Fastenal Company

Greetings. Welcome to the Fastenal Company second quarter 2019 earnings results conference call. At this time, all participants are in a listen-only mode. A brief question and answer session will follow the formal presentation. If anyone today should require operator assistance during the conference, please press star zero on your telephone keypad. Please note this conference is being recorded. I would now like to turn the conference over to Ellen Stultz with Investor Relations. Ms. Stultz, you may now begin.

Welcome to the Fastenal Company 2019 Second Quarter Earnings Conference Call. This call will be hosted by Dan Flournas, 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 September 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 Flournus.

Thank you, Ellen. Good morning, everybody. Before I start, I just want to share a thought with the group. And I had the distinct pleasure of my 23 years at Fastenal to have worked with some really fine people. And two of them I'll mention, our original CEO, Bob Curlin, and his successor, Will Overton, two individuals that I think were stellar in the role and I learned a tremendous amount from. And not only were they great at their role. They're really good people. I remember back in, I believe it was 1998, October, and our business growth dropped in one month, about a third. We went from 27% growth. We dropped 10 points. I think we went from 27 to 17. Don't quote me on that, but I think that's what it was. And we did six simple things. And if you want to, if you're a CEO out there and you want to know six things to do in a time like this, these are really useful. The first thing you do is you take a step back. You revisit your long-term priorities. These priorities should center on your goals or something's wrong to start with, but you take a look at your priorities. And that's step one. Step two is you remind everybody about these priorities and you remind everybody, hey, we keep doing these things. 20 years ago, that was opening branches because we were spreading across North America. Today, it's executing on our growth drivers. Step three, you take a step back and you identify those things that are really, really important to your long-term success, but you pull back on that a bit. And you explain to everybody why. And a good example of something that we're pulling back, back in late May, I sat down with Renee Weiskopf, our head of HR, and Peter Gettinger, our head of our professional school business, and I said, you know what, we need to pull back expenses and we need to do it in a bunch of places. We need to pull back our instructor-led programs for the second half of the year because we need to pull back the travel expenses. So if you're an airline right now or a hotel in Winona, Minnesota, or one of our distribution centers, you will lose some business in the next six months because we pulled back about 40% of our instructor-led trainings. And the team didn't react with anger, didn't react with fear. They reacted with resiliency. And now maybe they had some fear in their stomach. Maybe they had some anger in their stomach, but they didn't let that show. And they immediately identified with some of the resources they would be freeing up, what could they do that helps Fastenal in the short term and long term. And they identified some courses they're going to develop. Most of our courses are delivered online. We identified an abrasives course, a metalworking course, a blueprint reading course, an ISO quality course, several new Courses relating to Lean and Six Sigma. Now, my guess is there aren't anybody on this call that's signing up to take those courses. But they're really important to our employees and to our customers. And that's something that you do when you do tradeoffs and you pull back expenses in the short term. Really important thing. There's no organization or individual, in the case of me, that believes in education more. But in the short term, you pull back because we don't have the dollars to pay for it. Step four. You also identify those activities that don't support your long-term priorities or that, quite frankly, aren't really that necessary in the first place. Fortunately for us, we're pretty frugal. So we don't have many of those, but we are human beings, so you always develop some. And those you just stop, and you stop today. The third thing you do is you communicate this throughout your organization. You create normalcy in your organization. You remove fear and replace it with resiliency. And then step six, you repeat that communication to everybody, and you repeat it again and again, and you build resiliency in the organization. Six really simple steps, but they're really effective. In a time when all of a sudden your business has slowed down and you're not sure how long. I feel comfortable we're taking market share, but the business has slowed down. Had a call with our regional VPs at 7 this morning. Actually, Holden did. I chimed in at the tail end of it. I talked to them about a number of things we're doing right. I also talked about them on aspects of the corridor that don't fall into normalcy, where our execution faltered. And gross margin is one that stands out. You know, to be honest with you, last fall, we thought we had a really good plan to address some of the inflation we were seeing in the, you know, there's been tariffs now in place on steel-based products for a year, on fasteners since late last fall. and felt we had a really good plan coming into the year, how to approach it. I often encourage our team to think big about the business. Unfortunately, on that front, I fell shy on where we were last fall in that we had a good plan coming into the year. We didn't have a great plan. And part of where we faltered was the resiliency part. We didn't prepare our team for a bunch of things coming their way. We prepared them for that big wave coming in, It was tariffs that were direct. That's an easy one to identify. That's an easier one to go after. It's not easy to take it downstream, no pun intended, but it is easier to go after. We also prepared them for some of the things that would be coming from our suppliers in the U.S. that