Strong business model, but little margin of safety

The company’s solid business model and dividend growth stand out, but its high valuation limits short-term profits and margin of safety

Author: Kenio Fontes

Abstract

• Fastenal’s on-site business model drives operational efficiency and revenue growth, positioning it as a key player in industrial distribution.
• High stock valuation multiples limit near-term growth as cyclical pressures and economic uncertainty weigh on earnings growth potential.
• While Fastenal has a strong dividend track record, its higher price reduces its margin of safety, impacting future returns for investors.

Generally speaking, when investing in stocks, we look for companies with strong brand power, differentiation and significant barriers to entry. This is not the case with Fastenal Co. (FAST, Financial). Since the company operates in the industrial goods distribution sector, there is little differentiation and the barrier to entry is low.

However, the company makes up for this with the very effective implementation of its business model, offering diversified solutions, warehousing solutions and has a large distribution network that guarantees it a secure moat.

As a result, Fastenal has an enviable track record of gradually improving its financial performance and, in turn, its shareholder value distribution.

Even though this is a very solid and attractive company, there are two main risks that need to be monitored. First, the cyclical nature of the market. Secondly, its valuation, which is only “reasonable” in the base case scenario.

Strategic evolution ensures continued growth and operational efficiency

Fastenal is a distributor of a wide range of industrial and construction products, including safety materials, screws and other tools and equipment. It also helps its clients with inventory management, cost reduction, and more.

One interesting strategy that Fastenal has been developing in recent years is participation in on-site events through initiatives such as FastBin and FastVEnd. This practice turns out to be good for both parties. For Fastenal, it develops and builds customer loyalty (improving relationships), increases operational efficiency through automated sales and better logistics, and makes revenues more recurring. On the client’s side, it optimizes inventory costs, facilitates and streamlines management, and provides quick access to needed materials.

In recent years, the company has reduced the number of branches and expanded stationary locations. In 2014, the company had 214 brick-and-mortar locations and on-site revenues were $387.70 million, accounting for nearly 10% of total net revenues. In 2023, the number of stationary locations increased to 1,822 (in the second quarter 1,934), which represented approximately 40% of revenues.

It should be remembered that such a business model combined with good implementation translates into good financial results of the company. Even in cyclical industries, good management has allowed for steady growth in net revenues as well as evolution of net margins. If we focus only on the last few quarters, we can observe a slightly slower growth rate and greater difficulties in achieving margins. Management mentioned that customer sentiment remained challenging, along with other data such as the U.S. Purchasing Managers’ Index, which was 48.80 in the second quarter, but this was partially mitigated by improved customer acquisition and contract growth.

Thus, even with a greater representation of on-site operations, the challenging scenario, combined with other factors such as short-term inefficiencies in the supply chain, resulted in gross margin declining by 0.40 percentage points year-on-year to 45.10%, while revenue margin declined from 21% to 20.20%, which was influenced by the increase in sales costs and general administrative costs. Nevertheless, Fastenal emphasized that it remains cautious and intends to keep costs low in the third quarter.

From a long-term perspective, this slightly more difficult moment is almost invisible, especially if we focus on the dividend per share, which is growing gradually and consistently, and at the same time very well supported by the growth of earnings per share. On the other hand, some stagnation is already visible due to the factors listed in diluted earnings per share.

Overall, these profits are converted into cash generation, which consequently maintains a good return for shareholders, both in terms of dividend growth and possible buybacks. Keep in mind that there is not much capital expenditure required relative to the amount of cash generated, which also makes distribution to shareholders healthier and more predictable.

Finally, the capital structure is quite comfortable. In addition to continuing to generate cash, its debt is low at just over $500 million, while its cash and cash equivalents are just over $250 million. Since leverage is very low, there is no need to make large principal repayments or interest expenses.

Overall, Fastenal has a solid track record of execution. Good management, effective strategies and cost reduction have proven that a cyclical company operating in a market without visible barriers to entry is able to provide steady and sustainable returns.

Valuation concerns

The main problem with this thesis is that the market already rewards stocks. This premium is even higher at an unfavorable time for Fastenal, because despite interest rate cuts and some statements about the resilience of the economy, there is still some cloudiness regarding the growth of economic activity in the short term and, consequently, uncertainty regarding its growth in the coming quarters.

When broken down, Fastenal’s valuation is slightly multiplied, with a forward price-to-earnings ratio of 33.30, a forward enterprise value-to-Ebitda ratio of 23.20, and a forward price-to-operating cash flow ratio of 29.80. All of these multiples are well above their medians.

However, multiples are always relative. For a high-quality company with predictable accelerated growth fundamentals, 33 times forward earnings may not be enough. However, I don’t think this is exactly the case with Fastenal. As I explained earlier, the business model and its implementation are very good, but analyst forecasts for the coming years do not predict such strong growth. The consensus estimates that Fastenal will post earnings per share of $2.40 by 2026 – which represents sustainable and reasonable growth based on 2023 earnings of $2.02 – but this figure nonetheless implies a price gain of over 29 by 2026

Paying this premium jeopardizes shareholder returns because the dividend yield is ultimately low compared to the higher payout. With estimated earnings per share in 2026, if the company makes an 80% split, the yield at the current share price would be 2.70%, which is still below the average of the last 10 years, which means a dividend yield of 3.15%, and this thinking about something that would take another two years to get.

As the company is not in a favorable cycle, it is normal to see a bit more pressure on earnings and a resumption of this cycle could be beneficial for the company, especially when combined with some internal cost optimization initiatives, a better mix of revenues with more on-site operations, which could result not only in a resumption of revenue growth but also in a continued gradual increase in net profit margins.

Even in this scenario, you still have to believe that the company will grow its free cash flow at an accelerated rate and discount those cash flows at a very low rate. Using a discounted cash flow model, we found a fair price for Fastenal to be just $60, taking an 11% increase over the next two decades and discounting it at 7%. In other words, this valuation is reasonable, but I don’t find it attractive. While I believe the outlook for the company is positive and credible, an 11% annual rate already reflects this optimism well, calling into question the margin of safety.

Final thoughts

Fastenal is an excellent company to have on your radar as it is a solid option for mixing. Effective management allows it to generate good shareholder value, with good prospects for maintaining sustainable cash-generating growth and being a good dividend payer, ideal for investors looking for alternative companies with high-quality income.

On the other hand, the current share price is a bit stretched even with the company’s more timid results, so in my opinion a more cautious approach is needed to enter the stock or increase positions when there is a greater margin of safety.

Disclosures

I do not have a position in any of the stocks mentioned and we do not plan to purchase new positions in any of the stocks mentioned in the next 72 hours.