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Fastenal Earnings Disappoint, but the Industrial Sector Shows Improvement

Industrial supply company Fastenal (NASDAQ: FAST) is always closely watched during earnings season because its results come early and the company is seen as a bellwether of the manufacturing sector. As such the stock’s near-5% decline on the day of its earnings release this week might have caused industrial investors to fear the worst. However, on closer inspection the fall appears to be related more to concerns about Fastenal rather than a vote of no confidence in the manufacturing sector. Here’s why.



Fastenal Earnings Disappoint, but the Industrial Sector Shows Improvement


© Provided by The Motley Fool
Fastenal Earnings Disappoint, but the Industrial Sector Shows Improvement

Three takeaways

The key points for investors are:

  • Fastenal’s valuation (trading with a trailing price-to-earnings ratio of 31 and a forward P/E of 28) has a lot of optimism built into it, part of which comes from expectations for strong sales of personal protective equipment (PPE).
  • Surging PPE sales have diluted gross margins and the market may well be worried about a glut of PPE equipment, such as face masks.
  • Underlying manufacturing-related products, including fasteners, are showing improving trends.

Putting these points together, it could be argued that the stock market reaction is more about concerns over Fastenal’s particular sales and margin trajectory rather than fear that the industrial recovery has been thrown off course.

Fastenal’s gross margin

The company’s net sales rose 2.5% in the third quarter and are up 5.7% in the first nine months of the year. However, the decline in the company’s gross margin — largely as a result of relatively more lower-margin PPE product sales — meant that gross profit declined 1.6% year over year in the third quarter and rose only 1.7% in the first nine months of the year.



Fastener sales are closely aligned with manufacturing production.


© Getty Images
Fastener sales are closely aligned with manufacturing production.

While it was not surprising to see gross margin decline on a year-over-year basis, it was somewhat concerning that Fastenal’s gross margin declined sequentially even as the share of sales from safety products declined in the third quarter. The table below shows this dynamic at play.

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As you can see in the table, third-quarter 2020 gross margin of 45.4% was lower than the 45.5% in the second quarter, even as fastener sales grew as a share of the total.

Metric

Q3 2019

Q2 2020

Q3 2020

Fasteners revenue share

33.7%

26%

30.5%

Safety products revenue share

18.2%

34%

23.8%

Gross margin

47.3%

45.5%

45.4%

Data source: Fastenal presentations.

What happened

During the earnings presentation, management said “The largest gross margin impact was lower safety margins.” Of particular note, management said COVID-19-related safety and janitorial equipment made up 14% of sales in the third quarter and the gross margin on those products is down to “mid to high-single-digits.”

In addition, during the earnings call, CFO Holden Lewis said that “products like 3-ply masks and disposable respirators are oversupplied and prices have declined.” This sort of commentary is obviously a concern for a company like 3M that’s been ramping up production of such equipment.

It’s also a worry for Fastenal, especially as CEO Dan Florness discussed analysts’ concerns that Fastenal had $30 million worth of “slow moving PPE inventory” on its balance sheet — the implication is that Fastenal will have to cut prices in order to sell it.

However, Florness said that sales of those products actually rose 18% on a sequential basis. Moreover, Holden believes that the price decline on these products will “correct itself based on the sell-through of these products out of our inventory. However, this process may take until the second half of 2021.”

Time will tell if Fastenal manages to reduce the inventory at prices that don’t put pressure on margin.

Fastenal and manufacturing

It would be a mistake to conclude that Fastenal’s issues in the quarter come down to its manufacturing-based sales. As you can see below, its manufacturing-based sales are still negative on a year-over-year basis but the trend has turned positive and management noted sequential improvement on a monthly basis through the quarter.



chart, line chart: Data source: Fastenal presentations. YOY= year over year.


© Chart by author
Data source: Fastenal presentations. YOY= year over year.

Digging into the numbers in more detail, Fastenal’s fastener product line, which is highly correlated to spending trends in the industrial world, is showing improvement. It’s not a spectacular improvement, but it does look like there is a positive trend in place.



graphical user interface, chart, line chart: Data source: Fastenal presentations.


© Chart by author
Data source: Fastenal presentations.

The key takeaway

All told, the underlying industrial environment does appear to be improving, but investors in companies that have been generating earnings on the back of masks and respirators — like 3M — need to be aware that there appears to be a glut of such products. As such, Fastenal’s earnings disappointment is more about the company’s specific earnings/margin trajectory than it is about any disappointment over a cyclical recovery in the industrial economy.

Lee Samaha has no position in any of the stocks mentioned. The Motley Fool recommends 3M. The Motley Fool has a disclosure policy.

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