import product and resell it to us. Not as easy to identify, but relatively easy. And I think on those two fronts, we did a relatively good job. We realized in the process we were going to share some of it with our customers. We were going to share some of it with ourselves. We are a supply chain partner. Our customer is not a means to an end for us. We're not a business that just sells products and the customer goes away and we don't really care what they do with it. We are a supply chain partner, and that's what we represent to our customer. Where we failed, though, is there wasn't just a couple waves coming in. There was a bunch of riptides, too. And those riptides came from a bunch of different directions, and we weren't ready for that. And as a result, and Holden will touch on a little more detail about that, we lost some gross margin. To me, that's the thing that stands out in this quarter that is troubling from the standpoint. If the economy slows down, the economy slows down. If the economy expands, the economy expands. You react to both. We did not execute on gross margin. And as a result, a statement I made to this group, I believe it was back on the January call, where I said, when I look at Fastenal, and I'm describing it to our folks internally, you know, when we're a $10 billion company, I believe a 46 gross margin is a reality that we can achieve. I believe a 24% operating expense is a reality we can achieve, and we should aspire to an operating margin of around 22%. I believe it then, I believe it now. I didn't think I'd be sitting there six months later talking to you about a quarter where we just put up gross margin at 46 and change. 46.7, I believe, is the number. And in that regard, we have some work to do as we go into Q3. I'll go to now the flipbook. The sales growth slowed about 8%. It's our first sub-10% reading in nine quarters. We continue to realize double-digit growth through vending and onsites, and our national account customers are growth drivers, if you will. Our fourth growth driver, construction, did weaken as we got deeper into the quarter. Not exactly sure what's driving all of that at this time. But overall, our activity in the end markets we serve slowed as we stepped into the quarter. I don't know if it continued to slow during the quarter, but it did slow as we stepped into the quarter, and I'll let Holden touch more on that in a few minutes. There were a few milestones in the quarter, and one that occurred right after the quarter that I'll touch on as well. The first milestone was we installed our 100,000th, that's a hard thing to say, vending device during the quarter. We have a little over 85,000 vending machines now. We have another 15,000 that we lease to some customers where they use them for check-in, check-out. So 100,000 of them out there. I'd like to personally thank Oshkosh Corp., and specifically their Pierce Manufacturing Facility in Appleton, Wisconsin. They were an early adopter, I should say an early guinea pig of our vending program back 11, 12 years ago. Continue to have a great relationship with that organization, and they added machine number 100,000 in early June. And they had the opportunity to go over there and and thank them in person. It worked out really well because they're based in Appleton, Wisconsin. My father-in-law, Gus, lives about 10 miles away in Neenah. So I didn't need to get a hotel that night. But I had a chance to learn a little about their business. And what they do is pretty special. They make fire trucks. Beautiful product. Late in the quarter, we signed on-site number 1,000. I think that's a big accomplishment. It took us quite a few years to get the branch number 1,000. It took us a lot less time to get to onsite 1,000. I'm not at liberty to share with you the name of that customer right now. I believe we're announcing it in a day or two. You need to get all the formalities worked out, but I'd like to thank them incognito for onsite 1,000. I think we're at 1,026 right now. A third milestone occurred. It's not in the flipbook, but yesterday, and it wasn't even in the quarter. Yesterday, our facility in Connecticut, Wallingford, Connecticut, Holochrome, Back in 2009, we acquired Holochrome. They were in the process of being shut down. Within two years of the acquisition, we moved them from an 80-year-old facility that was rather tired into a newly renovated facility. But Holochrome Manufacturing started back in 1929, kind of an odd year to start, given what happened in the next decade. But they celebrated 90 years of operation yesterday. My congratulations to the team at Holochrome. They've been a great addition to the Fastenal family. Price realization, as I've alluded to, has been insufficient to fully offset the tariffs and general inflation we're seeing. We're seeing it in a bunch of fronts. Obviously, the direct impact of tariffs, but the indirect through companies we buy from. Some pass it on in different ways. Some spread it across all products. Some apply it strictly to tariff-related products. Nonetheless, it's created a lot of supply chain inflation. In the short term, we've not been able to realize the price to fully pass that along. We have taken further price adjustments going into the third quarter. We will, as a supply chain partner, share some with our customer. We will absorb some of it. But we plan to claw back the gross margin degradation that came beyond just customer mix in the current quarter. As a result, we struggled to obtain leverage. We did get operating expense leverage. The flipbook talks about that. The only disagreement I'd have with the flipbook is that's looking at operating expense to sales growth. I think of operating expense to gross profit, dollar growth. And in that regard, we did not lever. But I think the team did a good job of managing operating expenses in the second quarter. We are dialing them down as we go into the third. On the next page, I don't need to read these all individually. What I can say as it relates to our growth drivers, the team did a great job continuing to take market share. We just need to continue to do a great job on executing the business. With that, I'll turn it over to Holden.

