Fastenal Company

Good day, ladies and gentlemen, and welcome to the Fastenal Company fourth quarter and full year 2018 earnings results conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. If anyone should require operator assistance, please press star then zero on your touch-tone telephone. As a reminder, this conference call is being recorded. I would now like to turn the conference over to Ellen Stultz of Investor Relations. You may begin.

Welcome to the Fastenal Company 2018 Annual and Fourth Quarter Earnings Conference Call. This call will be hosted by Dan Flourness, our President and Chief Executive Officer, and Holden Lewis, our Chief Financial Officer. The call will last for up to one hour, and we'll start with a general overview of our quarterly results and operations, with the remainder of the time being open for questions and answers. Today's conference call is a proprietary Fastenal presentation and is being recorded by Fastenal. No recording, reproduction, transmission, or distribution of today's call is permitted without Fastenal's consent. This call is being audio simulcast on the Internet via the Fastenal Investor Relations homepage, investor.fastenal.com. A replay of the webcast will be available on the website until March 1, 2019, at midnight Central Time. As a reminder, today's conference call may include statements regarding the company's future plans and prospects. These statements are based on our current expectations, and we undertake no duty to update them. It is important to note that the company's actual results may differ materially from those anticipated. Factors that could cause actual results to differ from anticipated results are contained in the company's latest earnings release and periodic filings with the Securities and Exchange Commission, and we encourage you to review those factors carefully. I would now like to turn the call over to Mr. Dan Flournas.

Thanks, Ellen, and good morning, everybody, and welcome to the fourth quarter conference call for Fastenal. Before we delve into Holden's flipbook, I just want to touch on a few things, and I So if I go back in time to late 2015 or just 2015 in general, we'd seen a dramatic slowdown in the economy we sell into. We'd had a tough year. I was stepping into this role, and I remember the first comment I made to the team was, hey, folks, we have a ton of great things we can do for our customer, what we can do for our employees, our suppliers, and our shareholders. Let's focus on the future, and let's just get going. And in 2016, it was a year of investment. We invested in inventory in our branch network to support our customer. We invested in growth drivers of the business and the infrastructure to support those growth drivers. And as all you recall, we had a tough year from the standpoint of nominal growth, but we really grew our expenses and our working capital because we were setting ourselves up to be a better supply chain partner for our customers. In 2017, we armed with an economy that was not kicking us in the face but was actually giving us a little bit of tailwind. We looked at the team and said, you know what, let's grow our sales and earnings this year. And when I talk about earnings, I'm not talking just about FASTA. I'm talking about our people too. And we did a nice job that year of doing all three. In 2019, we've improved that from the standpoint. I think we found a better balance. in growing the aspects of our business. And one thing that was really important to us was an incremental margin that started with a two. And the second half of the year, we've been able to deliver that. It was good enough in the second half of the year that we produced it for the year. And that's an important component because it's not just about growth, but it's about profitable growth and creating opportunities for your customer and your employee in the process. In 2019, I think that mantra is let's find a little bit more balance, and let's extend what we're doing already, but let's extend it to the cash flow statement and really hit all pieces and reward all constituencies. And speaking of constituencies, we keep it really simple here. There's four. There's customers, there's employees, there's suppliers, and there's shareholders. It has to work for all four for our business to be successful short-term and long-term and We look at everything with a long-term perspective, but we try to have a short-term edge to it to have a sense of urgency. From a customer's perspective, the biggest thing that we do every day is we thank them for their business. Thank you for trusting and embracing our supply chain partnership. The supply chain is critical to each and every one of our customers, and I thought I'd share a few tidbits out of a recent customer letter that came in. Actually, it was an unsolicited letter I received last week. It was a customer where we had taken on We signed it on-site earlier in the year. It's been a customer for years from an MRO perspective, but we took on their OEM fasteners. And as we've