Fastenal: Leveraging a Legacy Moat

Fastenal is an industrial distributor primarily serving manufacturing and construction customers across North America. The business stands out among large distributors thanks to its roots in complex fastener distribution, local density and scale, and an obsession with getting closer to customers.

Background

Founded in the late ‘60s, Fastenal opened its first branch in tiny Winona, Minnesota and distributed threaded fasteners to businesses in other small nearby cities. Over the last five decades Fastenal now operates over 3,200 in-market locations and generates over $5B in revenue across multiple product categories. It appears they’re just getting started.

Products

Until 1993 Fastenal was solely focused on distributing fasteners – bolts, nuts, screws, studs, washers, pins, and other hardware – to manufacturing and commercial construction customers. Fasteners still make up about 35% of revenue and are an important part of Fastenal’s structural advantage, on which I’ll elaborate later.

Safety products such as safety glasses, masks, ear plugs, gloves, and other personal protective equipment (PPE) make up nearly 20% of revenue and represent an increasingly important part of the business.

Tools make up the last major product category at 10% of revenue with the rest of the business consisting of a hodge-podge of industrial supplies.

Selling Location Types

Fastenal operates two types of selling locations – traditional ‘branches’ and on-site locations. Until 2015, the company’s growth depended on growth in the branch model. Branches are warehouses stocked with a wide selection of items and service a wide variety of local customers. Fastenal currently operates roughly 2,200 branch locations, a number that should remain largely flat in the coming years. While branches are an important foundation of the company’s service, the real growth opportunity is in on-site locations.

On-site locations are tailored inventory stocking services for an individual location. In this model Fastenal services a customer from physically within the customer’s facility. Typical operations include bin-stocks, vending machines filled with high-volume inventory, and specialized inventory rooms. The business operates over 1,100 on-site locations, a number that should grow drastically for many years.

Competitive Position

At first glance Fastenal appears to offer undifferentiated products and services that should be susceptible to intense competition from other distributors and ecommerce players (Amazon anyone?) and is unprotected by any persistent advantages. On the other hand, the company earns both consistently high returns on capital, and consistently better returns than competitors (who themselves already earn respectable returns), suggesting there is something else at play.

These 25%+ returns on capital are great, though they aren’t dramatically higher than Grainger’s. More importantly, the model Fastenal has adopted should prove more durable, and less susceptible to other ecommerce-focused distributors, than a more capital-light distribution model like Grainger or MSCI Direct. This should translate to higher returns for longer periods of time and with a higher degree of certainty.

The keys to Fastenal’s competitive advantage lie in:

- Strength in a complex legacy fastener business;

- Unmatched local scale and density leading to cost and service advantages, and;

- On-site location emphasis compared to the traditional branch network.

Complex Legacy Business

Screws, bolts, and other fasteners are largely commoditized products that cost very little compared to the machines or structures in which they’re used. At the same time, fasteners are often critical in machines or structures functioning in the way that they’re intended, making them critical components.

Despite the commoditized nature of the products, fastener distribution is complex. This is in part due to the very high weight-to-value ratio leading to cost challenges when trying to move product from suppliers, most of which are outside of North America. Further complicating the matter is the tremendous geometric variability based on the use of the fastener, making it difficult to appropriately stock thousands and thousands of SKUs in the right place at the right time without creating a huge inventory drag on returns. To succeed in this space, a company must maniacally control costs, offer exceptional service, and have a deep logistical expertise.

Because of the critical nature of fasteners the most important aspect is availability. When a machine goes down because of a screw failure a manufacturing plant cannot wait days or, even hours in some cases, to get a new part installed. Fastenal understands this and has built a distribution network accordingly by emphasizing density in any market they enter to ensure they’ll have product available whenever a customer needs it.

Local Scale and Density

Fastenal’s answer to ensuring product availability was to build public branches, and lots of them. A quick google search reveals there are four Fastenal locations within 20 minutes of my house. It’s not as if I live in a major MSA either - I’m writing this post from the bustling metropolis of Grand Rapids, Michigan; population 200,000.

Building a dense presence in all key markets is a common theme for Fastenal. As Scuttleblurb highlighted in a 2017 post, Fastenal had 9x the locations of Grainger with 40% of the sales:

One would assume that spending so much money on infrastructure compared to competitors would depress relative returns on capital, when in fact we’ve seen the opposite, again highlighting the fact that service is critical in this space.

In addition to many physical points of distribution, Fastenal made the decision to own its trucking fleet. While building out a fleet is a substantial initial and ongoing investment, it gives the company more control over its service level and fixed-cost leverage that competitors who outsource shipping can’t benefit from.

Fastenal also dedicates considerable effort to building employee know-how. Through an internal corporate university known as the Fastenal School of Business (FSB) the company delivers a comprehensive curriculum of industry and company-specific training to employees. In 2019 the company completed 489,000 FSB trainings with an average of 16 hours of training per employee.

As a result of these decisions over 60% of Fastenal’s inventory can be delivered same-day with virtually all of the rest available within one day. When service counts, customers know Fastenal will deliver.

Through investments in infrastructure and personnel, Fastenal has spent 50+ years honing the art and science of effectively managing and improving this complex supply chain. The company’s scale, owned distribution network, frugal cost structure, and collective customer data drive both cost and service advantages in fastener distribution. I don’t see any other distributor meaningfully encroaching on Fastenal’s competitive position in this area.

The company’s dominant position in seemingly innocuous fastener distribution has provided a springboard for success in adjacent product categories and revenue streams, such as the newly emphasized on-site model.

