Fastenal Company (NASDAQ:FAST) Q4 2022 Earnings Call Transcript

Fastenal Company (NASDAQ:FAST) Q4 2022 Earnings Call Transcript January 19, 2023

Operator: 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.

Taylor Ranta: 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, investor.fastenal.com.

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 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: Thank you, and good morning, everybody, and welcome to our fourth quarter earnings call, and Happy New Year. If you — some highlights on the quarter. I’m on Page 3 of the flip — of flipbook. So 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. So we’re looking at our cash conversion, it returned to historic levels. And that’s really a sign of moderation and the level of inflation that we’re seeing in the marketplace. But also a more stable supply chain and the ability to not need — that for a double negative, not need to expand our stocking levels to ensure a reliable supply line for our customers.

So it gives us some flexibility as we go into 2023. Very pleased to see that. 2022 was a year of milestones and they all centered on $1 billion. So in October, our e-commerce revenues surpassed $1 billion for the first time ever. Our — and that’s on an annual looking at annual milestone. Our international sales exceeded $1 billion. We hit that milestone in the month of November. And as noted in the release this morning, our company-wide net earnings topped $1 billion for the first time ever and that was for calendar 2022. When I look at that chart on the upper left, it’s hard to decide where do you start explaining all the the noise you have really over the last 3 years, as we went through COVID, as we emerged from Covius, as we went through supply chain disruptions and inflationary period.

So I chose to not and just compare to 2019 from the standpoint of what was our cumulative sales growth in each of the quarters of this year because I think it tells a more stable story and talks about the things that we’ve built. So 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, expanded to about 31% in the third quarter and in the fourth quarter, we’re about 35% larger than we were in the fourth quarter of 2019. Now you shouldn’t conclude from that, that, Geez, that expanded 7 points from Q1 to Q4. Because in all — in full disclosure, 2019 was weakening a bit as we went through the year. I would see this as ignoring COVID, ignoring supply chain, ignoring inflation, we’re 30% bigger than we were 3 years ago, and I think that’s a testament to the business model and to the team executing the model and the marketplace, recognizing Fastenal for what it is, a great supply chain partner to their business.

If — and I’m pleased to say, I think we’re exiting the pandemic stronger than we entered. The — 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’s going on there, and we knew what was coming. The safety, I would say the same thing, it’s challenging like anything is challenging, but we knew what to expect there. And I think on these first 2 buckets of fasteners and safety, we understood it, and we managed through it quite well. The remaining clients, a lot of those products, aren’t as prevalent in the recurring pattern, the planned spend component of our business, whether it be through the vending portion of FMI or the BIN or the FASTStock portion of FMI.

And so it takes different tools and different means to manage that. And we had some challenges there. And again, Holden will touch on a little bit more later in the call. When I look at the final piece and the reason we were able to maintain a stable operating margin, we’ve done a really nice job with headcount. We did add a few more people in the fourth quarter than I would have liked to have seen. I suspect some of it is after a period of being really difficult hiring and as it eased throughout the year, there are some spots that we needed to fill, that were filled. But I look at it in totality for the year. We’ve really done a nice job. And I’ll touch on it a few more — a little bit more in a few minutes, but we’ve done a nice job in the last 3 years as well.

Flipping to Page 4 of the foot book, the — Onsite, we had 62 signings in the fourth quarter and finished with 1,623 active sites, so up about 15% from a year ago. The — if you ignore the sales at transfer over when we opened an Onsite, where it’s an existing customer, we grew our Onsite-based revenue in the high teens and reiterate our goal for 2023, our intention is to sign 375 to 400 Onsites next year. And I’m pleased to see, for us, we often talk about participation inside the organization. Just over 80% of our district managers signed an Onsite back in 2019, and when society closed up and folks weren’t as excited about us moving in to stay with them during the day, our — that participation dropped dramatically as our Onsite dropped in both 2020 and 2021.

And I’m pleased to say in 2022, 80% of our district managers signed at least 1 Onsite. Now would I prefer to see that go to 85% or 90%? Sure, I would. But 80% is a nice threshold to get above again because we have done it once before, and that was in 2019. So my congratulations to the team. FMI Technology. We signed 4,730 weighted devices in the fourth quarter, that’s 76 per day. A year ago, we were signing 64 per day. And the activity through our FMI Technology platform represented almost 39% of sales in the fourth quarter. That was 35% a year ago and 27% 2 years ago. For 2023, our goal is to sign between 23,000 and 25,000 MEU devices, whether it be FASTBin or FASTVend. E-commerce, the next piece of our, what we call, digital footprint, daily sales rose 48% in the fourth quarter.

