Fastenal (FAST) Q1 2018 Earnings Conference Call Transcript

Logo of jester cap with thought bubble with words 'Fool Transcripts' below it

Image source: The Motley Fool.

Fastenal (NASDAQ:FAST)
Q1 2018 Earnings Conference Call
April 11, 2018 10:00 a.m. ET


  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:


Good day, ladies and gentlemen, and welcome to the Fastenal Company’s First-Quarter 2018 Earnings Results Conference Call. At this time all lines are in a listen-only mode. Later, there will be a question-and-answer session and instructions will be provided at that time. Now I’d like to turn the conference over to Ellen Stolts.

Please go ahead.

Ellen StoltsFinancial Reporting and Regulatory Compliance Manager

Welcome to the Fastenal Company 2018 first-quarter earnings conference call. This call the hosted by Dan Florness, our president and chief executive officer, and Holden Lewis, our chief financial officer. The call will last for up to 45 minutes, and we’ll start with a general overview of our quarterly results in operations, with the remainder of the time being open for questions and answers. Today’s conference call is a proprietary Fastenal presentation and is being recorded by Fastenal.

No recording, reproduction, transmission, or distribution of today’s calls permitted without Fastenal’s consent. This call is being audio simulcast on the Internet via the Fastenal Investor Relations home page, A replay of the webcast will be available on the website until June 1, 2018, at midnight Central Time. As a reminder, today’s conference call may include statements regarding the company’s future plans and prospects.

These statements are based on our current expectations and we undertake no duty to update them. It is important to note that the company’s actual results may differ materially from those anticipated. Factors that could cause actual results to differ from the anticipated results are contained in the company’s latest earnings release and periodic filings with the Securities and Exchange Commission, and we encourage you to review those factors carefully. I would now like to turn the call over to Mr.

Dan Florness.

Daniel L. FlornessPresident and Chief Executive Officer

Good morning, everybody. and thank you for joining our first-quarter conference call. To sum up the quarter, I believe we had a good quarter in the first quarter 2018. We had some unusual weather as the quarter laid out, and we had the distinction of ending the quarter on Good Friday, which, while a business day, is often a muted business day.

Last year, if you recall, Good Friday was in the month of April. Weather hit us hard in the quarter. And probably the best way to convey the impact of weather is to think about it from the standpoint of what my kids endure during the winter, and that is days that the school is closed because there’s no bus running and to think about it from the context of our semi fleet and the number of routes we run and the impact to those routes. So we run about 4,800 routes per month.

So in the quarter, we ran about 14,500 routes across our branch and Onsite network throughout North America. In the first quarter of 2017, we had about 200 routes that were canceled, so just under 1.5% of our routes were canceled due to weather impacts. In the first quarter of 2018, the number of canceled routes increased by 65% to 332, so about 2.3% canceled. Much of that product ends up getting to the branch on a different route or maybe through a third party.

Unfortunately, that’s usually a more expensive trip. Some of that product ends up not being sold because the customer was shut down that day or the business was impacted in some way. Three geographic areas jump out to me when I think of the first quarter. The first one probably doesn’t surprise anybody on the call.

Scranton, Pennsylvania, which services basically from Pittsburgh up to New England and down into the Maryland-D.C. area. They had a 50% — excuse me — they represented 50% of our cancellations in the quarter and their cancellation rate was about three times what it was a year ago. And for those of you who live on the East Coast, you’re probably not surprised by that comment.

Interestingly enough, about 7% of our cancellations occurred in Atlanta, Georgia, routes coming down into Florida, west toward Mississippi and Alabama and north into the southern part of the Carolinas. The — normally, that area has no cancellations. So about 7% of our cancellations were there. Probably the only area that had improved weather from a year ago was our Seattle, Washington, D.C.

or the Pacific Northwest. Their cancellations were 1%. Unfortunately, we do a lot more business in the other areas than we do in the Pacific Northwest. So I feel the 13.2% to be solid growth.