Great. Thank you, and good morning. Before jumping in, I just want to remind everyone that on May 22nd, we split our stock two for one. Therefore, any references in the materials to per share information such as EPS will reflect this action. Moving to slide five, total sales were up 7.9%, which includes up 7% daily sales in June. Pricing in response to tariffs and general inflation contributed 70 to 100 basis points during the period It's a lower range than what we saw in the first quarter, but that largely reflects the current period having to grow over last year's rising contribution from price. Sequentially, we believe price realization was stable. From a macro standpoint, it's clear that activity slowed. The purchasing managers index averaged 52.2 in the first quarter, which is still suggestive of a growing market, but well off the 56.9 level recorded as recently as the fourth quarter. Similarly, U.S. industrial production in April and May was up 1.3%, which is well below the 3.7% growth that we experienced just in the fourth quarter of 2018. There's no panic in the market, and the month-to-month cadence through the quarter was mostly steady, but sentiment has become more cautious. In terms of end markets, manufacturing was up 9.1%, oil and gas remained soft, and our heavy equipment categories also slowed. Construction was up 7.2% in the second quarter, with larger customers outperforming smaller ones. For a product standpoint, fasteners were up 5.5%, with non-fasteners up 9.5%. Fasteners are the most cyclical of our product lines, and we believe the relatively faster deceleration from 1Q to 2Q likely reflects the slower macro environment. From a customer standpoint, national accounts were up 12.5% in the quarter, with 72 of our top 100 accounts growing. Our non-national account growth was less than 1%, with roughly 59% of our branches growing in the second quarter. After eight quarters where quarterly growth averaged 12.9%, our current rate is fully disappointing. Still, ebbs and flows of the cycle aside, the goal every day is to capture more market share of a fragmented industrial distribution market. Judging by our outgrowth relative to industrial production, we believe the blue team continues to execute its growth drivers effectively. Now to slide six. Our gross margin was 46.9% in the second quarter, down 180 basis points versus the second quarter of 2018, a larger decline than was expected. There were a handful of smaller drags, including the year-to-year comparison in transportation, but there were two primary factors behind the decline. First, customer and product mix. This remains an expected outcome of our success in driving market share gains to our current growth drivers, However, the greater deceleration in our higher margin non-national account customers, which grew less than 1% in the quarter, served to widen that mixed drag, which was 80 to 90 basis points in the quarter. Second was a widening in our price cost deficit to an estimated 40 to 60 basis points. As Dan alluded to, initial steps to raise price to offset tariffs were effective as far as they went, but were not expansive enough in terms of the range of products covered or their ability to offset generalized inflation above and beyond, and frankly, catalyzed by the tariffs. We continue to pursue a range of actions to mitigate these effects, including a broader price increase that we've already instituted in the third quarter. Broadening our sales streams and realizing the incremental benefits of the pricing we recently introduced should improve our gross margin performance in the second half. Our operating margin was 20.1% in the second quarter of 19, down 110 basis points year over year. We leveraged operating expenses despite the slowdown in sales growth, but not sufficiently to overcome the lower gross margin. Looking at the pieces, we achieved 20 basis points of leverage over employee-related costs, which were up 6.8%. This growth was largely due to a 6.6% increase in absolute and FTE growth in the period. We realized 25 basis points of leverage over occupancy-related costs, which were up 2.5%, comprised of higher vending expenses as we expand the installed base and flattish occupancy expenses. We generated 20 basis points of leverage over other operating and administrative expenses, which were actually down slightly in the period. In light of the slower top-line growth, we will seek to reduce our own spending. We'll continue to add resources as necessary to finance our growth drivers and support our ability to take market share, but costs and investments that do not support those growth drivers will be more tightly managed. Putting it all together, we reported second quarter 19 EPS of $0.36, which was down 3.2% from the $0.37 in the second quarter of 2018. Recall, however, that last year's quarter did benefit by two pennies from a one-time tax gain. If we adjust this out, our EPS were up 1.5% in the second quarter. Turning to slide seven, looking at the cash flow statement, we generated $128 million in operating cash in the second quarter, which was 63% of net income. Remember that cash generation in second quarters are typically seasonally lower. The conversion rate in the current quarter is below last year's 72%, though last year we would have been closer to 66% absent one-time benefits deriving from the Tax Act. Overall, we view the current quarter's conversion rate to be consistent with a typical 2Q conversion rate. Net capital spending in the second quarter was $67 million, up from $25 million in the second quarter of 2018, but consistent with our expectations. This reflects investments in hub property equipment and vehicles that are necessary to support our high levels of service, as well as investments in vending equipment to support growth in our installed base. Our 2019 range for total net capital spending is unchanged between $195 million and $225 million, with the same factors driving the second quarter increase impacting the full year. We increased funds paid out in dividends by 16% to $123 million. We finished the quarter with debt at 16.6% of total capital, above last year's 16%, but down sequentially and from year end. and at a level that we believe provides ample liquidity to invest in our business and pay our dividend. The working capital picture remains challenging. Inventories were up 15.7% in the second quarter. Almost 40% of this increase relates to inventory added to support onsites. We believe we can reduce overall inventory even while making these investments, and as a result, began to reduce our overseas purchasing in the fourth quarter of 2018. This can be difficult to discern, both because of the lag between such an action and its impacting our balance sheet, and because of the slower sales growth this quarter, which lowered our inventory burn rate. However, we would expect these actions to become more visible through the second half of 2019. Our accounts receivable grew 11.7% in the second quarter. Customers continue to aggressively push payments out past quarter end, and as a result, the 2.9-day increase in our receivables days is unsatisfactory. Still, the rate of increase has moderated versus last year, and there are signs that we're reacting more effectively to our customers' actions. As has been the case in recent quarters, we are not seeing any meaningful change in hard-to-collect balances. That is all for our formal presentation. So with that, operator, we'll take questions.