Again, incredible traction in that area. We’ve really seen that traction move in the last 3 years, partly a function of COVID, and I think a lot of people are seeing those kinds of patterns, but also — we’ve gotten better as an organization and our ability to execute on e-commerce, and that’s times through the numbers as well. So EDI and punched out catalogs and really large customer-oriented e-commerce was up 45% and our web sales was up almost 60%. Looking at our digital footprint. So that’s looking at FMI plus the piece of e-commerce that doesn’t come from FMI was 52.6% of sales in the fourth quarter, and that was 46.5% a year ago. Our goal is 65% of net sales going through our digital footprint next year. In the interest of full disclosure, that’s an aggressive goal, but it’s our goal nonetheless.

If I flip into Page 5, we put this table in the release last January as well. And it’s really intended to show over time what’s really happening to our network. And that is, as FMI becomes a bigger piece of our business, as our mix of customers changes, as e-commerce becomes a bigger piece, you rationalize your footprint because you need for a footprint change. So you can see in 2013, we peaked out, and I’m going to start at the bottom of this set of bullets and work my way up. So in 2013, looking at our data, we had a 30-minute access to about 95% of the U.S. manufacturing base. And this is just looking at the U.S. branch network because the Canada follows a similar trend as far as what you’ve seen in the number of branches, whereas the rest of the planet are continuing to open locations because we’re quite young there.

Looking at the 1,450, which we think is the ultimate number we get to for branch count, the — in the U.S. and Canada, the U.S. piece of that where we have really good data, we think that 95% drops to about 93.5%, which we think is incredible coverage and puts us in a great position to be a great local supply chain partner and still have a really efficient network. And you’re seeing that in our operating expenses over the last few years. If you look at our headcount numbers — and I touched on it earlier, and I thought I’d share a different view rather than the year-over-year view you have on Page 5 of the earnings release. And that is, again, a 3-year view of what’s happening. So our in-market locations from an absolute basis since 2019, our headcount is down about 567 people in the branch and Onsite network, which is about a 4% drop.

And again, things like FMI and rationalizing locations have really allowed us to leverage that. However, our sales headcount is up because every headcount we’ve reduced has moved into some type of sales role supporting the branch and Onsite network. So I’m pleased to say we were able to realign our resources in that time frame and really be a better growth-driving organization for the long term that aligns with our strategy of a branch and Onsite network. The other thing that should stand out is a year ago, we had 377 more branches relative to Onsite. So we had 1,416 Onsites. We had 1,793. So 377 delta between the 2. At the end of 2022, that delta has contracted to 60. So we have 1,623 OnSites. We have 1,683 branches. I don’t know what quarter that flips.

But it won’t be too much — too far into our future that we’ll actually have more Onsites than branches which has been very much a planned thing within our business over time. Again, the FMI digital footprint helped us leverage our headcount and our rationalization of branches. The other piece that’s an important and growing component, we’ve talked about our LIFT initiative, and we ended the year with just over 17,000 of our vending machines being resupplied out of our LIFT facility, which really allows us to operate more efficiently, ultimately allows us to rationalize some working capital, and our sales team can focus on selling more than managing some of the back-office items in a branch. The final thing, if you look at our headcount over the 3-year period is we’ve been able to really rationalize our support labor.

So we have added folks in the distribution because of LIFT. However, in the — if I look at DC and manufacturing, we’re up 98 people in the last 3 years. So again, that team has done an incredible job of managing their headcount. And if I look at our support areas in general, 51% of our headcount increase in the last 3 years has been focus going into IT. That’s how we’re able to do things like FMI, how we’re able to do things like LIFT and build the technology to support it. 35% has gone into either a growth driver or into our international team or supporting our sales team and 14% has gone into all other categories combined in the last 3 years. I think that’s an organization that dramatically improved itself in the last 3 years as we prepared for the future.

One last item — when you see our release in February, I usually don’t get ahead of myself on what’s going to be in a future release. One thing to note is in 2022, our team in India added approximately 50 interns, and we ended up hiring 54 of them because a number of those interns told their friends about Fastenal, and they joined the Blue team and they added to our IT group. We saw such great success with that. It’s a very efficient way to add folks. Here in early January, we added 96 — or 98, 1 of the 2. So you’re going to see the number grow by about 100 in the month of January in our support infrastructure. Don’t conclude from that Fastenal is not managing its headcount. Conclude from that Fastenal is investing in resources to support its technology side.

With that, I’ll turn it over to Holden.

