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Fastenal (FAST): A Vivid Case of Overvaluation

February 02, 2012 | About:


Our normal policy is to produce articles and analysis on companies that we believe offer attractive valuations based on earnings and cash flows. However, we’ve recently received numerous requests to write about companies that may be overvalued by Mr. Market. This article is going to cover a company that we have owned in the past, and very much admire for its long consistent record of operating excellence as reflected by its consistent record of earnings and dividend growth. This superb business is Fastenal Company (FAST), and we believe it is an extraordinary business that the market is currently overpricing.

Fastenal (FAST) is a leading retailer and wholesaler of industrial and construction supplies. The company operates approximately 2500 stores located in the United States, Puerto Rico, Canada, Mexico, Singapore, China, the Netherlands, United Kingdom, Hungary and Malaysia. The company’s primary product lines range from fasteners, tools, hydraulics and pneumatics, to janitorial supplies, batteries, sealants and much more.

Fastenal Company: A Legacy of Operating Excellence

Fastenal Company (FAST) has a long history of increasing their earnings at a high and consistent rate. The following earnings and price correlated F.A.S.T. Graphs™ reviews their operating history from calendar year 1994 to the end year 2008. Our purpose for stopping the graph at calendar year 2008 was to illustrate three important facts. First, we wanted to show how they have increased earnings per year at a compounded rate of almost 24% per annum up to the great recession of 2008. Second, we wanted to graphically illustrate how the long-term trend line movement of the stock price has closely correlated to and tracked earnings growth. Finally, we wanted to illustrate how the market has often priced their shares at a premium to earnings growth.

Therefore, to summarize the following graphic: From 1994 to 2008 the Fastenal Company grew earnings from $.6 a share in 1994 to $.95 a share by 2008, resulting in a 23.7% compound annual growth rate. The normal PE line depicts a trimmed (the highest PE and the lowest PE trimmed) average PE ratio of 36.3, this simply indicates that the market has often priced this company at a peg ratio in excess of one. On the other hand, it is clear from the picture that the stock price often moved above and below the normal PE, and in many cases traded at its orange earnings justified valuation line.

FAST-One.png

Our next earnings and price correlated graph covers the 15-year period 1998 to current time. There are a couple of important points that should be emphasized here. Notice how the 35% drop in earnings for calendar year 2009 impacted Fastenal Company’s compounded earnings growth rate. This one-year drop in earnings reduced its average annual growth rate from 23.7% to 17.4%. However, also notice how earnings growth since calendar year 2009 has actually exceeded the long-term average of 23.7%, averaging 33.9%. Also, notice that the normal PE ratio now calculates to 32.4 instead of 36.3. It’s important that the reader understands that these measurements simply represent barometers rather than absolute values.

To reiterate, since calendar year 2010, Fastenal Company has grown earnings at the average rate of 33.9% per annum. This accelerated earnings growth should be considered as coming off of the low base which was created by the recession of 2008. Furthermore, we believe this accelerated earnings growth greatly attributes to the company’s current abnormally high PE ratio of 37.8. In other words, the market is valuing this company very optimistically.

FAST-2.png

When you review the performance associated with the above earnings and price correlating graph we discover an almost perfect correlation between Fastenal’s earnings growth rate of 17.4% and the capital appreciation it generated for shareholders of 17.6%. Also, notice that the company is a Dividend Contender that has increased its dividend every year for 13 consecutive years (note that the dividend cut reflected in the table for 2009 is due to a special one-time extra dividend that was paid in 2008).

FAST-3.png

Fastenal Company - A Clear Picture of Overvaluation

The following estimated earnings and return calculator is drawn based on the consensus of 10 analysts reporting to Capital IQ. The consensus of these leading analysts forecast earnings growth over the next five years at 19%. The Value Line Investment Survey forecasts approximately 15.5% earnings growth, and the consensus of nine analysts reporting to Zacks expect five-year earnings growth of 18.1% . The point is that all of these various estimates are more or less in alignment, with only modest and reasonable deviations from each other. Therefore, we’re comfortable in stating that a 15% to 20% growth rate on this extremely high-quality company with its great track record seems reasonable, all things considered.

Therefore, assuming that the estimates from the various analysts are within reason correct, then we would argue that this high-quality company, with no debt on its balance sheet, and a great record of earnings growth, is nevertheless very expensive today. We believe this is also apparent in the context of the fact that there are numerous other companies with similar operating histories, and dividend yields that are trading at PE ratios one-half to one-third of what is currently being awarded to Fastenal Company.

We beieve that we would all agree that if you took one dollar’s worth of Fastenal’s dividend to a store to buy something, and one dollar’s worth of dividends from another company with a similar growth rate, the store proprietor would not give you more change on Fastenal’s dollar than they would the other company’s. In other words, one dollar’s worth of earnings of one company is worth no more or no less than one dollar’s worth of earnings of another.

Since this is true, how do you explain the fact that the market will value Fastenal’s one dollar’s worth of earnings today at $38, and for example, only value a dollar’s worth of earnings from the luxury retailer Coach (COH) at only $21 a share. This is especially befuddling when you consider that Coach’s historical earnings growth rate of 33% per annum is almost twice as high as Fastenal Company’s.

FAST-4.png

To put a final perspective on why we believe that Fastenal is overvalued, is to calculate the earnings yield that the current valuation reflects. The following earnings yield estimator shows that at today’s valuation, Fastenal only offers prospective investors an earnings yield of 3.2%. Additionally, the dividend yield of 1.5% is less than what can be earned on the riskless 10-year Treasury bond. This seems like an awful low return from earnings and dividends for the amount of risk that the prospective investor is being asked to assume.

