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Fastenal (FAST) - A Significant Investment Opportunity for Long Term

January 22, 2008 | About:
Barel Karsan

Thomas Macpherson

0 followers

We believe Fastenal (Nasdaq: FAST) represents a significant investment opportunity for long term investors.

Fastenal supplies customers, including manufacturers and commercial contractors, with 271,000 varieties of fasteners and 310,000 general-purpose maintenance, repair, and operations products. The company utilizes 12 North American distribution centers and an in-house truck fleet to facilitate five deliveries per week to roughly 85% of its 1,700-plus company-owned stores. Fastenal's over 6,700 store employees receive incentive compensation based on new account development.

We base our recommendations on several key measurements. These include a compelling valuation based on a discounted cash flow analysis, profitability measures, and management focus on long-term shareholder value generation.

Valuation

Utilizing a discounted cash flow model we estimate the company is worth roughly $69.50 per share. The current price of $33.13 ( 01/19/2008 ) represents a roughly 52% discount to fair value. We derive the estimated value of $69.50 per share with the following assumptions:

Cost of Capital:
9.7%  
Projected Annual Growth Rates (Free Cash Flow): 2008 - 2010: 14.0%
  2011 - 2017 12.5%
Projected Annual Growth Rates: (Revenue): 2006 - 2015 16.0%

Financials

In the 4 th quarter of 2007 Fastenal reported year end results with sales and earnings up 14.0% and 16.9%, respectively, from the previous year. In addition, the company expects to increase store locations by roughly 8% for the next 5 – 7 years. Fastenal has averaged 22% returns on equity (ROE) and 14% return on assets (ROA) over the past ten years. Operating margins have increased from 13.7% in 2003 to an estimated 18.1% in 2007. The firm reinvests a significant majority of its free cash flow in opening new stores. At the end of 2007 Fastenal had no debt and $57.3 million (cash and marketable securities) on the balance sheet. The company is expected to generate over $130 million in free cash flow this year.

Allocation of Capital

Great companies have management focus on profitable allocation of capital. During the years 2003 – 2007 Fastenal generated a sum total of $5.31 in earnings per share. Roughly 80% of these earnings were retained by the company with the remaining 20% paid out to shareholders in the form of a semi-annual dividend or stock re-purchases. Management achieved a 21.4% annual return on these retained earnings. Fastenal and its management team have proven to be exceptional capital allocators and provided significant value to their shareholders.

Return on Invested Capital

ROIC is simply a measure of how much cash a company gets back for each dollar it invests in its business. It improves on such regularly used metrics as Return on Equity (ROE) and Return on Assets (ROA). This measurement measures the profitability of the core business and strips out ancillary accounting impacts. Fastenal’s ROIC for the last 5 years has been 29.8%, 31.5%, 30.6%, 29.4%, and 31.2% respectively. We see this as another measurement of management’s effective use of capital.

Management Incentives

Fastenal utilizes compensation policies targeting revenue growth and cost containment. These incentives are in place from senior management to the newly hired sales clerk. These incentive bonus arrangements place emphasis on achieving increased sales on a store and regional basis, while still attaining targeted levels of gross profit and collections. As a result, a significant portion of the Fastenal’s total employment cost varies with sales volume. The company also pays incentive bonuses to its leadership personnel based on one or more of the following factors: sales growth, profit growth, profitability, and return on assets, and to its other personnel for achieving pre-determined cost containment goals. All of these incentives are in alignment with shareholder values.

Conclusion

Fastenel is a well managed company focused on creating shareholder value. Management maintains its efforts in achieving high levels of corporate profitability, return on invested capital, and a pristine balance sheet. Utilizing a discounted cash flow model is roughly 50% below fair value. All of these factors point to Fastenal as a strong investment opportunity for value investors.

DISCLOSURE: The author is long Fastenal
_____________
Mr. Macpherson is a partner at Macpherson Consulting Group. He specializes in corporate strategy and financial modeling. He received his undergraduate and graduate degrees from Harvard University.

About the author:

Thomas Macpherson
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 3.4/5 (25 votes)

Comments

kfh227
Kfh227 premium member - 6 years ago
I've always liked FAST. People need to read about their products though. They really are a good investment.

