Fastenal Company (FAST) Q2 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Fastenal Company Second Quarter 2013 Earnings Release Conference Call. [Operator Instructions] As a reminder, today's conference is being recorded. I would now like to turn the call over to your host, Ellen Trester, Investor Relations. Please begin.

Welcome to the Fastenal Company 2013 Second Quarter Earnings Conference Call. This call will be hosted by Will Oberton, our Chief Executive Officer; and Dan Florness, our Chief Financial Officer. Also present is Lee Hein, our President. The call will last for up to 45 minutes. The call will start with a general overview of our quarterly results and operations by Will and Dan, with the remainder of the time being open for questions and answers. Today's conference call is a proprietary Fastenal presentation and is being recorded by Fastenal. No recording, reproduction, transmission or distribution of today's call is permitted without Fastenal's consent. This call is being audio simulcast on the Internet via the Fastenal Investor Relations homepage, investor.fastenal.com. A replay of the webcast will be available on the website until September 1, 2013, at midnight, Central Time. As a reminder, today's conference call includes statements regarding the company's anticipated financial and operating results as well as other forward-looking statements based on current expectations as defined by the Private Securities Litigation Reform Act of 1995. Forward-looking statements may also -- may often be identified with words such as we expect, we anticipate, upcoming or similar indications of future expectations. It is important to note that the company's actual results may differ materially from those anticipated. Information on factors that could cause actual results to differ materially from these forward-looking statements are contained in the company's periodic filings with the Securities and Exchange Commission, and we encourage you to review those carefully. Investors are cautioned not to place undue reliance on such forward-looking statements as there is no assurance that the matter contained in such statements will occur. Forward-looking statements are made as of today's date only, and we undertake no duty to update the information provided on this call. I would now like to turn the call over to Will Oberton. Go ahead, Mr. Oberton.

Thank you, Ellen, and thank you everybody for joining us today. Looking at the results for the second quarter, I think the main story is slow sales growth, and we believe that's really caused by a few things. One is a slow economic condition. It's very slow out there from an industrial side. And the other would be that we have just become too tight -- or we were too tight on adding people in the fourth quarter and for the -- basically the last 3 quarters. With our headcount down negative 2% at the store, we've just -- we do not have enough time in the stores to get out and make the number of sales calls that we need to make. Our plan going forward to try and address that is to add between 100 and 150 FTE per month for the next 6 months throughout the rest of the year, adding 600 to 900 FTE for the year. So we can't do anything about the economy, but we do have the balance sheet and the strength to go out and add the people to grow the stores. And the decision to add the stores -- we've spent a lot of time looking at that, looking at the data, but mainly we've spent time talking to our store managers and asking them what it would take to free up some time or to get out there and make more calls, and that was the common theme, was, "Hey, give us a little help, we'll grow the business." One positive -- actually, a very positive on the sales side of the quarter were our June results. Our sequential growth from May to June was 3.2%. The historical number is 2.8%. So we're really hoping that, that continues and that…

Good morning, everybody, and thank you for participating in our call today. I have a handful of points I'll make just to highlight some items in the press release. Somewhat redundant to Will's, and bear with me as I run through them, please. First one, I agree with Will, huge plus on the quarter. The fact that we we're able to leverage earnings on 5.5% sales growth I think is a pretty strong feat, when you look at the type of investments that we continue to make into our business. I think it talks a lot about the pathway to profit that we started back in 2007, where we really slowly moved our business to being a more variable cost structure than historically when we we're constantly adding stores at a higher clip. We were introducing a lot more fixed cost into our cost pool, the occupancy associated with those sites and the fixed headcount in those sites, that it gives us a little bit more ability to adapt. That combined with the fact that we had a 60-basis-point improvement in gross margin, those 2 things really allowed us to grow our headcount -- or excuse me, our earnings. Will touched on some of the things, with investing little more heavily in our stores in the coming months, which we think will also help on the revenue side because we're probably running a little bit too lean at the store level. Second item, reiterate what Will mentioned on Page 4. In June, we beat the sequential trend. To be honest with you, that's a good feeling. We believe that positions us a bit better going into the tail half of the year. And when you look at the ISM reading out there, it really isn't because there's a rising tide…