Our pre-tax growth, and I’ll break — I’ll talk about pre-tax a little bit more than net earnings because of the noise of the tax reform act. Pretax earnings grew about 10%. Frankly, not horribly impressive in the context of a 13% sales growth. Similar to — speaking of tax reform, similar to the fourth quarter of 2017, we realized a P&L benefit of the tax reform act.

About 85% of our business occurs in the United States, so anything that changes the tax rate in the United States, it’s incredibly meaningful to our business. That lifted our quarter, provided about a $ 0.10 benefit to our quarter, and our earnings per share grew about 31% on that 10% pre-tax growth. Growth drivers. Despite the fact that I’m not overly impressed with our 10% earnings growth, I’m incredibly impressed with our growth drivers in the quarter, but more to that when I get to Slide No.

4. I’m still on Slide No. 3. Leverage.

It’s all about gross profit. I think we’re doing a respectful job managing our operating expenses. There’s always some things we can improve upon, but it’s about gross profit. And this quarter, despite the fact that our gross profit is down roughly 70 basis points from a year ago, I think there’s some really good stories within the number and there’s some things we need to fix.

When I think of our growth drivers and I look at Onsite, we’re doing a very nice job of managing our gross margin within that business, within Fastenal, despite the fact there is inflation going on and despite the fact we’re rapidly ramping up that business. So I think we’re managing that very well and our gross profit was pretty steady from Q1 to Q1. Within our vending business, about a 12-year-old business for us, again, similar to the story in Onsite, we’re doing a nice job managing our gross margin there. In fact, we saw a slight uptick in our vending in the local business, offset a little bit by the national accounts, but very nice job there.

I think we’re doing a nice job managing our gross margin in the national accounts. Again, I say that in the context, as you all know, there’s meaningful inflation going on in our business and if we don’t stay ahead of it, we can run into some problems on the gross-margin line. But two things that stand out for me, which, in my estimation, cost us about $ 3 million this quarter, center on habits at the local level and that’s habits within our fastener business. So, as you all know, about 50% of our business is national account.

And if you add large regional accounts on to there, that number moves closer to 60%. Within our local book of business, we do a fair amount of fastener business, about 15% of our revenue that’s completely priced and driven locally, and then we have a sizable number in non-fasteners as well. In the non-fasteners, our margin there is treading water, and we’re doing a nice job managing that component. In the local fastener business, we are seeing inflation in that product.

Unfortunately, in that business, we’re not matching the inflation in our sell price and we gave up about 130 basis points of gross margin, 130 to 140, in that 15% of our revenue. That’s disappointing, because that’s a habit and it’s a habit we need to fix. The good news about it is it’s something that’s very fixable in our business. It takes our attention.

So this morning, I had a call with our leaders throughout the business. I congratulated them on a nice quarter. I also congratulated them on hitting goal for the quarter and two out of three months in the quarter. The month of January, we’re just shy of goal because of weather, but we did a nice job growing the business.

I challenged them on our fastener pricing at the local level. I challenged them on our freight that we charge at the local level. Fuel prices, as you all know, are going up and that impacts us like it does everybody else. We’re losing a little bit of ground on the freight component.

I also challenged them on accounts receivable. Our — we added about two days of accounts receivable during the quarter. It impacted our cash flow, the last point of the — of Page 3. And — but all in all, I’m pleased with the results for the quarter except a couple of components within gross margin.

So up into Slide 4. If you are an investor in Fastenal, Slide 4 is a pretty darn encouraging page. I think it speaks a lot to the potential that is Fastenal and our strengths as far as being a distributor within our marketplace. In the first quarter, we signed 100 Onsites.

If I give that context, back in 2015 — these are rounded numbers — we signed about 75. 2016, we signed about 175. 2017, we signed 275. In 2018, the number I have in my head is 375.

