Fastenal can preserve its winning streak

Management at Fastenal (US:FAST) seem like the sort who enjoy the competitive nature of business. Not only does chief executive Dan Florness refer to the company’s 22,000-plus employees as the 'Blue Team' (the colour is a feature of Fastenal's branding), but the distributor of industrial consumables also recently extended a long-term partnership deal with North America’s National Hockey League.

Fastenal, as its name suggests, started life providing fasteners – nails, screws, nuts and bolts, etc – to customers. These still represent around a third of its business but it now sells a much broader range of consumables and offers reams of data to clients who use them. It can warn when certain stocks are running low, for instance, or limit (through the use of code-operated vending machines) the number able to be distributed to a given workplace.

It is still a thoroughly North American business: although it operates in 26 countries, less than 5 per cent of its sites are outside its three main markets of the US, Canada and Mexico. And in the past couple of years it has scored some big wins as manufacturers scrambled to secure the components needed to keep production lines moving.

First it was safety equipment during the early stages of the pandemic, then it was everything else. The company was able to fund big increases in its own inventory because of what Florness recently described as a “pristine balance sheet”. The fact that it has its own manufacturing facilities (which make around 4 per cent of the items it sells) to produce hard-to-source or custom parts has also helped.

Sales and operating profit have grown at a healthy compound annual rate of 10 per cent over the past five years, although its operating cash flow conversion ratio has fallen below its ideal rate of over 100 per cent in three of the last seven years. On two occasions – 2018 and 2022 – Florness attributed this to the need for extra working capital to fund growth, which he has said was “a good problem” to have.

The fact that this cash outflow is now reversing, therefore, is both a plus and a minus. Clearly, the conversion of 121 per cent of net earnings into cash in the first nine months of this year – the highest level in a decade – is a benefit. It has allowed Fastenal to cut net debt to $242mn (£195mn), or just 7 per cent of total equity at the end of September. This compares to 18 per cent at the end of last year. That has been achieved by the company gradually managing down the excess stock it had built up.

However, one reason why it no longer requires an additional buffer is that the market is softening. Its daily sales growth slowed to 4 per cent in the third quarter, down from 16 per cent in the same period 12 months ago. Pricing is also under pressure, given slowing demand. Activity in the US manufacturing sector was flat in October, ending five previous months of decline, according to S&P Global. Backlogs of work for manufacturers – who make up over 70 per cent of Fastenal’s customer base – contracted for the 13th month in succession.

In that context, Fastenal has held up well. Its third-quarter operating margin of 21 per cent was largely flat year on year, as it grew the number of onsite locations it operates within customers’ premises.

The big question for investors is where it goes from here? Analysts are split about its prospects, with the company currently attracting more sell ratings than buy, according to FactSet. This isn’t because it’s suddenly hit a losing streak, though – more that as a favourite it has become too heavily backed.

For instance, William Blair analyst Ryan Merkel thinks that long term EPS accretion of 12-13 per cent is perfectly achievable but only has a ‘sector perform’ rating on the company’s shares given that they trade off a price/earnings ratio of 28 – in line with their five-year average but almost double that of peers. Even when factoring in a US premium, this looks steep given end-market shakiness. So while this is a quality company worth keeping an eye on, a better entry point may emerge in the future.