talked about in the past, OEM fasteners is a very intimate relationship because we're selling them not just the stuff they need in their facility. We're selling them the components of what they're representing and selling to their customer. We're part of their DNA in the OEM fastener world. And the letter touched on a handful of bullets about the business. It first talked about the bidding process. Last sentence in the brief paragraph, Fastenal by far presented the best with the most advantages for present and future growth. Fastenal is the best option. From a transition implementation, again, that's a scary place for a customer to be because your production line is dependent on hiccups that can occur in a transition process. And the second sentence in this paragraph, Fastenal immediately brought on site a team of professionals with a lead implementation person that managed through each item of inventory with each group function within our company. Stockouts, through the process which started in March 2018, we have not seen a single stockout situation within our company. Communication was and is top notch on all matters. Urgency. Urgency. Fast communication and sense of urgency has been exceptional. Engineering support. Knowledge support and testing that we get now on all parts is exceptional. Sourcing. We have been able to keep current manufacturers as well as looking at other options for cost savings. The value we bring is a high level of service, but it's also an opportunity to challenge status quo and take costs out of supply chain. That's what we do for our customer. It's not just about fulfillment. That's an important component. But it's also about bringing the supply chain knowledge to lower your cost and improve yours and your customers' value proposition in the marketplace. Service support. Fastenal on-site management has been exceptional. And our letter closes to say we look at Fastenal as an extension of our company. And with the on-site service we have, our folks don't have any doubt on where to go. So I thought I'd share that letter. It was really fun to receive it. I called the individual that sent it and personally thanked her. But it's really indicative of what our business and our on-site strategy is about as it relates to engaging with our customer. Secondly, employees. So we grew our business 13% in the last 12 months. Our FTE growth is up about six. Now, it's no secret in the marketplace there's some inflation going on because it's a tight labor market. There is also when you have advancements in your organization, folks that are stepping into leading a new onsite. Maybe you were the second or third person in the branch before. Getting added to our implementation team, our national account sales team, our industrial services teams, all the teams within Fastenal, our base pay we saw increase about 9%. So on a 6% increase in headcount, base pay is up about 9%. Some of that is inflation. Some of that is advancements in positions within the organization because of the opportunity our team and our customers are creating. Incentive compensation. That's commissions at the branch. That's incentive to our leaders. That's incentive to the folks in the support areas of our organization. Despite the fact that it had grown handsomely in 2017, it grew again in 2018. It's up 20%. Profit sharing. We share the rewards of the business with everybody in the business. From 2017 to 2018, I'm proud to say our profit-sharing contribution this year is up about 24%. Despite all that, we were able to leverage our employee cost, which meant we were able to leverage our SG&A. Our total employee costs are up about 11%. Another way to think about it, there's a lot of ways to think about productivity, and productivity is key to our current and future success because it's bringing greater value to the customer but doing it in a more cost-efficient manner. Every dollar we spent in payroll in 2017 translated into $1.02 of profit. So we had $881 million of profit last year. We spent $862 million in total payroll. Holden's probably cringing right now that I'm sharing that number because people want it again and again and again. Sorry, Holden. But I think that's an important component of our business, But despite all the investments we made in people and resources in the last year, the last three years, in 2018, we spent $962 million in total payroll costs. That's everything in there, base pay, incentive, profit sharing, Social Security taxes, workers' comp, health insurance, everything added up. We spent $962 million, but it didn't generate $1.02 of profit. It generated $1.04. We generated $999, essentially a billion dollars in profit in the last 12 months. That's productivity, and I'm really excited what that means for our team, and I think there's a lot of opportunities to expand that in the future. Our suppliers, that third constituent, had really successful years with us. Suppliers that have been willing to evolve and change to support our vending business in the last 10 years, our on-site