Fastenal Company

Greetings and welcome to the Fastenal Company 2021 Second Quarter Earnings Results Conference Call. At this time, all participants are on a listen-only mode. A question and answer session will follow the formal presentation. If anyone would like to ask a question, please press star 1 on your telephone keypad. If anyone should require operator assistance during the conference, please press star 0 on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Taylor Ranta of the Fastenal Company. Thank you. Please go ahead.

Welcome to the Fastenal Company 2021 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 will 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 1st, 2021 at midnight central time. As a reminder, today's conference call may include statements regarding the company's futures, 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 Forman.

Thanks, Taylor. And good morning, everybody. And thank you for joining our second quarter earnings call. Similar to the last five quarters, we're going to start with a few stats on our COVID experience. So to date, we've had 1950 cases of COVID-19 among our employee base. So about nine and a half percent of our employees have contracted the virus over the last five quarters. Looking at it from a pattern standpoint, and as we've discussed in previous quarters, our worst quarter was the fourth quarter of 2020. November of 2020 was our worst month. But in the fourth quarter, we averaged about 60 cases per week. In the first quarter of 2021, that dropped to 44. In the second quarter, that dropped to 20 cases per week. And I'm pleased to say in the month of June, we averaged eight cases per week. We had about 30 cases throughout the company. So very good patterns, not unlike what we're seeing generally speaking in society, especially in the countries in which the bulk of our employees are located. One of the things that should jump out at a reader of our earnings release or in some of the commentary, one of the struggles that we are seeing that is not unique to FAFSA at all I suspect most companies will cite this, is difficulty in the hiring on the addition of people as we're re-emerging from the shutdown economy of 2020 and the first part of 2021. And there's, I think, three distinct subsets that drive it, at least in our case. As you all know, historically, we are a promote from within culture, and we believe in starting early in a person's career in that promote from within culture. And we hire a lot of part-time employees, and those part-time employees, a very high percentage of those employees are full-time students. And we think of it as, in most cases, in a perfect world, you're not hiring a part-time employee, you're hiring a future full-time employee. And we provide a tremendous amount of flexibility to folks early in their career. We focus very acutely on four-year state colleges, and two-year technical colleges. And so in a period where schools are closed and people are studying remotely, a big chunk of our recruiting base has vaporized from the areas that we traditionally approach. And that has created some challenges for us. I'm pleased to say those challenges have lessened over time, but they're still pretty acute. A fair number of our part-time employees, especially in our distribution centers, a lot of them We represent a second job. I heard an example the other day of an individual that had pulled back their hours with us because they hold a second job because they have a child in college. It's a great way to earn extra money. We're incredibly flexible with employees on scheduling. But their employer has gone to mandatory overtime, and so they just don't have the hours to work for us. So that's creating some challenges. The third, and this is more across when I think of, generally speaking, our branch and on-site network, We are seeing some geographic biases in the numbers as far as country by country and state by state in the United States, depending on how open or closed the society is, what impediments there are to hiring from the standpoint of public policy. We are seeing some patterns there. We are seeing no meaningful pattern from a racial perspective of hiring. The progress we've made over the last decade, we continue to see that throughout the business Where we have seen a stark weakness, and I talked about this in our April annual meeting, is on the gender side. We've seen the application side of the business during 2020, and this has continued in 2021, our female applications are down about a third from what we've seen in recent years. And we've seen worse than historical patterns as far as turnover. In an environment where society is shut down and a lot of schools and daycares closed, we've seen a dramatic impact, and that's fallen largely on the female portion of our employee base and our potential employee base, and we're making efforts to improve that, but they're difficult. But with that, I'll switch over to the flipbook. Sales and manufacturing construction customers grew 21.5% in the second quarter. There was, as expected, a fall off in the pandemic-related sales, a frankly, a good thing, which resulted in overall flat sales performance from a year-over-year basis. I believe we continue to manage costs really