[Operator Instructions] Our first question comes from Hamzah Mazari with Crédit Suisse. Hamzah Mazari - Crédit Suisse AG, Research Division: The first question is just on vending. Just trying to better understand what has led to the change in strategy from maybe Q1 where you wanted to grow your installed base as fast as possible and now to sort of taking a little more of a measured approach. I realize some of this maybe you're running too lean, maybe your profitability expectations have changed on vending. Just any color you can provide there.

I'll start out with no, our profitability expectations have not changed at all. It really comes to what I said in the call is that we're getting the signings by working very hard with the managers and pushing hard on signing vending machines. But when we really looked hard and listened to our managers about how we can improve our sales quickly, month-to-month versus year-over-year, the word was let us go out and just make regular sales calls, call on contractors and small accounts and pick up orders rather. The vending cycle, if we sign a vending machine, typically, it takes about 5 to 6 months to be producing revenue for us. It's a great business. It's just a longer cycle business. And so we said, okay, let's just let it flow naturally. And the fact that we signed almost 5,400 machines without putting all the pressure on, to me, was actually a pretty impressive number. And so it's nothing about our view long term of vending. We think it's still a fantastic opportunity for us. It's just about how much time you can consume in the store for just one initiative that's a longer-cycle initiative. Hamzah Mazari - Crédit Suisse AG, Research Division: That's very helpful. And just a follow-up, any -- you mentioned the June number was pretty good, 6% relative to 5.3% in May. Has there been any change in July, what you're seeing? I know it's early days in July, but any change versus expectation?

Hamzah, this is Dan. First off, experience has taught us whenever we try to predict on the 10th of the month, our odds of being incorrect are incredibly high. And so we tend not to go down that path, especially in the July month because with the Fourth of July, it even adds a little more uncertainty. But our expectations, going into the tail half the year, we think we're doing some things on the headcount side, on the vending side, on a whole bunch of aspects of our business to position us better for the upcoming months and the last months.

Our next question comes from Sam Darkatsh with Raymond James.

This is Josh filling in for Sam. I wanted to get your thoughts, you called out the nonresidential construction industry as being a bit of a headwind to margins and the lackluster growth there. Could you give me any thoughts on your outlook for that vertical and what you think of it in the coming months?

As we touched on, the -- it's been essentially treading water for some time. And earlier in the spring, we thought it was very weather-centered because we really had a tough weather pattern. I mean, I know from first-hand knowledge we had snow storm here in the first week of May and a lot of the upper Midwest was hit hard. And so there was some weather going on. But when I look at the May numbers in total, I look at the June numbers, I mean the construction is weak. As I touched -- alluded to earlier, there are some things that we're doing, testing a few hundred stores with putting some more products in, that we've seen some positive results from, and it's going to cause us to take -- expand that more in some additional locations. As far as predicting where it could go, your guess is as good as mine.

But that isn't applying pressure on our margin. I don't think Dan didn't say...

On the gross margin, it does give us a little pressure because our construction business does run at -- or runs at slightly higher gross margin, so there's a little mix issue there. And I was just trying to identify pluses and minuses to gross margin.

Got it. And then could you maybe just elaborate a little bit more, going back to the vending program, on how you're defining a quality of an installation? Is it purely the revenue potential of the machine or are there other factors that you're considering?

It's really about the revenue potential of the customer. There were just 2 things. One is revenue potential of the customer and how many machines per customer. What we identified is that in some cases, because of aggressive sales people there saying, "Hey, we need to put 6 machines in here." And as we went in and sized up the customer, we found that really 4 was -- or 4 or 5 was a more appropriate number. And so what we're really doing is just a screening process. Now that we have so many machines out and so many customers, we have great data. And it's really looking very hard, to say is that the correct number of customers -- or per, for that customer or is this customer even capable of getting one machine. We've always done it, we just have better data today.