Dr. Paul Price
Dr. Paul Price premium member - 6 years ago
Your thoughts are well written and make sense. Please don't fudge on the price though- the Friday [Jan. 18th] close was $33.61 not where you said it was when recommending it on Saturday.
TheBeaver
TheBeaver - 6 years ago
How do you justify such high growth assumptions?
tkervin
Tkervin - 6 years ago
Fast's growth rate will be tied to a combination of residential and commercial construction. Commercial construction has been strong over the last few years. I believe that trend is changing. Residential will stay weak thru '08 at least and commercial may be entering a multi year soft patch. Fast looks great on a fundamental basis currently but I don't believe the stated growth rates are likely.
kfh227
Kfh227 premium member - 6 years ago
I think what tkervin said makes sense. I think any time growth rates are in excess of 10%, one should be skeptical though.

Also, what people always seem to ignore is the long term. The cash flows from 2010 should be factored in today. This is what all the experts in media ignore (even that Cramer genius *snickers*). Even though 2008 and 2009 might be bad years, what about 2010 and beyond? People get to emotional over the short term and forget even wit ha few bad years, value can be found if you assume better times several years ahead along with a margin of safety. This very concept is why I like PFE so much right now. And it’s a reason to consider financial stocks along with homebuilding stocks like FAST.

When I get home tonight, I might do a valuation of FAST.

JLAnnello
JLAnnello - 6 years ago
I don't really get how their fair value came to such a high number.

Consider this valuation that I did:

Revenue growth of 16% for the next 7 years- then 14% for the 3 years after that, and 9% for years 10-15. This has them generating $13bb in Revenue in 15 years vs just $2b now.

Then, keeping operating cash flow margins at this years 8.9% (high for them historically), and less than 1% of Revenue going to maintenance capex (low for them historically). That puts this years FCF at $161mm, and year 15 FCF at $1,141, or 7x as much as current FCF. These are pretty aggressive growth assumptions. Then, into perpetuity, they grow at 2.5%, or slightly faster than the US Economy has over time, or about a 15.5x multiple on the last year's FCF. Someone stop me if I'm being unrealistic here.

If we take all of these cash flows and discount them at a 10% rate, what are they worth? By my calculation, $4.8b. What's FAST's current mkt cap? $6b.

I fail to see the value here, or how you get a value of $70/share. At $70 a share, with 150mm shares outstanding, you are placing a valuation of $10.5b on FAST! That's 5x Revenue and 65x Free Cash Flow? I'd need a mighty good explanation for that.
JLAnnello
JLAnnello - 6 years ago
PS, if anyone wants the spreadsheet for that valuation, let me know. jeff.annello@gmail.com

JLAnnello
JLAnnello - 6 years ago
Sorry, I checked my valuation, and a spreadsheet error made me err. The proper valuation with those inputs is $6.9b, or $45 a share. My point remains. These are very aggressive assumptions I used, with double digit growth for the next 15 years, and I only get $45 a share. The $70 seems inordinately high. I'm even gifting them a higher FCF number this year (161) than McPherson at 130.
kfh227
Kfh227 premium member - 6 years ago
JLAnnello Wrote:

-------------------------------------------------------

> PS, if anyone wants the spreadsheet for that

> valuation, let me know. jeff.annello@gmail.com

>

>

I don't want to prod, but it would be nice if gurufocus let us upload images(capped by size of course) and various data files. Data files can always be zipped.

You got a PM coming jeff.

kfh227
Kfh227 premium member - 6 years ago
I just tried doing a DCF without any influences.

Historical FCF numbers are all over the place. I can't see how projecting future cash flows reliably makes any sense. If anything, that 50% discount to IV is totally justifiable. What is not justifiable is the growth rates used.

High single digits to start makes some sense for growth (maybe 10 or 11% even). Growth rates in the mid single digits (5% or so) for 10 years and beyond is required with FAST.

Because of this, I'd simply ask you this. Is it worth the current PE of 25? Does the IV calculation that puts IV at 70 make sense? Think about it this way. At $70 and future EPS of 1.8, that is a PE of 39!!!!

At that price, does the calculation make sense? I see a simple answer. No.

Will the yield calm your nerves if the IV calculation is off? Probably not, it's currently at 1.3%.

I think a PE under 15 is required prior to even thinking about a purchase of FAST stock.

It stinks to, because I love this company. The PE ratios that correspond to IV and even the 50% discount to IV are hard to swallow.

I'd look elsewhere or atleast wait tilll the PE ratio is around 15. In other words, I'd be hard pressed to pay over $30 for this stock. The worse one could do is look at JNJ or many of the other stocks that are undervalued when DCF is utilized and PEs are glanced over.
JLAnnello
JLAnnello - 6 years ago
KFH-

Agreed. I'd wait for $30.

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