business in the last three, four years, our construction business, our national account business, our local business. a fast no model, have had really successful years. I've met with a lot of them over the last two months and really excited about what 2019 can mean and what they're seeing downstream in their business. Finally, shareholders. You know, our shareholders haven't been rewarded as well. Our stock has been a little bit in purgatory, it feels like, for a period of years. We've started to move out of it, though, and we were seeing that, you know, some in 17, some in 18. Our sector is no secret to the folks on this call. I've seen a bit of a multiple compression. And we've tried to offset some of that by strong dividend and buyback aspects. And I'm pleased to say when I look at that press release we just put out or last night on our dividend and our stock buybacks, if I take the dividend we just declared for the first quarter of 2019 and extend it to the year, assuming we pay about the same each quarter, And look at the last nine years and add the $600 million of buybacks we've done. We've returned almost $4 billion, $3.85 billion to be exact, to our shareholders in a business that's thrived and grown in that time frame. And we've essentially doubled in size in that 10-year time frame from a little over $2 billion to about $5 billion in revenue. In the last five years, we've returned about 65% of that number, about $2.5 billion. And on a $15.5 billion market cap, we've returned about 16% of that number over the last five years. We're proud of that number. And we believe we have ability to grow that in the future. We just need to work on our cash flow statement a little bit better to be able to juice that even further. Turning to the flip book, and before we started on that, I do want to cite, you know, I mentioned the aspect of employees within Fastenal, a part of our blue team. There's a few blue team members I want to cite right now. First is we have two employees that are going to hit a really big milestone. And we believe in service and milestones. And every year at our Florida event, we recognize our 25-year employees. We actually have two employees here in 2019 that are going to recognize 40 years of service within Fastenal. The first one is Nick Lundquist. In March, he joined us in 1979. In March, he will hit 40 years with the company. You know, he must have started when he was about 10, 10, 11 years old. Because he's got the spunk he has in him and the dedication he brings to the organization every day is impressive. And he continues to develop people around him, which is a sign of a great leader. The second person is Dana Johnson. In August, Dana will celebrate 40 years with the organization. Dana might not be as well known to this group. Dana leads our property area, and over the years, Dana's had a multitude of roles within the organization, and the professionalism and the talent he brings to every role he serves is impressive. So I congratulate both of them on the 40-year milestone this year. Speaking of Blue Team, two people that are particularly close to me within Fastenal recently lost a parent. In December, Renee Weisskopf lost her father. And here, several weeks ago, Nick Lundquist lost his mother. Now, both of those individuals enjoyed long lives. They had great families. But for Nick and Maria and for Renee and John, you're an important part of our Blue Team family, and our condolences and prayers are with you. Now let's flip to the book. Fourth quarter of 2018, it came in at 59 cents. There's a discrete tax item in there, a little bit of noise in tax items in the last four or five quarters, something about a new tax law signed in the U.S. creates a little bit of noise. Absent this, our EPS would have been 60 cents for the quarter. Adjusting for discrete items in both years, EPS grew about 14%. Demand is strong, 13.2% sales growth in the fourth quarter. That's our sixth quarter of at least 13% growth. We continue to execute really well on our growth drivers, and I'll touch on that in a few minutes. Operating leverage remains strong. We have gross margin pressure. Some of that's self-imposed because our growth drivers naturally lower our gross margin, but inflation and more recently tariffs are creating some ripples in our business. Despite that, we had an incremental margin of 21% in the quarter. Prices are trending favorably, and when I talk about price and cost in these discussions, Price is our sell price to our customer. Cost is the inbound, whether that is a cost of goods cost, a freight cost, or an OPEX cost. But I'll try to use those terminologies to be more concise in how we describe things. Price tended favorably, but it's still lagging cost inflation a bit. And that is pressurizing our gross margin more than just pure mix, and Holden will touch on that in greater detail. As you all know, List 3 of the tariffs did impact fast and all, But most of the impacts on the working capital, they added to inventory late in the year, and again, Holden will touch