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Fastenal Company (FAST - Analyst Report) announced dismal third-quarter 2013 results, missing the Zacks Consensus Estimate for both earnings and revenues as its struggle with the top line continues.

Fastenal’s adjusted earnings of 40 cents per share in the third quarter of 2013, increased 8.1% year over year. Earnings of this national distributor of industrial/construction supplies, however, missed the Zacks Consensus Estimate of 41 cents by a penny. We believe that weak sales and soft margins led to the lackluster performance in the quarter.

Fastenal reported net sales of $858.4 million, up 7.0% year over year. Net sales once again lagged the Zacks Consensus Estimate of $865 million as the company continues to see softness in fasteners and non-residential construction growth.

Fastenal serves customers in the manufacturing and non-residential construction markets. Sales were slow in both the markets.

Struggle with Top Line Continues

The company has been witnessing a consistent decline in daily sales growth rates for the past few quarters. The declining daily sales rates are due to lower sales of its fasteners product line which were being hurt by end-market slowdown and broader economic uncertainty. Moreover, the construction as well as vending businesses have also been soft since the past two quarters.

Fastenal’s total average daily sales growth rate remained flat with the second quarter at 5.3%. Foreign exchange dragged down third-quarter daily sales growth rates by 0.3%.

Fastenal’s daily sales growth rates came in at 2.9%, 7.2% and 5.7% for the months of July, August and September, respectively, significantly down from the daily growth rates of 12.1%, 12.0% and 12.9% in the corresponding prior-year months. Though August sales recovered from a slower July, the sequential improvement was not repeated in September. The sequential change in daily sales for nine months from January to September also fell short of the historical averages.

Daily sales to manufacturing customers (representing almost 50% of revenues) grew 4.7% in the third quarter, much lower than the 14.0% growth in the prior-year quarter and 5.9% in the preceding quarter. Daily sales growth rates to manufacturing customers declined sharply due to lower sales of its fasteners product line, hurt by end-market slowdown and broader economic uncertainty.

The company supplies two types of products to manufacturing customers, one for industrial production and the other for maintenance of the manufacturing business.

Sales of products for industrial production dipped significantly, owing to a continuous decline in daily sales growth rates of fastener products (used mainly for industrial production) to 1.0% in the quarter from 6.0% in the prior-year quarter.

Sales of non-fastener products (used mainly for maintenance) increased 8.9% in the third quarter of 2013, down from 18.0% in the prior-year quarter. However, sales of these products improved slightly from the 8.5% growth seen in the sequentially-preceding quarter.

In the non-residential construction market, daily sales to non-residential construction customers (representing 20% to 25% of revenues) grew 3.9% in the third quarter of 2013, down from 8.2% in the third quarter of 2012. Management blamed the government policy uncertainty and sequestration in the U.S. for the decline. Poor weather conditions also hurt construction sales. However, third-quarter sales improved from 0.7% growth recorded in the second quarter of 2013, maybe due to some recovery being seen in the non-residential construction market.

Vending Machine Activity

The company has adopted FAST Solutions, an industrial vending process that has the potential to revolutionize the industrial distribution system and increase profitability. The company installs vending machines that aid in controlling inventory and administrative costs while reducing product consumption.

In the third quarter, the company installed 2,699 new machines, down 34.0% sequentially. As of Sep 30, 2013, the company operated 32,248 FAST Solutions vending machines. The vending machines now account for over 33% of the company’s sales. During the quarter, the company signed 4,372 vending machine contracts, down 18.4% sequentially. The daily sales growth to customers using vending machines was 15.2% in the third quarter, down from 32.9% in the prior-year quarter and 18.9% in the second quarter of 2013.

The overall vending trends have been softer since the past two quarters due to management’s new initiative to deliberately slow down focus on vending. Management has eased pressure on stores to sign up vending machines as a vending contract takes about 5–6 months to generate revenues. Instead, stores are being encouraged to focus on improving near-term sales.

Margins Were Soft

In third-quarter 2013, gross margin improved only 10 basis points (bps) from the prior-year quarter to 51.1% and declined 110 bps sequentially. An unfavorable product mix (due to weakness in fastener products which generate higher margins) hurt gross margins in the quarter. Moreover, a higher headcount boosted the operating costs for the company, thus pulling down margins.

Fastenal has taken a strategic decision to increase sales personnel at its stores. It is adding 100–150 store personnel per month in order to free sales managers to focus more on selling which could drive near-term sales growth.

The company recorded operating and administrative expense of $254.9 million, up 6.8% year over year. Operating expense ratio stood at 29.7%, almost flat year over year, largely due to slowing sales growth.

Tre-tax profit was 22.0% of revenues in the quarter, up only 10 bps year over year, due to gross margin softness and higher operating expenses.

Other Stocks to Consider

Fastenal carries a Zacks Rank #3 (Hold). Some other building products/retail companies that are currently doing well include Liquidators Holdings, Inc. (LL - Snapshot Report), The Home Depot, Inc. (HD - Analyst Report) and Lowe's Companies Inc. (LOW - Analyst Report). While Liquidators Holdings carries a Zacks Rank #1 (Strong Buy), The Home Depot and Lowe’s carry a Zacks Rank #2 (Buy).

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