Earnings Call Transcript - FAST Q2 2023

Operator, Operator

Good morning and welcome to Fastenal's earnings conference call for the second quarter of 2023. As a reminder, this call is being recorded. I will now turn the call over to Taylor Ranta from Fastenal Company. Thank you, and you may begin.

Taylor Ranta, Host

Welcome to the Fastenal Company 2023 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 1 hour and will start with a general overview of our quarterly results and operations, with the remainder of the time being 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 consent. This call is being audio simulcast on the Internet via the Fastenal Investor Relations homepage, investor.fastenal.com. A replay of the webcast will be available on the website until September 1, 2023, at midnight Central Time. As a reminder, today's conference call will 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

Good morning, everyone, and thank you for joining our second quarter earnings call. Before I discuss Fastenal, I want to take a moment to share a message. When I joined Fastenal in 1996, I came on board as the Chief Financial Officer, thanks to Bob Kierlin’s offer. My entry into the company was unconventional since I didn't start at a branch or distribution center and work my way up. Joining an organization that promotes from within can lead to uncertainty about how you'll be received. One of the first people I met was Colleen Quad, Bob Kierlin's sister, who had retired after a few years working in sales support. She was one of the kindest people I've ever known, and we lost Colleen earlier this year. My condolences go out to her children and grandchildren, as well as to Bob for the loss of his sister. She was a wonderful person, and we were all fortunate to have known her. Our five founders are not young anymore; they began this journey in 1967. Van McConnon, our first employee, who goes by Van, joined us early on and earned his stake in Fastenal. He lost his wife, Wilma, this spring, and I extend my condolences to him as well. Now, let's move on to our quarter. The second quarter of 2023 was challenging. Last December, during our leadership meetings, we recognized that 2023 would have its difficulties, and we warned our team to manage expenses prudently. We forewarned that the second and third quarters would demand rigorous expense management due to ongoing economic challenges, including tariffs, COVID-19, supply chain issues, and inflation. We've been experiencing a slowing economy, and it's essential to prepare for what this means for our operations. Our earnings for the quarter were $0.52, reflecting a 4.5% increase. However, softer manufacturing activity caused our sales growth to decelerate, with a 5.9% growth rate for the quarter. Notably, we did not achieve leverage, which is crucial for our business. While sales grew by 5.9%, we faced changes in our mixture, and our gross profit dollars increased by 3.6% while operating expenses rose by 4.1%. This combination was not favorable for earnings leverage. We hadn't anticipated the degree of softening, and our operating expenses needed to decrease more rapidly. Historically, in periods of economic downturn, the high amount of working capital on our balance sheet significantly impacts our cash generation ability. The second quarter also typically brings a financial strain due to tax payments for our profitable business in the United States. We usually generate between $0.60 and $0.70 in operating cash flow for every dollar in earnings, and I cannot recall a second quarter where our cash operating flow exceeded earnings. It may have been back in 2009, but this quarter generated strong cash flow due to our working capital management. In recent years, as supply chains faced congestion, I've made it clear to our supply chain team that we have a commitment to our customers to not let them down. This commitment sometimes required holding extra inventory to ensure our customers' needs were met. We made some leadership changes in the second quarter. Jeff Watts, who has been with us since 1996 and has led our international sales efforts since 2015, will now oversee all sales efforts globally. Terry Owen, formerly EVP of Operations, has been designated as our Chief Operating Officer. In closing, despite cyclical challenges, we have made significant improvements in our labor and inventory productivity over the last several years. This positions us well for long-term growth. Moving to the topic of Onsites, we had 86 signings, which is below our internal goal of 100 per quarter. Before COVID, we had seen a climb, hitting 362 in a year. The pandemic hindered our ability to sign new Onsites due to safety concerns about in-person visits. We recovered somewhat last year with 356 signings but have adjusted predictions for this year to be in the low 350s. Still, having 15% more Onsites than last year is a positive development. Regarding FMI Technology, our goal is to achieve 100 Onsites each quarter, and this quarter we successfully signed 106 per day, showing strong market share gains. Year-to-date, we reported close to 99 signings, which is promising. E-commerce is growing nicely, up 45% this quarter, and while we've traditionally not been strong in this area, we are seeing positive trends. Our web sales now account for 6.5% of total sales, which has significantly increased from 2% in 2015, showing that we are catching up in this space. Looking at our digital footprint, 55.3% of our sales came through digital channels this quarter, an increase from 47.9% last year. While our goal was initially set at 65%, we have recalibrated it to 60%. The FASTStock tool, implemented in 2019, significantly boosts our efficiency, allowing us to manage inventory more effectively. Starting in October, we plan to introduce an internal-facing Order Pad app. Additionally, we have developed an external-facing app called FASTScan for smaller customers to manage their stock more independently, which we aim to launch in August. Overall, while we still have much progress to make, we are continuously working to enhance our capabilities in e-commerce and customer relationship management.