well. I'm so impressed with the team throughout Fastenal and in our ability to manage expenses well. We did have some resets, and Holden talks to that in the earnings release. Branch and onsite are incentive comp. There's a reset going on there because a year ago, a lot of customers were idled or shut down And a lot of our surge business was direct container shipments, or not container shipments, excuse me, direct pallet and truckload shipments. And so it was a different cost structure. So I'm pleased to say our branch and onsite business is coming back in a resounding fashion, and we're paying people for that. We're also seeing an incredible reset in the health care. I believe health care expenses were up about 25% this quarter. And that's really a function of we're self-insured when it comes to health care. People weren't using it a year ago. They're using it now. So we're seeing a reset there. Where we're seeing some partial resets on things like travel. Our airfare was up about tenfold from second quarter 2020 to second quarter 2021. Now, before you read anything into that, that's meaningful. We're still 82% below where we were in 2019. We don't know ultimately where that number settles on. The number I've challenged our team with is with some of the technology tools we have and some cultural changes as far as working from a distance and communicating from a distance. I do believe that 30% to 40% reduction is an achievable number, and time will tell if I'm correct or if I'm full of it. But I believe it's something that will be achievable. Right now we're about 80% down. Price actions to date have largely matched cost increases. There's a ton of inflation going on. There's inflation because of disruption in shipping, i.e., the cost of moving a container. And this is pretty public information, so I don't need to cite figures. But it's gotten really expensive to move a container across the ocean. And it takes a longer time than it did 12 and 18 and 24 months ago because of all the congestion at the ports. And so massive inflation going on. We've been largely able to move with that. The higher gross margin we experienced is really about product mix. The fact that the organization is moving more product and more stuff going through our manufacturing, there's a utilization of the corporate overhead organizational leverage going on. And within the safety product category, there's a meaningful shift in customer mix. And when you're shipping truckloads of product versus pieces of product, the gross margin profile is different, and we're seeing that play through in the numbers. The final point talks, and I see the team put it in here a few times, the conversation. I think it's on both pages about our digital footprint. I guess they wanted to make sure Dan didn't screw up and miss it. But if you think about the digital footprint we're talking about, so about 42% of our sales are part of what we call our digital footprint. It starts with FMI. In FMI, there's a device component and there's a mobility component. The device component is our vending machines that we've talked about for the last decade. It also includes... In growing importance over the last 12 to 15 months, our digitally enhanced, our technology enhanced bins, where the bins tell us when they're hungry, just like the vending machine tells us when it's hungry and needs to be fed. And so about 21% or so, 22% of our business is going through one of those devices. Another about 10% is going through what we call fast stock. That's where the mobility that we've deployed. We're out there scanning bins. And that's really about a productivity play in the short term, but I believe an ability to grow faster in the long term. And on page four in the earnings release, Holden has a great table in there that lays out the FMI pieces, the devices as well as the fast stock. The third piece is looking at e-commerce. And that's growing quite dramatically, and I'll touch on more of that in a second. But about 10% of that is outside the FMI world. So you add those three pieces together, about 42% of our sales is now digitally connected. And the vast majority of that is where it's FMI. And the importance of FMI, the goal shouldn't be an easier way to order. The goal should be If it's recurring business, why the heck are you ordering it? And why don't you have a partner that supplies it when you need it? And that's what we endeavor to be, a great supply chain partner for our customer. Flip into page four of the book. Pleased to say our on-site signings ticked up again in the second quarter of 21. We had 87 signings. That's our best quarter since COVID started. And Of equal importance, it's about participation. How many of our district business units are signing an onsite? We had 30% of our district business units sign an onsite. We haven't been north of 30 since the first quarter of 2020. So not only are the numbers strong, it's broadly dispersed across our business, so there's great participation. We ended the quarter with 1,323 active sites, just over 9% increase from second quarter last year. And our daily sales in the on-site business grew just over 25%. So very, very strong performance there, and it's improving. And that builds upon our ability to engage with our