on that. One thing that's positive, we have a supply chain relationship with our customers. Tariffs and inflation are not a foreign concept, no pun intended, to our customers. And those discussions are going well, and I'm encouraged about what we saw in the month of December, what we're seeing in January, February, and March, what we expect to see in February and March. as it relates to our ability to pass through those tariffs, or better yet, find better cost options for our customer. In many cases, that involves substitution. Q4 cash generation continues to be impacted by the working capital trends. However, we were still able to return $177 million to our shareholders via repurchase and dividends, while retaining what I would consider a pretty flexible capital structure. Now let's go to the growth drivers, page four, onsites. The team really is making progress there. When I think about back in 2014, we had a couple hundred onsites. We were adding 10 a year, which meant 3% to 5% of our district managers were really engaged in this game. The rest of the folks were really engaged in the more traditional side of our business, plus the vending that we've introduced in the last 10 years. We started to change that in 2015, and we went into high gear in 2016, 2017, and 2018. In 2015, about 25 percent of our district managers signed an onsite. Next year, that went to 50. Last year, it was in the low 70s. And we always talked about let's drive that to 80 percent. If we drive that to 80 percent, we are an onsite company because we're engaged in it throughout the business, not in a subset of our business. In 2018, 79 percent of our district managers signed signed an onsite, we will pierce that number of 80% in 2019. And I'm really excited about what that means for our ability to keep growing and manage the business. However, when you go from 200 onsites to 900 onsites in a few short years, you do deleverage that business quite dramatically. And so our average onsite back in 2014 did $150,000 a month. Today, our average onsite does $120,000 a month. And it isn't because we're lowering the bar on opportunity. It's because we have a whole bunch of really young onsites, and that's deleveraging the business. But on the flip side of that coin, our branch network has been leveraging like crazy, and that's what allowed us to maintain an incremental margin in the last two years of a low 20%. But on onsites, we signed 336 for the year. Not quite our goal. Our goal was pretty aggressive, but well above the 270 of last year. We have 48% more active sites today than we did just a year ago. And our goal for next year is 375 to 400. Vending. We have really breathed new life in the vending. The team has done a wonderful job in the last few years. We met our goal for the year. We signed 22,073. We signed over 90 a day in the third quarter, incredible milestone in my mind. And our install base ended the year at just over 81,000, about a 14% increase from last year. Product sales through those devices is up more than 20%. For next year, our goal is 23,000 to 25,000. I told the team there's 254 days next year. If we hit 100 a day, that's 25,400. It's a really nice number. But our stated goal is 23,000 to 25,000. One thing that isn't mentioned in this list of bullets is construction. You know, when we were making these investments back in 16, 17, and 18, a big one was inventory in our branch network. We had languished in the construction market for a better part of a decade with growth between 3% and 4%, very unfastened like. We were focused on other things, and we lost our sight on construction. Between putting inventory in our branch, opening the door to our customer in that we had a great local plan, and in the process beginning the development of a good national and international plan, our construction business is now not growing three or four. It's growing 15% as we exit the year. The construction market itself has grown about five, the end market. We're tripling that. That's market share gains, and it's about a great team going after that market, being prepared. We ended the year with just over 3,100 locations versus 2,988 a year ago. despite the fact we closed 157 branches. So that leveraging we're getting in our system is coming from people leverage and occupancy leverage, and we're converting those closed locations into ever more customer-serving locations by moving on-site, by moving in and lowering our cost structure and improving our value proposition to our customer. National accounts, they had an outstanding year, 18% growth in the fourth quarter, Large customer growth was also 18% for the entire year. Our non-U.S. daily sales, it's about 14% of sales, grew at mid to high teens rate and slightly below in the latter part of the year. Europe and Asia have slowed a little bit, and currency has given us some headwind. With that, I'll turn it over to Holden. Great. Thank you, Dan. Good morning. I'm going to begin with a quick recap of our 2018 results before moving on to the quarter. In 2018, Fastenal