FAST-5.png

Conclusion

We believe that the Fastenal Company is an extremely high-quality stock with a very bright future. Nevertheless, we feel that the current valuation the market is placing on their shares is not only higher than their fundamentals justify, but also seem excessive in light of the valuations that the market is generally applying to other businesses. Consequently, we believe that shareholders would be prudent to either sell their shares or at least take some of their profits off the table. The stock has had a great run over the last three years but valuation now appears to be excessive. The great investor Warren Buffett once advised us that “price is what you pay, but value is what you get.”

Disclosure: No positions at the time of writing.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.



About the author:

Chuck Carnevale
Charles (Chuck) C. Carnevale is the creator of F.A.S.T. Graphs™. Chuck is also co-founder of an investment management firm. He has been working in the securities industry since 1970: he has been a partner with a private NYSE member firm, the President of a NASD firm, Vice President and Regional Marketing Director for a major AMEX listed company, and an Associate Vice President and Investment Consulting Services Coordinator for a major NYSE member firm.

Prior to forming his own investment firm, he was a partner in a 30-year-old established registered investment advisory in Tampa, Florida. Chuck holds a Bachelor of Science in Economics and Finance from the University of Tampa. Chuck is a sought-after public speaker who is very passionate about spreading the critical message of prudence in money management. Chuck is a Veteran of the Vietnam War and was awarded both the Bronze Star and the Vietnam Honor Medal.

Visit Chuck Carnevale's Website


Rating: 4.0/5 (24 votes)

Comments

pravchaw
Pravchaw premium member - 2 years ago
Chuck - Thanks for this article and the excellent choice of Fastnel. I came to a similar conclusion independently and sold the Fast shares I was holding since 2008. In the future I plan to get back into FAST as Mr. Market comes back to its senses. However Momentum being what it is - its hard to say when.
JeanPierreSarti
JeanPierreSarti - 2 years ago
Excellent, very easy to follow and understand.
chuckc
Chuckc - 2 years ago


Pravchaw,

Thanks for sharing, you make good sense.

Regards,

Chuck
chuckc
Chuckc - 2 years ago
JeanPierre Sarti,

Thanks, I am glad to hear that.

Chuck
hschacht
Hschacht - 2 years ago
I could not agree more... which is why I am short FAST. Good article!
gurufocus
Gurufocus premium member - 2 years ago
Henry,

is your short purely based on valuation?
hschacht
Hschacht - 2 years ago
Yes. And I'm not trying to be cute, but what else would I base a short on?
batbeer2
Batbeer2 premium member - 2 years ago
@ Henry

Poor management. I don't think that is the case at Fastenal.

Among overvalued companies, there are those that are also mismanaged.
hschacht
Hschacht - 2 years ago
I have not had any luck shorting companies with poor managers (a subjective measure) where the valuation is not stretched.
SharadDhingra
SharadDhingra - 2 years ago


The danger in shorting a company like Fastenal, and considering it as classically overvalued is overlooking two factors: Fastenal has no debt, and corporate AAA debt is trading virtually on par with the 10 year treasury bond, at historically low yields. To me, Fastenal's shares are trading at a premium, due to the debt arbitrage that would play out if the stock was trading 30-40% lower than it is today.Simply put, Fastenal could go to the debt markets, issue debt with a sub-3.5% effective rate, buy back shares, and deflate the P/E ratios further, if the company traded at a 22-30 P/E. To me, Fastenal will remain at elevated prices so long as the ten year bond remains below 3%, to remove this arbitrage opportunity. That being said, the stock is too high to build a new position.

Once the ten year bond starts to fall, Fastenal may underperform the market, as the debt arbitrage opportunity dissipates. That is my humble opinion, but I respect your views, Mr. Carnevale, and definitely take them into consideration.
chihin
Chihin - 2 years ago
If you read up on the history of Fastenal, lots of very smart people have lost money shorting Fastenal in the late 1980s and 1990s. And the stock was arguable trading at even more inflated values back than it is today.

I even remember some "bullish-Fastenal" newspaper article back then proclaiming that "these smart people just keep coming".

I think we all acknowledge buying a poor company at great valuation is not a very good idea (Benjamin Graham aside). If we invert this argument, then shorting a great company at a poor (high) valuation would not be a good idea too.

hschacht
Hschacht - 2 years ago
When did Fastenal become a great company? Don't get me wrong, I don't think it is a lousy one, but great? And people lost a lot of money shorting Netflix too... was that a reason not to short it? Come on. This is a tiny short position for me and I don't want to be the poster child for FAST shorts, but some of these contrary arguments are silly.

The past performance of shorts in a stock is no indication of future shorting results! Although I might argue that there is an inverse relationship... but I won't bother.
SharadDhingra
SharadDhingra - 2 years ago
I feel that this endorsement makes Fasetenal great:

http://www.cnbc.com/id/23449956/Warren_Buffett_Answers_Your_Emails_on_Squawk_Box_Transcript_Part_2

At that time, the company was valued at a fairly high P/E as well. I personally think if Buffett gives a vote of confidence to the company, and identifies it as the best company he doesn't own, I put it in the great category.

Hschacht, it is all about timeframes. You could very well make 10-20% in the short-term, and be right. Good luck.
Burak
Burak - 2 years ago
This company is 3 times (!) overvalued. I calculated a fair range of 14 to maximum 18 Dollars for this businness. Everything above that is only hype. This is a kind of company that seems to grow very fast what can cause a big problem. Unfortunatelly here is no Fastenal store so that i could go and analyse it in the way like you should do if you really want to get a closer look to the value.

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