Holden Lewis, CFO

Great, thanks, Dan. One loose thread there perhaps to pull a bit. Last time we had cash conversion of this level, it was actually in the second quarter of 2020. For those who don't remember the second quarter of 2020, there was an event occurring at the time that we now know as the pandemic. But I think it reinforces the point. It took a once-a-century event to create a second quarter that, despite several tax payments, produced cash conversion in that 100% range. The fact that our teams are able to do that in a quarter where thankfully, there has not been anything remotely resembling a pandemic really gets to the success of the teams in managing kind of the post-pandemic environment. So yes, it does take a condition of that sort. Jumping into the details on Slide 5 of the deck, daily sales increased 5.9% in the second quarter of 2023. Since March, we have seen overall business activity moderate, culminating in June daily sales growth of up 4.7%. The most meaningful change in trend has occurred in our manufacturing customer. This segment grew 10.4% in the period despite sustained sub-50 PMIs and flat to negative industrial production. This reflects the impact of our investment in Onsite and greater sales focus on key account plan spend, which tends to be significant within manufacturing. Even so, we did experience weaker sequential in May and June that represents a macro-driven change from the strong sequentials we had from 2021 to February of this year. As it relates to pricing, they contributed 190 to 220 basis points to growth in the period, declining approximately 470 basis points from the second quarter of 2022 and approximately 100 basis points from the first quarter of 2023. This trend is not a surprise and will likely continue in the second half of 2023. Other factors cited in recent quarters, specifically weakness among some large retailer customers, lack of growth in our rest of world geography, and contraction in our construction end market remain factors in the current quarter, but the dynamics around these areas were largely unchanged from prior periods. While we continue to pursue key account plan spend in construction, this market has historically had a disproportionate amount of smaller transactional spend where we are currently putting less emphasis. We believe this shift contributes to manufacturing outgrowth, better labor leverage, and better asset efficiency. We have experienced manufacturing-driven weak sequentials in three of the last four months. Regional leadership continues to characterize customer sentiment as cautious, with greater scrutiny over operating and capital spending and some mention of slower or deferred orders. As usual, we have limited forward visibility, but most indicators seem to be pointing to the immediate outlook remaining soft. Now to Slide 6. Operating margin in the second quarter of 2023 was 21%, down from 21.6% in the prior year. The incremental operating margin was 11%. Gross margin was 45.5%, down 100 basis points in the prior year. This decline is almost entirely due to product and customer mix as we experienced widening sales growth outperformance of non-fasteners over fasteners and of Onsite growth over non-Onsite growth. Freight was favorable for gross margin, reflecting record freight revenues that allowed for good leverage of our captive fleet, reduced use of external freight providers, lower fuel expenses, and reduced shipping costs. The benefits of freight were offset by higher organizational or GAAP expenses. Reductions in purchasing and shipping activities of imported products, stemming from a smoother and more predictable supply chain relative to the year-ago period, caused higher prior period costs to be relieved from the balance sheet to the P&L. The impact of price cost was immaterial to gross margin in the second quarter of 2023. On the operating expense side, we produced 40 basis points of leverage, which was not sufficient to fully offset the decline in gross margin. This was due entirely to payroll expenses, of which we experienced 60 basis points of leverage related to lower incentive compensation from last year's record level. This was offset by modest deleveraging of both occupancy costs and other expenses. There were three distinct elements playing out in our operating margin in the second quarter of 2023. First, I alluded to the GAAP expenses. The GAAP expenses had the convergence of a difficult comparison, aggressive inventory reductions, and shortening product order cycles. This alone is a 50 basis point negative impact and is unlikely to repeat by anywhere near the same magnitude in the second half of 2023. Second, certain expenses such as 16% growth in IT spending and 13% growth in costs for FMI devices represent planned and prudent investments in our business, the impact of which is magnified by the slower sales growth environment. Third, the Blue Team did not adjust spending quickly enough to the slower macro environment with the variable costs for meals, travel, supplies, all increasing double digits. While lower incentive compensation produced leverage in the second quarter, we continue to have growth in headcount and part-time hours that exceed sales growth. I would expect us to tighten this spending appreciably in the third quarter of 2023. Putting everything together, we reported second quarter 2023 EPS of $0.52, up 4.6% from $0.50 in the second quarter of 2022. Turning to Slide 7. We generated $302 million in operating cash in the second quarter of 2023 or approximately 101% of net income in the period. Traditionally, normal second quarters have a conversion rate in the 60% to 70% range. So this is a strong cash performance relating to a reduction in the use of cash for working capital versus the prior period. This allowed us to reduce debt with debt ending at 9.4% of total capital in the second quarter of 2023, down from 13.7% in the second quarter of 2022 and from 10.9% in the first quarter of 2023. Year-over-year accounts receivable was up 6.1%, largely tracking sales growth with the impact of mix due to faster growth from larger customers. This is offset by improved receivables quality. Inventories fell 6%. This is a function of normalized supply chains, allowing us to unwind inventory layers we built up in late 2021 and early 2022 to manage that period’s product bottlenecks. That process will likely continue, though likely to a lesser degree, throughout 2023. It is also notable that our days on hand fell to 138.5, a level not seen since 2002, which reflects improved velocity of inventory through our internal network, a reduction of retail stock in branches, and improvements in stocking processes. We have significant strategic flexibility in inventory at this point. We have retained our range for net capital spending in 2023 of $210 million to $230 million, reflecting higher spending on hub investments, fleet equipment, and IT equipment. At the same time, we have deferred certain projects related to slowing demand, suggesting our capital spending will be at the low end of the range. The second quarter of 2023 was obviously challenging. We expect to have better cost comparisons and to more tightly control those costs that we can affect in the second half of 2023. We have little control over end market demand. Whatever direction that takes over the next six months will influence our profitability. However, these shorter-term issues shouldn't cloud the structural improvements to our business. The second quarter saw record labor productivity that creates some significant strategic flexibility in our inventory and further improvement in our return on capital, as reflected on Page 9 of the investor presentation. We believe we are positioned to strongly outgrow the market, particularly as the industrial cycle stabilizes and improves. With that, operator, we'll turn it over to begin the Q&A.