And if I could just get one more, and you mentioned wholesale pricing not necessarily being a component of your bullishness on gross margin. Could you talk about the pricing environment in the industry?

Well, the pricing environment is always difficult. But with the economy slow like it is, it's more difficult to go in and ask for a price increase. And I think some of it is just reluctance of salespeople. When your customer's already putting pressure on you, it's harder to go in and push pricing. So it's just a more difficult environment. There's not real dynamic, not a lot going on. It's just when business is robust, it's a lot easier to walk in with a price increase than it is when business is slow. Timing is tough.

Our next question comes from Adam Uhlman of Cleveland Research.

Could you elaborate a little bit more on the headcount increase for the stores, exactly what type of people are you looking at adding, support people or actual outside sales reps? And help us better understand when the revenue contribution from that could hit. Could we see anything in the back half of this year? Is that more for next year? And then, wrapped into that, if you could just talk about the active account trends that you're seeing today?

The headcount increase, we've started adding some people in June as you saw in the numbers, and we're going to continue, as I said, to try and add 100 to 150 FTE per month. The majority of the people we'll be adding will actually be part-time support people, which will allow the managers and the salespeople to get out of the store and contact the customers. Because in talking to many, many managers, which myself and Lee and the whole entire team has been doing, it's -- they're saying, "Hey, we're stuck inside packaging orders, which someone else could do if I had the time or if we had the hours." As far as the -- when we expect to see improvement, based on looking at historical data of when we've added people and when it's -- the sales have improved, it actually comes very quickly. We would expect to see maybe slight improvement in August, but by the October, by -- the beginning of the fourth quarter, it should make a difference in our incremental gains, our month-to-month gains. And then really, as I had said in the call, our goal is to set ourselves up for a good first quarter, more of a historical first quarter in that high-teens, maybe pushing that 20% if we can do things very well between now and then. That's -- and, probably a little economic help as well. Who knows if that comes. But it's really about adding support so the salespeople can get out and monitoring it very close to see where we're getting the gains and where we aren't.

Okay. And where's the active account growth running right now?

Well, excuse me, I -- it's up slightly, but we -- it's pretty flat. And we believe most of that is attributable to not making enough sales calls, not having the time to get out and pound on doors. It's like anything, if you don't stir it up, it doesn't happen.

Our next question comes from David Manthey with Robert W. Baird. David J. Manthey - Robert W. Baird & Co. Incorporated, Research Division: Guys, I was wondering, first off, with what you said, Will, earlier. You mentioned that there's no change in your profitability expectations. And as you're adding these -- the full-time equivalents, getting the store people out in the field more, it sounds like your growth expectations have not changed either, if anything, maybe have gone up. I'm just trying to figure out where these lines intersect. It sounds like the vending might be contributing a little bit less as it matures and as there's fewer being installed, but you might get a little bit of a boost from some of the more active selling efforts. Could you talk about your expectations on growth just from sort of a secular basis? Has it changed at all with what we're talking about here today?

No, it really hasn't. And we don't expect any less from vending. Although our signings slipped from first to second quarter, we still have thousands of machines that are being installed. We still have...

We did 20% more than last year.

