Earnings Call Transcript - FAST Q3 2022

Operator, Operator

Greetings, and welcome to the Fastenal 2022 Third Quarter Earnings Results Conference Call. All participants are currently in a listen-only mode. A question-and-answer session will follow the formal presentation. 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.

Taylor Ranta, Host

Welcome to the Fastenal Company 2022 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 begin with a general overview of our quarterly results and operations, followed by a question-and-answer session. Today’s conference call is a proprietary Fastenal presentation and is being recorded. No recording, reproduction, transmission, or distribution of today’s call is permitted without Fastenal’s consent. This call is also 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 1, 2022, 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.

Dan Florness, CEO

Good morning, everybody, and thank you for joining us for our third quarter earnings call. We had a good quarter. When I look at the performance of the team, I am proud to be a member of the Blue Team. The 16% daily sales growth that we experienced in the quarter, we were able to translate that into 19% operating profit growth, and ultimately, we were also able to translate it into strong operating cash flow growth. We grew our cash flow 54% from the third quarter of 2021 to third quarter of 2022. And in the expansion of our ability to generate operating cash relative to our level of earnings, we haven’t been able to lay claim to that for over a year and a half, as I believe you have to go back to prior to 2021 where you can see that. And it was really great execution throughout the organization and the fact that supply chains have become a bit more stable. That doesn’t mean they have become easier; it just means they have become more stable, and you can rely on what you are seeing in your level of safety stock, doesn’t be quite as deep. As far as customer demand, that was stable throughout the quarter. Now September’s 2.7% sequential growth versus August does lag the way we look at the historic pattern, and history would say we should be up 3.4%. The real driver of that is if you look at the storms that hit the Southeastern United States, Hurricane Ian late in the quarter essentially pushed some business out of September and into October. The storms likely reduced our sequential Daily Sales Report (DSR) by about 0.5%. We see it as stable demand. We are preparing for a softer 2023. I thought I’d share some thoughts on what that means. First off, I remember back in the fall of 2015, I believe it was a Tuesday morning—don’t quote me on it—when I learned after our Board meeting that I’d been selected as the next President and CEO of Fastenal. It was a tough environment for not just the organization, but for industrial entities in general. During the Q&A section the next day, I was probably a little more animated than I typically am and commented on what I thought was the state of the economy. The next day, my wife informed me that I was on the front page of the Wall Street Journal. But we are not in that kind of environment. We are not in something where I am going to proclaim something. But we are preparing for a softer 2023, and a lot of that centers on two things. First, this is something that has nothing to do with 2023. If you would have been on the call I had an hour or two ago with our leadership globally, I gave them the typical October talk about being a seasonal business. If you look at history, between September and December, our daily sales typically drop off 12% to 13%. I am going back to the time before COVID and even before some of the tariff period; specifically back to the 2016 and 2017 numbers. Just looking at sequential patterns—I don’t think this should surprise anyone listening to this. A business that operates in Northern North America, with a significant chunk of revenue generated in that region, after you get past Canadian Thanksgiving and move toward the U.S. Thanksgiving and Christmas, the business slows down. We are preparing ourselves for that. When we talk about 2023, it’s about a lot of the numbers we