Fastenal (NASDAQ:FAST) is a company we have followed and admired for many years. The Company is a distributor of manufacturing and construction supplies - generally consumable parts and products such as fasteners (i.e., screws, nuts/bolts) and various items used in the maintenance, repair, and operations (MRO) of customers’ plants. The company has established a differentiated position in its industry by investing heavily to get itself as close as possible to a generally smaller, less urban customer base than its competitors. This is most evident in its extensive network of more than 2,500 branch locations, which the company effectively uses as selling and distribution outposts to serve its customer base. We contrast this with Fastenal’s largest competitor, Grainger, for example, which has only 300-odd branch locations (and shrinking) despite having twice the revenues as Fastenal. We believe this has led to a fairly healthy segmentation between the Company and its competitors: Fastenal has specialized in smaller, geographically dispersed clients who are more heavily reliant on the Company’s local distribution capabilities, sales expertise, and somewhat more specialized, locally tailored product lines; Grainger and other competitors specialize in larger, more urban clients who have more distribution and service requirements, so these distributors generally focus on more standardized products, in large quantities at the lowest cost. When we observe the healthy, and remarkably steady, returns on investment across the major competitors in the space, we view this as confirmation that the major players, for the most part, have managed to carve out profitable segments of an attractive industry without tripping over each other.
Fastenal has extended its differentiation in recent years through three other initiatives designed to get closer to its customers. First, the Company has installed over 60,000 vending machines in customers’ plants, in which they constantly replenish products customers use regularly in their manufacturing processes. Second, the Company has accelerated the expansion of its Onsite program, in which it basically opens a small Fastenal store within a larger customer’s plant. Fastenal staffs and stocks this mini-location, effectively taking control of a portion of the customer’s supply chain. It is important to note that both the Vending and (especially) Onsite initiatives further integrate the Company into a customer’s operations, helping to make these customers stickier. Third, Fastenal has invested in additional inventories over the past several quarters, while also shifting a higher percentage of its inventory from its distribution centers into its branch locations. This once again is designed to get Fastenal as close to its customers as possible - if the Company has the products its customers need, already waiting in their market, available for same-day delivery, at an attractive price, there is no need for those customers to take their business elsewhere, whether that be to a larger, out-of-market competitor such as Grainger or to an online competitor such as Amazon.
We became increasingly interested in the stock around the middle of the year, as we saw Fastenal’s valuation begin to imply an accelerated decline in its end markets, particularly energy and manufacturing. However, our research from our energy holdings helped inform us on this score, as we see North American energy production approaching an inflection, which should help reinvigorate manufacturing-heavy energy service and support industries. We also noted that both presidential candidates were pitching large infrastructure spending projects which would be supplemented by a federal highway bill passed in 2015 - the first long-term bill in over ten years after a series of short-term stop-gaps that did not allow states to plan any large or long- term construction projects – and could begin to generate some demand in the near future as states begin to implement spending plans. That said, with the stock trading at or near post-recession lows on most valuation metrics, we did not believe we needed any of these potential catalysts to emerge in the near future, but we were happy to have the possibilities in front of us.
Overall, over a multiyear timeframe, we believe Fastenal should be able to continue to grow at an attractive pace for several years, particularly due to the Company’s continuous reinvestment and explicit focus on profitability. With the stock trading at valuation multiples similar to the last recession, and with key end markets already having been in recession for two years with signs of potential recovery emerging, we think Fastenal represents an excellent long-term investment opportunity for portfolios.
From David Rolfe (Trades, Portfolio)'s fourth quarter 2016 Wedgewood Partners investor letter.
