Fastenal Company

The Fastenal 2023 Second Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. The question and answer session will follow the formal presentation. If anyone should require operator assistance during the call, please press star zero on your telephone key. As a reminder, this conference is being recorded. At this time, I would now like to hand the call over to Taylor Ranta of Fastenal Company. Thank you. You may begin.

Welcome to the Fastenal Company 2023 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 1st, 2023 at midnight central time. As a reminder, today's conference call will 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.

Good morning, everybody, and thank you for our second quarter earnings call. Before I start on Fastenal matters, I'd like to share a message. When I joined Fastenal back in 1996, one of the things that – was unique in my joining is that I stepped into the role of Chief Financial Officer. Bob Curlin offered me the opportunity. And so I joined in an unconventional way in that I didn't start in a branch or in a distribution center and work my way up through the organization. And sometimes when you join an organization that promotes from within, you're not sure what kind of reception you'll get when you join. One of the first people I met was Colleen Quaid. It was Bob's curling sister. She had retired, and in her retirement, she worked for Fastball a few years in sales support. One of the nicest ladies I ever met, and we lost Colleen earlier this year, and to her children and grandchildren, you have my condolences, and as well to Bob, I lost your sister. What a wonderful lady, and we were all blessed to know her. We started back in 67, so our five founders aren't in their 20s anymore. And van mcconnan, Henry mcconnan, he goes by van, he, he was our first employee. In fact, I think that's how he earned his stake in fast and on. Yeah, he did well with that stake. And I'm proud of him. He lost his wife Wilma earlier in the year and the same message. Van was could not have been more of a welcoming person to me when I joined the organization. And here's my condolences and the loss of his of his wife this spring. With that, I'll move on to the Fastenal quarter. Second quarter of 23 is a challenging quarter. Last fall when we, or last December, when we had our leadership meetings and our planning discussions for 2023, the ISM had weakened. We knew that 2023 was going to have some slugging aspects to it. We cautioned our team. Second quarter and third quarter are going to be tough quarters to get through, and prepare yourself. prepare your teams from the standpoint of we're going to have to manage our expenses really well. We'll have to keep all of our heads screwed on the right way because there's been a, it's been an interesting number of years between tariffs and COVID and congested supply chains and inflation and all this stuff. There's noise, noise, noise, noise, noise. We're going to experience something we haven't experienced for a number of years, and that's a slowing economy. And prepare for what that means, and get the muscle memory back. But it was a challenging quarter. Our earnings came in at $0.02, rising about 4.5%. Softer manufacturing activity led our daily sales growth to decelerate. We grew 5.9% in the second quarter. We did not leverage. That's an important element of our business. Our sales grew 5.9%. But as we're cycling through some mixed changes and hold in touch on a little more detail, our gross profit dollars grew about 3.6% and our operating expenses grew 4.1. And I'm not real good with math, but I know that's not a good combination if you want to leverage your earnings. And one of the elements is we didn't anticipate it softening quite as much as it did. And that 4.1 needed to be a little bit lower. We didn't adjust our variable cost quite quickly enough. As we've seen in prior timeframes when the economy is weakening and it affects our ability to grow, the high amount of working capital on our balance sheet really can influence our ability to generate cash. And given my old role as CFO, second quarter is a painful quarter for us typically because we have two tax payments. And when you're a profitable organization and you operate a lot of business in the United States, you pay a lot of group tax. And so second quarter hits us really hard. And normally we, for every dollar in earnings, we generate 60 to 70 cents in operating cash flow. I don't recall us ever having a second quarter where we generated more cash, operating cash flow than earnings, perhaps holding aside an example where we did. But maybe it was 2009. But that's as strong a cash flow as we've ever seen for this time of year. And a chunk of it is from not just what's happening in the economy and the working capital needed to fund receivables and to fund inventory for growth. In the last several years, as supply chains were really getting congested, the message that I made very clear to our supply chain folks and our teams, we have a covenant with our customer, and that is we're their supply chain partner. We will not let our customer down in their supply chain If that means we need an extra 15, an extra 30, an extra 45 days of inventory, don't get ahead of yourself, but we need to have inventory to support the business, period. And when the ports on the west coast of North America were getting congested, the economy was turning back on, everything was getting congested, we beefed up our inventory. We were harvesting that. We were doing it in the first quarter. We're doing it this quarter. I think the team's done a wonderful job. It means we have capacity now to look at our balance sheet and say, where does it make sense to make strategic investments in inventory? I'm not saying there's stuff on the table right now, but that discussion can be had, whereas a year ago and two years ago, we couldn't really even think about it because we were focusing all of our energy on something else. In the second quarter, we made some leadership changes. First off, Jeff Watts, who joined Fastenal back in – 1996, so he's been here for 27 years, and started in our Canadian organization when we had just a handful of locations in Ontario. He's led our international sales efforts since 2015, and he will oversee all of our sales efforts across the planet. And obviously we know each other really well, the team in the U.S. The international knows him really well because he's led that team for quite a few years. But the U.S. team is no stranger to a 27-year employee. So we know each other well, but I believe we'll have greater coordination on our efforts. And Jeff has a very entrepreneurial approach to how he leads a business, and I welcome him and look forward to the success he's going to see. Terry Owen, who's been in an EBP operations role, We formalized his role in that he's our chief operating officer. And, you know, this bullet was added kind of late in the process. I found out yesterday as a team, but I should mention this since we had announced it this quarter. And there's an error in our release. I thought I'd let you know. And it's probably not material in the true aspects of life, but it says Terry's been here 28 years. And I know he joined in June of 1999. If I do the math, I think it's 24. So sorry we didn't catch that error in our process. But in conclusion, you know, cyclical factors aside, the last several years, we've taken a lot of steps to improve both our labor and our inventory productivity. And I believe this forms an excellent foundation for our ability to generate long-term share gains in the marketplace. Switching to the next page. On-sites, yeah, I'll state the obvious. 