I think Holden’s stated range is 360 to 385 to give us some bookends. But I’m pleased to say, with three months into the year, our 2,000 goal is intact on our challenge to sign 360 to 385 Onsites in the year and I feel really good about that. In-market locations. We just topped above 3,000, 3,007 to be exact.

What I like about that is we’re growing our capabilities. We’re growing our footprint. We had a number of years where we were contracting our footprints and I talked about that in our — in the president’s letter to this year’s annual report. I’m very excited in what we’re seeing there.

And that’s really, obviously, being driven by our Onsite expansion. We signed 5,679 vending devices in the quarter, a nice way to start the year. Equally impressive, the number of our removals is declining. We removed 18% fewer devices in the first quarter than we did in the first quarter of last year.

So we’re signing more. We’re pulling fewer out. It’s a nice combination. Similar to my comments on the Onsite goal, our 2,000 goal is intact.

Our goal is to sign 21,000 to 23,000 devices during the calendar year. Product sales through vending, not surprisingly, grew north of 20% in the quarter, driven by improvements in the existing devices out there as well as the new ones we’ve added. National account sales grew 17% in the quarter. Well done to the national account team in growing our relationships with customers around the planet.

Well done to our branch and Onsite network to serve that business and everybody else for supporting them in their efforts. Speaking of around the globe, if I look outside the United States — inside the U.S. and in Canada, we had some weather impacts during the quarter, but if I look at rest of world, and this includes Canada, we grew our business 25% in the first quarter of 2018. We leveraged it and grew earnings even faster.

Canada grew its business in the 20s, Mexico grew its business in the 20s and the rest of the world grew even higher, so really impressive performance throughout our international operations. When I think about the business, as you all know, starting several years ago, we really began to invest heavily in what are now the growth drivers of our business. And there’s a price to that. You see it — and Holden will touch on it when we look at operating expenses.

Our labor costs continue to rise, some of that because of adding resources, some of that because of inflation, some of that because of incentive comp expansion. But what I’m really excited about is the resources we’ve added into our growth drivers in the last two years. So we’ve added roughly 160 people into our national account team, half of that dedicated solely to implementing new business, including Onsites. We added 15%.

Fifteen percent of that number is selling resources, most of that in what we call a TSR, territory sales rep, the quarterback for the national account business in a given geography. Fifteen percent of that increase was for construction-centered personnel. We’re seeing double-digit growth in our construction these days. Fifteen percent of that in our safety personnel.

We’re seeing great growth on our safety products. If I look outside of national accounts, we added 225 people roughly in the last two years to support our vending initiative, most of those in the district business units, but quite a few as we took over hosting operations and continue to expand our footprint into deploying devices. We added resources into Onsite, e-com, about 15 into both. We added resources into our government business.

E-com, which we’ll touch on a bit next week at our Investor Day, we’re seeing great — it’s a small piece of our business, but we’re really seeing impressive results within that component as well. Because of our local and same-day delivery capabilities, it puts us in a unique spot. We also added roughly 50 people into IT. Those resources are dedicated to being able to roll out new products for our branch network, our Onsite network and our customers faster, increase the bandwidth and a handful of folks to improve the security within our systems.

So I think we’re making investments in the right places, really impressed with what the team is doing. These people will execute a little bit better on our local fastener business and our freight. With that, I’ll turn it over to Holden.

Holden LewisExecutive Vice President and Chief Financial Officer

Great. Thank you, Dan, and good morning to everybody. Jumping over to Slide 5. As Dan stated, total and daily sales were up 13.2% in the first quarter.

It’s a deceleration from up 14.8 daily sales growth in the fourth quarter, but it is a third straight quarter of at least low-teens growth for the company. We believe that pricing contributed between 50 and 100 basis points in the period. Mansco added another 120 basis points. Bear in mind that this quarter represents the completion of Mansco’s first full year as a member of Fastenal’s family.