Holden Lewis: Great. Thanks, Dan. Starting on Slide 6. Total and daily sales increased 10.7% in the fourth quarter of 2022, which included an up 8% reading in December and represented further deceleration from prior quarters. We attribute this deceleration to slower industrial production, which shouldn’t surprise anyone that tracks the purchasing manager index and more difficult growth and pricing comparisons. But even so, significant elements of our business continue to perform well. For instance, manufacturing, which was roughly 73% of our sales in the fourth quarter of 2022, grew 16% and slightly exceeded normal quarterly sequentials. In addition, our largest customers, as reflected by our national accounts program and which approximated 59% of our sales in the fourth quarter of 2022, grew 15%.

We believe continued healthy performance in these areas reflect our investments in Onsite and changes to our branch structure and sales roles. Feedback from our regional leadership on the outlook entering 2023 remain constructive and largely unchanged from the third quarter of 2022. There are a few areas where we have seen incremental weakness, however. For instance, a handful of our large retailer customers tightened their belts regarding facilities and labor and our non-North American sales softened on a strong dollar and geopolitical events. Now we’ve made significant investments and seeing enormous growth in these areas over the last few years and the current weakness in our view relates to market-specific factors. Construction revenues were also softer, which reflects the conscious decision we have made to position our branches to focus on larger key accounts, which is contributing to better labor leverage.

These 3 areas, large retailers, non-North American markets and construction together, represent more than 15% of sales and went from double-digit growth as recently as the first quarter of 2022 to declining in each case by the fourth quarter of 2022. As always, we have limited visibility as it relates to future demand. However, we do believe that our sales initiatives continue to gain momentum and expect good outgrowth in 2023. Now to Slide 7. Operating margin in the fourth quarter of 2022 was 19.6%, flat from the prior year. We continue to manage operating expenses effectively, producing 120 basis points of SG&A leverage in the fourth quarter of 2022. Occupancy costs are being restrained from strategic branch closures, while initiatives such as digital footprint, LIFT and the changes we’ve made to our brand strategies are contributing to improved labor leverage, which accelerated in 2022.

As Dan indicated in his opening remarks, we were a bit more aggressive with headcount adds that might be prudent given the cloudy manufacturing outlook heading into 2023. However, we think that can adjust quickly, and it is likely annual FTE growth peaked in December or will peak in January before decelerating through the first half of 2023. Although the ultimate level of growth in the marketplace will have it say, we do believe that we can continue to leverage operating expenses in future periods. SG&A leverage was offset by a matching 120 basis points decline in gross margin, which was greater than anticipated. Certain factors were familiar. The drag related to product and customer mix widened as non-fastener growth began outpacing fastener growth, which was expected.

The price cost drag widened slightly, which is a little more than expected, reflecting some improvement on the fastener side but incremental challenges in other products offsetting this. In fact, we experienced broader product margin pressure in our non-fastener and non-safety products. These categories tend to have a less centralized supply chain and the spend tends to be more unplanned, which when combined with slower demand and a better stock marketplace resulted in broader discounting. We believe this relates more to our actions than the state of the market and have plans to address it in the first quarter of 2023. On the positive side of the margin ledger, we continue to have healthy freight revenues and narrower losses related to maintaining our captive fleets.

We had a higher tax rate, reflecting the absence of certain favorable reserve adjustments that benefited the fourth quarter of 2021 than higher nondeductible payroll and state income tax expenses in the fourth quarter of 2022. Our fully diluted share count was also down 0.8% from share buybacks for the last 2 quarters. Putting it all together, we reported fourth quarter 2022 EPS of $0.43, up 7.1% from $0.40 in the fourth quarter of 2021. Now turning to Slide 8. We generated $302 million in operating cash in the fourth quarter of 2022 or approximately 123% of net income in the period. This reflects a typical fourth quarter conversion rate in contrast with the preceding 5 quarters where our conversion rates lagged. This is due to comparisons in the second half of 2021, we began to finance significantly more working capital to navigate supply chain constraints and inflation.

We do not expect to have to make a similar incremental investment in 2023, which should produce better cash flow. Year-over-year, accounts receivable was up 12.6% on higher customer demand and an increase in the mix of larger key account customers, which tend to have longer terms. Inventories rose 12.1%. The supply chain has largely normalized. Inflation is moderating. And our fulfillment rates are at healthy levels, which is causing our inventory growth to align more closely with growth than was true earlier in the year. Our days on hand was 161.5, more than 4 days better than the fourth quarter of 2021 and more than 13 days below the fourth quarter of 2019 despite the challenges in the last 18 months. We continue to identify sustainable efficiencies in how we manage our inventories.

