Good morning ladies and gentlemen and welcome to the Fastenal Company fourth quarter and full year 2018 earnings results conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session and instructions will follow at that time. If anyone should require operator assistance, please press star then zero on your touchtone telephone. As a reminder, this conference call is being recorded. I would now like to turn the conference over to Ellen Stolts of Investor Relations. You may begin.

Welcome to the Fastenal Company 2018 annual and fourth quarter earnings conference call. This call will be hosted by Dan Florness, our President and Chief Executive Officer, and Holden Lewis, our Chief Financial Officer. The call will last for up to one hour and will start with a general overview of our quarterly results and operations, 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 March 1, 2019 at midnight Central time. As a reminder, today’s conference call may include statements regarding the company’s future plans and prospects. These statements are based on our current expectations and we undertake no duty to update them. It is important to note that the company’s actual results may differ materially from those anticipated. Factors that could cause actual results to differ from anticipated results are contained in the company’s latest earnings release and periodic filings with the Securities and Exchange Commission, and we encourage you to review those factors carefully. I would now like to turn the call over to Mr. Dan Florness.

Thanks Ellen and good morning everybody, and welcome to the fourth quarter conference call for Fastenal. Before we delve into Holden’s flip book, I just want to touch on a few things. If I go back in time to late 2015 or just 2015 in general, we’d seen a dramatic slowdown in the economic we sell into. We’d had a tough year. I was stepping into this role and I remember the first comment I made to the team was, hey folks, we have a ton of great things we can do for our customer, that we can do for our employees, our suppliers and our shareholders that’s focused on the future, and let’s just get going. In 2016, it was a year of investment. We invested in inventory in our branch network to support our customer. We invested in growth drivers of the business and the infrastructure to support those growth drivers, and as all you recall, we had a tough year from the standpoint of nominal growth but we really grew our expenses and our working capital because we were setting ourselves up to be a better supply chain partner for our customer. In 2017, armed with an economy that was not kicking us in the face but was actually giving us a little bit of tailwind, we looked at the team and said, you know what? Let’s grow our sales and earnings this year, and when I talk about earnings, I’m not talking just about Fastenal, I’m talking about our people too. We did a nice job that year of doing all three. In 2019, we’ve improved that from the standpoint I think we found a better balance in growing the aspects of our business, and one thing that was really important to us was an incremental…

Great, thank you, Dan. Good morning. I’m going to begin with a quick recap of our 2018 results before moving onto the quarter. In 2018, Fastenal generated a record $4.97 billion in sales, which is up 13.1% from 2017. We generated at least 13% growth in each quarter of the year, reflecting what have been stable and sustained macro tailwinds as well as effective execution of our growth drivers. To touch on those growth drivers, for onsites we signed 336 new agreements in 2018. That was shy of our 360 to 385 goal, but it’s well above last year’s 270 signings. If I exclude the branch transfer revenues, sales through onsites grew more than 20% for the full year. We’re targeting 375 to 400 signings in 2019. For vending, we finished 2018 with more than 81,000 installed product dispensing machines, which is up 13.6% over 2017. Our 2018 signings of 22,073 machines were up 14% and around the midpoint of our 21,000 to 23,000 signing goal for the year. Sales through our machines rose more than 20% in 2018, and we’re targeting 23,000 to 25,000 signings in 2019. Lastly, national accounts paced the overall business with sales growth to our largest customers in 2018 accelerating to up 18.1%. We were active with new signings, but this acceleration also reflects success in expanding our sales to existing customers. Though today they represent a relatively small part of our business, we also continue to see healthy growth in our non-North American revenues as well as sales through our ecommerce channel. Our operating margin was flat year to year at 20.1% in 2018. This stability does mask improved leverage as the year progressed, with our operating margin expanding by about 30 basis points in the second half of 2018. Our gross margin finished…

[Operator instructions] Our first question comes from Chris Dankert of Longbow Research. Your line is now open.

