While I liked short-cycle recovery plays earlier this year (and names like Parker Hannifin (PH) did pretty well), in recent months I’ve been getting more concerned that valuations were starting to overshoot the likely path of the recovery, setting the stage for potential disappointments and re-ratings. Fastenal’s (FAST) basically inline quarter and negative market reaction isn’t enough to claim “vindication” on that call, but with both Fastenal and Yaskawa (OTCPK:YASKY) seeing inconsistent recovery trends and large banks seeing soft C&I loan demand, I am concerned that shorter-cycle names could re-rate through the rest of the year.
Valuation is never an easy discussion with Fastenal, as a premier share-gaining company is worth a premium. So, I’m not surprised that the shares trade above a DCF-based fair value, though the implied long-term returns are worrisomely low. Looking at the typical premium Fastenal has enjoyed over the past three years, you can argue for a 17.5x multiple on forward EBITDA, but that only gets you to a fair value around $43.
When Inline Is Vaguely Disappointing
Fastenal didn’t have a bad third quarter, but I believe the Street needed beat-and-raise to support the momentum and they didn’t get that. Revenue was basically in line with expectations, and margins too were basically on target.
Revenue rose more than 2% in the quarter, with fastener sales down 7% and “non-fastener” sales split between still-hot performance in safety (up 34% yoy, though down 35% qoq) and weaker results in “other (down 2%). Core manufacturing sales were still weak, down 5% from the prior year, but up from the 9% decline in the second quarter and with improvement throughout the quarter (down a bit less than 4% in the month of September). Heavy equipment sales improved to down 7% (from down around 15%), while construction sales worsened to down 11.5% (versus down 10%) as projects complete without new projects in the pipeline.
Gross margin declined about two points in the quarter, missing the sell-side average by about 60bp but coming basically inline with my expectation. On the other hand, operating income was up 3% and operating margin barely budged (up 10bp), which was a modest disappointment relative to my expectations but a little better than the Street.
Net net, Fastenal did pretty much as expected, and I suppose that’s disappointing to investors who needed to see more evidence of a robust underlying recovery in manufacturing and construction. Given that non-residential construction has been such a workhorse sector for many multi-industrials, this is definitely an area to watch; activity held up better than expected in the first half, but I’ve been worried about the ramifications of a shrinking project funnel on 2021-2022 numbers.
As far as manufacturing goes, this is pretty much what I expected, as there are some sectors starting to perk up (like autos), but still plenty that are well below year-ago levels. This was also reflected in Yaskawa’s earnings report (Yaskawa is a manufacturer of servos, inverters, drives, and robots), with patchy performance below an overall “gradual trend of improvement”.
Multiple Long-Term Drivers In Place
While the next couple of quarters could be more volatile than investors prefer, I see nothing wrong with the basic model here, and I continue to see multiple opportunities for Fastenal to expand its share of the industrial distribution space.
Fastenal remains a leader in vending and vendor-managed inventory, with both vending units (up 7%) and OnSite locations (up 15%) growing at a very healthy pace relative to the challenges created by COVID-19. While these offerings do create some margin headwinds, there are compensating factors, including less capex needed to support physical store locations and better working capital management, as the company has better visibility into sell-through and actual inventory needs. To that end, while gross margin has been steadily falling, FCF margins have been improving (from the mid-single-digits to the low double-digits).
Gross margin likely isn’t coming back, but increased private label product sales can help partially offset the impact, and Fastenal is still below Grainger (GWW) and MSC (MSM) on this metric, with a low-to-mid teens percentage of sales coming from private labels. With a lot of opportunities to expand into areas like tools, I still see meaningful growth potential there. I’d also note that customized fasteners are an underappreciated opportunity for Fastenal over the longer term.
Logistics also still offer some incremental margin upside. I mentioned this a while back, but Fastenal owns its distribution/logistics assets and has been looking to lease capacity to vendors/suppliers, customers, and unrelated third parties as a way of essentially monetizing deadhead miles (time when the trucks have to run empty).
I expect to see some improving performance in industrial end-markets like autos and factory automation as the year comes to close, and I’m still cautiously bullish on some areas within heavy machinery (like agriculture and mining). I’m not as bullish on non-resi construction, and this is where I see the biggest risk to Fastenal versus expectations, as a notable slowdown in non-resi for 2021-2022 is not yet the consensus view.
With a quarter that was in line with my expectations, there’s not much to do on the modeling side apart from fine-tuning. I’m still looking for long-term revenue growth around 6% and mid-teens FCF margins, both of which support a 9% to 10% long-term FCF growth rate. None of that really matters, though, as the shares trade quite expensive on discounted cash flow.
The valuation is more mixed on a returns/margin-driven EV/EBITDA basis. Fastenal trades well above where a normal industrial with similar margins and returns would, but factoring in a “quality premium” consistent with what’s been in place the last three or so years would push the prospective EBITDA multiple to around 17.5x, supporting a fair value around $43.
The Bottom Line
I continue to believe that Fastenal shares are too richly-valued, and now I’m a little more concerned that the short-cycle recovery momentum that has support the shares since March is more at risk if this recovery doesn’t accelerate quickly. In quality terms, I have no concerns about Fastenal, but with a valuation well above norms, the market won’t be so merciful if expectations have to come down for the sector.
Disclosure: I am/we are long MSM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.