Fastenal: About to Come Undone?

According to BusinessWeek, Fastenal (NASDAQ:FAST) is the best-performing stock over the past 25 years in the Russell 1000. Long term, it’s done well; short term, it’s up 69% in the past 52 weeks (as of March 1) compared to 6% for the S&P 500.

In the past decade, FAST has experienced just two down years — 7.3% in 2006 and 11.8% in 2008. Although it can’t seem to lose, all good things must come to an end. While the stock isn’t a top short candidate, maybe it should be — it’s just too darn expensive.

Morningstar gives FAST rating of one star out of five. That’s no better than the basket case that is Sears Holdings (NASDAQ:SHLD). But before all you Fastenal fans rip me a new one, let’s examine the pros and cons of the leading fastener distributor in North America.

I highly doubt there’s anything to indicate Fastenal is a badly run company (companies that are don’t have stocks that have grown 28% per year since 1987) so most likely I’ll only be able to  present a case as to why the stock is overvalued. Whatever FAST’s fair value, I can’t help but marvel at its performance. It’s all-world for sure.

Fastenal: First, the Pros

FAST consistently grows revenues and profits. In the past decade, both figures have increased in nine out of 10 years. You can’t get much better than that. In terms of margins, consistency rules once again. On only three occasions in 10 years did FAST’s gross margin slip below 50%, finishing 2011 at 51.8% — 100 basis points lower than its all-time high in 2008.

Farther down the income statement, FAST’s operating margin has held fast, dropping below 15% on two occasions, in 2002 and 2003. In 2011, the company set a record of sorts for operating margins, delivering over 20% for only the second time since 1987. Certainly, Fastenal’s business is operating as efficiently as it ever has.

The company reminds me of Tractor Supply (NASDAQ:TSCO), the rural retailer that sells recreational farmers a diverse group of products that can’t be bought under one roof anywhere else. Fastenal’s product assortment is second to none in its industry, providing a competitive advantage that’s hard to match.

The company is also innovative: Fastenal has installed 7,500 vending machines at its customers’ plants to provide easy access to its nuts and bolts, helping to keep growth alive.

Now for the Cons

I’ll admit I’ve dug myself into a pretty big hole — one I might not be able to extricate myself from. And that’s O.K. I’m merely pointing out the caution signs if you decide to make an investment at this point in the stock’s history.

Up first is my concern about free cash flow and the dividend. For a company that has been remarkably consistent in terms of revenue and profit growth, it pays just $0.68 annually, for a measly 1.3% yield. Those who’ve been on this ride since 1987, including founder and Chairman Robert Kierlin, dividends are clearly not a concern.

However, with a huge downward move pending thanks to reversion to the mean, anyone getting in late in the game (I have no idea when this move will take place, but it always does) should question whether the reward justifies the risk.

Between 2007 and 2011, Fastenal’s cumulative free cash flow was $906 million, paying out $819.5 million in dividends and share repurchases. In 2011 alone, FAST paid out $192 million, or 130% of its free cash flow, on dividends.

Money managers would probably like to see a higher dividend, but you have to wonder about the compny’s capacity to raise it. On only one occasion in the past decade (2009) has Fastenal generated free cash flow in excess of its net income. If it were to double its dividend payout, to $1.36 a share, for a 2.6% yield, it would have to pay out $403 million in 2012. Free cash flow won’t come close to meeting those kind of numbers.

Therefore, unless Fastenal decides to take on debt to fund those payments, which it probably won’t, there’s absolutely no way it can swing this cat. It’s capital appreciation or bust.

My second concern has to do with earnings growth. Analysts estimate growth of 19% per year for the next five years. That shouldn’t be a problem since earnings grew almost as much in the past decade. However, in a previous article about IBM (NYSE:IBM) and share repurchases, I made the point through author Andrew Hallam, that share prices should follow profits.

If that’s the case, and I believe it is, Fastenal’s shares have clearly run away from profits. Over the last decade, Fastenal’s earnings have grown 17.7% annually. At the end of 2001, adjusted for splits and dividends, the stock was trading at $7.38.

If following profits, the share price today should be $37.65. As of March 1, it is 29.8% higher, at $53.93. Taking the argument further bac, to 1987, I’m sure the difference would be even greater.

The bottom line: Fastenal management is asking investors to trust them to keep moving the stock forward as they have in the past. For investors who currently own the stock and have made a lot of money from it, the decision’s an easy one: Sell now before the whole world realizes that this type of business should never have an enterprise value 25 times EBITDA. For those who haven’t bought just yet, buyer beware.

As of this writing, Will Ashworth did not own a position in any of the stocks named here.

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