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.
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:
|Projected Annual Growth Rates (Free Cash Flow):||2008 - 2010:||14.0%|
|2011 - 2017||12.5%|
|Projected Annual Growth Rates: (Revenue):||2006 - 2015||16.0%|
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.
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.
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.