Industrials

Brooke Sutherland is a Bloomberg Gadfly columnist covering deals. She previously wrote an M&A column for Bloomberg News.

Investors need to ease up on Fastenal Co. 

The $12 billion distributor of nuts, bolts and other industrial parts initially surged as much as much as 6.9 percent on Wednesday after reporting decent second-quarter results, only to give up those gains and tumble by nearly as big a percentage. As of 1:50 p.m. in New York, the shares were down about 2 percent. Investors just couldn't maintain their enthusiasm.

There was little to dislike in Fastenal's actual numbers: revenue climbed nearly 11 percent, product pricing ticked up modestly and its gross margin increased for the first time in 14 quarters (analysts had anticipated another drop). But Fastenal's unwillingness to definitively call a bottom in margins made shareholders doubtful the improvements are going to stick, and that's likely what caused the reversal, says Edward Jones analyst Logan Purk.  

What Goes Up...
Doesn't always have to go down

While that's a fair concern, such a dramatic response seems unwarranted. Fastenal shares were already down about 7 percent year to date through Tuesday, in large part because of those very same margin concerns, compared with an 8.5 percent gain for the S&P 500 Industrials Index.

It probably didn't help Fastenal that rival MSC Industrial Direct Co. also reported results on Wednesday and had a weak showing on gross margins. The cause of pain for both companies is a shift in the types of customers and products they focus on. Fastenal has made a concerted push to target larger accounts that are more stable sources of growth but pay discounted rates because they buy in bulk. Expanding into on-site vending machines for dispensing industrial parts and inventory-management services has also crimped margins.

The Struggle Continues
Analysts expect Fastenal's margin decline to continue -- not reverse
Source: Bloomberg

But again, these aren’t new problems. And Fastenal appears to be making headway in coming up with solutions. In this most recent quarter, it was able to make up for the adverse impact of its customer and product mix with cost-saving and supply-chain initiatives including the accelerated sales of higher margin private-label goods. The mix issues aren't going away, which is in part why Fastenal CFO Holden Lewis said "we'll just have to kind of see what Q3 and Q4 look like." But he also noted that there's nothing to indicate the efforts that helped mitigate those margin pressures are unsustainable. That may not be as positive as what shareholders were looking for, but while we're on the topic of things Fastenal didn't talk about, here's another one: Amazon.com Inc.

The e-commerce giant's name didn't come up once on the conference call. That's a bit astounding given the industry-wide alarm bells that were set off last quarter when Fastenal rival W.W. Grainger Inc. announced plans for price cuts in an apparent effort to combat Amazon's foray into industrial distribution. You can bet the question will come up when Grainger reports earnings next week, but Fastenal's moves to remake its business model -- yes, those very same endeavors that erode its margins -- are also arguably helping to insulate it from the Amazon threat and a potentially even greater whack to its profitability. 

Long Shot
Analysts don't have very high hopes for Grainger's second-quarter results
Source: Bloomberg

Fastenal and Grainger have a good amount of product overlap, but the former's lockers for pickup of spot purchases give it a leg up in terms of convenience and accessibility while its on-site vending and service offerings have made it more deeply ingrained in customers' supply chains. The traditional fastener business doesn't lend itself as easily to e-commerce because it requires customization and logistics support. Fastenal has 2.5 times the number of salespeople that Grainger does, Credit Suisse Group AG analyst Andrew Buscaglia noted in April.

It's not clear how serious Amazon really is about industrial distribution. A senior executive for Amazon Business last year specifically referenced making a "land grab" in this area. Since then, though, the company has made a big push into groceries with the planned $13.7 billion purchase of Whole Foods Market Inc. Could it do both? Sure. But it seems highly unlikely that Amazon is going to hire a swat team of sales and service professionals to take on Fastenal. In a note earlier this week, Stifel Financial Corp. analyst Rob McCarthy said Amazon is probably not going to be in the market for an industrial distributor takeover any time soon, but should it decide to, Fastenal would be the best fit because it fills in a lot of the company's gaps.   

Fastenal undoubtedly still has margin issues to work through, but the situation doesn't appear as dire as some of its peers. At least it doesn't have Amazon breathing down its neck ... yet.   

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

  1. This was part of court testimony in connection with Staples Inc.'s attempt to salvage its takeover of Office Depot Inc. 

To contact the author of this story:
Brooke Sutherland in New York at bsutherland7@bloomberg.net

To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net