On-Site Locations

Fastenal’s mantra is “Growth by Customer Service” which they achieve by “getting closer to the customer”. You can’t get much closer to your customer than in the same physical building, which is what Fastenal has done. Typical on-site services include bin-stocking and vending machines that carry high-moving consumable products (like gloves, sanitizing wipes, and ear plugs).

The business opened its first on-site location in the 1990’s, but only started emphasizing this model in 2015. After establishing a dense presence and excellent reputation in core markets, company leadership realized the many benefits of morphing from a one-to-many to a one-to-one customer relationship. The advantages of on-site locations include:

1) Less investment is required as the physical space is already available inside the customer facility.

2) Despite having lower gross margins initially, on-site locations are more capital-efficient as the inventory stocked is site-specific leading to better inventory turns. The cost-to-serve is also materially lower (vending machines are simple to stock once they’re set up) on an ongoing basis.

3) On-site locations lead to substantial revenue opportunities with large customers. If a customer previously mostly bought fasteners from Fastenal, why not switch to other consumable industrial supplies if they’re already going to be located within your facility?

4) Once an on-site location is established it’s likely to result in an enduring relationship. Fastenal becomes ingrained in a customer’s inventory management when they are co-located, providing stickier revenue, more opportunities to cross-sell other products, and grow into other locations with large multi-site corporations.

Importantly, as the company discussed on its Q3 earnings call, because of the previously mentioned frugal cost structure and shipping cost advantages, Fastenal can succeed in on-site locations with roughly half the revenue as a competitor would require to make the same location profitable.

Fastenal’s legacy fastener business and resulting dense distribution network provided both a defensible revenue base and the foundation for future growth in other product categories while further entrenching the business within a customer’s operation. 2020 was a perfect example, as the company’s moat in industrial supplies distribution has resulted in its addressable market expanding. Sales of safety supplies rocketed 116% in Q2 and 34% in Q3 and brought new customers such as government institutions, hospitals, and schools – none of which were considered a material part of the company’s addressable market before. Surely the elevated demand for these products with subside, some of the new customers may churn off, but management expects a meaningful portion of new customers to remain with Fastenal after the pandemic eases.

Management and Culture

The obsession with getting closer to customers spills over into how executives manage the company. According to the 2019 proxy:

“we are a decentralized company with decisions made by those closest to our customer. We minimize central planning as we believe it stifles the creativity of our people and because it is, quite frankly, too slow”.

If this sounds familiar it’s because it closely resembles the way other managers we admire (Berkshire, HEICO, Transdigm, other Outsider management teams) run their businesses.

Fastenal encourages branch managers and field employees to take entrepreneurial risks and maintains a simple compensation structure. They strive to match rewards as closely to the time when the work is performed and results are achieved, which means employees often receive monthly or quarterly cash bonuses instead of waiting until the end of the year or several years out. In the 2019 proxy the company explains:

“In our line of business, undue risk manifests itself quickly in unacceptable financial results, and our compensation system is designed to ensure that unacceptable financial results are immediately reflected in our peoples' compensation so as to provide them with the feedback and motivation necessary to take prompt corrective action. Our entrepreneurial environment, where actions are rewarded and penalized, means our people immediately feel the effects of their decisions.”

Executive cash compensation is generally below market median, and variable compensation is based on one very simple measure – pretax earnings growth.

A decentralized, entrepreneurial operating model with a highly rational incentive plan combined with a formidable competitive position is a great recipe for long-term growth.

Growth and Returns

Though the company has grown handsomely over the past five decades, Fastenal is just scratching the surface of its addressable market. The company estimates that their core market is north of $140B in North America alone, which doesn’t include the aforementioned addressable market expansion they enjoyed in 2020. That puts Fastenal’s market share at less than 4%.

I have no idea what Fastenal will do over the next 6 to 12 months as the continued effects from soft traditional manufacturing customers may or may not be offset by continued increases in safety supplies. What I do know is the proven on-site model has plenty of room to run. According to the company’s 2019 estimates, the business has a long way to go to reach its potential in on-site and vending:

For context, the company does around $2K in revenue per equivalent vending machine. In a situation where Fastenal installs another million machines it would lead to incremental revenue of $2B, or 40% growth compared to 2019 total revenue. Remember this is growth from just vending machines – one piece of the business.

Additionally, new locations and branches become more profitable and productive the longer they are open due to fading startup costs, increased penetration, and leverage on fixed and personnel costs.

Finally, these figures don’t contemplate the company further expanding its addressable market opportunistically, like we’ve seen in 2020. Their moat in fasteners translates into competitive advantages in other industrial supplies and I’d bet on the company continuing to expand its product offering. In other words, Fastenal has a moat and the moat is widening.

Since 2015, when Fastenal pivoted towards emphasizing on-site location growth, the company has retained roughly 30% of earnings and reinvested them at 25%+ pretax incremental returns. The next several years should look similar to the past 5, with Fastenal replicating the successful on-site model and expanding into adjacent product categories. I’d envision earnings compounding at roughly 5-7% and dividends and buybacks contributing another 3-4% for a ~10% base annual return. Fastenal is not going to be the world’s fastest grower, but it does possess above-average growth potential over long periods of time, a formidable competitive position with upside optionality, and is run by rational and able management.

Presently the stock trades for around 30x earnings, in the realm of fair value. Though shares are not currently cheap, the company is exposed to cyclical end markets (manufacturing and commercial construction) and therefore subject to occasional share-price volatility. If you don’t spend time getting to know these types of businesses when they’re “expensive” you may not have the time to get to know them well enough to buy them when they’re “cheap”. For example, the business traded at 18x earnings periodically in 2018 and investors who bought at those prices have already doubled their money.

Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.

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