Morning guys, thanks for taking my question. I guess first off, and I know visibility is limited, but we’re going into the new year here, obviously price cost was a headwind; last year, we’re kind of comping on that. Given that you’re going to be pushing some more pricing in a more focused way, given that volumes are going to be up, is it fair to assume that gross margin in the first quarter should be up a little bit sequentially, or are we still kind of fighting sideways here?

Well, I think if you look sort of sequentially at how things usually play out with gross margin, historically we’ve seen an uptick in Q1 over Q4, but over the last three years really the Q4 to Q1 cadence has been more flattish, and I think a lot of that has to do with sort of the inherent volatility in gross margin in Q4. It can be difficult to predict. We’re moving into a quarter where we’re going to see how the tariff price cost dynamic plays out. We still have an inflation price cost dynamic playing out. I think if what you’re asking about is what you should think about in terms of sequential gross margin, I would think about Q1 looking somewhat similar to where Q4 comes in.

Got it, thanks. That’s helpful. Just as a quick follow-up, thinking about the full year price cost, with the team in place, is it fair to expect that by Q2 we’re starting to claw back some of that price cost, or is this more of a back half type of dynamic?

Well, what I’ll emphasize is we have improved our price realization each quarter this year, and setting aside the question of tariffs, just looking at generalized inflation, I would expect that that’s going to continue as we enter 2019. Given that, the question really comes down to what do we expect out of costs as we go into 2019. I’ll tell you that as much as we’ve realized the incremental pricing, we’ve also realized incremental costs each quarter this year as well, so we still see pressure there, quite frankly. But that said, we are making a lot of progress in terms of our ability to realize price. We talked a little bit about the pricing tools that went in, in midyear 2018, we talked a little bit here about how we’ve sort of re-jigged the group a little bit to give us a bit more focused information, etc., and I think that’s going to continue to provide us some additional incremental benefits. Our expectation in 2019 is that we’re going to continue to narrow and, frankly, get rid of the gap that exists today between price and cost.

Got it. Thanks Holden, that’s so helpful. Congrats on ’18, and good luck in the new year.

Thanks Chris. Just one item I’ll add to Holden’s commentary. When I think of the dynamic that’s going on right now, whether it’s inflation or tariffs in general, I think this is a huge opportunity for the Fastenal supply chain capabilities where we can flex our skill set. I mean that from the standpoint we’re not a fulfillment company, we don’t just supply you what you ordered, we also challenge in the process of saying, you know, the item you’re ordering, based on what we know about your business, we question if that’s optimal for your business. Sometimes it’s substituting the product from the standpoint of the durability of that product, does it fit, either is it adequate or too adequate to the demand of the use, but also we have great partner brands, we have great exclusive brands, and sometimes it’s coming to a customer and saying, you’ve used this same brand for years, we have this brand that we actively support and we have a better price point on, a better cost point which translates into a better price point, and we can offset inflation and/or tariffs by actively substituting, and that comes from an active engagement with knowing how the customer is using it and where their pain points are, where they’re willing to be flexible and where they can’t be flexible. I think that’s an important component of Fastenal’s supply chain.

Awesome, thank you, Dan.

Thank you. Our next question comes from David Manthey of Baird. Your line is now open.

Hi, good morning guys. Happy new year. First of all, I’m hoping I can get a little bit of color on these large customer pricing conversations. Are you through all of them? When do the changes start taking effect, and I assume you’ve outlined agreements for the 10 and 25% tariff environments, but have you also reached contractual agreements as it relates to when the tariffs are eventually rolled back?

