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Fastenal: Sales And Sales Trends Cash Flow Impact Items

The following excerpt is from the company's SEC filing.

which contain a more in-depth discussion of the following:

Sales growth, monthly sales changes, sequential trends, and end market performance

– a recap of our recent sales trends and some insight into the activities with different end markets.

Operational working capital, balance sheet, and cash flow

– a recap of the operational working capital utilized in our business, and the related cash flow.

We are omitting some of the more detailed discussion points included in previous releases to focus on the most important aspects of our business in the current environment. Those aspec ts include: (1) what’s driving the weakness in sales growth, (2) how did we get such strong operating leverage (i.e., growth in operating income versus growth in net sales), and (3) what is happening within the cash flow statement as we have been buying back some of our common stock. This press release is laid out with a brief narrative, followed with several detailed components for additional background.

The most important thing to note before you read this is to remember Fastenal is several businesses within itself. A fastener distributor (about 40% of our business) and a non-fastener distributor (about 60% of our business):

FASTENER SALES

First and foremost, we are a fastener distributor. We have been in this business for almost 50 years. We are good at it. We have strong capabilities at sourcing and procurement, at quality control, at logistics, and at local customer service. Each of these capabilities is focused on the customer at the end of the supply chain. This business is split about 50% production/construction needs and about 50% maintenance needs. The former is a great business, but it can be cyclical because about 75% of our manufacturing customer base is engaged in some type of heavy manufacturing. The sale of production fasteners is also a sticky business in the short-term as it is expensive and time consuming for our customers to change their supplier relationships. While our customer base values the capabilities we bring to the table, in the last nine months this group of customers has seen a contraction in its production and therefore its need for fasteners. During this time frame, our fastener product line has seen its daily growth decrease from about 10% growth in the last six months of 2014 to about 4% contraction in the third quarter of

2015. Said another way, our market share gains continue to be strong, but the contraction from our existing customers, plus some price deflation, has eliminated our growth.

NON-FASTENER SALES

Second, we have a non-fastener maintenance and supply business. We have actively pursued this business in the last 20 to 25 years. The capabilities we developed as a fastener distributor, described above, provide a backbone to growing this ‘newer’ business. This backbone has been enhanced in the last five years with our added capabilities in industrial vending. Given our local customer service, we believe we have a structural advantage in the industrial vending business. There is more to industrial vending than the device or the financial resources to deploy; we believe the ability to replenish with a local team from an integrated supply chain network (i.e., the 'Team behind the Machine') is critical to the long-term success of this channel. Because of these capabilities, the non-fastener business remains more resilient. However, similar to our fastener business, our non-fastener business has weakened in the last nine months. During this time frame, our non-fastener product line has seen its daily sales growth decrease from about 18% growth in the last six months of 2014 to about 6% growth in the third quarter of 2015. The weak environment has hurt our business, but the 6% growth compared to our end markets and to our competitors continues to demonstrate strong market share gains.

Please read through the detailed

Sales and Sales Trends

section later in this press release for additional insight.

Our gross profit decreased from 50.8% in the third quarter of 2014 and increased from 50.3% in the second quarter of 2015 to 50.5% in the third quarter of 2015. The relationship between sales and gross profit depends on our success within our large account business (an area that is still under-represented in our customer mix). The large account end market produces a below ‘company average’ gross profit; however, as demonstrated in recent quarters, it leverages our existing network of capabilities and allows us to enjoy strong incremental operating income growth. Given the sequential weakness with our largest customers, we saw a sequential improvement in our gross profit. Our gross profit is also impacted by supplier incentives. With weaker net sales growth and our tight management of inventory levels, the growth of spending with our suppliers is lower; hence, our supplier incentives are reduced.

In regards to operating expenses, we added 1,554 people to the Fastenal organization in the last twelve months (about 83% of these people were added to a store or some other type of selling location), and a large majority of these additions came in the last nine months. This provided a meaningful increase in our capacity. However, we needed to fund this increased capacity. We did this by (1) reducing our total operating and administrative expenses outside of payroll related costs, and (2) managing our hours worked in a very focused site by site fashion (our headcount grew by 8.4% in the last twelve months, but our average full-time equivalent headcount only grew by 4.6%). These two items allowed us to invest in store personnel and fund that investment in a weak economic environment. To assist in your read of this release, here is a quick recap of our full-time equivalent headcount to supplement the information on page one of this press release:

Change Since:

Average full-time equivalent store employee count

10,715

10,376

11,269

Average full-time equivalent employee count

15,866

15,512

16,594

Note – Full-time equivalent is based on 40 hours per week.

We touched on our industrial vending earlier, but here is a quick recap: During the third quarter of 2015, we signed 4,689 devices (we signed 5,144 devices in the second quarter of 2015 and we signed 4,072 devices during the third quarter of 2014), our installed device count on September 30, 2015 was 53,547 (an increase of 17.4% over September 30, 2014), the percent of total net sales to customers with industrial vending was 42.1%, and our daily sales to customers with industrial vending grew 4.8% over the third quarter of 2014.

Finally, some thoughts on capital allocation: During the latter half of 2014 and the first nine months of 2015, we have been modifying our capital allocation by buying back some stock. This is in response to several factors. The first centers on our external valuation. Our relative stock valuation has weakened over the last several years, which prompted us to reassess our cash deployment. To this end, we have spent approximately $318 million buying back stock in the last five quarters and have repurchased approximately 2.6% of our outstanding shares from the start of this time frame. We are mindful of our shareholders’ expectations relative to our dividend paying history and have primarily funded this buyback with debt. Over the last three to four years, we had dramatically increased our capital expenditures, relative to our net earnings, for the rapid deployment of distribution automation and industrial vending. These investments will continue in the future; however, we expect capital expenditures, relative to our net earnings, will moderate and will allow us to continue to fund our cash needs for

our day-to-day business primarily from continuing operations. Please read through the detailed

Cash Flow Impact Items

section, and the Condensed Consolidated Statements of Cash Flows later in this press release for additional insight.

SALES AND SALES TRENDS

While reading these items, it is helpful to appreciate several aspects of our marketplace: (1) it's big, the North American marketplace for industrial supplies is estimated to be in excess of $160 billion per year (and we have expanded beyond North America), (2) no company has a significant portion of this market, (3) many of the products we sell are individually inexpensive, (4) when our customer needs something quickly or unexpectedly our local store is a quick source, (5) the cost and time to manage and procure these products is meaningful, (6) the cost to move these products, many of which are bulky, can be significant, (7) many customers would prefer to reduce their number of suppliers to simplify their business, and (8) many customers would prefer to utilize various technologies to improve availability and reduce waste.

Our motto is

Growth through Customer Service

. This is important given the points noted above. We believe in efficient markets – to us, this means we can grow our market share if we provide the greatest value to our customers. We believe our ability to grow is amplified if we can service our customers at the closest economic point of contact. For us, this 'closest economic point of contact' is the local store; therefore, our focus centers on understanding our customers' day, their opportunities, and their obstacles.

The concept of growth is simple

find more customers every day and increase our activity with them. However, execution is hard work. First, we recruit service minded individuals to support our customers and their business. Second, we operate in a decentralized fashion to help identify the greatest value for our customers. Third, we have a great team behind the store to operate efficiently and to help identify new business solutions. Fourth, we do these things every day. Finally, we strive to generate strong profits; these profits produce the cash flow necessary to fund the growth and to support the needs of our customers.

SALES GROWTH

Note – Daily sales are defined as the total net sales for the period divided by the number of business days (in the United States) in the period.

Net sales and growth rates in net sales were as follows:

Nine-month Period

Three-month...


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