Thank you. To ask a question today, you may press star 1 from your telephone keypad, and the confirmation tone will indicate your line is in the question queue. You may press star 2 if you would like to remove your question from the queue. For participants that are using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment, please, while we poll for questions. Thank you. Our first question comes from the line of Ryan Merkle with William Blair. Please receive your questions.

Hey, thanks. So a couple of questions on gross margins to start here. So first, what exactly is the issue with recapturing product inflation? I recall you thought you'd recapture the 20 basis point price cost deficit last quarter, this quarter, but it in fact got worse. So what exactly is going on?

The goal coming into the year was to eliminate the price-cost deficit that we had. That was the goal the prior year as well. We still wound up with one, and so it comes down to execution. The issue was we put in place a plan to address tariffs in particular, and that resulted in our getting incremental price to offset those tariffs. What I think we underestimated, Ryan, was the degree to which There was general inflation in the marketplace, including general inflation that was being sort of caused and following on the tariffs that were going into place. And on top of that, the pricing improvements that we put in affected a significant amount of product within our overall portfolio, but didn't necessarily affect all of it. And we had assumed that we would get enough price to sort of make up for what we didn't address in terms of the product categories, but we didn't quite get there. And, again, a lot of the reason for that is simply the incremental inflation above and beyond tariffs that we saw in the marketplace. So, you know, we've looked at the situation. We've sort of evaluated the issues that were in place, and we've taken additional pricing actions at the beginning of Q3, the end of Q2, really to address both the gap that we had for the inflation that we didn't build into the original expectations, so to catch up, if you will, as well as the new tariffs that are beginning to come through the system that we'll experience in our COGS in the latter half of the year.

So just to follow up, if I understood what you said correctly, it sounds like your systems aren't capturing inflation appropriately for you to be able to pass it on, because you're not saying that you've been unable to pass on the price inflation of your customers, or that they're pushing back too hard. Am I hearing that right?

No, that's correct. The pricing that we put through, we captured. What we didn't capture is the pricing that we didn't put through that we should have. And so the new pricing is intended to address the gap between what we did capture and the price increases that we've seen and sort of what we didn't wind up putting through the first time around.

Okay, and then presumably you've improved the systems and you have a better handle on what more inflation is coming. So how much price do you estimate you're going to need in the second half of 2019, maybe into 2020, to offset rising product inflation?

You know, I think we've looked at it and we're expecting – we're putting into place a couple of percentage points of price.

Okay, and you're confident that will cover or at least offset most of the price-cost deficit?

Yes, we are.

Okay, I'll pass it on. Thanks. Thanks.

Our next question is coming from the line of David Mantley with Robert W. Baird. Pleased to see you with your questions.

Thank you. Good morning, guys. Good morning. First question on gross margin. Holden, I think you gave some data on this, but could you just disaggregate the gross margin decline of 180 basis points into mixed factors versus pricing factors. And then along with that, Dan, I'm wondering if you can address the 46%. I'm wondering why is 46 a line in the sand when you're at 47 and change today and your gross margin has been declining, I don't know, 70, 80 basis points annually for the last five plus years. Can you talk about that issue as well?

Yeah, I'll handle the mechanical side of it first, and then we'll pass it over. But the mix piece was about an 80 to 90 basis point drag, which was probably about 20 basis points more than I would have expected, frankly. The price-cost piece was a 40 to 60 basis point drag, which, again, was a widening versus what we saw in the first quarter. There was about a 20 basis point drag from freight. Then there was a couple other sort of organizational elements that make up the difference.

Dave, I would think about it this way. Think about it as it's a desired outcome. If we desire over the next $5 billion of growth to expand our operating margin, there's two ways to do it. Either you do it by how much you allow your gross margin to move or how much you allow your operating expense to move or force your operating expense to move. Could you make the math work by it going to 44 and operating expenses going to 22? That's conceivable, but that's really difficult to do because you really have to understand how much of your business is going to be going through our onsite model versus our branch model, what our average branch is going to do. You know, the old pathway to profit that we talked about years ago was really about as that branch population matures, it becomes much more profitable because you run away from a lot of your fixed costs. And so it's really a case of putting a line in the sand tells your team, because this is about a message for internal as much as this message for external. It tells your team that if we want to be able to afford these things in the future, We have to claw back on this piece, this piece, this piece, and this piece. Sometimes that clawing back on gross margin, it's not about price. Sometimes it's about cost. Sometimes it's about mix. Sometimes it's about how much freight you put on your own truck versus somebody else's, how much you charge for freight. It's looking at all those pieces and saying, if we can be a $10 billion company at 46, we can afford to be at 24 and hit 22. If we can't, And that goes to 45 or 44, which is conceivably possible. I mean, in January I talked about that. Then we either need to decide is 24 the number and we're willing to be at 20 or 21, or do we squeeze that down to 23 and 22? So the line in the sand is more about the desired outcome and what you're going to challenge your business internally to do to achieve that outcome.