customer and grow the business long-term. FMI, I touched on that yesterday, or excuse me, on the last slide. And I did touch on it yesterday with the board, but that's a different matter. There's 5,843 devices. That's a weighted number signed in the second quarter. That's 91 per day. Similar to onsites, a nice, improving, strong performance. Our ending installed base was up just over 9% from June of last year. And if you look at it, and I'm going to flip to some points on that table on page four of the earnings release. So sales through the devices are up 40.4%. Sales through fast stock is up 148%. And you combine the two together, FMI grew 61.4%. Really excited about what we have going there as far as momentum. E-commerce, 53% increase. Large customer-oriented EDI was up 51%. That's about the economy. That's about strengthening of our existing customer base, and we're seeing it happen play out right there. When I look at web sales being up 61%, that's about habits changing. That's about how our customers are engaging with us. So two dynamics going on, both very positive from the standpoint of how our customers are engaging with us and how is our underlying customer doing as far as business. I'm going to skip the digital footprint since I covered that pretty thoroughly already. And flipping to page five, this is a new table. I believe Holden plans to have it in here in this quarter. I suspect next quarter, maybe fourth quarter, but... It's really doing a quick snapshot of understanding if we ignore the noise of COVID-19 for a second and just say, you know, what did our business do in the second quarter of 2019? What did it do in the second quarter of 2021? Some things that stand out. Our margin is down about 40 basis points in that period, and that's about the shift that we've talked about in prior quarters of our business to more of an onsite, a higher proportion of our business being onsite. where it's larger customer, larger transaction, better expense leverage. And you see that expense leverage play out in the operating administrative expenses being down 140 basis points in that same time period. So our operating income is up 100 basis points. Pleased to say we had great incremental margin, about 31% in that time frame. And with that, and we generated good cash. With that, I'll turn it over to Holton. Great. Thanks, Dan. Now, turning to slide six, as indicated, our sales were basically flat in the second quarter of 2021. I think everybody understands the dynamics at play here. About 350 to 360 million in surge business from last year did not repeat, and that was offset by a significant rebound in demand from our traditional manufacturing construction customers and, to a lesser degree, new sales to customers that had never bought from Fastenal prior to the pandemic. Our fastener products grew 28.4% and best represent the strength of our underlying business conditions. If we were to adjust out the impact of surge sales, we believe that safety and other products would have grown at a level that's comparable to our fastener growth. Manufacturing, and particularly heavy manufacturing, is exhibiting broad strength. And in the case of both manufacturing and non-residential construction, sequential quarterly growth in the period exceeded historical norms. Combined with access to customers that is approaching pre-pandemic levels, as evidenced by our improved on-site and FMI signings in the second quarter of 2021, our outlook remains positive. It's also worth highlighting that while government sales were down 63% in the second quarter of 2021, they were up 37% versus the second quarter of 2019. We had similar dynamics play out with certain large customers. We continue to believe that we gained market share during the pandemic. Now to slide seven. Operating margin in the second quarter of 2021 was 21.1%, up 20 basis points. Gross margin was 46.5% in the second quarter of 2021, up 200 basis points versus the second quarter of 2020. Our safety product margin improved in a combination of mix as lower margin COVID-affected PPE mix retreated to pre-pandemic levels and a recovery in pricing as the market is normalized. We leveraged overhead costs on an improvement in volumes and favorable rebates, which is a combination of lower rebates to certain customers that were heavy surge buyers in 2020, and our own purchasing of key products improving versus 2020. Product mix, specifically growth of fasteners versus non-fasteners, was also a significant contributor to the growth and was a significant factor in gross margin outperforming our expectations for the period. Our pricing actions largely matched inflation we are seeing in the marketplace, and price cost did not meaningfully affect gross margin in the second quarter of 2021. The increase in gross margin was partly offset by operating expenses growing faster than sales. In the second quarter of 2020, in response to the onset of the pandemic, we took certain proactive steps to reduce costs. Certain costs naturally declined as a result of the weak business, and a large portion of our surge sales went direct as opposed to through our branches. which is a very low labor intensity source of revenue. In response to improving conditions in the second quarter of 2021, these situations