You know, the agreements we have allow for windows for discussions. We’ve talked about this in the past of when pricing can change. Legally, you can do things beyond that from the standpoint of there’s always force majeure elements of contracts. We’re not a fan of that up or down, because we don’t think that’s part of a supply chain partnership. We’re having active discussions with the customers. The discussions are going quite well. Are some more successful than others? Yes, a lot of times it depends on where we find success in the things I just mentioned - the ability to substitute, the alternative sources of supply, the level of service trade-offs, are we growing our business, etc., but we’ve been largely successful. We’re seeing some price increases that are going into place as we speak and will be going in place over the upcoming months. In regard to the specifics of what happens when it goes from 10 to 25, or what happens when it unwinds, you can talk through scenarios but there’s no agreement that contemplates the--I don’t know if I want to use the word craziness or the noise, or all the stuff that’s going on in the marketplace, so it’s going to be a fluid environment on all regards. The one thing, we did put through some price increases that took effect in mid-December, and in those we just--we really had a discussion with our customers, saying you know what? The tariffs started on September 24, here is the latency we’re putting in, these tariffs unwind, here’s how we’ll unwind the tariffs in those discussions, and really having the same kind of latency. The idea was trying to match up as best you can where it’s impacting your P&L, where it’s impacting your business, and having a fair trade-off on the in and out because there are going to be distinct lines in the sand. But it’s not a foregone conclusion that the 10 or 25, what’s going to happen when or if, some or all of it remains there essentially and perpetually.

What I’ll add to that, David, is yes, I do believe that the vast majority of the conversations have been had. In fact, when I asked why our signings of onsites were perhaps a little bit lower in Q4 than we’d seen the rest of the year, one of the answers I got was, because of all the time and attention that we diverted to having those conversations. So those groups, both locally and international accounts, have worked really hard to have those conversations in a compressed period of time, and they came to those conversations with a great plan and, every bit as important, with great data which allowed us to define the issue fairly precisely. It’s a known issue, and I think those are the elements that have given--that make us be very encouraged about how those conversations have gone down. We do believe that those conversations have been generally successful. The costs related to the 10% tariff will begin to roll into the P&L in the first quarter, but frankly I think that most of the agreements that we’ve reached with many of our customers will also begin to roll in, in that January and February window as well. What that means in terms of the incremental price cost in the January-February time frame, time will tell, but that’s just a timing issue. Like I say, we’re encouraged by how those conversations went and we’re sort of expecting that we’re going to largely be able to neutralize the tariff impact.

That’s great color. Thanks guys.

Thank you. Our next question comes from Ryan Merkel of William Blair. Your line is now open.

Hey, a couple questions from me. First, I’m getting a lot of questions about tariffs and FIFO accounting, so how should we think about gross margin first half ’19 to second half ’19 as it relates to FIFO?

Well, that’s why we began to build some cost into inventory in the fourth quarter, based on when the containers began to hit the shores at the end of September. We expect that we will begin to see that inventory that’s currently sitting there roll into cost of goods as we get into the first quarter. That was all expected, Ryan. We knew that there would be some impact on the inventory side of the ledger, but it will take some time for that to roll through. But the nature of the tariffs as opposed to our usual purchasing was going to compress that window. That’s why we spent so much time talking to investors in a very tight window, is because we knew how that was going to roll out in Q1. I think the effects you’re alluding to are certainly playing out, but our original goal was to have pricing conversations ready to roll out as we began to see the costs shift off the balance sheet and into the income statement, and we think that we have largely achieved that goal. Going forward, we’re going to continue to see the containers move through the inventory and into the COGS as sort of comparable rate, and we should begin to see the pricing in Q1 and then Q2 related to that specifically, and that’s how we tend to view it. I’m not sure that I see a huge difference between the first half and the second half as it relates to the tariffs.

The only thing I’ll add to Holden’s commentary, and this is putting my old hat on for a second, is when I think of our business just holistically and I think about over the years, we’ve had roughly 160 days of inventory, plus or minus a handful, and I’m not going to get into exacts but just holistically, about 100 of those days were physically at the branch and about 60 of those days were physically at the distribution center. Now in the case of a lot of our products, and I’m setting vending aside and I’m setting OEM fasteners aside, in the case of a lot of our products, that kind of mirrors where the replenishment cycle is coming in, and really what put us in a position of having these discussions and having a little bit of a window to react to them. But that product that was in the branches is now we’re three months away from--a little bit over three months away from the start of tariffs, that product that’s going into the branches is starting to get replaced with stuff that was coming in, and so you’ll see bits and pieces of it coming in in January and February and March. They’ll be building as they go through the quarter. The full steam will really hit in Q2.