Operator, Operator

Our first questions come from David Manthey with Baird.

David Manthey, Analyst

Dan, Holden, I hope you guys are having a great summer. So I have a clarification and then one question. Clarification, Holden, when you're on Slide 5 and you're talking about price contribution, you said this will continue in the second half of '23. I'm wondering what you're referring to there, first. And then the question, I'm hoping you can update us on KPIs relative to your CFCs and the Focus 5 initiatives.

Holden Lewis, CFO

Sure. The clarification is we continue to expect moderation in the overall contribution from price in the back half, really just a continuation of what we've been seeing over the past few quarters. Does that help?

David Manthey, Analyst

Yes.

Holden Lewis, CFO

Yes, the CFC continues to experience very strong growth. In the second quarter, considering the growth of our CFC or hunter program, the books of business saw an increase of over 50% compared to the previous year. We are continuing to see good success, especially with the CFC program. I don’t have specific numbers on the target 5 for you, but CFCs have their own targets, which gives you an idea of the growth happening. Overall, the CFCs are growing significantly more than our business and represent the same key account approach that the target 5s are integrated into.

Operator, Operator

Our next questions come from the line of Michael Hoffman with Stifel.

Michael Hoffman, Analyst

Dan and Holden, regarding the trend data you provide, do you believe you are nearing the bottom despite having limited forward visibility?

Holden Lewis, CFO

I guess I'll just reinforce we have very little visibility to what the market will hold. Here's what I'll say. I've always respected the PMI as an indicator of future activity levels. I tend to think it has a forward look of 3 to 5 months. I think we all know that the PMI in June hit 46, which is not a meaningful new low but a new low nonetheless. The message we gave to our people internally was that this would suggest that the back half of this year is going to remain soft. So I don't have an indicator internally that would give you any real insight into what's going to happen in August, September, October. But the PMI has always been a good indicator, and the PMI remains relatively low, suggesting the back half is going to be weak and that's what we sort of take our cues off of.