86 on-sites is a disappointing number. Our aspiration internally has been to drive that to 100 per quarter, 400 per year. That's been our stated aspect mentioned internally. Prior to COVID, we hit 362, and that was a wrap-up from 80 in 2015 to 176 to 270 to 336 to 362 per year. When COVID came along, it really impaired our ability to sign onsites because the last thing you want when you're worried about people being around you is inviting a bunch of folks with blue shirts to come in and operate inside your four walls. And so we saw that drop dramatically. We recovered to about – we did 356 signings last year. We broke 102 out of four quarters. Perhaps some of the leadership changes we made in the last 60 days created some distraction. Perhaps we're not as focused as we should be. But that number needs to be 400 a year or more. And right now we've adjusted our number. We think we'll probably come in similar to last year, somewhere in the 350s. And with that said, the fact that our onsites are up, we have 15% more onsites than a year ago, that's a great number. We're just not building the pipeline the way we need to. FMI technology, that's a different story. So our goal in onsites is $100 a quarter. Let's get there and then figure out how we take it to $110, $120. But let's get to $100 first. With FMI technology, it's not $100 a quarter, it's $100 a day. And I'm pleased to say in the fourth quarter, excuse me, the second quarter, we did $106 per day. And that's market share gains. That's us going out and planting new flags in new locations to improve the supply chain for our customer, illuminate the supply chain for our customer, and us being a great supply chain partner. That's a huge positive. I believe it tells me the marketplace is conceding this space to us. Maybe I'm wrong on that, but I believe it is because we are so far out ahead of the marketplace. I told the board yesterday we're with 106 this quarter. We had our board meeting yesterday. With 106 this quarter, we're at 100 year-to-date. I misspoke. We're actually at 99. But I'm really pleased at what the group's doing there. And the 39.8% of our sales went through our FMI platform in the second quarter. Newsflash, it was 40% in June. So we hit 40%. Now we need to get to 45% and 50%. But continue to see really nice progress there. E-commerce continues to grow handsomely for us and grew about 45% in the quarter. For us, this has been a different journey than other things because a lot of e-commerce is unplanned spend. If you think about our FMI technology, that's all about planned spend. That's stuff you're using daily, weekly, every month in your business, and it makes sense to stage it accordingly. E-commerce, a lot of that is stuff that you're hopping on to order, so it's unplanned. Historically, not a strong suit for us. And I'm pleased to say it's growing to be a bigger piece of our business. It's up, as I mentioned, 45%. The EDI portion of it is up 37%, and that's typically larger customers. The web portion of it can be large or small, and that's up almost 70%. And to give you a magnitude of how that's changed, and again, we're not great at this piece of business. But we can be. But with that said, in 2015, when I stepped into this role, the web portion of it was less than 2% of sales. And we were at 3.8, 3.9 billion at a company back then. So about 75 million going through web sales back in 2015. In 2023, in the second quarter, it was 6.5% of sales. So, you know, right now we're on a 12-month run rate of about $7.5 billion. So that's a business that's approaching $500 million. And we're not that good at it, but we can be. And so it's six and a half times bigger than it was a handful of years ago. And obviously it's been accelerated by the events of the last few years. COVID is a perfect example. What really accelerated it is people do – some people are working remotely. Some people are ordering a lot more stuff. electronically, we're seeing that in our numbers, and we're getting better at it every day. And when you push the FMI technology and the e-commerce together, and you think about our digital footprint, that was 55.3% of sales in the second quarter of 23. It was 47.9 a year ago. We thought we could get to 65 this year. We've tweaked it to 60. I don't know if I completely agree with our language there about fast stock conversions. I think part of it is a case of we're doing more and more every day. But some of the activity, because a lot of the fast stock, for example, is going into fastener installs. It's going into OEM production areas. It's going into MRO production. And we're doing more transactions every day. However, the transactions are a little bit smaller because industrial production is slowing down in our business. And so we might be doing more orders. They're just fewer of them. And I'll, I'll show you, show you a few statistics. In January of 2022, our fast stock, we did 234,000 scans of orders through, for, through our tool, which is 11,100 every day. So our employees are going out with an Android device and scanning 11,100 planograms every day and generating about a $250 order. Actually, it was closer to 260. And then in January of this year, that 11,100 had grown to 14,700. And between January and June, that 14,700 scans per day is now 16,300. That's a combination of market share gains and conversion. Instead of going out with a yellow notepad, we're going out with an Android device and scanning BIMs. And so that's a huge win in our system from efficiency. It's a huge win from standpoint of ability to take market share. But looking at the numbers, our average order size was $258 in calendar 2022. In January, that number had dropped to 246. It was down about 4.7%. Now, I think there's enough transactions going on there. That's probably more a tone of the economy than anything else because when you're doing $300,000 a month, it's not a mixed thing. Between January and June, the $246 order dropped about $222, so it's down $24, which is 9.6%. That's primarily activity that's declining in the industrial marketplace. And there might be an element between January and June of a little bit of deflation, because there's some fasters in there, but it's mostly about activity. Just thought I'd share those, sorry to get into weeds. And I will share one last thing before I turn it over to Holden. And that is, again, this FastStock tool, this Android device that we have out there. In October of, excuse me, in the summer and fall of 2019, We did a beta version out in the Southern California of that device and worked through some bugs, worked through some bugs, and started rolling it out to regions late in the year with a planned two-year rollout. COVID hit, and we accelerated that rollout, and we rolled it out across the company by June of 2020. We did a two-year rollout in six months, and today that's about 12% of our revenue. In October of this year, we plan to roll out what we call our order pad, which will be on the same device. It will be an internal-facing device and use it in beta in the October timeframe. If all goes well, our goal would be to roll it out in Q4. And essentially, it's a tool for our personnel when they're out visiting a customer. Not only can I take a recurring order, I can easily take a customer asking for something, or I can do a search on it, and I can respond to the customer right in front of them. That's a capability we've never had, and we expect to have that by the end of this year for 2024. A second piece, that's an internal-facing app. We've also developed an external-facing app called FastScan. It's with beta customers right now. Our goal is in August to have that out in the Apple Store and the Google Play. For customers, if they choose to download that, and that would be a bin stock app for customers, primarily smaller customers or customers that might be a few hours from a facility in Montana or in western Canada, where they can do some bin stock scans themselves, transmit the order so when we visit, we aren't surprised by a stock out. And it makes for a better supply chain for that customer base. That will be, again, coming out in August. And depending on the success we find with our order pad, our goal would be next summer to roll that out in the customer-facing app as well. Again, we're not great at the web portion of our business. It's a half-a-billion-dollar business within Fastenal now, but we can be, and we're building tools to do that because we think that's a better reaction to some of the buying habits that's going on in the marketplace. With that, I'll turn it over to Holden.