I think maybe another way to think about it is traditionally when we buy a product from overseas, it might take six months or two quarters, or whatever, to move into our system, but the tariffs were not applied at the point that you purchased the product, the tariffs were applied at the point that it hit the shores. So when the tariffs went into place on September 24, I think it was, any container that hit on September 25, where we might have bought the product three months earlier, but that tariff hit right then, so that’s why when you talk about the timing, the timing as it relates to tariffs and how our system is compressed compared to our normal purchasing period. Does that make sense?

Yes, okay. That’s helpful, guys. Secondly Holden, I think you mentioned the goal for incremental margins in 2019 was that 20, 25% range. Just two questions on that: first, what level of sales growth do you need to achieve that, and then secondly, it sounds like you’re assuming that you can neutralize tariffs and product cost inflation with price.

Well, currently we’re assuming that we continue to grow double digits. Now however the cycle plays out will have a lot to say about that, but we believe that the momentum that we have in our growth drivers is going to continue. We think that we’ll continue in the current environment to improve the price profile, so the real question is what does the cycle do. But at least through Q4, demand is still fairly healthy, so we’re assuming we’re going to grow double digits in order to achieve that.

The one thing I’ll add to that, Ryan, is if you look at it in the last couple years, Terry Owen--we had our board meeting yesterday and Terry Owen came in and talked to the board about--Terry oversees a big chunk of our behind-the-scenes business, so all of our national accounts team, our solutions people, which is onsite, which is vending, our government, our marketing folks, our finance that support national accounts, all those things rolled into one. Those are the bedrock of our growth drivers. We’ve added 30% more people into his team or teams over the last three years, and so when you look at that non-branch, the sales headcount that’s non-branch, that’s the part I’m talking about. We plan to keep adding aggressively into that area because that customer letter I talked about, that’s reflective of what that group does, as well as our local team and the district manager, of bringing that type of execution to our customer. So in a double digit environment, we’re going to keep growing that group aggressively to support what we’re doing. Obviously if we’re weren’t in a double-digit environment, I’d have to go to Terry and I’d have to go to a bunch of folks in the organization and say, hey folks, tighten the belt because we don’t have the luxury to add that. But before I stepped into this role, one thing I learned from this population quite acutely is great incremental margin if you’re not growing doesn’t matter. Now it’s changed a little bit - great growth where you don’t have great incremental margin doesn’t matter either, and I agree with both statements. But we want to be very mindful of growing infrastructure to be great at onsite because this is--just like vending, it’s incredibly disruptive to the space, and we are designed to be the best at this, so let’s go after it with a vengeance.

Just to finish off the last part of that, so yes, with regards to tariffs, we do expect that the success we’ve had will allow us to neutralize that. That’s a different conversation from price costs. Price cost, I think was about a 30 basis point drag to our business for the year. Our intention is to eliminate that drag, and we’ll see how that plays out over the course of the year, but our expectation is to eliminate that drag.

We think we have a good plan to do it, yes, and that would be part of achieving that incremental margin.

Helpful, thank you.

Thank you. Our next question comes from Scott Graham of BMO Capital Markets. Your line is now open.

Hi, good morning Dan, Holden, Ellen. I want to go back to what your just now comment was, Holden, on price cost and looping your earlier comment that the key to gross margin in 2019 will be to get to this, call it price cost neutrality, price cost broadly defined as being your entire P&L as opposed to just materials, I assume. I guess as we look at the trends of your sales, recognizing that on a longer term basis the onsite stuff does start to even out a little bit, but the mix is still running negative, so you have in the past said you have to look to backfill something like 20 to 30 basis points to just keep your gross margin flat due to mix. Is that number still applicable, and maybe connect the dots here for me that why is that not as important as managing price cost to get to your gross margin, to improve the [indiscernible] gross margin?