It makes sense. Thanks, Dan. I appreciate it. And one thing I would also mention is recall when we sort of had that initial conversation about those aspirations, we also noted that the impact of mix and stuff might pull the margin down to 45, and then improvements we make in the business would actually add another 100 basis points or what have you. Now, that's from $5 billion to $10 billion. Obviously, we haven't had the time to get that additional 100 basis points of improvement just from the things we do to improve our supply chain, right? So when you think about the baseline, don't forget that always inherent in that guidance was the suggestion that over that period we would also make process improvements on our own business that would offset some of that mixed drag.

Got it. Okay, thank you. And then just quickly on the SG&A, I mean, you've only been growing it at a 5% or 6% rate in the first half before you've taken any actions relative to the slowing market, but And obviously, if things slow down, you'll get a little natural flex in OpEx lower. Where can you take that set point in the back half of this year? I mean, are you prepping this for sort of mid-single-digit top line, and you can set that at 3%? Or can you take it to flat? I don't know. I mean, you've done a good job to this point. I'm just wondering how much further you can work down on that.

Yeah. I'll answer, Dave, in this context where our thinking is right now, based on what our business is doing right now. We are closing, you know, we're closing some branches every quarter. That frees up some expense every quarter. You know, based on our run rate, we're going to do about 100 branches that we close. So that gives us some flexibility. There are some branches that we need to expand the existing footprint and expand the cost. But we're able to fund all that through the branches that we're closing. And some of our onsites, the customer might not have sufficient room, and we might have a low-cost storage within a mile or two of our customer. And while it's a lot cheaper than a branch, it's still an expense. And so that's funding that piece. And so our branch occupancy, onsite occupancy, net-net is not growing. In fact, that's been contracting slightly. The growth in occupancy is coming from the fact we put more vending machines out there. If you look at expenses, other non-labor operating expenses, we've done a really nice job of just reining that in. And we have some pieces, triggers for pulling right now, for example, the travel component, because we reduced our training in the second half of the year. The real dollars is in labor, if you think about our operating expenses. So there we have some flex points from the standpoint of how our incentive comp works. I can tell you this, the incentive comp for a number of folks within Fastenal is materially different in July of 2019 than it was in July of 2018. And what that does, and you've described it aptly in the past as the shock absorbers, it gives us the luxury of not having to get crazy with expenses right today, in the last 90 days. Because you're not sure what's happening. But we are pulling back headcount growth rapidly. Because that expense can't be growing at 6% or 7% in an environment where sales are growing 8% and gross profit is growing 4%. So that's really where you're going to see the toggle. Because the other two components, which are 30% of SG&A, those are managed really well. And we've been managing the first one labor really well, but that was for a different environment, and we need to change our tact.

Yeah, if you think, David, if you look at our headcount ads, whether it be full-time or, you know, FTE, I mean, they were up 6.5%. And just zip back to May, go back one month, and if I look at the absolute headcount, it was up 7%. That's actually the highest rate of growth in our headcount. that we've seen through this cycle, right? And so obviously we need to take that rate down and there's room to do so. Certainly outside of the selling functions, we all need to look at sort of where we have opportunities to be more conservative. But even within the selling organization, we are going to continue to invest in people to support the onsite growth. We need to do that because it drives our market share gains. But if you look at where headcounts are getting added, payroll is getting added there, you're seeing growth you know, outside of the onsite environment as well, even in an environment where we're closing some branches. And so, you know, whether it's in the selling organization outside of the onsites to support growth or whether it's in the non-selling organization, you know, we're coming off a quarter where we had pretty good growth in heads. That's simply that rate needs to come down given the reality of the growth in the marketplace and should be able to.

You know, a good example over the last few years as we ramped up our onsites, our implementation team that we have in the field, I believe we took the number over the last two years from about 140-ish, 130-ish, to about 230 to handle all these implementing of national counts and onsites. So it's not just onsites, but national counts in general. That team we're not having to grow as rapidly now. In fact, it's relatively stable because we're not going from signing 80 onsites to 280 to three something to 450. We're kind of in that zone of around 400. We think that's a good cadence for our customers and for our business. So it doesn't require us to expand that group. So that group has been, I think we're up five in the last 12 months. So there's things like that that we can do in the short term.

Great call, guys. Thanks.

Thanks.

Our next question is from the line of Nigel Coat with Wolf Research. Please receive your question.