reversed. Our headcount remains under control but is appropriately ticking up as demand recovers at our branches. Further, incentive compensation was up almost 20% and healthcare costs are up 25%. Travel expenses are growing strongly off very easy comparisons as the economy fully opens. Fuel costs are rising sharply. As we indicated last quarter, deleveraging operating expenses in the second quarter of 2021 is a function of anniversarying the first periods of pandemic-related cost savings measures combined with a strongly recovering marketplace. Setting aside these optics, however, we believe the organization continues to manage costs well. If you put it all together, we reported second quarter 2021 earnings per share of 42 cents, which is flat versus 42 cents in the first quarter, I'm sorry, the second quarter of 2020. Now, turning to slide eight, operating cash flow was $172 million in the second quarter of 2021. This was down 32% annually and was 71.5% of net income. Now, recall that in the second quarter of 2020, pandemic-related legislation allowed us to defer two tax payments into the third quarter of 2020. That deferral was not available to us in the second quarter of 2021, and we made those two payments, as we historically have. The better way to think about cash generation is by considering that in the five years from 2015 to 2019, our second quarter cash conversion averaged 63.5%. Against this, we were pleased with our cash generation in the second quarter. Year over year, accounts receivable was up 3.1%. Though sales were flattish, the shift away from PPE surge buyers last year and toward traditional buyers this year blended up our day's outstanding. Inventory was down 5.3%, and there's a lot of moving pieces here. A part of this is due to the difficulty in getting sufficient imported products, although our hub inventory deficit has not widened meaningfully versus where it was in the first quarter of 2021 as we are finding domestic sources of product. However, the decrease also reflects deliberate efforts to clean out slow-moving hub and branch inventory, branch closures, and the shift in our stocking focus in the field. We believe these represent improvements in our working capital that will be sustained. Net capital spending in the second quarter of 2021 was $32 million, down from $38 million in the first quarter of 2020. This was largely from lower FMI hardware spend, which was a product of lower signings over the past 12 months and greater refurbishment of FMI equipment. Our 2021 net capital spending range is unchanged at $170 million to $200 million, and we're tracking in the lower half of this range at this time. We returned cash to shareholders in the quarter in the form of $161 million in dividends. And from a liquidity standpoint, we finished the second quarter with net debt at 2.5% of total capital, down from 6.4% in the year-ago period to 5.1% versus the fourth quarter of 2020. Essentially, all of our revolver remains available for use. Now, before moving to Q&A, I wanted to update a few subjects of current interest. First, we continue to experience significant cost inflation, particularly for steel, fuel, and transportation. In the second quarter of 2021, price contributed 80 to 110 basis points to growth. This largely tracked our increase in costs, and the impact of price costs on margin was immaterial. Cost pressures remain high, however, which will require us to institute further material price actions in the period. The marketplace is still receptive to price actions, and the tools and processes we have developed have been effective. Given the rate of inflation, maintaining price-cost parity will be a bigger challenge in the third quarter of 2020. Global supply chains remain tight. We have managed this well domestically, which has allowed our customer service levels to remain high as a result of spot buys, which do tend to carry a lower margin, and inventory in certain areas to build to meet projected future needs. Internationally, there continues to be a shortage of capacity, which has made moving products, particularly fasteners, increasingly costly and sustained long lead times. We believe this dynamic could persist at its current level intensity through 2021. Now, Dan commented earlier on the labor shortages in most of our business. We have largely managed this to this point. However, we are beginning to see those pressures be reflected in our labor costs, and the increase in onsite signings and implementations could introduce some additional strains there. However, recognize a few things. First, this is all partly a byproduct of strong demand and happens to some degree with every cycle. Strong growth will allow leverage of other costs that will help us to mitigate these pressures. Second, much of what we're doing with our digital footprint and the change in our branch model will address many of these matters. Third, none of these pressures are unique to Fastenal, but we believe that our culture and our structure is uniquely geared to navigate them. We have seen no moderation in these pressures over the past three months, but we continue to believe that we'll gain share through them. That is all for our formal presentation. So with that, operator, we'll take questions.