The Nuts and Bolts of Higher Profits

02/17/2009 10:26 am EST


Paul Larson

Editor, Morningstar StockInvestor

Paul Larson, editor of Morningstar StockInvestor, and analyst Matthew Warren like a retailer that focuses on mundane items and is intentionally reducing its own growth rate.

Fastenal (Nasdaq: FAST) has leveraged its vast store and distribution network into decades of profitable growth. This "wide-moat" firm continues to turn out new stores, dominate the fastener niche, and take share in a highly fragmented market.

As the name suggests, this company focuses on fasteners—everything from nuts and bolts to screws and anchors. Fastenal has a dominant presence in many small and rural markets, in addition to its presence alongside larger competitors like W.W. Grainger (NYSE: GWW) in larger metro markets.

Fastenal supplies customers, including manufacturers and commercial contractors, with 300,000 varieties of fasteners and 380,000 general-purpose maintenance, repair, and operations products. The company utilizes 12 North American distribution centers and an in-house truck fleet to facilitate five deliveries per week to roughly 85% of its 2,000-plus company-owned stores.

Historically, Fastenal has added to its store base at a 15% annual clip, [but now] the firm is getting closer to its soft target of 3,500 North American stores. [So,] management's decision to ratchet back new store growth to about 8% makes sense.

At this point in its life cycle, Fastenal expects that ramping up its hiring pace for outside sales professionals (who pound the pavement in search of new accounts) will help it achieve a similar growth curve but require less capital reinvestment.

Besides better cash-flow growth, we also expect the company's strategy shift to yield solid margin improvement as it begins to more prominently display the true earnings power of more seasoned stores.

Although [growing] at a slower pace, Fastenal will continue to increase store density in underserved markets, further pressuring regional competitors. We expect Fastenal will continue to steal market share from small, independent industry players.

We are projecting 17% top-line growth during the next five years and expect operating margins will climb to 22%. Given the firm's all-equity capital structure, we use a relatively low 9.5% cost of equity.

We are most impressed that managers continue to execute year after year. Management is relentless in its efforts to continuously improve the appearance and efficiency of existing stores.

Fastenal is extremely shareholder-friendly. It has good governance practices on paper, and its actions speak louder than its words.

Free cash flow is reinvested in value-creating growth, and any excess funds are returned to shareholders. Top executives are all paid similar amounts, with an emphasis on cash incentives. Stock option issuance is extremely light. This company is downright frugal compared with its peers. Five out of nine board members are independent, and directors and officers own almost 16% of the company, aligning owners' and managers' interests.

Our fair value estimate is $63. (The stock closed near $34.50 Friday—Editor.)

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