst
Okay. That's helpful. And then I wanted to ask about FTEs. I noticed it was flat year-over-year in September, it's down from January. Is this intentional or is this due to labor shortages? And then are you seeing applications pick up now in some of the states where the benefits have ended?
Dan Florness, CEO
It is not intentional. I would actually prefer to be on this call explaining that we missed expectations by a small margin because we brought on more people. I sense there has been some improvement. The most critical area for us is in building our pipelines, whether that’s sales pipelines or talent pipelines. Our most effective talent pipeline for the last 50 years has been reaching out to students with a year or two left in college, whether they are in a four-year university or a two-year technical college. We offer them the chance to work with us, providing experience and some income, which is always beneficial for a student, typically around 15-20 hours a week. Essentially, we're dating with the hope that by the time they graduate, they'll have a favorable impression of us, and we will feel the same way, leading to them joining our team and advancing their careers. However, this recruiting strategy has been challenging over the last year and a half. When colleges shut down and students returned home, our approach of hiring students on campus became ineffective. This has significantly impacted our talent acquisition. Students have returned to classes now, but we are only a month or five weeks into the new school year. I haven't noticed a significant improvement that I can explicitly identify; most observations are anecdotal. I do believe that our hiring will improve, although I’m not sure if that's a result of my optimistic outlook or the general desire for people to return to a sense of normality, which includes the need for part-time jobs in college. However, it hasn’t been a strategic plan.
Ryan Merkel, Analyst
Got it. Alright. Thanks, Dan.
Dan Florness, CEO
Thank you.
Operator, Operator
Thank you. Our next question is from Michael Medinger.
Michael Medinger, Analyst
Thanks. I was hoping to hone in on the fasteners, importantly, times you alluded to in the release. Is there a way to aggregate what the total lead time is from mill support, and then how those fasteners turn relative to your remaining product set when they do get into domestic stock? And if it makes sense to compare how that is in a normalized environment versus the congestion we're seeing now?
Dan Florness, CEO
Holden, I don't know if you have that slide deck that we were looking at the other day.
Holden Lewis, CFO
Here it is.
Dan Florness, CEO
As you can appreciate, at the end of the quarter or during the quarter, there are many different variables to consider, and I want to avoid providing inaccurate information. What I can share is that the buffer we are creating in our supply chain for imports is substantial and is being measured in weeks rather than days. I could almost suggest it may take months instead of weeks, but I'll spare you the details. The situation is significant. Yesterday, during our board meeting, I shared a thought with them. One of the responsibilities of the board to its shareholders is managing risk, and I highlighted a risk we need to be particularly aware of. Honestly, I cannot predict if this awareness needs to be in six months or six years. The uncertainty surrounds how things will unfold since a lot of shipping capacity was reduced last year, resulting in limited availability. The question is whether this situation is becoming our new normal, where we need to factor in an additional 30 to 45 days into our supply chain. The risk lies in when that dynamic changes. I cannot say whether it will be in six months or six years, but when it does change, we need to recognize it immediately. Currently, we sell $13 million worth of inventory every day. If products start arriving three to four weeks earlier than expected, that could lead to an additional $260 million in inventory within just a month. If we aren't attentive and managing this situation carefully, it can escalate quickly. However, it’s important to note that it is currently measured in weeks, and I apologize for not having more detailed information readily available.
Michael Medinger, Analyst
Not a problem, I guess switching gears to the Onsite I believe the normalized target remains 375-400. Can you discuss the revenue per site normalization or baseline you see as this initiative continues to mature? And with the backdrop being? You started Onsite, I think the average was 150, and now it's 100 per site. Does this normalization create a wider net for you to drive more signings in 2022?
Holden Lewis, CFO
In terms of the revenue per site, you are right. I mean, when we started this, we had a smaller cohort of Onsites that did between $1.8 and $2 million in revenue per site, and today, frankly, that's probably more in the $1.45 million annualized level. That's an improvement over last year, and frankly, it's actually an improvement over 2019 as well. So we have begun to see that improvement occur. It's one of those things I think is relevant to talk about because we talk about the signings being somewhat weaker. But that team in the on-site group, we've seen the average size go up. We've actually seen the margin on that group go up, and we've seen the inventory on hand actually decline in terms of the days on hand number. As we have talked a lot about, as you get out of this hyper-growth process into more of a fast-growth process, that comes at a certain level of production efficiency. We have seen that over the last 12 months. When we get back to being able to sign 375-400 when the market normalizes, I think we are doing so off of a larger and more productive base, and I think that's an exciting development. Does that answer the question or did I miss the point of it?
Dan Florness, CEO
I'm going to refer back to the last question by reviewing my notes from a couple of days ago. In September, the total transit time for deliveries in August reached a record 58 days for Fastenal. At that time, September was showing an upward trend in transit times from the update provided a couple of weeks ago. Looking back to the first quarter of 2020, which is the earliest data on my chart, transit times were in the 30s for days. This figure includes the time taken to reach the port and the average duration from when the goods are discharged at the port to their destination. It’s not just about the time taken to cross the ocean and reach the port, nor how long the containers sit either at sea or at the port. An important point when we negotiate shipping rates is that we typically arrange for the rate to cover the journey from the port in the originating country to our distribution center, with the steamship lines taking care of that entire trip. In the third quarter, 35% of our containers couldn’t be delivered to our destination due to a shortage of containers. Those 35% had to be manually unloaded at the port, transferred onto trucks, and driven to our distribution center. All the reports indicate issues with container costs rising from overseas, and this doesn't even take into account the additional costs incurred by transporting containers via truck across North America, which is significantly more expensive than using a train. We have experienced a fourfold increase in container costs year-over-year. When factoring in those additional expenses, the total increase is closer to sixfold. This has contributed to substantial inflationary pressure. I see we're five minutes away from the hour, and I hope we have addressed most of the questions satisfactorily. If you have any follow-up questions, I'll be available for the rest of the day. I also want to highlight that Fastenal has been recognized by EHS Today, along with nine other companies, as one of America's safest companies. I appreciate our EH&S Team, the safety teams that created our plan, and all our employees who adhered to and respected that plan. Thank you for maintaining safety in 2020, your contributions to society, and congratulations on this recognition. Take care, everyone.
Holden Lewis, CFO
Thank you.
Operator, Operator
Thank you for your participation. This concludes today's event. You may disconnect your lines or log off the webcast at this time and enjoy the rest of your day.