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Morningstar | Strong Top-Line Growth Continues During Fastenal's 3Q; Operating Margin Improves

Fastenal reported strong third-quarter results, in our view, that beat consensus revenue and EPS estimates for the second consecutive quarter. Third-quarter revenue increased 13% year over year for the wide-moat-rated industrial distributor to $1.28 billion, beating consensus by about $7 million. And adjusted diluted EPS of $0.68 increased 36% year over year, beating the $0.67 consensus estimate. Yet, Fastenal's earnings release triggered its stock to sell off, presumably due to the 100-basis-point year-over-year decline in the firm's gross margin and uncertainty surrounding the potential impact of tariffs. However, like previous quarters, much of the gross margin decline was due to a continued mix shift toward lower-gross-margin nonfastener products and national accounts. Higher freight costs also weighed on gross margin during the quarter. Despite the 100-basis-point gross margin contraction, Fastenal's operating margin expanded 30 basis points to 20.5%, which demonstrates Fastenal's ability to leverage its fixed costs. Incremental operating margin during the third quarter was 23%, up from approximately 21.5% last quarter and 16.5% during the first quarter. We've raised our fair value estimate of Fastenal's stock to $55 per share from $54, as the favorable impact from the time value of money since our last update and our downward-revised operating expenses as a percentage of sales assumptions more than offset our tempered gross margin assumptions.

Fastenal continues to enjoy strong organic revenue growth driven by improving end market demand and the company's vending and onsite growth initiatives. Fastenal's industrial vending and onsite strategy continues to gain traction with customers, supporting the firm's strong growth. At the end of the quarter, 78,706 Fastenal vending machines were installed at customer facilities, up 14% year over year, and the firm had 828 active onsite locations versus 555 onsite locations last year.

After failing to recover rising costs with price increases during the first half of 2018, management noted that increased prices mostly offset cost inflation during the third quarter. This is a welcome development, and we're hopeful that Fastenal can maintain a tighter price-cost spread going forward, which should support future gross margin stability. While management noted that the magnitude of tariff-related cost headwinds is uncertain, CFO Holden Lewis said that "being able to neutralize the impact of inflation in the third quarter speaks to a rebuilding of pricing muscle memory in the organization and the effectiveness of the tools we've introduced. These will be helpful as the situation with tariffs plays out."

Revenue growth during the quarter was broad-based. Nonfastener product revenue grew almost 15%, while fastener product revenue grew about 11%. Fastener sales accounted for 34.7% of revenue during the third quarter versus 35.6% last year. Sales from national account customers grew 18% year over year. Revenue from national account customers accounted for 51.5% of total sales during the quarter compared with 48.7% during third-quarter 2017.