generated a record $4.97 billion in sales, which is up 13.1% from 2017. We generated at least 13% growth in each quarter of the year, reflecting what have been stable and sustained macro tailwinds, as well as effective execution of our growth drivers. To touch on those growth drivers, for onsites, we signed 336 new agreements in 2018. That was shy of our 360 to 385 goal, but it's well above last year's 270 signings. If I exclude the branch transfer revenues, sales through onsites grew more than 20% for the full year. We're targeting 375 to 400 signings in 2019. For vending, we finished 2018 with more than 81,000 installed product dispensing machines, which is up 13.6% over 2017. Our 2018 signings of 22,073 machines were up 14%, and around the midpoint of our 21,000 to 23,000 signing goal for the year. Sales through our machines rose more than 20% in 2018, and we're targeting 23,000 to 25,000 signings in 2019. Lastly, national accounts paced the overall business, with sales growth through our largest customers in 2018 accelerating to up 18.1%. We were active with new signings, but this acceleration also reflects success in expanding our sales to existing customers. Though today they represent a relatively small part of our business, We also continue to see healthy growth in our non-North American revenues, as well as sales through our e-commerce channel. Our operating margin was flat year-to-year at 20.1% in 2018. This stability does mask improved leverage as the year has progressed, with our operating margin expanding by about 30 basis points in the second half of 2018. Our gross margin finished 2018 at 48.3%, down 100 basis points, largely from product and customer mix, freight costs, negative price costs, and growth allowances. Our ability to narrow our gross margin declines going forward will rest heavily on our ability to close the gap between rising prices and rising costs. We generated an offsetting 100 basis points of SG&A leverage. 30 to 40 basis of this was from employee-related expenses as we cleared our incentive reset in the second quarter of 2018 and grew headcount more slowly than sales. 30 to 40 basis points was from leveraging occupancy as the closure of 157 branches in 2018 mitigated growth in our base of vending machines. Finally, we leveraged our remaining operating costs by 30 to 40 basis points. Given continued growth in our business, there remains further room to leverage our operating expenses. Given continued healthy growth, our overall goal for operating margins entering 2019 is unchanged. Achieve an incremental margin between 20 and 25% and deliver some margin expansion. Below the operating line, interest expense is up 39% on higher average debt balances, largely from share repurchase activity. Our tax rate fell to 23.8% in 2018 from 33.7% in 2017. Excluding discrete items from both periods, our tax rate fell to 24.5% in 2018 from 36.5% in 2017, reflecting the Tax Act, which had the effect of lowering our tax rate beginning in the first quarter. It all blended to a full year 2018 EPS figure of $2.62 versus $2.01 in 2017. If I exclude the discrete tax items, however, our EPS would have been $2.59, a 35% increase from $1.92 in 2017. If I further adjust for the differing tax rates that applied between 2017 and 2018 as a result of U.S. tax reform, our EPS grew 13.4%. Moving to slide five and our review of the fourth quarter. As Dan covered, sales were up 13.2% in the fourth quarter of 2018, which included daily sales growth of 14.5% in December. We have now grown our organic daily sales at a 10% plus rate for 19 consecutive months. We continue to see good contribution from our growth drivers. We also saw continued favorable macro trends, as illustrated by fourth quarter 18 purchasing managers index and industrial production readings. Still, sentiment was a bit choppier in the period, with rising consciousness in November seeming to dissipate a bit in December. Our business does not provide much visibility to future trends, and so we cannot speculate as to whether this choppier tone will persist. However, it did not affect performance in the fourth quarter, as you can see by the growth of our end markets, our products, and our channels provided in slide five. As it relates to pricing, during the quarter, we put in place focused resources to evaluate and execute our pricing strategies. This is appropriate in light of the prevalence of inflation and tariffs, as well as the growth of our national accounts business, all of which makes the pricing environment more complex than we have seen it in many years. In addition to this group's strategic objectives – It has also taken a fresh look at how we measure price and cost with two observations resulting. First, as we reported before, we have achieved improved price realization throughout 2018 with a notable step up in the third quarter, as is necessary because our costs have also risen throughout 2018. Second, the impact of price on our results is slightly below what we had previously modeled. As a result, we realized