see; they are not numbers unique to Ireland. I am looking at industrial production, and Holden will touch on some of that here later. The most important feedback that we focus on is what our regional and district leaders are hearing from their customers about their confidence going into 2023. I’ll be honest with the group; that confidence isn’t strong. It’s not a case of the sky falling, but the confidence is very, very cautious. We are preparing for that type of environment, which means being very thoughtful about investments, and not getting ahead of ourselves. We have signed a lot of Onsites this year, and that gives us resiliency moving into next year. We need to staff for what we know without getting ahead of ourselves on staffing for what we don’t know. That’s our mindset heading into 2023. Last week, I traveled in Europe; my first trip outside North America since before the pandemic. There’s something to be said for that human interaction and the energy you get from it. I spent time at what we call EHUB—our distribution facility in the Netherlands—where most of our European leadership was there for discussion. I traveled down to Northern Italy, primarily Lombardy, to meet with our team. The growth and talent I saw in that group was impressive, especially considering everything that’s been going on in Europe over the last three years. That business is now 80% larger than it was in 2019. If I left it in local currency, it would be closer to $90%. When we were there two years ago, it hadn’t tripled in size but was close. It’s a powerful story of how the marketplace has recognized what is unique about Fastenal over the years. Despite the challenges, I believe we are replicating that with our team in Europe. One positive is that our pre-pandemic margin profile has reemerged. Back in 2016, 2017, and 2018, we were discussing how our future growth would become more Onsite-driven. It alters your gross margin profile but also your operating expenses. We believed this was a solid trade-off, as it ultimately results in greater profit and return on investment. We saw that our operating margin was stuck within 20 to 30 basis points of 20% for several years; Year-to-date, we managed to rise above that, reaching 21% or slightly better. I’m very pleased with that. I am also impressed with our cash flow performance over the last couple of years, as it’s been tough. I’m glad to report that for the first time in several quarters, I see year-over-year improvements, and I believe it has staying power. We are in a better position to improve cash generation. Flipping to page four of the book, Onsite signings softened a little during the quarter—86. Active Onsites totaled 1,567, up about 15% from a year ago. Our goal for the year of 375 to 400 remains intact. Given where we are, we expect to be at the lower end of that range. In terms of FMI Technology, we signed 5,187 weighted devices, averaging about 81 per day—a year ago, we signed 75. I’d be lying if I didn’t say I’d like that number to be closer to 100, but we are achieving good execution. Notably, the revenue per device is expanding nicely. Regarding FASTBin, we are posting impressive numbers. If you look at the signings per day, a couple of years ago, one of those signings was a FASTBin; today, it’s 15. It's rapidly expanding and I'm very impressed with how our field teams are embracing the technology. Daily sales for eCommerce rose 50%. Ecommerce is intriguing because historically it was stagnated around 5.5% of our sales. We have changed our perspective; we are a service organization and a supply chain partner, not a catalog-centered or eCommerce company. In the quarter, we achieved $5 million in daily sales through eCommerce. In September alone, we reached 49.9% of our business now flows through the Digital Footprint, compared to 43.7% a year ago. We are still aiming to hit 52% of our sales through the Digital Footprint for 2022. If you look at internal participation, growing from 17% in 2018 to 52% now of our branches generating over 10% of their sales from eCommerce shows improvement across the organization. This growth comes from widespread activity, becoming part of our company's DNA.