Yes, sure. I don’t want to give the impression that mix is not important as something that we need to mitigate, right, because we do need to find ways to improve our profitability, and to the extent that whatever the mix number is, we should be able to reduce it just through other activities. But let’s not lose sight of the fact that the mix is going down or the mix is a drag on gross margin because we’re getting tremendous growth in our growth drivers. I don’t think I’ve ever asserted to you that our gross margin was unlikely to decline provided we are successful with our growth drivers, but it is still incumbent upon us as an organization to do everything we can to maximize our gross margin and mitigate the impacts of that, but you shouldn’t have any expectation that our gross margins are going to be flat to going up as long as we are successful with these growth drivers. Look - onsites have a gross margin in the neighborhood of 35%, give or take. It’s just math, right? I mean, if we’re going to grow that business 40%, take out the transferred sales it’s 20%, the math is going to tell you it’s going to be difficult for us to expand our gross margin in that environment. But it’s a real big reason why we’re outgrowing everybody else in the space, so we’re not as hung up with the idea of offsetting mix fully as perhaps your question suggests that we should. But that said, price cost, that should be in our control. We know when our costs are rising, we know what we need to offset, the market should allow it, and we should be able to go to our customers and say, look, we’re not trying to take advantage here, this is what the marketplace is doing, this is what we need to be doing. That’s something that’s about our discipline as an organization. It’s a very different conversation than the one about mix.

Understood, thank you. I was under the impression that if you were able to backfill the 20 to 30, that the gross margin would be flat for the year; but it sounds to me like you’re not saying that.

Yes, I mean, whatever the number is, if we could backfill it, obviously it would be flat, and we always try to backfill. But the fact is, it’s difficult to find those in any given period, so no, I think we’ve been fairly open that if we’re going to be this successful with our vending and our non-fasteners and our onsites, in all likelihood over a period of time, our gross margin will go down. That doesn’t mean, by the way, that our operating margin needs to go down. We get tremendous leverage from the growth that we’re seeing, and we saw that this year as well. I think the dynamic you saw this year is very comparable to the dynamic we expect to continue to see. Now, I’ll tell you, mix expanded beyond that 20/30 in 2018, and it did so because if you think about it, national accounts in 2017 grew 14.5%, it grew 18% in ’18. Onsites grew 35% including transferred revenues in 2017, they grew 42% in ’18. Non-fastener accelerated. With those accelerations, we did see an expansion in the impact from customer mix, but again, we can’t lose sight of the fact that growth in national accounts going from 14.5% to 18% also drives more dollars to the revenue line that we then have leveraged at the operating expense line. That’s how our model works at this point.

Understood. Thank you. Just a quick follow-up would be in the past, you’ve talked about in product line and in channel mix, so products, fasteners versus non-fasteners, markets, manufacturing versus non-residential. Did you see anything in the mix in any of these four groups that went with you or went against you?

You mean within the group itself, as opposed to the changing mix of the individual groups?

That’s correct.

Yes, where products are concerned, our non-fasteners grew faster than our fasteners this year.

I think he’s talking about within the individual components, the dynamic of margin.

Yes.

Oh, okay, I got it. Yes, I mean, the element of price cost was a drag in a lot of these areas, right? I think I indicated price cost was about a 30 basis point drag to margin for the full year, and I think that that affected the margin in most of the channels and products that we’re in. Now, it affected fasteners more than non-fasteners without a doubt. It was probably more significant in the local business than it was on the onsites and the national accounts, etc. There was some differential, but price cost was a challenge across the business.

Fine, thank you.

Thank you. Our next question comes from Adam Uhlman of Cleveland Research. Your line is now open.

Good morning everybody, happy new year. I was wondering if I could go back to the cash flow outlook for this year. How should I be thinking about working capital in your plan right now for 2019? We’ll get rid of some of the one-time pull forward impacts that you outlined on inventory, but just directionally, should we see cash days improve? Then could you just talk about your downturn scenario planning, if you’ve done any? What if the business kind of ground to a halt? It’s a lot different than several years ago, the last downturn. How would you expect working capital to perform with the change in the mix of the business?