Great. Thanks, Dan. One loose thread there perhaps to pull a little bit. Last time we had cash conversion of this level was actually in the second quarter of 2020. For those that don't remember the second quarter of 2020, there was an event occurring at the time that we now know as the pandemic. But I really think it reinforces the point. It took a once a century event to create a second quarter that despite several tax payments produced cash conversion in that 100% range. And the fact that our teams were able to do that in a quarter where thankfully there has not been anything remotely looking like a pandemic, again, I think really gets to the success of the teams in managing kind of the post-pandemic environment. So yeah, but it does take a condition of that sort. Jumping into the details on slide five of the deck, daily sales increased 5.9% in the second quarter of 2023. Since March, we have seen overall business activity moderate, which culminated in June daily sales growth of up 4.7%. The most meaningful change in trend has occurred in our manufacturing customers. This segment grew 10.4% in the period, despite sustained sub-50 PMIs and flat-to-negative industrial production. This reflects the impact of our investment in onsite and greater sales focus on key account plan spend, which tends to be significant within manufacturing. Even so, we did experience weaker sequentials in May and June that represents a macro-driven change from the long string of strong sequentials that we had from 2021 to February of this year. As it relates to pricing, it contributed 190 to 220 basis points to growth in the period, declining approximately 470 basis points from the second quarter of 2022 and approximately 100 basis points from the first quarter of 2023. This trend is not a surprise and will likely continue in the second half of 2023. Other factors cited in recent quarters, specifically weakness among some large retailer customers, lack of growth in our rest of world geography, and contraction in our construction end market, remain factors in the current quarter, but the dynamics around these areas were largely unchanged from prior periods. While we continue to pursue key account plan spend in construction, This market has historically had a disproportionate amount of smaller transactional spend where we are currently putting less emphasis. We believe this shift contributes to manufacturing outgrowth, better labor leverage, and better asset efficiency. We have experienced manufacturing-driven weak sequentials in three of the last four months. Regional leadership continues to characterize customer sentiment as cautious with greater scrutiny over operating and capital spending and some mention of slower or deferred orders. As usual, we have limited forward visibility, but most indicators seem to be pointing to the immediate outlook remaining soft. Now to slide six. Operating margin in the second quarter of 2023 was 21%, down from 21.6% the prior year. The incremental operating margin was 11%. Gross margin was 45.5%, down 100 basis points in the prior year. This decline is almost entirely due to product and customer mix, as we experienced widening sales growth outperformance of non-fasteners over fasteners. and of onsite growth over non-onsite growth. Freight was favorable to gross margin, reflecting record freight revenues that allowed for good leverage of our captive fleet, reduced use of external freight providers, lower fuel expenses, and reduced shipping costs. The benefits of freight were offset by higher organizational, or GAAP, expenses. Reductions of purchasing and shipping activities of imported products stemming from a smoother and more predictable supply chain relative to the year-ago period caused higher prior period costs to be relieved from the balance sheet to the P&L. The impact of price costs was immaterial to gross margin in the second quarter of 2023. On the operating expense side, we produced 40 basis points of leverage, which was not sufficient to fully offset the declining gross margin. This was due entirely to payroll expenses, off which we experienced 60 basis points of leverage, which was related to lower incentive compensation off last year's record level. This was offset by modest deleveraging of both occupancy costs and other expenses. There were three distinct elements playing out in our operating margin in the second quarter of 2023. First, I alluded to the GAAP expenses. GAAP expenses had the convergence of a difficult comparison, aggressive inventory reductions, and shortening product order cycles. This alone was a 50 basis point negative impact and is unlikely to repeat by anywhere near the same magnitude in the second half of 2023. Second, certain expenses, such as 16% growth in IT spending and 13% growth in cost for FMI devices, represent planned and prudent investments in our business, the impact of which is magnified by the slower sales growth environment. Third, the blue team did not adjust spending quickly enough to the slower macro environment, with variable costs for meals, travel, supplies, all increasing double digits. Also, while lower incentive compensation produced leverage in the second quarter, We continue to have growth in headcount and part-time hours that exceed sales growth. I would expect us to tighten this spending appreciably in the third quarter of 2023. Putting everything together, we reported second quarter 2023 EPS of 52 cents, up 4.6% from 50 cents in the second quarter of 2022. Turning to slide seven. We generated $302 million in operating cash in the second quarter of 2023, or approximately 101% of net income in the period. Traditionally, normal second quarters have a conversion rate in the 60% to 70% range, so this is a strong cash performance relating to a reduction in the use of cash for working capital versus the prior period. This allowed us to reduce debt, with debt ending at 9.4% of total capital in the second quarter of 2023, down from 13.7% in the first quarter of 2022, and from 10.9% in the first quarter of 2023. I apologize, 13.7% in the second quarter of 2022. Year over year, accounts receivable was up 6.1%, largely tracking sales growth with the impact of mix due to faster growth from larger customers, which tend to have longer terms, being offset by improved receivables quality. Inventories fell 6%. This is a function of normalized supply chains, allowing us to unwind inventory layers we had built up in late 2021 and early 2022 to manage that period's product bottlenecks. That process will likely continue, though likely to a lesser degree, throughout 2023. It is also notable that our days on hand fell to 138.5, a level not seen since 2002, which reflects improved velocity of inventory through our internal network, a reduction of retail stock in branches, and improvements in stocking processes. We have significant strategic flexibility in inventory at this point. We have retained our range for net capital spending in 2023 of $210 million to $230 million, reflecting higher spending on hub investments fleet equipment, and IT equipment. At the same time, we have deferred certain projects related to slowing demand that suggest our capital spending will be at the low end of the range. The second quarter of 2023 was obviously challenging. We expect to have better cost comparisons and to more tightly control those costs that we can affect in the second half of 2023. Obviously, we have little control over end market demand. Whatever direction that takes over the next six months will influence our profitability. These shorter-term issues shouldn't cloud the structural improvements to our business. The second quarter saw record labor productivity, the creation of significant strategic flexibility in our inventory, and further improvement in our return on capital, as reflected on page 9 of the investor presentation. We believe we are positioned to strongly outgrow the market, particularly as the industrial cycle stabilizes and improves. With that, operator, we will turn it over to begin the Q&A.