Thanks. Good morning, guys. Thanks for the details. Just going back to the price increases, and I think, Holden, you mentioned 2%. Is that across the whole board, or would that be the non-national accounts? And sort of the spirit of the question is, are you able to get price for national accounts, or is that sort of contractually locked in at this point?

Well, we are not looking at our business differently in that sense as it relates to the impact of cost increases and the price we're putting in place. We can't go after the 50% of our business that is non-national account and not address the 50% of the business that is national account. Now, national account has certain mechanisms that are built into the contracts that make that process perhaps a little bit more mechanical. but the intention is to work through that process and get price increases there where necessary as well because we're selling the same products into national accounts as we are non-national accounts, and the costs are behaving the same. So, no, we're not taking half of our business and setting it aside and saying we're not going to touch this. We can't do that and be successful in what we're trying to achieve.

One thing I'll just add for a little colors is – Holden cited an average. Average sometimes can be dangerous. If you think about China as an industrial producer, I believe 52% of the steel that's produced on the planet Earth is produced inside of China. I might be off a point or two, but I'm in the ballpark. Our faster product, which is roughly a third of our business, is made of steel. And a high percentage, most of the, you know, there are the holochromes of the world, the company I cited earlier, but they represent a minority of the fasteners that are consumed in North America. So most of the fasteners, regardless of where you're getting them, I mean, who's the distributor or who's the importer, most of the fasteners on this planet are made in China. And we've moved some production out. Actually, we've moved, if you look at the amount we've moved in the last nine months, out of China and compare it to what the U.S. economy is moving, we've actually moved more than the U.S. economy has, if you look at the statistics. But the reality is even in a 10 or a 25% tariff environment, they oftentimes are still the lowest cost producer of an item. And so there's, while Holden might cite an average across a whole bunch of products, there's a lot of different Parts in there, you know, there's four lists of items that have been identified by the U.S. government. List one and list two didn't really impact us that much. We don't import raw steel. List three last September hit us quite hard, and that list went from 10% to 25% here in the second quarter. That hits squarely into our faster product. List four, nothing's happened yet. It's on hold. I don't know what's going to happen there. We do have products on list four, and most of those would be in the non-faster area. And so there are parts where we're raising materially higher than 2%, and there are parts we're not touching. But be mindful of that.

And as it relates to national accounts versus non-national accounts specifically, so yeah, 2% is an average. Difficult to say whether national accounts would be more or less at any given quarter or what have you. But again, the intention, we are not setting aside 50% of our business and saying this is not something we think that we can impact. we think we can.

Understood. Understood. And then, Holden, very quickly, I mean, can you maybe just address the gross margin cadence of the balance of the year? Because we tend to have a seasonally lower gross margin second half versus first half, 2Q. How does the price increase that you're implementing, how does that impact that normal seasonal pattern?

Yeah, so the price increases have already been installed. So I would expect that we'd begin to see some benefit in July and that we'd see a greater benefit in August or September and then heading into the fourth quarter, right? So that'll ramp up. The cost from the new tariffs, now, of course, we're already behind on cost and generalized inflation, but cost from new tariffs would begin to impact us probably in the middle part of Q4. So think about that cadence on cost. If I think about the pieces that affected our gross margin this quarter and how that plays out, seasonally, I think Q2 would typically be down 10 to 20 basis points, maybe flat to down 20 basis points from Q2. So I think that's probably the typical seasonal pattern. But I think that some of the drag from freight, I think we might be able to get 10 basis points back from freight that we saw this quarter. I think that there may be a path to 40 basis points, give or take, on price cost in the third quarter. And when you lay that all out, I think that there's a path in the third quarter to have a gross margin that's a little bit north of 47%, which would cut the 180 basis point drag we had this quarter in half. And I think that we could expect something like that, maybe a little bit a little bit less of a decline in the fourth quarter as well, given the things that we're seeing. So that's kind of the cadence that we see. Obviously, it relies on our executing effectively, which we expect. But should we do so, I think that there's the seasonality that I think you can add a little bit from price-cost gain, and you can add a little bit from freight gain.

Right. Okay. Thanks, guys.

Yep. The next question is from the line of Robert Barry with Buckingham Research. Please proceed with your questions.

Hey, guys. Good morning. Maybe actually just to pick up where you left off there, Holden. So it sounds like you think you can kind of claw back into the call it low to mid 47s on the gross margin. But then I think you also said that the impact of the new tariffs are going to start to hit you in the fourth quarter. So does that mean you need to go back then again and get more price, or would we then kind of start moving back down in the other direction there?

Well, first, I think what I said was a little over 47. I don't think I ever said mid-40s, first off.

