Introduction
I have good and bad news.
The bad news is that a lot of cyclical companies are currently showing stock price weakness, as it seems that the market is recognizing that cyclical growth is unlikely to rebound soon.
While we're far from a steep sell-off, industrial stocks have weakened and are now trading roughly 4% below their 52-week highs. Cyclical transportation stocks (XTN), for example, have sold off 15%.
The reasons are sticky inflation, geopolitical uncertainties, a Fed that made clear that it needs more evidence of substantially lower inflation before normalizing rates, and the fact that cyclical growth indicators like the Philly Fed manufacturing index (current conditions) continue to show sluggish growth, unable to start a meaningful uptrend.
The good news is that this comes with opportunities, as a few highly attractive cyclical stocks are currently suffering, bringing their valuations back to reasonably attractive levels.
One of these companies is the Fastenal Company (NASDAQ:FAST), a company I started covering with a Hold rating on March 26 in an article titled "Fastenal: A New Member Of The Dividend Aristocrat Club You Probably Didn't Know."
Since then, shares have fallen by roughly 16%, despite the market trading close to its all-time high.
In this article, I'll revisit my thesis, explain what makes it so special, and how recent events have impacted the risk/reward for dividend (growth) investors like myself.
So, let's get to it!
What Makes Fastenal So Special
Before we dive into financial numbers, I want to quickly reiterate why I have the FAST ticker on my radar.
Fastenal is an industrial company with a $37 billion market cap.
This Minnesota-based company is a fascinating industrial distributor that sells to a wide range of customers, including heavy manufacturing, transportation, non-residential construction, and many others.
The company has figured out a way to take industrial distribution to the next level by managing a network of Onsite locations and branches that are supported by e-commerce to deliver industrial supplies whenever and wherever they are needed.
Although I usually make the case that I prefer companies with a wide moat, I also like companies that have found a way to penetrate markets with low entry barriers.
Fastenal has found a great way to do just that, as it has shrunk its branch locations from 2,637 in 2014 to less than 1,600 going into this year.
Meanwhile, it has boosted its Onsite locations from 214 to more than 1,800 during this period, which puts supplies closer to customers.
Onsite locations offer services like daily replenishment of supplies, supported by advanced data to optimize the process.
By including technologies and systems like Fastenal Managed Inventory ("FMI"), FASTStock/FASTBin, and FASTVend, it has created a vending machine-like network that allows customers critical supplies whenever they are needed.
Roughly 66% of the company's installed base consists of locker-based solutions that are similar to the vending machines where we buy cans of co*ke and bags of chips.
As I wrote in my prior article, the company finished last year with an installed base of 111,800 FASTVend models with an estimated growth potential of 1.7 million vending machines.
This has allowed the company to return 245% over the past ten years, beating the S&P 500's 228% return despite its recent stock price sell-off.
It also became a Dividend Aristocrat when it hiked its dividend by 2.6% on January 17, which brings the count to 25 consecutive annual dividend hikes.
The company currently yields 2.4%.
Using the Seeking Alpha dividend scorecard, we see highly favorable scores, supported by a 71% payout ratio and a five-year CAGR of 12.3%.
So, why is the stock selling off?
A Closer Look At Fastenal's Risk/Reward
Selling supplies to manufacturers is very cyclical, which explains why FAST investors are prone to frequent stock price sell-offs.
As we can see below, over the past ten years, investors have been through countless corrections similar to the current one.
During this period, there were two outliers:
- The 2015/2016 manufacturing recession caused investors to temporarily lose a quarter of their investment.
- The pandemic caused shares to briefly sell off more than 30%.
Needless to say, none of these corrections are "random."
Using the chart below, we see a strong relationship between the distance (in percentage terms) FAST shares trade below their all-time high and the ISM Manufacturing Index, one of my favorite economic indicators.
As I mentioned in the introduction, I believe investors are currently adjusting their expectations as the cyclical growth recovery has stalled.
Hence, we see these challenges in the company's most recent earnings as well, when the company used the earnings call to explain that its first quarter came with significant challenges, resulting in 1.9% growth, below the expected 4% growth rate.
One issue was a headwind from fewer sales days, as the CEO explained in the overview above.
However, that was an expected headwind, which does not explain why sales came in so weak.
The main challenge was weak underlying demand, with industrial production declining slightly, pressuring sectors like machinery production.
To add some color here, while total manufacturing saw a modest growth rate of 2.6%, the fastener product line experienced a 4.4% decline, which was largely due to soft industrial production and pricing headwinds.
Moreover, nonresidential construction and reseller segments continued to contract, although at a slower rate. Meanwhile, FMI sales stayed healthy, contributing to an 8.3% growth in safety products.
Adding to that, regional business activity was steady but weak.
The good news is that the company highlighted that the ISM Manufacturing Index moved back above 50, which indicates growth.
Fastenal is one of the very few companies that actually comments on this index regularly.
The bad news is that since then, the index has fallen back below 50 again.
With regard to margins, we're also seeing some headwinds, mainly due to an unfavorable drag in product and customer mix, which caused operating margins to decline by 60 basis points to 20.6%, with gross margins dropping by 20 basis points to 45.5%.
None of these developments are indicating unusual weakness.
Having said all of this, while cyclical headwinds persist, the company continues to focus on the things it can actually impact, which includes the expansion of Onsite locations.
The number of Onsite locations increased by 12%, although sales through Onsite locations increased in the low-single-digits due to sluggish demand growth.
Adding to that, the company's eCommerce platform approached 60% of total sales. Fastenal aims to push this number to 66% by the end of this year, with 85% being the ultimate goal.
Valuation
Due to economic challenges, analysts expect FAST to generate just 4% EPS growth this year. This would be the worst performance since the 2% decline during the 2016 manufacturing recession.
The good news is that after 2024, analysts expect an EPS growth recovery to 10% and 8% in 2025 and 2026, respectively.
Moreover, the company now trades at a blended P/E ratio of 31.7x, which is slightly above its longer-term average of 30.3x.
This implies a $75.50 price target, which is 17% above its current price.
Given economic developments, I'll change my rating to Buy if we see 10% more downside.
At that point, I'm interested in making FAST a part of my portfolio, as I believe this advanced distribution business model has a very bright future!
Takeaway
Cyclical stocks are facing challenges, with inflation and geopolitical uncertainties keeping growth subdued.
Fastenal, which has become a standout in the industrial sector, has seen its stock drop 16% from its recent highs.
However, despite the downturn, Fastenal's unique distribution model, extensive Onsite locations, and robust e-commerce platform make it a compelling investment.
Moreover, the company's history of consistent dividend growth and its strategic focus on efficiency and customer service through Onsite services support its long-term potential.
While current market conditions are tough, I see a significant opportunity if the stock drops another 10%.
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