Thank you. We will now be conducting a question-and-answer session. If you would like to ask a question, please press star 1 on your telephone keypad. A 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 using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment, please, while we poll for your questions. Our first questions come from the line of David Manthe with Baird. Please proceed with your questions.

Good morning, Dan Holden. Hope you guys are having a great summer. Thanks, Dave. Good morning. Yeah, good morning. So I have a clarification and then one question. The clarification, Holden, when you were on slide five and you were talking about price contributions, you said this will continue in the second half of 23, and I'm wondering what you were referring to there first. Second, the question, I'm hoping you can update us on KPIs relative to your CSCs and the Focus 5 initiative.

Sure. The clarification is we continue to expect moderation in the overall contribution from price in the back half, really just a continuation of what we've been seeing over the past few quarters. Okay. Does that help? Yes. Okay. And then, yeah, if you, the CSCs continue to experience very strong growth, I believe in the second quarter, if you think about, you know, the books of business that our CSC, our hunter program has, the growth in those books in the current quarter, relative to what those books did the prior year, it's actually up north of 50%. So we continue to see good success in particular with the CFC program. And I don't have specific numbers on the Target 5 for you, Dave. You know, CFCs to some extent have their own Target 5, so I think you get a sense of how that growth is occurring. But, you know, the – yes, I don't have specific on Target 5, but the CFCs continue to grow well in excess of our business. And I think the CFCs are a manifestation of the same key account approach, that the target fives are, you know, feed into as well.