We did 20% more than we did last year. So Dan and I, and we've talked about this a few times, we maybe got a little overzealous, throwing a 30,000 out there, but we've probably made bigger mistakes. So the vending, we expect it to continue to grow and continue to -- a higher percentage of our customers are deploying the technology, and it's going to continue to grow we believe at a rapid rate. As far as adding the salespeople, that's really nothing new. What happened there, and I take responsibility, is we got too tight in the fourth quarter. And part of the -- where we went wrong with the decision was I thought that vending was going to be automatically more -- it was going to automatically increase the efficiency in our stores. What I was missing on that is the tremendous amount of work to get to the position where it becomes more efficient, which it does, but there's a lot of work of introducing it and training it and setting it up. And all that work was taking away from sales calls. And that's what we're hearing from our managers when we spend time with them. So we're really getting back on the Fastenal model, the pathway to profit model, add 15% to 20% more -- or 15% more hours in the store, and you should get close to 20% more growth. That's what we're on. We've done a lot of work looking at the historical trends saying, hey, part of our sales growth problem, a lot of it is we need more hours to make more customer calls. Overall, the expectation has not changed, the mix has not changed. We basically slowed it down too much over really a 3-quarter period, over the last 9 months. Does that answer your question, Dave? David J. Manthey - Robert W. Baird & Co. Incorporated, Research Division: Okay. It does, Will. And related to that, I think THUB is slated to start coming on here and helping. It sounds like you're approaching this labor problem from 2 angles now. And could you talk about how THUB ramps up? And then if you have time, if you want to touch on the OEM fastener initiative, and then I'll hop off here.

THUB, we're kicking it off this month. It's going to really take probably 9 to 12 months to where we have it rolled up to all of our stores with the majority of the volume. So it will be a long ramp-up. But we know that we'll save hundreds of FTE equivalence in the stores by the time we've rolled it out. And it's really about taking labor out of the store and doing it in a more efficient fashion. We're very, very bullish on that, on that project. The other thing that it has is it has the potential, and we really believe it will happen, to make the economics of vending better because we lower the amount of labor that goes in to serve the customers and serve them at a higher level so there are some benefits there.

And we improve our ability to source the products going through vending.

Yes, the margin opportunity becomes much better with vending because we're buying tremendous quantities to bring into this one facility. So some very good reasons for doing it, and it's a few weeks behind schedule but for the most part, it's right on track. We we're hoping to get it going the 1st of July, and I think it's the 15th, so very good progress. As far as the OEM fastener initiative, we're also still very positive on that. But it's -- and I've said from the very beginning, it's going to be a slow process because most of the contracts or customers we're going after have their fasteners under contract. I would say on the average, that's a 3-year contract. There's 2 or 3 5s, but most of them are 3-year contracts, and so we're just positioning ourselves. So when those contracts expire, get close to expiring, we're standing at the door, the customer knows our capabilities and has a -- and we have a relationship with their buying team or engineering team and feel we're going to be well positioned when that happens. We have a lot of nice signings, but still not enough to really move the needle on the macro. But we believe that fasteners are a huge part of our future and that we have not done a very good job, broadly speaking, not done a very good job of explaining to the customers how good we are at fasteners and all the things we can offer with our manufacturing, with our importing capabilities, with our local store delivery, the things that most of our competitors really cannot offer that we can.

Our next question comes from Ryan Merkel with William Blair. Ryan Merkel - William Blair & Company L.L.C., Research Division: I wanted to go back to vending for a second, I guess a two-part question. I'm wondering what are you doing to fix the underperforming machines that you have out there today. And then secondly, is the lower revenue that we've seen per machine, is that mostly a macro issue, or is it a quality of machine issue?

I'll answer the first part first. We've identified all of the machines that are producing below what our expectations are. We've put together a very good program, and our district managers and our store managers are out visiting these customers. We have seen some improvement, it's coming slow. But in talking to the district and store managers, it seems like the customers are very open to, yes, I know we're not buying enough and it sounds like we have just not been aggressive enough with these relationships to move that forward. So we're very focused on it. I believe it's a well-designed program to communicate with the stores and the customers and move it forward. As far as the revenue per machine, it's really 2 things. One is the underperforming. If you pull them out, the revenues dropped maybe less than 10%, less than $100 machine, is that right, Dan?

Yes.

And so you pull out the underperforming, and it's back. But I think the other is pure macro, that the customers are not growing as fast. If you look out at the industrial economy, and you look at what other companies are putting up for numbers, it's probably manufacturing's maybe flat at best right now. And so in some cases, it's just -- there's not much growth there. And when we put a machine in and it reduces the spend, there's no way to grow that back. But overall, when you look at the growth of the customers that have vending and all the things we're doing, we're still very bullish on the overall industrial vending project and what it can mean to the company.