Holden Lewis, CFO

Great. Thank you, Dan. I will start on slide five. Total and daily sales increased 16% in the third quarter of 2022. Growth did decelerate by 200 basis points from the second quarter of 2022, and September’s DSR growth was below the historical norm. A lot of that was due to comparisons. Price contribution in the period was 110 basis points below the second quarter, which we expected. We also encountered difficult government comparisons in Q3, costing approximately 20 basis points, while foreign exchange impacted us by about 10 basis points and Hurricane Ian affected our Atlantic coastal region during September by about 20 basis points as well. While we experienced robust daily growth of 22.6% in our manufacturing end market, 18.2% growth in our fastener line, and 20.8% growth in national accounts. Regional VP feedback included caution, but overall, they assessed the business activity in the third quarter to be similar to that of the second quarter. Pricing contributed 550 to 580 basis points to growth in Q3, moderating from the second quarter as we started to grow over the pricing actions taken last year. Despite commodity indexes falling from their peaks, many global supply chains are full of product reflecting higher costs. It will take several quarters for lower-cost product to enter use, and we continue to see supplier letters requesting to recover these costs, which is stabilizing pricing levels in the marketplace. Overall, Q3 2022 reflected stable demand and stable prices, with tough comparisons. We see no reason to believe these conditions will change in Q4 2022. However, our visibility into the future is limited, and the cautious feedback from our regional VPs should be noted. Now, to slide six. Operating margin in Q3 2022 was 21%, up from 20.5% in the same period last year. Our incremental margin was 24.5%. Gross margin was 45.9%, down 40 basis points year-over-year. Numerous factors impacted results this quarter. The price/cost relationship negatively impacted the period by 30 basis points. Over the past 15 months, the Blue Team excelled at defending profitability despite rising fastener costs. The market is now less receptive to further price increases, even with higher cost products being imported. As I mentioned earlier, product pricing remains stable, and there are initial signs of easing product inflation. Timing of product flows suggests while the price/cost relation might stay negative for a few quarters, its magnitude will likely moderate. The second factor dragging down gross margin is a write-down of nitrile gloves, impacting margins by 20 basis points. This is similar to our mask write-down in Q1 2021, stemming from decisions made during the pandemic. As pandemic pressures ease, the value of our inventory relative to the market has inflated, and we consider this a discrete event for Q3. The third factor is customer and product mix that was dilutive mostly due to relative growth in our national accounts and Onsite customers, which is anticipated from our growth strategies. Partly offsetting these impacts were strong freight revenue growth of 30.6%, mitigating losses from our captive fleet, and leveraging organizational expenses as higher volumes absorbed overhead. We achieved 110 basis points of operating expense leverage in Q3 2022, mainly from occupancy costs reflecting our branch rationalization efforts. We also leveraged employee-related costs due to lower healthcare expenses and moderating annual growth in total compensation. Putting it all together, we reported Q3 2022 EPS of $0.50, which is a 17.4% increase from $0.42 in the same period last year. We generated $258 million in operating cash in Q3 2022, approximately 91% of net income for the period. This is still trailing compared to typical expectations for this quarter, reflecting ongoing impacts of our working capital actions to support customers. However, this marks the first time in six quarters that cash conversion has improved year-over-year. As product availability across our hubs has reached our goal, we have managed to slow inventory build while improvements in the supply chain have allowed us to slightly shorten ordering cycles. Year-over-year, accounts receivable increased 17% due to strong customer demand and a rising mix of larger key customers, which often have longer terms. Inventories grew 19.8%, reflecting strong demand, inflation, and our hub inventory build. However, improving supply chains contributed to a sequential decrease in our days on hand from 161 days in Q2 2022 to 157 days in Q3. This trend is currently about 10 days below pre-pandemic levels, demonstrating efficiencies in our inventory management. Net capital spending in Q3 2022 was flat at $44 million year-over-year. Year-to-date, spending was $121 million, up 13% largely due to FMI hardware, hub automation, and IT upgrades. We are reducing our 2022 net capital spending to a range of $170 million to $190 million, down from $180 million to $200 million. In the quarter, we returned $178 million to shareholders via dividends and conducted share buy-backs amounting to $95 million. Our liquidity position at the end of Q3 was debt at 14.9% of total capital, up from 11% last year.

Operator, Operator

Thank you. Our first questions come from David Manthey with Baird. Please proceed with your questions.

David Manthey, Analyst

Good morning. Hi, Dan and Holden. How are you guys doing?

Dan Florness, CEO

Good morning, Dave. Fine.

Holden Lewis, CFO

Hi.

Dan Florness, CEO

Thanks, Dave.

David Manthey, Analyst

Good. Hey, so as you are thinking about gross margin into 2023, if pricing remains flat like you say it is right now, what margins—gross margins, that is—come under pressure as you cycle through rising cost of goods sold because of your FIFO inventory method? And on Slide 5, you say the material prices have started to decline. While market prices remained flat, I’m just trying to understand how you are thinking about gross margin here and where those lines intersect?

Holden Lewis, CFO

As you know, through most of this cycle, we have been fairly flat from a price/cost standpoint and that reflected our ability to kind of match the cadence of our price increases with how we are seeing costs come through. As you pointed out, we have a long supply chain and are at the point where pricing levels are stable, but we are still seeing some product come through that was bought months ago at a higher cost, impacting us and that’s where the 30-basis point drag from price/cost sort of evolved to in Q4. What we are also seeing—if you look at the same indices—we start seeing material costs like steel have come off from prior peaks. You are starting to see that material costs, things like steel, have come off from prior peaks. Therefore, we are seeing product being loaded onto boats in Asia that won’t arrive for months; it won’t flow through our supply chain; it takes time. You are starting to see that inflation in that product has begun to come off. In September, the cost levels of product that we are purchasing were fairly flat for the first time in a long time. I think that tells you that we were a little shy of all costs in pricing actions, and that impacted us in Q3. As that less inflated or non-inflated product begins to flow through over the next several quarters, with price levels holding, it should all stabilize. I think, for Q4 and perhaps Q1, we will still see some of that but I don’t expect it to worsen; it will probably remain at or better than that level. By mid-next year, we should see some of that product reflecting moderation in costs coming into our system.

David Manthey, Analyst

Alright. Holden, thanks for the color. Appreciate it.

Operator, Operator

Thank you. Our next questions come from the line of Jake Levinson with Melius Research. Please proceed with your questions.