Got it. That's helpful. Thank you.

Thank you. Our next questions come from the line of Michael Hoffman with Stifel. Please proceed with your questions.

Thank you very much, Dan and Holden. The trend data that you share so generously, can you, can you, and I get that you have limited forward visibility, but do you think you're hitting a bottom?

I guess I'll just reinforce we have very little visibility to what the market's going to hold. Here's what I'll say. I've always respected the PMI as an indicator of future activity levels. I tend to think it has a forward look of three to five months. I think we all know that the PMI in June hit 46, which is not a meaningful new low, but a new low nonetheless. And I think the message that we gave to our people internally was that that would seem to suggest that the back half of this year is going to remain soft. So I don't have an indicator internally that would give you any real insight into what's going to happen in August, September, you know, October. But, you know, the PMI has always been a good indicator and the PMI remains relatively low and suggesting the back half is going to be weak. And that's what we sort of take our cues off of. Okay.

And then on the digital transformation, one of the things that I think I understand correctly is you tend to gain a greater percentage of wallet of the individual customer over the life cycle of that penetration. How would you characterize where you are in that journey and how that's influencing some of the share gain?

You know, I think, so if you think about it at the, The digital – well, I'll talk about the FMI component of the digital footprint. That's about 40% of our business. And internally, the number we've always talked about is we think we can get that to about 65%. A good chunk of that is converting existing customers to the new platforms, and it allows us to – to share insights with our customers in ways that historically you couldn't. It brings efficiency to the business. And the efficiency isn't just for efficiency's sake, which is nice. It's to free up time to engage in the marketplace. And so ultimately, we see that time freed up as a means to grow the business faster because you can engage more. The other piece is it's a separator in the marketplace. There's... We have a customer event each spring where we bring in thousands of customers, and they meet with suppliers, engage with different tools of the business. And we are winning business because of the capabilities. I sat in a customer discussion last summer, and our national account person was speaking to the purchasing team from a bunch of locations within a conglomerate, and they were explaining how our RFID program worked. And that's essentially a Kanban system with an embedded RFID chip. So when that bin is empty, instead of somebody having to walk around and check things and find stuff and see what needs to be replenished, that bin is placed on the top shelf. The top shelf has a simple RFID reader. It sees, oh, bin 14 is empty. Oh, okay, I'm hungry. I need to be fed. And that's how a replenishment works. And her response when she learned about it, she looked at a person across the room and said, you remember the issue? And she talked about four different manufacturing plants where they struggled. She said, this thing's unbelievable. She asked a few clarifying questions, and she looked at the person and said, this is unbelievable. This would solve all of our problems. And that's a light bulb that pops off a lot when people realize what this is. I was visiting an employee down in Illinois recently, Two weeks ago, an employee celebrating 40 years, I drove down to spend the day with him and thank him for 40 years of service. And he said, hey, you want to go visit a customer with me? And I'm like, I'd love to. And he showed me something in his wallet. He pulled out a little size of a credit card. And I said, what's that? And he said, that's my RFID chip. And he said, the customer you're going to, I'm going to show you how we're using it in ways above and beyond just a Kanban system. They're using it for pallet replenishment. So they have a little envelope on the pallet rack, and they have a little card in there, and it's a little plastic card with an RFID chip. They grab that, and they throw it in the top bin on the Kanban system, and it tells our branch, we need to know the pallet of this product. Not only is that incredibly efficient for us, the customer loves it. The customer showed it to me. He says, our folks love this because they don't need to write stuff down and then call up Fastenal to bring another one over or wait for you guys when you come over tomorrow to check it and realize you need to bring another one over. We just tell you, but it's done in a matter of seconds. That's something a supply chain partner does, and we're great at plan spent. And that is winning us business because when other customers come and tour that facility when they're in the RFQ process, They see stuff like that, and that's a separator, just like vending is a separator. Sorry, I went a little long there, but I think it's helpful to sometimes use some examples.

And I might add as well that I think that those two actually interconnect in the sense that to the extent that it helps to reduce our overall cost of operations, and it does, that actually allows us more flexibility in bidding processes, and I think makes us more competitive in the marketplace and contributes to our ability to win and gain market share as well. It plays really strongly in both our ability to leverage as well as our ability to grow.

In February, I think it was February, I was down in Indiana visiting, speaking to a group of branch managers and visiting with Randy Miller, our most senior regional vice president. And they asked me if I wanted to go up and visit a customer. And the customer they took me to Well, it's a large onsite. They had contacted us in the fall of, I believe it was 2020. I might be wrong on the year, but I believe it was 2020. And they needed some help, and we set up an onsite in there. And the incumbent had been staffing the onsite 24 hours a day. And our folks really studied the activity and said, you know, if we put out a handful of – if we put out product in a handful of lockers in a way that we wouldn't typically do it, We could give you better service and staff at 10 hours a day instead of 24, and you'd get better service than you were getting before, and we'd have a better – it'd be easier for us to recruit. We could ramp up faster the business. Because finding folks to work 24 hours a day is sometimes challenging. Finding folks to work 10 hours a day or a 10-hour window, especially when it's during the daylight, is less challenging. And, again, it was a case of that separated us in that instance. And I visited that customer, had a great visit with them, And they were showing me some of the stuff that we were doing that they just loved about our model.

