Description

Fastenal Company claims to be “the fastest growing full-line industrial distributor and the largest fastener distributor in the nation.” In these challenging times with the U.S. manufacturing sector struggling and the commercial construction industry in a slump, this wouldn’t seem to be a business that would be a belle of the stock market ball. Fastenal, however, continues to trade at a robust 33 times trailing 12-month earnings and nearly five times book value.

True, Fastenal has been consistently profitable, has continued to grow, and has no debt. Nevertheless, a number of negative trends have developed that, in combination with the questionable industry outlook, suggest that Fastenal’s stock could get knocked off its lofty perch and that a short sale strategy may be appropriate. Following is a discussion of some of the key trends.

Same-store sales that are likely flat to negative -- Fastenal does not report same-store sales (often a concern in its own right), but a look at quarterly revenues over the last nine quarters appears to be instructive. Fastenal indicates that sales for new stores ramp up over at least the first 12-24 months, and it can therefore be difficult to sort out the impact of same-store trends, new store openings, and store maturation on overall growth rates. However, since March 2001, the proportion of immature stores in the total store count has been relatively stable, whether looking at the cohort of stores less than 12 months old or at the cohort less than 24 months old. It seems reasonable to conclude, therefore, that the decline in revenue per store (net of sales from a business that was acquired in 2001 and divested in 2002) from $212,000 in March 2001 to $196,000 in March 2003 is driven by same-store results, not dilution from new stores, as follows:

Revenue/Store Stores<12 Mos. Stores<24 Mos.
March 2001 $212,000 13.5% 19.0%
June 2001 $207,000 15.1% 21.5%
Sept. 2001 $201,000 15.3% 22.4%
Dec. 2001 $185,000* 12.5% 21.1%
March 2002 $199,000 9.7% 21.9%
June 2002 $207,000 10.1% 23.7%
Sept. 2002 $204,000 10.8% 24.4%
Dec. 2002 $187,000* 12.3% 23.3%
March 2003 $196,000 12.9% 21.4%

* Sales are seasonally slow in the December quarter.

From Fastenal’s reports, you would not be likely to draw the conclusion that the company is experiencing difficulty with same-store sales. Fastenal’s latest press release focuses on “daily sales growth” which was a spectacular 14.5% in March and the Supplemental Information available on the website shows sales growth rates for stores older than two years. Neither statistic is adjusted for the number of stores included in the calculation, though, so neither provides insight into same-store results.

Dramatic inventory build and negative cash flow -- Historically, Fastenals’ inventory turnover has ranged from about 120 to 140 days. As recently as the March 2002 quarter, inventory turnover was approximately 130 days (adjusting for the divestiture) and total inventory was approximately $150 million (reported at $157 million before the sale). By March 2003, inventory turnover leaped to 178 days and the inventory balance jumped to $233 million. On a per-store basis, inventory increased from $144,000 – consistent with historical average – to $193,000, a 34% spike.

Largely because of this inventory buildup, cash and marketable securities have declined from $91 million at March 2002 to $57 million at March 2003, even as Fastenal reported $77 million of net income over that period.

So what’s going on here? Why is Fastenal pouring so much money into inventory and is it a prudent investment or a desperate effort to keep sales growing? At least part of the answer lies in Fastenal’s Customer Service Project (CSP) which is expanding the number of parts stocked at each store and allowing for immediate order fulfillment, rather than fulfillment from a regional distribution center. As of March 31, 370 of the 1,205 stores were operating in the CSP format and most were apparently converted beginning in the third quarter of 2002.

With 103 new stores added since June 2002, it would have been reasonable to expect an inventory increase of $14 million, representing $140,000 per new store. Instead, inventory increased approximately $71 million. If all of the $57 million differential was accounted for by the CSP conversions, this would suggest that more than $150,000 of inventory was added at each CSP location, more than doubling the amount of inventory normally required for each site.

I have not yet been able to determine how much of the inventory buildup is due to the CSP conversions vs. other factors, but the overall level of inventory is reaching alarming levels. Inventory turnover in the last two quarters averages nearly 180 days, which seems to be extraordinarily slow for a company that is stocking finished, commodity goods. Even if the inventory buildup can be fully accounted for by the CSP conversions, it raises questions about whether Fastenal is compromising its business model to maintain revenue growth.

It’s hard to fathom why a company such as Fastenal would pump such enormous amounts of cash into inventory, particularly when the financial results, at least in the short-term, do not appear to be compelling. Combining the revenue and inventory trends, we get an impression of a company that is highly focused on growth, but which is struggling to maintain that growth. By pumping inventory into the system, Fastenal will presumably capture incremental sales that may keep its same-store sales from declining more dramatically. However, in the absence of an industry rebound, this may be merely an expensive, short-term fix. Higher inventory levels increase the risk of obsolescence and other inventory losses and will hold back the tide for only so long. From a stock price perspective, it seems unlikely that investors will tolerate a continuing cash drain quarter after quarter if Fastenal is only holding steady at roughly a $1.00 per share earnings level, rather than gaining ground. And, of course, any meaningful decline in earnings would likely have a significant negative impact on the stock price.

Catalyst

1. Revenue and earnings estimates may be reduced due to weak industry conditions.
2. Increased focus on same-store sales may lead to a re-evaluation of Fastenal’s valuation parameters.
3. Bloated inventory could lead to unexpected charges and to changes in business strategy.