Jake Levinson, Analyst

Good morning, everyone.

Dan Florness, CEO

Good morning.

Jake Levinson, Analyst

Hi. Just on the non-res construction side, I know sales have slowed a little bit there and you made some cautious comments in the release. Just curious, and I’m sure there are storm impacts in September, but just curious what you are hearing from the field in terms of trends in that market, especially in particular regions or verticals that seem better—or worse?

Holden Lewis, CFO

Yeah. I think there could be a few things playing out in construction. One is, as you said, the weather probably wasn’t our friend during the most recent months in southern markets. But I think there’s a few other things occurring, too. We tend to be slightly later in the construction cycle, as we don’t supply high-volume, low-margin products, typically stepping in as projects develop. As we move further out from the pandemic, more restarted projects may benefit us from timing. However, I also think the adjustment of our branch model had an effect; we reduced the size of showrooms and redirected walk-in business to online. While this has been successful, walk-in business tends to be prevalent in construction. I suspect our shift towards larger key accounts affects some of the walk-in business we might have entertained before.

Dan Florness, CEO

The other factor is that we have reduced the number of physical locations over the years, while that doesn't primarily impact current patterns, it carries some significance.

Holden Lewis, CFO

Yeah.

Jake Levinson, Analyst

Okay. That’s helpful; that’s it from me today. Good luck, guys.

Dan Florness, CEO

Thank you.

Holden Lewis, CFO

Thanks.

Operator, Operator

Thank you. Our next questions come from the line of Chris Dankert with Loop Capital Markets. Please proceed with your questions.

Chris Dankert, Analyst

Hey. Good morning, guys. Thanks for taking the question.

Dan Florness, CEO

Hi.

Chris Dankert, Analyst

Holden, we have talked about this in the past. Given the high sales growth and necessary focus on sourcing alternative products and re-pricing, as some of that moderates, can we refocus more on Onsites? Is that part of the productivity improvement and the SG&A leverage we saw in the quarter?

Holden Lewis, CFO

The stability in the supply chain reduces an enormous distraction for the entire organization. If we don’t have product available in our distribution centers or are struggling to locate products, our branch and Onsite become the first point of contact for customers to find items. However, the sourcing takes longer away from pushing a button for inventory; this returning energy puts us in a position to grow the business. This lets us focus more on productivity because we don’t need to hire more staff quickly due to burdens on our time reducing.

Dan Florness, CEO

Underestimating energy diverted in the last 15 months on customer conversations about price increases instead of discussions about how to provide solutions to additional challenges would not serve us well. Normalizing discussions allows us to proactively engage with challenges instead of reacting defensively.

Chris Dankert, Analyst

Thank you both.

Dan Florness, CEO

Sure.

Operator, Operator

Thank you. Our next questions come from the line of Tommy Moll with Stephens. Please proceed with your questions.

Tommy Moll, Analyst

Good morning, and thanks for taking my questions.

Dan Florness, CEO

Good morning.

Holden Lewis, CFO

Good morning.

Tommy Moll, Analyst

We appreciate the insights from your RVPs regarding cautious comments you’ve noted. I’d like to delve deeper into how that caution applies to manufacturing end markets or if you’ve noticed different trends there versus construction and other markets tied to consumers adjusting earlier this year.

Holden Lewis, CFO

Some manufacturing elements are linked to capital spending; commodity markets are stronger than manufacturers touching consumer markets. That dynamic has persisted to some extent for the last two quarters and remained true in September. The feedback we are receiving from RVPs isn’t universal; some report strong markets, but trends show that the mindset among customers has shifted from simply working through backlogs to concerns about new orders.

Tommy Moll, Analyst

That's helpful. Thanks. On a more strategic note regarding Onsites, are we through many access issues faced during the pandemic, allowing for more conversations? Should a recession spill into the industrial economy, would that accelerate or inhibit decision-making around Onsites?

Dan Florness, CEO

If your business is in the Americas or Europe, then access is very good. In areas like Asia, particularly China, access remains very restricted. Fortunately, for us, 99% of our revenue is in regions where access is open. Historically, during busier times, decision processes tend to slow down. A slightly weaker environment could be beneficial because our Onsite model promotes a more efficient supply chain with cost advantages.