Thank you very much.

Thanks. Thank you. Our next questions come from the line of Chris Denker with Loop Capital Markets. Please proceed with your questions.

Hey, morning, guys. Morning. Holden, you had kind of a mid-teens growth in IT spend and an FMI investment. As we're thinking about kind of SG&A spending and investment going forward, can you kind of give us a sense for how you put the trend in the back half of the year to kind of keep investing for growth here?

Yeah. Well, you know, I mentioned the IT and the FMI spend because those are investments in our business that we're making that are wise investments to make. And I don't necessarily anticipate where we're making investments in those areas that we're going to pull meaningfully back in those areas. The areas we were talking about more had to do with expenses that we had for travel, both sales and non-sales, and related type expenses. When we think about how we're using our part-timers and the fact that hours among our part-timers are up 12% in June in a marketplace where revenues are up less than five, there's just a number of things that we talked about that are variable. that we weren't really treating those expense lines as though we're in an environment that's growing at 5%. And the message is we need to get there. Now, what was the impact of that? If I think about the travel, meals, supplies, et cetera, that was about a 10 basis point impact on our business in terms of overall profit impact. If I think about the increase in base pay, that comes from higher absolute headcount, that comes from higher part-time hours, you know, those sorts of things, you know, that would have been about a 450 basis point impact to margin. Now, that was offset by the fact that incentive compensation was down because last year was such a strong year relative to this year. But those are areas that as an organization we need to tighten up a lot of our behavior and patterns to reflect more of the environment that we're in. And, again, I expect that we'll make progress on that in the third quarter.

I'll add on, and I'll put it onto that, as it relates to IT, is when I stepped into this role back in 2015, one of the first things that I said to the board and I said to our team is everybody is going to get lower pay the next 12 months. because we're paid off of earnings growth. If you read our proxy, you'll see how our compensation programs work. We're all going to take a pay cut because we are going to increase the investment in IT. And I tapped a senior leader who had grown up through our branch network, was a district manager, was a regional vice president, had led our government sales, our vending business, and his name is John Soderberg. I tapped him. I said, John, I know you know nothing about IT other than you show me, you know, apps you download on your Android device. But you're a great leader of people. We have great folks in our IT group. I don't think they're connected well enough to the business, and I think we're underinvesting. And we increased our spend on IT by 50 basis points in 2016, and we've held that number in there ever since. And I told them we will not sacrifice our investments in the short term. If it's longer term, we have to be pragmatic. But last year we added 50 people into our Bangalore group, Tech Center. In January, we added another 100 people. We're not there yet, but I suspect at some point in time we'll have more people in our India technology group than we do in our three U.S. technology groups. And that's partly about availability of recruiting, because we have great folks here. We just can't add them fast enough. But we will continue to make those investments. And because we made those investments, today we have a digital footprint. There's 55.3% of sales and the productivity gains of the last three years would not have happened without it. I think it's a wise investment and we'll continue that.

Absolutely. Yeah. Thank you so much for the call guys.

Thanks. Thank you. Our next question has come from the line of Ryan Markle with William Blair. Please proceed with your questions.

Hey guys. Hey, Brent. Morning. I had a couple questions on margins. So first off, on gross margin, how should we think about the rest of the year? Is normal seasonality the right framework for 3Q and 4Q?

You know, I think in the first quarter, we sort of talked about normal seasonality would apply, but at a bit more of a muted rate. And I think that's still appropriate. You know, I mean, second quarter was down about 20 basis points in the first quarter. I typically think of it being down 30. 3Q is fairly typically flat with 2Q, and I think that's a reasonable ballpark. And 4Q is usually down about 30 basis points from 3Q. And again, maybe it'd be a little bit more modest than that. I mean, I think about the mixed question is still an open one, right? Because the reality is in a weak cycle, your fasteners weaken more, and that winds up sort of having a bigger impact on gross margin and mixed than you would normally expect. And you saw that this quarter. just as you've seen in the past. And so to some extent, Ryan, part of the question is, well, what's going to continue to happen with the cycle and the gap between fasteners and non-fasteners? And that's a cyclical question I can't answer. But if I think about, you know, the transportation piece of it, I think that's going to continue to have a sustained beneficial impact for a number of quarters. If I think about, you know, sort of the timing elements, the gap stuff that I talked about I don't think that that impact is as great in Q3 and Q4 as what we saw in Q2. I think we'll still be price mix neutral just as we were this quarter, right? So when I put all that in together, I think the seasonality is reasonable, but I would mute it against history for the next couple quarters. That's my expectation. And like I said, the wild card really in my mind is what happens to the cyclical element of seasonality related to fasteners.

