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Fastenal Down to Underperform

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We have downgraded our rating on Fastenal Company (FAST - Analyst Report) from Neutral to Underperform following unimpressive second quarter results.

Though the company’s second quarter 2012 earnings of 38 cents per share beat the Zacks Consensus Estimate by a penny, total revenue of $805 million was below Zacks Consensus Estimate of $806 million mainly due to a slowdown in sales to manufacturing customers. Daily sales growth rates declined sharply in the quarter due to a sluggish market as well as foreign currency headwinds. Daily sales growth rates stood at 17.3%, 13.1% and 14.0%, respectively, for the months of April, May and June, significantly down from the daily growth rates in the corresponding prior-year months. Daily sales to manufacturing customers (representing almost 50% of revenues) grew 15.8% in the second quarter, much below growth of 18.5% in the prior-year quarter and 20.3% in the sequentially preceding quarter. In the second quarter, sales growth of fastener products used mainly for industrial production was significantly less than the first quarter and even less than 2011 and 2010. The sequential change in daily sales for the first half of 2012 was also below historical averages highlighting the rising uncertainty in the growth outlook of Fastenal’s end markets.

Fastenal’s current business strategy involves the opening of new stores at a very fast pace. Though this builds the infrastructure for future growth, it significantly hurts near-term profitability due to the start-up costs involved in opening a new store. Moreover, a new store takes time to build a customer base and typically requires 10 to 12 months to achieve its first profitable month. Moreover, opening stores in new locations also pose challenges.

The company had introduced its ‘pathway to profit’ strategy, in 2007, which called for a slowdown in the pace of store openings and instead use the resultant savings to increase the headcount in stores. This plan aimed to increase average annual per store sales, capturing earnings leverage, and increasing pre-tax earnings. The company aimed to grow its average store sales to $125 thousand per month in order to achieve pre-tax earnings growth as a percent of net sales of 23% (up from 18%) by 2012. However, the company failed to achieve its goal as the new store opening plan was reduced to a range of 2%-5% and headcount additions were almost stopped during the economic setback in 2008-2009. Now, with the economy slightly improving, the company hopes to meet its pre-tax earnings percentage goal with less than the $125 thousand per month figure. Fastenal believes the pre-tax earnings percent goal of 23% might be accomplished with average store sales as low as $100 to $110 thousand per month through cost control in 2013. We are skeptical of the company’s ability to achieve the set targets.

All these factors combined with the margin pressures due to rising cost of fuel has forced us to downgrade our recommendation on shares of Fastenal.

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