Sorry, mid-47, like 47.5. Yeah, I would just throw something in. The latest round of tariffs came into play in the Q2. So there's product that were – and stuff that was on the water was not impacted, but if it hadn't shipped, it is impacted. So we have costs that are coming in right now that are from that latest wave. Some of those costs will turn in July, and then a bigger piece will turn in August, and a bigger piece will turn in September. It's based on – our faster inventory does turn at a certain cadence, but there is – customer-specific product that we might bring in that turns in 60 days. So the price moves we're doing and the cost, while it comes in in waves, we're putting in place right now. And some will go in place in August, and some will go in place in September. But they're both moving now. It isn't a case of there's multiple waves. The message I've given to our team is, We're not doing one price increase on every part. You're doing some stuff every month based on what's happening in that month working with your customer in their individual supply chain. Because keep in mind, a big piece of what we sell is stuff that's unique to a customer. That's what makes it more difficult to manage systematically, but our team can be responsive locally.

And when I talk about 40 or 50 basis points of clawback in the back half of the year, I am assuming that you get both a little bit more price and a little bit more cost in Q4 versus where you are in Q3. So that's how we see that playing out. I do think costs will be higher in Q3. They'll be a little bit higher than that in Q4, but I think the price side of it will also escalate a little bit as that flows through.

Right. So given the mention of the waves, I mean, when is the full impact of the List 3 at 25% kind of fully into the P&L?

You know, you start seeing the fuller impact of it by the time you get into the middle part of Q4, past that.

Got it. And I guess just to circle back to an earlier question about, you know, achievability, I mean, given the slowing demand environment, and the fact that these are now much bigger numbers than 10%, I mean, what's the confidence on getting to price-cost neutral? Or is that even the goal? Because I think you mentioned earlier planning to share some of the burden with the customers.

I don't believe getting cost-priced to be neutral is realistic. With that said... We have to work to get – you have to work to get close to it. And some of it, as I said on prior calls, some of it involves having a challenging conversation with your customer. Sometimes it's price substitution. Sometimes it's looking and saying, you know, the cost of this is up. Here's a different alternative that's a cheaper price to start with. For whatever reason, maybe it's a more standard product. Maybe what the customer is using is actually a non-standard item, and there is a more standard substitute. And it requires, in some cases, some engineering support to get it approved for use in that process. Those are the challenging aspects. But in times like this, you create more friction to create those challenges. Because then it allows both Fastenal and our customer to win. Neither one of us takes the full brunt because you change the math. But it takes a lot of work.

And bear in mind as well that I think the environment today might be a little bit more challenging than it would have been six months ago. We also are better at executing this than we were the first time we did it. We've learned more about the systems that we have. We've made tweaks to the systems that we have so that fewer things won't be covered and that sort of thing. So I think you're right that the environment perhaps is a little bit more difficult than was true six months ago. I think that our knowledge of how to manage the process is also better. And so now we just need to go and execute it. All right. Thanks, guys.

Thanks.

Thank you. The next question is from the line of Josh Persinski with Morgan Stanley. Please receive your questions.

Hi. Good morning, guys. Morning. Good morning. I just want to follow up on the deceleration you guys saw in non-resi in June. Holden, any color on maybe some specific pockets or verticals there, anything you heard from the regions that may give a little bit more of an indication how persistent that is versus maybe one bad month?

You know, not as much color as I wish I could give you. Our larger customers did pretty well. The customers that we have a lot of volume with that tend to be national accounts grew fairly well within the construction side. What did not grow as well was the smaller customer base. Now, some of the RVPs commented about, you know, wet weather and things like that. But, you know, that was scattered. It wasn't a consensus by any means. And so, you know, I'm not sure exactly why that piece of the market was slower for us than was true of the larger customers. I wish I had more color for you, but I don't think I have a lot. Got it.

And then just on the kind of directionally similar national account deceleration, I couldn't help but notice in the press release as well some comments around monitoring investment. How much of that is directed to national accounts or on-site programs versus kind of the general concept of investment or cost containment. Just trying to think about if there's a trend to be had here on national accounts as some of those dollars get cut.

Well, our intention is to continue to invest in those things that allow us to gain market share. We believe that we continue to gain market share in the marketplace at a pretty good clip. And that's ultimately the goal, right? Whatever happens in the market happens in the markets. But what we can control is how much we gain market share. And so our intention is with onsites, we have to be able to staff onsites. And we're going to continue to add personnel to be able to deliver that model to the customers that are entrusting more of their supply chain with us. With vending, we're going to continue to invest in what we need to pursue that 23,000 to 25,000 unit goal this year. So there was nothing in there that was intended to convey that, we were going to be tighter on growth drivers because we're not. We need to invest in those to continue to gain market share. It's really resources outside of the growth drivers where we have to look at it and we have to say, you know, where can we save ourselves some expense? And headcount was one thing that we talked about that. And again, I think I emphasized there that, you know, we're going to continue to staff the onsite. That's not where we're going to be going after the headcount. But there's other areas where, whether it be the hubs, whether it be the branches, whether it be the Winona headquarters, et cetera, when growth slows, there's an opportunity to slow the rate of headcount in areas like that. And those are the types of things we need to look at. But no, when we talk about monitoring investment, monitoring spending, that really is more of a message outside of the growth drivers, provided we're doing the right things on the growth drivers, by the way. If we find that we're doing something you don't need to in a growth driver, we'll address that as well. We're not looking to spend where we don't have to anywhere. But, you know, the real scrutiny has to occur outside of the growth drivers because we're not, you know, our goal is to gain market share and the growth drivers are key to that.