Net capital spending in 2022 was $162.4 million, a bit below the $170 million to $190 million anticipated at the end of the third quarter, mostly related to project and equipment deferrals. Those deferrals, combined with higher spending on hub investments, fleet equipment and IT equipment, resulted in an anticipated net capital spending range for 2023 of $210 million to $230 million. We finished the fourth quarter of 2022 with debt at 14.9% of total capital, up from 11.4% in the fourth quarter of 2021 and unchanged at 14.9% in the third quarter of 2022. Though we had strong cash generation in the fourth quarter of 2022, we were also, again, more aggressive in returning cash to shareholders in the form of $177 million in dividends and $93 million in share buyback.

Last night, we announced an increase in our quarterly dividend from $0.31 in the first quarter of 2021 to — I’m sorry, of 2022 to $0.35 in the first quarter of 2023. Now before the questions, one quick note. This week, we released our inaugural ESG report, which is accessible through the ESG link found at the bottom of fastenal.com. This report highlights the strong alignment of FAST culture and mission with the environmental and human capital objectives of our stakeholders. I want to congratulate and thank the community of Blue Team members that work to pull this outstanding piece together. And with that, operator, we’ll turn it over to Q&A.

Dan Florness: Before we start Q&A, my adder to the Holden’s comment on the ESG report, I encourage to focus on this call to read it. Don’t wait for the movie. It’s a — I think it’s a well-written story in the context of how Fastenal tell its story about how our business and our team have addressed this topic really throughout our history, but communicated in a way that is conscious of the formatting in the structure that society has grown more accustomed to. The other piece that I wanted to highlight is another announcement went out last night, which was, we announced that our international team has surpassed $1 billion in revenue for the first time during 2022. My congratulations to everybody listening to this call as part of our international team that spans the Americas, Europe and Asia.

And to our team in China, where — your society has opened a bunch more in recent months, recent weeks, I would like to wish you a Happy Chinese New Year. I believe it’s the year of the rabbit. And I hope you since I — sincerely hope you have a nice opportunity to visit with family as the socities opened up a little bit more. With that, we open the Q&A.

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Q&A Session

Operator: Our first questions come from the line of Ryan Merkel with William Blair.

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

Holden Lewis : Yes. Well, from a mix standpoint, 30 to 50 is probably a low number now versus where it was in the past, primarily because our strategies have changed, right? I mean we have shifted towards really prioritizing key and larger accounts. Now that might be a larger regional account at a branch level. It might be national accounts. But I mean we’ve shifted our strategy to prioritize those, as you know. And so I think that you’ve probably seen a bit of a widening in the expected mix impact from gross margin. Again, there’s nothing that’s surprising about that. And I would again point you to the improved labor leverage that we’ve been seeing in the last few years has been the flip side of those decisions, right? So that’s deliberate.

So I wouldn’t be surprised if the type of leverage that we’re looking at from a mix standpoint is more in the 50 to 70 basis points range. But again, as I said, I think that’s expected. And I think that it’s offset by the labor leverage that we get from the and strategy. And I think that we’re product — where mix is concerned, you have to balance both what’s happening at the gross margin with the offsetting impact on operating margin.

Ryan Merkel: Right. Got it. Okay. And then next, moving to incremental margins, your kind of exit 4Q at about 20%. Is this a level you think you can achieve in ’23 on mid-single-digit sales growth? It sounds like FTEs will be down. You’ll have the incentive comp that’s down. Anything you can add there would be helpful.

Holden Lewis : Yes. I think that you’re hitting on important elements from an OpEx standpoint, and we do continue to expect good leverage there, right? And I think we’ve seen on the labor side, wage inflation has moderated a bit. You’re right, incentive pay. Look, I’d love to be paying greater levels of incentive pay. But if the market slows down, that wouldn’t happen. So you wouldn’t see that kind of growth there. And I think we’ll continue to control headcount and the mix will shift as well, where a lot of the headcount that we add will be part time as we rebuild those ranks or — so the mix will shift that way. So I think that there’s still good opportunity to leverage labor in 2023. And I think the same for occupancy. End of day, the question though, is what’s going to happen on gross margin.

And if we can limit the decline in gross margin to our mix, I expect that we’ll be able to grow our operating margin year-over-year, which would get you more than that 20% incrementals and would get you, I think, solid into the 2025. I think the question, and I’m sure there’ll be additional questions coming up, but I don’t want to just leave this hanging out there, ultimately, is how do you think we execute some of the pressure that we’ve seen in the other product side and any level of deflation that may occur down the road if it occurs? And I think those are variables that are harder to sort of judge. And I think get down to whether or not you believe that we’re going to execute effectively on some of the things that we cited that pressured the gross margin this quarter.