Well, the thing, I think, I'll add is just based on sometimes asking a bunch of questions behind the scene, and you learn some things. And I think part of the issue is, Ryan, you mentioned quality of machine. I would phrase it a little differently. I'd say some of them, the quality of the implementation. That's been our issue. The right parts -- are the right parts in it? Are we providing a high level of service? And are we -- a lot of times, you might have a machine that goes in, and inertia is a powerful thing. And it might have been on day 1 we're putting this machine in -- part of the agreement was some business getting turned over to us because some of the stuff in the machine we're already selling to the customer. And 3 months later, 6 months later has that happened, and are we popping in -- am I popping into Lee and say, "Hey, Lee, you said you're going to turn this $500 worth of this over to me." We're just not seeing that activity yet. And Lee is like, "Yes, you're right. We got to get that going."

Ryan, I'll jump in. One comment is we've learned some things, too, over the course of the year, and that is we're starting to lead our customer instead of sitting and waiting for them to choose the items. We were finding it -- the speed to revenue, is part of leading our customer. Really saying, basically, try this, try this, we know this will work, you should have a box cutter, you should have some batteries, what have you. That's helping, too. Ryan Merkel - William Blair & Company L.L.C., Research Division: Okay, great, that was really helpful color. And then the second question I had, this is a big positive, and I think Will you pointed this out. But you nearly hit a 23% EBIT margin with 92,000 a month in average sales. So does this suggest that pathway to profit margin can be even stronger than you originally talked about, and this is because you've done so well without ramping the sales as much you would have expected at this point?

We've been saying for the last 2 or 3 years, Dan and I, that the 23% is a point in time, and it really has to do with the average store size. It depends on what our gross margin does. At the end of the day, our real goal is return on invested capital, so whether it's 22% or 25%, as long we can continue to grow profitably, we think we can continue to move it up as the average store size grows. And what we're doing with the labor, adding people into these stores, as I said earlier, it's a direct piece of pathway, but more people on our existing stores create greater growth. And if we do that, our pretax profits will grow as a percentage of sales. So I guess the answer to your -- long answer to your question, but the answer is yes.

[Operator Instructions] Our next question comes from Brent Rakers with Wunderlich Securities.

Wanted to talk a little bit about the cost implications of the sales force additions. And then I guess on the other side, your non-seller employee number increases have actually pretty significantly exceeded the seller increases. I was hoping maybe you could talk about that historically, and then also talk about what the outlook is for hiring there.

I'll start with the non-seller piece. On that, it's more of a function of just the way the comparisons work out because we've been -- on a year-over-year basis, the numbers are up, but if you look at the various components, we've been managing that area pretty tightly. We've added some folks into our IT area. We've added some folks into select resource areas. But it's probably more of a function of what you really look at, as far as June-to-June comparison, than anything else. Will, if you want to touch on the store side?

I think -- well, on the store side -- I lost the question.

The cost of the FTE adds.

The cost of the FTE adds is really 2 things. One is we believe we still have room to improve our gross margin and offset some of it. But looking at the math and looking at how we believe we can ramp the sales up, we think we can pay for most of it in gross margin improvement because if we get -- it doesn't take a tremendous amount when you look at an almost $300 million monthly revenue. You don't need to see a lot of incremental improvement to pay for 100 to 200 people a month. And so we need to work very -- we're very focused on that. We've talked to the regional vice presidents again this morning on a teleconference, making sure they understand that their -- as our labor goes up, they need to improve their gross margin or increase their gross profit dollars to pay for these people. And in one-on-one conversations with our regional vice presidents and district managers, all of them feel very confident they can do that because they think they're going to get some pretty quick improvements. So overall, Dan and I are not afraid of it in the macro number from an earnings in the fourth quarter and the first quarter because if we do this right, we think it will actually be a positive in the fourth quarter and the first quarter.

Okay, great. And then I guess my second question and I think, Will, you talked about increasing, I believe you said 15% more hours of productivity for some of the store managers and the sellers. Presumably, that's coming both from reduced pressure from vending, but also some of these additional kind of store support hires. Over what time frame you think you can get that profitability improved by about 15%?