Got it. And I guess just a corollary to that inventory and that comment in the release, you know, I would imagine that, you know, given some of the advanced purchases last year, they weren't much, but there were some and the cutting of purchases this year, Should we expect something to show up in terms of the rebate structure looking like a little bit more of a headwind than you would have contemplated before?

Well, you know, with regards to inventory, I think we're sort of past that sort of accelerated purchase that we made in Q4. I think between Q4 and Q1, that kind of adjusted itself out. I think more meaningful for the inventory as you go into the second half of this year is our purchasing teams, our supply chain teams, they've really reduced their spend starting in Q3, Q4 last year through Q2 of this year, and fairly meaningfully so, because we have enough product in the hub today for the level of demand that we're currently seeing, and that allows us to be a little bit more cautious with that spend. And so we have seen a reduction in spend, particularly of imported product, you know, currently versus where we were three quarters ago, two quarters ago. And I think that will begin to flow through in lower inventory as we go through the third quarter and fourth quarter. Now, interestingly, rebates are actually a heavier component on domestic spend than they are in the imported spend. And so I wouldn't necessarily assume that a reduction in imported is going to have a terribly dire impact on the rebate piece. The rebates tend to be more affected by the domestic spend. And right now, we've really gone after that imported spend as much as anything else. Make sense?

Okay, got it. Yep, appreciate the call. Thanks.

Thank you. The next question is coming from the line of Adam Ullman with Cleveland Research. Please proceed with your questions.

Hi, good morning. Hey, Adam. Hey, Dan, you made an interesting comment a little bit ago that the company has moved more suppliers out of China than before. the broader economy. I kind of missed what exactly we were getting at there. Could you just share with us in more detail kind of the actions that the company has taken on moving activity out of China? And then maybe just share with us today where do we stand in terms of your total purchases that are coming out of that country?

I'd prefer not to get into specifics from a standpoint of percentages. Just from the standpoint, I don't necessarily want to share that information publicly. And that's for competitive reasons, quite frankly. But we always have multiple sources of supply for product. In the case of fasteners and non-fasteners, they include a variety of suppliers. And sometimes that can include a variety of countries. But the universe of countries is not that large, but the universe of suppliers is quite large. And you do that because our covenant with our customers, we will have product available for them when they need it. And the other reason to have it is the one challenging thing from the standpoint of how many you have and how fast you can move it is not only do you have to have confidence in your supply, you need to have confidence in your quality of supply. Because at the end of the day, we're selling a product that holds stuff together or is used by people. Half our revenue is either a fastener or a safety item. And so you have an important quality consideration in all the products, especially in those. But if you look at the statistics, and the statistics are out there for me to look at, the amount of product that has been resourced as far as what's coming through and is measured by by U.S. Customs, the percentage that's been resourced is actually fairly small. And a lot of it is there's sophisticated supply chains out there that are difficult to change that have been set up not in the last five years, but in the last 25 years. In the case of us, where we had a cost ability early on, because the other challenging thing is we might have other source of supply, but they might be 5% more expensive, they might be 12% more expensive, they might be 20% more expensive in different places. You don't move the 5%. The 5% stuff you move, if you can, and you try to get ahead of everybody else who wants to do the same thing when there's tariffs at 10. But the 12, you might not or you might, depending on what you think is going to happen next. And so we moved on some of that fairly aggressively late last fall. And so we moved a chunk of our product out of China. most of that that we moved went to other Asian countries, Taiwan primarily. And so there's inflation introduced because of that because you're probably buying it for more, but you're paying less or equal to the tariff. And it's really because of the supply chain relationship we have with our customer. But percentage-wise, we've moved more than what the U.S. economy has looking at import data.

Okay, gotcha. And then a clarification, you had mentioned that the incentive comp was reduced a lot. I'm just wondering if that came through the P&L in the second quarter or if that's a third quarter event and if it was material for the quarter.

Thanks. It would have come through on the second quarter. It's a piece of the equation because If you think about what's going on with labor expenses, there's two dynamics there. I mean, one is the sheer headcount – well, three dynamics. One is the sheer headcount growth. The other is there is inflation, particularly in the part-time areas, but there is inflation in general in payrolls across the U.S. economy because we have very low unemployment. And so those two dynamics are adding – are pushing it up. This actually pulled it down a little bit.

Yep.

Okay, thanks.

Thank you. At this time, there are no additional questions. Would you like to make some closing comments, Mr. Flores?

Just want to thank everybody for their time this morning and hope you found this call and our disclosures useful in understanding what's happening in our business selling into industrial North America and the rest of the planet. Thank you.

Thank you. This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.