between 110 and 140 basis points of price in the fourth quarter of 2018 were which is improved on the 85 to 150 basis points of price that we realized in the third quarter of 2018. As it relates to tariffs, there was minimal impact on the P&L in the fourth quarter of 2018, but that will grow in the first quarter and full year of 2019. The impact on the balance sheet is also modest at this point, with one exception. While we did not buy any excess inventory in anticipation of higher tariffs, we did accelerate the shipping of planned spend to arrive before the potential 25% tariffs kicked in, which was originally expected on January 1st. This pulled roughly $12 million in inventory that would have otherwise gone into the first quarter of 2019 into the fourth quarter of 2018. Now to slide six. Our gross margin was 47.7% in the fourth quarter of 2018, down 110 basis points versus the fourth quarter of 2017. This decline was slightly more than we expected. Relative to prior periods, we did see the negative effects of freight and net rebates moderate in the fourth quarter, primarily as a result of easier comparisons. However, product margin was below where we thought it would be. The negative impact of price cost widened as product cost increases outpaced our price increases. The negative impact of customer product mix similarly widened as an increasing proportion of our growth derived from our growth drivers. Our operating margin was 19% in the fourth quarter of 2018, up 30 basis points year over year. Continued healthy growth drove 130 basis points of cost leverage and generated an incremental margin of 21%. Looking at the pieces, we achieved 60 basis points of leverage over employee-related costs, which were up 10%. Growth in headcount was below growth in sales, and growth in incentive compensation, though healthy, moderated versus last year. Occupancy-related costs were up 7.2%, generating 25 basis points of leverage. Total occupancy costs grew very slightly, with higher expenses at non-branch facilities more than offsetting a decline in branch facilities. As a result, most of the growth in costs related to higher vending expenses to support the growth in our installed base. we realized an additional 55 basis points of leverage of other and operating administrative expenses. Putting it all together, reported fourth quarter EPS were 59 cents versus 53 cents in fourth quarter 2017. However, the current year does include a 3.2 million discrete tax charge, while the prior year period includes a 24.4 million discrete tax benefit, both related to the effects of the Tax Act. Excluding these discrete items, fourth quarter 18 EPS would have been 60 cents We're up 34.2% from the fourth quarter of 2017, boosted by a lower tax rate as a result of the Tax Act. Absent tax reform, EPS growth would have been 13.9%. Turning to slide seven, we generated $178 million in operating cash in the fourth quarter of 2018, or 106% of net income. This is slightly below the conversion we typically see in fourth quarters, again relating to working capital. I'll cover that in a moment. Net capital spending in the fourth quarter of 2018 was $78 million, bringing our year-to-date outlays to $167 million, an increase of 48.3% over 2017. We expected an uptick in spending in the fourth quarter just based on project timing related to hub investments, but we also had an opportunity to purchase property in North Carolina for future hub expansion that was unanticipated and added nearly $20 million to this total. Our current growth and growth drivers require additional investments in 2019, and we expect net capital spending to be in a range of $195 million to $225 million, largely for investments in hub, property, and equipment, vending devices to support our rising success in this initiative, and vehicles. We paid $114 million in dividends in the quarter and $442 million for the year. We also repurchased $63 million in stock in the quarter and $103 million for the year, the second most active year in our history. We finished the quarter with debt at 17.8% of total capital, a little above last year's 16.5%, but still at levels that provide ample liquidity to take advantage of opportunities to invest in our business. The working capital picture remained challenging. Inventories were up 17% in the fourth quarter, and days on hand ticked up slightly for the first time in 2018. Some of the growth related to supporting demand and our growth drivers, and some was related to the accelerated shipments mentioned above. However, a third major element was simply the growing impact of inflation. Receivables grew 17.5% in the fourth quarter and is up more than three days. Sustained strong growth in national accounts and international businesses matter, but the biggest factor remains customers pushing payments past quarter end, which intensified further in the fourth quarter of 2018. Receivables quality remains good with no deterioration in past due balances. That's all for our formal presentation. So with that, operator, we'll take questions.