Michael Hoffman, Analyst

Okay. Regarding digital transformation, I believe I understand that as you increase your share of spending from individual customers throughout their engagement, could you describe your current position in that process and how it is affecting your market share growth?

Dan Florness, CEO

If we consider the digital footprint, specifically the FMI component, it accounts for roughly 40% of our business. We've internally projected that we can increase that to about 65%. A significant part of this growth will come from transitioning our existing customers to the new platforms, which enables us to provide insights in ways that weren't possible before. This not only enhances business efficiency but also allows us to dedicate more time to market engagement. Ultimately, we view this saved time as a way to accelerate business growth through increased engagement. Additionally, this capability sets us apart in the marketplace. Each spring, we host a customer event where we bring in thousands of customers to interact with suppliers and explore various business tools. Our capabilities are attracting new business. For example, during a customer discussion last summer, our national account representative explained our RFID program to a purchasing team across various locations within a large conglomerate. This program features a system with an embedded RFID chip that automates the tracking of inventory in bins. Instead of manually checking what needs to be restocked, the RFID reader identifies when a bin is empty and takes appropriate action. The moment she understood this, it was a breakthrough for her, realizing it could resolve their challenges. Recently, I visited an employee in Illinois who had completed 40 years of service, and during my visit, he invited me to meet a customer. He showed me an RFID chip he had in his wallet and mentioned that we were using it in innovative ways beyond just the Kanban system. The customer appreciates the simplicity of this process, highlighting how our supply chain innovations are winning business, especially when customers come to see these advancements firsthand.

Holden Lewis, CFO

I might add as well that I think that those two actually interconnect in the sense that to the extent that it helps to reduce our overall cost of operations, that actually allows us more flexibility in bidding processes, making us more competitive in the marketplace and contributing to our ability to win and gain market share as well. So it really plays strongly in both our ability to leverage and grow.

Dan Florness, CEO

In February, I think it was February, I was down in Indiana visiting and speaking to a group of branch managers. They asked me if I wanted to visit a customer, and they took me to a large Onsite. The customer contacted us in the fall of 2020. They needed help, and we set up an Onsite there. The incumbent had been staffing the Onsite 24 hours a day. Our folks studied the activity and said, if we put out a handful of lockers in a way that we wouldn't typically do it, we could give better service and staff 10 hours a day instead of 24. It would be easier for us to recruit, ramping up business because finding folks to work 24 hours a day is sometimes challenging. Finding people for a 10-hour window is less challenging. Once again, it separated us in that instance. It was a great visit, and the customer loved what we were doing.

Operator, Operator

Our next questions come from the line of Chris Dankert with Loop Capital Markets.

Chris Dankert, Analyst

Holden, you had a kind of mid-teens growth in IT spend and an FMI investment. As we're thinking about kind of SG&A spending and investment going forward, can you provide us a sense for how you would trend in the back half of the year as you keep investing for growth?

Holden Lewis, CFO

Yes. I mentioned the IT and the FMI spend because those are investments in our business that we're making that are wise investments to make. I don't anticipate pulling back in those areas. The areas we were talking about more had to do with expenses we had for travel, both sales and non-sales, and related expenses. When we think about how we're using our part-timers and the fact that hours among our part-timers are up 12% in June in a marketplace where revenues are up less than 5%, we need to tighten our behavior. The travel, meals, supplies, et cetera, had about a 10 basis point impact on our overall profit. The increase in base pay that comes from higher headcount and part-time hours would have been about a 450 basis point impact to margin. That was offset by the fact that incentive compensation was down because last year was such a strong year relative to this year. Those are areas that we need to tighten up a lot of our behaviors and patterns to reflect more of the environment that we're in, and I expect we'll make progress on that in the third quarter.

Dan Florness, CEO

Let me add on; as it relates to IT, when I stepped into this role back in 2015, one of the first things I said to the Board and our team is that everybody is going to get lower pay the next 12 months because we're going to increase the investment in IT. I tapped a senior leader who had grown up through our branch network, and we increased our spend on IT by 50 basis points in 2016 and we've held that number. We're not going to sacrifice our investments in the short term. Last year, we added 50 people into our Bangalore tech center, and in January, we added another 100 people. We won't stop making investments. The digital footprint owes a thanks to our investments. This 55.3% of sales and productivity gains over the last three years wouldn’t have happened without it.