Sure. Frankly, my rule of thumb model for our balance sheet would be a slight increase in days on the AR, simply because of the growth in national accounts and growth in international businesses. But you know, a meaningful multi-day decrease in days of inventory, that’s how we would like to build it out. Now, the reality is right now, there are some challenges that by the back half of 2018 it was very difficult for us to achieve those. We have to take steps in 2019 to get back on the track that I just laid out. We’re not there right now, but we have plans to begin to try to address that. Normally what I would tell you is for the full year, we should convert more than 100% of our net income into operating cash flow, and this year the biggest reason why we did not was because of working capital, and the expectation is that as we go into 2019, we should be able to deliver that. The challenges obviously are related to the inflation and tariffs and things like that, what impact that might have on inventory. That’s sort of the rule of thumb that I look at when I think about the balance sheet. We have to show that we can deliver to that again in 2019, because 2018 was a struggle and the variables that caused it to be a struggle in 2018 have not gone away. As it relates to a downturn scenario, traditionally if it’s a short, relatively normal downturn, we need less working capital in that environment, and our cash flow is traditionally pretty stable and steady.

I’ll just throw in a couple thoughts, just after being here for 20-plus years, I’m the old guy so I can give a little perspective. The interesting thing about a distribution business, it’s a working capital business. We have a little bit more fixed capital in our business now because of things like vending and automation in our warehouse and the fact that we have our own trucking network, but it’s really a working capital business. When we put up good growth, the number Holden just cited, that 100%, that becomes more challenging, and historically I would expect our number if we’re putting up good growth to pull down in to the mid-90s as a percentage of earnings, because your AR and your inventory are growing faster because you’re supporting an ever growing business. That’s considered a good problem. The dynamics have changed a little bit on that math because our tax rate is lower now, so we produced a higher--the 100 of earnings isn’t 100 of earnings anymore, it’s a little bit higher, so you can--it raises that relationship. If I look at when growth really stalls, I mean, the best year we’ve had for operating cash to earnings as a percentage, the best year that I’ve ever seen was 2009. I hope that never repeats itself. We threw out more cash than you could imagine because the business slowed down, and if you don’t have more sales, you don’t have more receivables. If you don’t have sales growing in the future, you don’t need to be beefing up your inventory. The only dynamic that can muck that up is if it slows down quickly because we can’t shut off the inbound inventory fast, but the receivables would drop off as the sales drop off.

With that, I see we’re at 9:59. I just want to close the call with a few final thoughts. First off, thank you for participating on our call today. Thanks for your interest in Fastenal and for being a shareholder in Fastenal. One thing for us to think about as we’ve moving from a $5 billion to a $10 billion company and you start thinking about gross profit, operating expenses and operating margin, the message internally is quite clear for our employees. As our business evolves, if I looked out to that $10 billion company and I was just putting a guess of where I think the numbers are, I think gross margin--if the mix ends up where I think it’s going to be, I think the gross margin is around 46 and I think there’s some things we have to do to get better at, to be at 46. Is there upside to that? Sure, but in planning for that 46, I also tell our team we need to plan on operating expenses being in the lower half of the 20s. Twenty-four is the number I always think of, and that allows us to be in a position where we could throw up operating margins at 22. I think that’s very realistic. If I look at regions where we have a lot of onsites and a mature business, the midwestern U.S. as an example, we’re above those numbers. This is a conservative view of the future, but I look at it and say, if I look at Page 9 of Holden’s flip book, the question a shareholder needs to ask himself is Fastenal is investing to grow rapidly - we’ve added 30% to our key account teams in the last three years. Technology, we decided three years ago to spend 50 basis points more every year to become a leader in technology in our industry, not a follower of technology in our industry. We saw with great partnerships over the years - our vending partnership for the last 10, our mobility partnership we put in place next year, we think we’re a different organization now. Fastenal Express, as I touched on in the last call, is not a train, it’s a rocket. It’s growing nicely in our business. It’s not about the revenue growth it can produce, which I think it can; it’s about the efficiency it can bring to our team. But looking at all those things and are you interested in being a shareholder in Fastenal, looking at the return on invested capital that we throw off, that Holden details out on Page 9, I think we’re a great proposition to own and I would challenge our shareholders to step up and buy some more, just like I challenge our employees to be willing to learn and change, and we challenge our customers to be open-minded about their supply chain. That’s how we all get better. Thanks, and have a good week, everybody.

Ladies and gentlemen, thank you for your participation in today’s conference. This concludes today’s program. You may all disconnect. Everyone have a great day.