That's not the profitability. What I meant by that is 15% more hours in the store. So if I have 3 people today working in the store, doing say, 140 hours a week, I'd want to add 15% to that number or roughly 20 more hours into that store to free up time. And if we really could free -- put 20 hours a week in a store and most -- the majority of that time, and not all of it is going to be spent on selling. If we could add 10 to 15 hours of selling every week in every store, we would see an impact very quickly is what we believe.

Will, how quickly do you think with these hirings will you get to the point of freeing up that 15% more hours?

Well, it's not really freeing it up. If you look at the fact we're going to add 100 to 150 FTE a month, you can really do the math on that looking at our macro. But it's really -- here's what they are today, here's what they're adding. And it really adds up to about 1.5, I believe about 1.5% more hours per month going forward if you just run the math on it.

Our next question comes from John Baliotti with Janney Capital Markets.

I was just curious, Dan, or Will, is it possible, as you add these heads, that you could approach both the short-term sales goals by spending more time with your customers but also work the vending at the same time that gives you that long-term growth piece?

We are -- we've said this a couple of times. We are working the vending at 5,300, 5,400 machines a quarter would still give us. Now could we move it up a little bit, maybe get to 6,000 or 6,500? Yes. But if you look at any other period in time 5,500 or 5,300 would have been a fantastic number. So we're still very committed, and so I think we are working both sides of it. Like I said earlier in the call, I'm actually quite happy that we've backed off the pressure and only lost, not a tremendous amount, quarter-to-quarter. And year-over-year, we had nice growth.

So Will, do you think that -- is that -- sort of that exit you talked after the last quarter that while you're not really expecting a 2,500 a month at this point, but you thought you're going to exit the year at that rate, is that still something you feel good about?

I don't want to comment on it because we'll see what the stores do. Because we've committed to the stores to back off on hammering it. Let's see what it does naturally. What we're really going to the stores with is let's get our incremental sales growth above the historical pattern, and if we're able to do that, we'll give you labor. With that, we expect you to move your incremental pattern up. And if we're able to do that, we'll position ourselves in the first quarter of 2014 to have a very good year in 2014, and end 2013 on a stronger note.

And the other dynamic that's going on, and I also touched on this earlier, is right now, 44% of our stores have more than 10 vending machines. So we're not too far from half of our stores having more than 10 machines. We're going to have the impact of our centralized vending distribution model taking some pressure off the stores. So we'll see where that number takes us, from the standpoint of we've always been very good at being decentralized when it comes to decision-making, being more centralized when it comes to areas where we can be more efficient like distribution.

Dan, I'll just jump in. I think how to look at this is we trust our managers that -- John, I'm sorry. We trust our managers that if we give them more hours, they make more calls, what happens on those calls will dictate what happens in our sales. Whether it comes in the form of construction products, vending, national accounts, key accounts, what have you. They're saying "Give us more hours, we'll make more calls," and then we let them determine what happens in the market based on where they make the call and what happens. And you really have to understand that the sales cycle of a branch and to the degree of what happens on the call.

And you guys -- I think you mentioned earlier about the impact or the absorption of the new salespeople and where you think you can offset that in the short term. And you've been able to keep that SG&A as a percent of sales in that 29%, 30% range. Is that -- so Dan, is that something you feel whether maybe if that goes up or you think you'd offset that with gross margins, is that kind of how you're looking at that in the near term?

I think we can maintain that range, or it will become challenging, and this is a good problem. If our sales growth moves up, and our profit payout moves up, it can move that percentage around, but I think we all would agree that'd be a good problem.

I'm not showing any other questions in the queue at this time, gentlemen.

Well, very good. It's 9:44. We try to hold these calls to 45 minutes. So thanks again, everybody, for participating in the call today, and thanks for your continued support in Fastenal. Have a good day.

Thank you. Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the conference. You may now disconnect. Good day.