In that period, it did achieve the revenue and earnings that we originally anticipated it would. It plans to build on that performance the next 12 months, but be aware that with the transaction anniversarying in the second quarter, we’ll no longer be breaking out its contribution specifically. From a macro standpoint, the PMI averaged 59.7 in the first quarter and industrial production continued to expand at a low- to mid-single-digit rate. Manufacturing end-markets continued to lead our growth with strength in heavy and general manufacturing as well as manufacturing going into transportation and building verticals.

Construction was up 9.6% in the first quarter, but after a weather-impacted January, we saw our growth return to the 10% to 11% range. From a product standpoint, we sustained recent quarters’ growth levels in both fasteners and non-fasteners. Though the last two quarters, we have seen meaningful acceleration in safety, which grew nearly 20% in the first quarter. From a customer standpoint, national accounts were up 17.3% with 78 of our top 100 accounts growing.

Growth to non-national accounts was steady, with mid- to high single-digit growth and nearly 66% of our branches grew in the first quarter. That’s a new high for this cycle. In terms of market tone, the quarter started with weather disruption and finished with Good Friday moving up from April of last year, but in between, conditions remained healthy, sentiment in the field remains constructive, and the good demand of the past few quarters appears to be carrying into the second quarter of 2018. Now over to Slide 6.

Our gross margin was 48.7% in the first quarter. That’s down 70 basis points versus the first quarter of last year. The usual factors that we’ve talked about were present here. Relative growth in national accounts and non-fasteners certainly affects the mix.

Mansco tends to operate at a lower gross margin. And as Dan touched on, freight remains a challenge. We began to realize pricing in the period to offset the inflation we discussed. And while that effort continued to gain traction through the quarter, it was uneven and not yet where it needs to be to offset the various elements of pressure in the marketplace.

However, we would expect additional gains in the second quarter in our pricing actions. Our operating margin was 19.8% in the first quarter. That’s down 50 basis points on a year-over-year basis. The 70-basis-point decline in gross margin was partially offset by 20 basis points of operating expense leverage.

If I look at those pieces, we achieved 50 basis points of leverage over general corporate expenses and occupancy-related costs. The latter was up 7.7% with the largest variables being growth in vending and non-branch occupancy expenses. Selling and transportation-related expenses were up 12.3, which was equally attributable to higher fuel costs and related to an increase in our branch fleet during the period. Our employee-related costs were up 14.4%.

That reduced our leverage by 20 basis points. This continued to reflect Mansco’s headcount, an increase in our total and FTE headcount of up 6% and up 7.4%, respectively, and that excludes Mansco and significantly higher incentive compensation across the organization reflecting our better growth. The incremental margin in the first quarter was 16%. While the second-quarter incremental margin will likely be challenged by a difficult gross-margin comparison, the anniversarying in 2Q ’18 of the Mansco acquisition and the incentive compensation reset should generate better leverage for us in the second half.

Putting it all together, the first-quarter earnings were $ 0.61, up 31% from the first quarter of ’17. In the absence of tax reform and the lower rate it provides us, EPS would have been $ 0.51 and growth would have been 10%. To give you a quick update on tax reform. Having had more time to evaluate the impact, we now expect our ongoing tax rate will be between 24.5% and 25%, absent any discrete events that may arise from changes in the application of the law or other ongoing activities.

Flipping over to Page 7 — Slide 7. We generated $ 160 million in operating cash in the first quarter, which is 92% of net income. This is a lower conversion rate than we typically see in the first quarter. Part of this is just math, as our lower tax rates benefited the P&L in the first quarter but has not yet flowed to the cash flow statement.

The other piece, however, relates primarily to those accounts receivable, which I’ll cover in a moment. We continue to anticipate good cash flow in 2018 based on good earnings growth and the cash flow benefits from tax reform that will begin in the second quarter of ’18. Net capital spending of $ 32 million increased in the first quarter of 2017 on expansion and upgrades at our hubs and corporate property. Our 2018 target for total net capital spending is unchanged at $ 149 million.