Yep, makes sense. Super helpful. And then on OpEx, Holden, you mentioned you're going to tighten that up a bit, and then you're also going to invest in IT, you know, for the long term, which I agree with. I guess, is there any metrics you can provide? Is there a goal for FTE growth in the second half? And I guess ultimately what I'm getting at is, you know, can you adjust SG&A fast enough where you can hold operating margins flat year over year in the second half, or is that maybe optimistic?

You know, it'll depend how aggressive we are. You know, the part of the operating margin is going to be a reflection of the gross margin. So again, I will have to cop out a little bit in your question about SG&A and say part of the answer to your question is going to rest in what happens to the cyclical element of mix, right? Set that aside and just focus on the SG&A. You know, I think that the we need to reduce the cost in our SG&A relative to Q2 By two, three million bucks. And we need to do that through tighter control of headcount, through tighter control of those expenses. And I feel comfortable that we'll be able to do that. I think the organization is already sort of responding to the messages and responding to the natural signal of their growth slowing down. So, you know, I do believe that we will have better leverage opportunities in the back half Again, with the wild card being what happens to the underlying demand environment and what impact does that have on fastener-related mix. Got it. Thank you.

I'll pass it on.

Thank you. Our next question has come from the line of Josh Pokeshavinsky with Morgan Stanley. Please proceed with your questions.

Hi. Good morning, guys.

Good morning.

Also, kudos to the operator for nailing the authentic pronunciation there. We don't get that too often.

I was going to ask. That was pretty close.

Yeah, that was old country right there. I like that. Just maybe a higher-level question for both of you. Obviously, we've seen a huge wave of inflation, supply chain tightness. Now, going back the other direction, at least with disinflation, I guess what would you identify, Dan, as – The biggest change you saw as a function of that and the biggest things that are changing now as those reverse could be customer facing, could be, you know, kind of margin profiles with the business, deliberately a broad question, but just thinking of how.

Well, I mean, the, the biggest change that we saw directly in our business from supply chain element was the fact that we had to add a heck of a lot of inventory and it was expensive inventory in, uh, in 2021 and 2022. you know, container costs were sky high. We were doing a lot of things. We were not going to let people down. And fortunately, we have the balance sheet to do that. And we have a shareholder base that appreciates we're judicious with their capital, but they were supportive of the move. And they were confident that when the need for that extra layer of inventory subsided, we would figure out a way to harvest that out of the balance sheet and move forward. That's probably the biggest thing to how it manifests itself, obviously, on our balance sheet and on our cash flow statement. We talked about that earlier. If I think about more broadly, we are seeing changes, and it's one of the reasons I touched on a bit the two elements of our business, the plan spend which I believe we've created over time an incredible ability to serve that market. And the unplanned, where we're good at it, we're not great at it, and partly because we haven't built the system to support it, whether it's technology or supply chain. And we've been busy building that the last several years, and I've talked about some of those pieces. And we've seen success on what we've built, but it's still a relatively small piece of business. But we are seeing that trend. You know, if a buyer is working remote two or three days a week or covering a bunch of locations, because with technology you can do a lot of things you couldn't do in the past and you can do it easily, they're buying in a different way. And we need to make sure our systems work for that different way. I hope that's helpful.

And I might, you know, specific on pricing. If you recall during the period of tariffs, we didn't do a great job, you know, sort of offsetting all the tariffs and inflation that occurred during that period of time. And the organization kind of buckled down and developed since then what we call the pricing review tool, a PRT. And I think what you've seen over the last few years in a period first of fairly significant inflation and now, you know, a period of perhaps modest deflation is I think you've seen that tool and our organization's ability to utilize it result in a much better outcome. There's the occasional glitch here and there. We didn't quite get all the inflation on fasteners, so that's come back. In fourth quarter, I think maybe we got a little bit behind on a certain area. But for the most part, we've been able to be price-cost neutral. for the entirety of this period of inflation and deflation. And I think it really is reflective of the organization's ability to deploy technology solutions to problems that we run into every day. The other thing that I would say is from an inventory standpoint, we talked about how inventories dropped a lot because we're unwinding or sort of harvesting some of the investments. We peaked from a days on hand standpoint between 185 and 190 days. We're currently sitting between 135 and 40. That's not just because of buying inventory and then harvesting it related to the pandemic. That relates to a lot of things the organization did in terms of how it views branch inventory strategically, in terms of, you know, what's in our hub versus where should inventory be, improving the velocity. And I think the fact that we were able to improve the overall performance of our assets even in an environment where we're getting a tremendous amount of pressure because of the needs of the pandemic when it started and as it was fading, really reflects the organization's ability to do more than one thing at once. And, you know, I think the organization can be proud of itself, how it's managed a lot of the things that have come up over the course of the past four or five years. Got it. I appreciate it.

That's comprehensive. Maybe just a quick follow-up. You know, as you've seen things decelerate and maybe, you know, disemployed a little bit, Does the competitive landscape change? I know you guys don't really see it maybe some of the way other folks do in the space, given your business model, but anything you'd comment on competition?