Holden Lewis, CFO

In terms of energy management, if customer interactions are more stable, predicting, planning, and implementing processes becomes easier. Conversely, dramatic economic inflections can hamper that ability. In a modest downturn, we should be better positioned to convey our offers; however, in extreme conditions, customers may struggle to focus on implementations.

Tommy Moll, Analyst

Very helpful. I appreciate your time and I will turn it back.

Dan Florness, CEO

Thanks.

Holden Lewis, CFO

Thank you.

Operator, Operator

Thank you. Our next questions come from the line of Chris Snyder with UBS. Please proceed with your questions.

Chris Snyder, Analyst

Thank you. I understand your commentary that fastener price/cost drag will narrow over the next few quarters as lower unit costs flow through the P&L. How should we factor fastener pricing into our revenue forecasts for next year? Is the expectation that pricing will remain stable or decline but perhaps not as significantly as the forecasted cost deflation?

Holden Lewis, CFO

Approximately 55% to 60% of our business is conducted through national accounts, which come with contractual terms. When raw material costs rise, we can adjust pricing accordingly, but we must also do so when costs fall. As we approach scenarios where costs are declining on products, we need to be prepared to make price adjustments for customers.

Chris Snyder, Analyst

I appreciate that clarity. Regarding your earlier commentary about cost increases flattening out in August and September, is this trend consistent across all product categories, or does it seem unique to fasteners?

Holden Lewis, CFO

There currently isn’t a significant difference between fasteners and other areas. The cost dynamics are similar across the board, but we still receive communications from suppliers asking for cost increases based on their own supply chain FIFO effects. It’s an exciting change, but we need to maintain strength before implementing any actions.

Dan Florness, CEO

Part of this stems from what initially caused the inflation. Consider fastener products: there's the raw steel cost and energy needed to convert it, which have increased and won’t decline. Human capital costs for this conversion, as well as transport costs that have softened but not returned to past levels, must also be considered. Given this, it looks like metal costs are the only ones potentially deflating; however, many cost factors remain sticky.

Chris Snyder, Analyst

I appreciate that context about fasteners. That is the foundation for my inquiry into the potential future pricing structure.

Operator, Operator

Thank you. Our next questions come from the line of Ken Newman with KeyBanc Capital Markets. Please proceed with your questions.

Ken Newman, Analyst

Hey. Good morning, guys.

Dan Florness, CEO

Good morning.

Ken Newman, Analyst

I have a follow-up question on the non-res side of the business. You've mentioned that your operational strategy has changed in this cycle. Would it be fair to assume that the gross margin price hikes you took this quarter were evenly distributed across all end markets? Is it a reasonable assessment of volumes down in non-res by 4-5% in September?

Holden Lewis, CFO

Honestly, I don't have a good answer. We haven’t broken down price/cost elements by end market, so I lack clarity on that front.

Dan Florness, CEO

However, there isn't anything indicating a major difference intuitively.

Holden Lewis, CFO

Correct.

Ken Newman, Analyst

Okay. For my follow-up, Onsite growth is solid in the quarter. As you think about past downturns and elevated uncertainty, do you evaluate the deceleration rate in the macro environment versus Onsite signings? Are you seeing changes in response to your strategic value proposition?

Dan Florness, CEO

Historically, our business would lend to steady creation through new branch openings. While we sell in cycles, having more Onsites signed provides assurance for a stronger anchor during economic fluctuations. The fact that we signed numerous Onsites in 2022 gives us confidence.

Holden Lewis, CFO

Our value proposition remains unchanged; it centers on connecting highly trained personnel close to the customer, allowing them to make impactful decisions. The tools we use are now more sophisticated, enhancing our appeal. Bringing Onsite installations, monitoring their efficiency, creates ongoing partnerships uninterruptable by economic downturns.

Ken Newman, Analyst

That's helpful; appreciate it. Thank you for your time.

Holden Lewis, CFO

Thanks.

Daniel Florness, CEO

We are nearing the end. I’ll briefly share a few final thoughts. Holden discussed Q4 and expense components that are fixed and variable. A significant portion of our expenses is now variable compared to the past 50 years. This is an area I believe greatly benefits our adaptation to market challenges.

Holden Lewis, CFO

We want to extend our gratitude for the participation and support from everyone on the call today. Thank you for your questions.

Dan Florness, CEO

Thank you, and have a great day.

Operator, Operator

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