Fastenal has one of America’s best corporate cultures (Morningstar 2006 CEO of the Year), high but not immediately obvious customer captivity, a very large growth runway, and the industry category-killer business model. A recent inflection point in the company’s development means EPS should grow at least 330% in 5 years (’06-’11), which should double the stock price within 3 years, all with very low risk. Misunderstood by investors who don’t understand the business model, this stock carries an 8.8% short interest ratio.
Company and industry overview
The company is alone among the large public industrial parts distributors in using a direct sales model (sales people visit the customer at their work site and personally deliver the same day), which is superior and hard to copy by normal competitors without outstanding cultures/managements. The direct model most closely matches customer needs, which are:
1) Have item in-stock for immediate delivery
2) Save customer time
Worth reviewing three industry success factors, to know why Fastenal has been so successful
Industry Factor#1, Price rarely if ever factors into MRO spend. A missing bolt that shuts down a job site is extremely expensive, therefore having an item there on time is critical. Over and over I heard from customers that price is not an issue because of the “total cost of ownership.” These small items don’t get price shopped and fall below the corporate cost-cutting radar screen, which makes for a good industry to be in. That said, my price checks show Fastenal price competitive on almost all items, which means customers get better service at the same price. Fastenal’s ability to hand deliver most parts within minutes/hours is a competitive advantage and the national distribution capability means almost everything else is available next day.
Industry Factor#2, Time/Convenience: Customers would rather not spend 2 hours driving to the local hardware store to spend $50 of the company’s money, and for little or no cost savings. Plus, many specialised parts are not stocked at the local Home Depot.
Industry Factor#3, Personal relationships: Hard to overemphasise the power of personal relationships in this business. Seeing the same rep every week (or more) is much more powerful than ordering from a catalog out of a centralised call center. Quantitatively, this is shown in the store ageing analysis in the 10-K, which shows a very strong relationship between store age and store revenue. Skeptics will say this is due to best stores being opened first, but I have worked on the inside of an industrial distributor and I saw the sales analysis by reps, and there was a very clear correlation between rep tenure and revenue.
Inflection point reached:
Up until this month, the prior strategy had been to blanket the market with stores (currently over 2,000), which sales reps use as a home base and a place to pick up product. Maybe 25% of sales are done via a customer store visit, so physical store fronts were never the key for success. Management thinks overall store penetration is high enough, and adding new stores at a high teens growth (the historical rate) is no longer the best driver of returns. So, instead, outside sales reps will be added to existing branches to fill in each branch (going from 2/3 sales persons per branch to 3/4/5). This leverages fixed costs and drives up margins. Sales reps are the driver of revenue, not the number of physical locations. Given the very fragmented state of the market, best-in-class business model, and management’s prior record, I see success as nearly a given.
Management’s stated targets (Given at April 24 Investor Conference)
Sales per store/mo.
Note: In 2011 Fastenal will have ~5% of the addressable ($66B) MRO market in which it competes (Fastenal doesn’t sell all MRO items, which in total might reach $200B). I assume growth will continue apace as it always has, which means a ~25x forward multiple is appropriate and a $100 stock price for 2010 (33% compound annual return)
Store returns by size (shows that higher sales per store drives returns)
# of stores
Source: April 24 Investor Presentation
Also, incremental upside in margins will be driven by:
1) Technology – rolling out hand scanners to sales reps by end of the year. Should save ~1 hour a day
2) Increased China sourcing (called Shanghai trading company)
Other Industry players w/ different business models:
Grainer operates a catalog/call center/pick up window at local stores.
MSC – known for having everything in a catalog, ready for next-day delivery via the post. Good competitor, but as Fastenal increases the SKU count they offer next day, via their better distribution system, I see FAST creeping into their space.
Mom-n-pops: Over 50% of the market.
Barriers to entry: The obvious question is whether a competitor could just copy the model. Besides customer captivity, I think perhaps FAST has the best company culture I have run across. It’s important to note that FAST competitors are mom-n-pops, which control well over half the remaining market (estimated $66B market size, or which FAST only has 3%), and the other public companies have small single digit percentages of the market. So, I see the risk in execution and not so much in what other competitors do.
Business model success factors: Cost is a major factor. Fastenal stores are located in out-of-the-way places, unlike Grainger for instance, which leads to lower costs. The company culture is maniacal about saving costs (e.g. while traveling, managers must sleep 2x to a room).
Management team recently given a large block of options struck at $45. CEO received 250K options vs. a total comp of $791K. For the last three years, no options were given directly by the company to top officers. Management can make many times their salary + bonus through the options, and this is the first time they have these option.
No debt on balance sheet
Very strong same-store sales growth shows power of model – usually over 10%/yr and in recessions barely breaks negative. Interesting that during most recent quarter, price was only 1-2% of the growth.