Operator, Operator

Our next questions come from the line of Ryan Merkel with William Blair.

Ryan Merkel, Analyst

I had a couple of questions on margins. First off, on gross margin. How should we think about the rest of the year? Is normal seasonality the right framework for 3Q and 4Q?

Holden Lewis, CFO

I think in the first quarter, we talked about normal seasonality would apply but at a more muted rate, and I think that's still appropriate. Second quarter was down about 20 basis points from the first quarter. I typically think of it being down 30. 3Q is typically flat with 2Q, and I think that's a reasonable ballpark. 4Q is usually down about 30 basis points from 3Q. The wildcard in my mind is the cyclical element of seasonality related to fasteners.

Ryan Merkel, Analyst

Yes, makes sense. Super helpful. And then on OpEx, Holden, you mentioned you're going to tighten that up a bit while also investing in IT for the long term. Is there any metrics you could provide? Is there a goal for FTE growth in the second half? Is it optimistic to believe you can adjust SG&A fast enough where you can hold operating margins flat year-over-year in the second half?

Holden Lewis, CFO

It will depend how aggressive we are. Part of the operating margin is a reflection of the gross margin. Step aside; focusing on SG&A, we need to reduce costs in our SG&A relative to Q2 by $2 million, $3 million. We need to do that through tighter control of headcount and expenses. I feel comfortable we'll be able to do that. The organization is responding to the messages and responding to the slowing growth.

Operator, Operator

Our next question is coming from the line of Josh Pokrzywinski with Morgan Stanley.

Josh Pokrzywinski, Analyst

Just maybe a higher-level question for both of you. We've seen a huge wave of inflation and supply chain tightness, now going back the other direction. What would you identify, Dan, as the biggest change you saw as a function of that? And the biggest things that are changing now as those reverse?

Dan Florness, CEO

The biggest change we saw directly in our business from supply chain elements was the need to add a lot of expensive inventory in 2021 and 2022; container costs were sky high. We were doing a lot of things; we were not going to let people down. Fortunately, we have the balance sheet to do that. However, when the need for that extra layer of inventory subsided, we figured out a way to harvest that out of the balance sheet. That’s probably the biggest change. More broadly, we are seeing changes for our customers. It's one reason I touched on the two elements of our business, the plan spend versus unplanned spend. If supply chains took 30 days longer, we built inventory to get it to them. So it’s not so much that there is a destocking element downstream; it might be because a customer built finished goods because they had a strong backlog. So when they lower production, that inevitably impacts us. It's about inefficient supply chains. As we illuminate inventory and understand how a customer's predecessor partner was supplying, we see inefficiency. As a supply chain partner, we help manage that down. But that’s not truly about supply chain time. I apologize to whoever was about to speak. I’m going to run into a meeting in a few minutes, holding this call to one hour.

Holden Lewis, CFO

There are also availability elements in the marketplace as well. During 2020, 2021, there weren't many distributors with product availability. We benefited from that, but the market has normalized. There's now a little more competitive environment, allowing us to focus more on our supply chain solutions as differentiators.

Dan Florness, CEO

While there are some elements of product cost deflation, labor cost deflation continues. That's still a big factor that influences the overall marketplace; nothing is changing in that regard. There’s no deflation in labor - it continues to increase. We have more success in recruiting, as does every business, but labor inflation remains prevalent.

Tommy Moll, Analyst

Can you give us an update on fastener product margins? Any update you could give would be helpful.

Holden Lewis, CFO

Yes. I mean product margins, when you break fasteners into OEM versus MRO fasteners, product margins are fairly stable. When I think about price cost in the fastener arena, it's fairly neutral at this point. We've had circumstances where contracts require some adjustment based on end markets where I believe we've begun that process. That is aligned with what we’ve talked about before regarding improved costing.

Dan Florness, CEO

With the better supply chain, do you see some of the same for customers? Do you see any impact on your daily sales trends from that?

Holden Lewis, CFO

We're the buffer. If supply chains are taking longer, we build inventory to accommodate that. If there's a destocking element, it may stem from customers working through their finished goods. That impacts us because they lower their production.

Dan Florness, CEO

Overall, we may have new customer relationships where they had inefficient stock levels due to undefined relationships with predecessors. We discover and alleviate their stock levels, but may not directly relate to the changes in supply chain timing.

Operator, Operator

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation and have a great day.