I don't think the competitive landscape has changed, if you look at it from a product perspective. And I think one element that's there, too, is while there's more than one element of inflation and there's more than one aspect of cost, There's inflation that we saw in product costs. There's inflation that we saw in transportation, container costs, things like that. Product costs dynamics are different than the container and transportation element. The third element, which is really relevant for our customers and for their supply chain, is the cost of labor. There is no deflation in labor. I'll guarantee you that. There continues to be inflation in labor. We do have more success in recruiting, but we are not unique. All businesses are seeing inflation in that arena to this day. And part of the nice thing about the total cost of ownership approach we take with our customer is we're really able to understand all those cost components and have intelligent conversations with the customer. They're not emotion conversations. They're fact and tactic conversations, which allows both us and our customers together to make better choices on puts and takes. But there are inflation elements still in the business. There are some deflation elements in the business. A container is coming across the ocean. It's cheaper today than it was a year and a half ago or a year ago.

and i would say there's also availability elements in the marketplace as well um you know during uh during 2020 2021 there weren't a lot of distributors that had availability of product and uh you know we benefited from that as the supply chain is normalized the marketplace sort of normalized as well and and i think you know what you see is it's a little bit more competitive in terms of customers being willing to say you know we're going to test the mark a little bit again i don't think that's unique to us i think it's fairly typical in the market And I think it's reflective of the degree to which things have, frankly, normalized at this stage of the game. And it allows us to really talk a lot about exactly what Dan said, which is, you know, the supply chain solutions and how that differentiates us, you know, in the marketplace.

Got it. Thank you both. And, Josh, in the interest of full disclosure, I probably would have gotten your last name incorrectly.

Thank you. Our next questions come from the line of Tommy Moll with Stevens. Please proceed with your questions.

Morning, and thanks for taking my questions. Morning.

Morning.

Can you give us an update on fastener product margins? And I know that associated with those, there's potential for some renegotiation just on pricing that is given some of the volatility around steel and shipping. Any update you could give there would be helpful as well. Thank you.

Yes. Yeah, I mean, product margins, when you break fasteners into OEM versus MRO fasteners, product margins are fairly stable. When I think about price cost in the fastener arena, it's fairly neutral at this point, right? So, I mean, from a costing and margin standpoint, I think things are fairly as expected. Now, I will say I do believe that we have had circumstances where, again, there's contracts that require some adjustment based on end markets where I do believe that we've begun that process. But that is really aligned with what we've talked about before as we see our costing improve and we have on imported product that we have certain agreements with certain very large customers that we'll adhere to. And I think that you're seeing that happen. It's largely, I think, as we expected. I don't think they were having any adverse impact on our overall profitability level, you know, and that's probably how I'd characterize it. Does that help? Indeed.

Thank you. I also wanted to talk about supply chain. And in the prepared materials this morning, you talked to the reduced inventory as as aided by a shorter product ordering cycle for fast and all. I'm curious, though, with a better supply chain, do you see some of the same for customers? And is there any impact in your daily sales trends from that?

You know, if you think about what we do for our customer, we're the buffer. You know, we're supplying product to them. And, again, I'm really talking about both sides of our business, whether it be planned spend or unplanned spend. If supply chains are taking 30 days longer, we build that inventory so we get it to them when they need it. So I don't know that there would be a destocking element downstream from us. I'm sure there's examples of it. If there is a destocking element, it's because a customer had built up finished goods because they had a strong backlog, and that backlog – has been worked down, their finished goods has been worked down, and as they're in that process, that impacts us because they lower their production. And so it isn't so much because the supply chain changed, it's because downstream their needs for finished goods changed. Where we typically see a supply chain impact the most is when we take on a new customer relationship. It's not uncommon for us to step into a new customer relationship where they'll have elements of inventory that we're going to be managing now for them, Where they have a six, a 12, a 15-month supply, a four-month supply. You know, the extreme examples are usually niche. But they, as we illuminate what they have in their inventory and or how their predecessor supply chain partner was supplying, and I'm not throwing in a predecessor under the bus because it could have been there's a bunch of different suppliers supplying this in and it's not a coordinated effort. And so you have months of inventory on something that is ridiculous to have months of. A customer a few years ago, first off, it was a part that I thought was fairly unique. I discovered that we had a regular supplier for it. But it was an item where the customer discovered they had 14 months of inventory, and they had no idea. They were appreciative of it, and we worked out an arrangement with them to manage it down, and they paid us something for helping manage it down. But we didn't have product sales for a period of time, but we had a lot of other sales. It was an onsite doing $130,000 a month. It just wasn't doing $160,000. But then when we burned through it, and that's what a supply chain partner does. But that's not about supply chain time. That's about just an inefficient supply chain. Thank you both. I'll turn it back. Thank you. And we're next. Sorry, go on. I apologize to whoever was in queue. Holden will be available at For calls, if you want to give him a direct call, I'm going to run to a meeting here in a few minutes, but we hold these calls to one hour, and we are at 10 o'clock Central Time. Once again, thank you, everybody, for attending our earnings call today, and best of luck in July in the balance of the year. Have a good day, everybody.

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a great day.