We increased funds paid out in dividends by 15% to $ 106 million and reduced our debt by $ 10 million. We finished the quarter with debt at 15.7% of total capital, consistent with last year and a level that provides ample liquidity to invest in our business and pay our dividend. The picture of our working capital is mixed. Inventories were up 12.7% in the quarter.

Inventory on hand fell five days, which we view favorably in light of inflationary pressures and plans for additional inventory investments in the field through 2018. Receivables grew 19.8% in the first quarter and days there expanded by 3 1/2. Days outstanding nationally expands as we experience relative growth to our national accounts and international businesses. However, in the last two quarters, this has been compounded by customer payments being pushed out past the quarter-end.

We have seen no meaningful change in hard-to-collect balances and so this is an area that we will work to improve upon the balance of the year. That’s all for our formal presentation. And with that, operator, we’ll take questions.

Questions and Answers:


Thank you. [Operator instructions] Our first question comes from Robert Barry with Susquehanna. Your line is now open.

Robert BarrySusquehanna International Group — Analyst

Hey, guys, good morning. So you mentioned price only partially offsetting freight and product cost inflation. Is that dynamic only in the local-fastener business? Or is it broader? And when do you think you can get to at least neutral on that price-cost dynamic?

Daniel L. FlornessPresident and Chief Executive Officer

I’ll handle that one. In the case of the fastener business, that’s local. And keep in mind, when I talk about local, I’m talking about where the pricing decision is made as far as what level of price. And so this is local business.

When I talk about freight, that includes both local business and national account business. So it includes all aspects of our business, but the decision of whether or not to charge freight is typically made locally. There might be some contractual limitation on certain sales, but generally speaking, that’s a local-made decision. So I would put both of them in that bucket.

In regards to how quickly we can crack upon it, the freight ones a challenge because in many of our growth drivers, vending is an example of growth driver, Onsite’s an example of growth driver, our propensity to charge freight is typically lower. Especially in the case of vending, it’s nonexistent for the most part. There are challenges to engage with a customer on doing backhauls of freight. And I often see examples of that.

On a recent trip, I saw, interestingly enough, down in Indianapolis, three pallets, large pallets, and each had a truck chap — a truck cab on it from a vintage truck that was being shipped from a scrapyard in Minnesota up to the East Coast. And that’s an example of backhaul as we do on our system to offset. The freight one is going to be challenging in the short term. The fastener one, that’s about habits and we can change habits tomorrow.

Holden LewisExecutive Vice President and Chief Financial Officer

I’ll just sort of chip in. To give you a little bit of color, the — if I think about the RVP commentary that came through to us over the course of the quarter, it improved as the quarter went on from January to February to March. So I think that the confidence in the field grew and the achievement in the field grew as we went along, which is what we would have expected to see. I would also tell you that if I think about the month-to-month contribution of pricing, it also grew as we went through the quarter.

So we’ve talked before about having to rebuild that muscle memory. Obviously, for us, in our model, these conversations are very much sort of customer-to-employee. And yes, I think there are signs that we were building up that muscle memory through the quarter and we just need to make sure that we continue to bulk up as we go into the second quarter, and that’s the expectation.

Robert BarrySusquehanna International Group — Analyst

Got it. I guess, just a follow-on to that, given there’s a lot of talk about tariffs and raising product costs, in particular on some of your products, just given what sounds like a pretty tough pricing environment, I mean, what’s the thought on the ability to pass those through or fully being able to pass those through?

Holden LewisExecutive Vice President and Chief Financial Officer

Well, to be clear, I don’t think that it’s a pretty tough pricing environment. We are getting pricing. It’s just the rate at which we’re getting it. Again, I think that the sentiment around how the RVPs are feeling about that environment has only gotten better as the quarter has gone on.

So I don’t think that I would characterize the pricing environment today as tough. It’s just a matter of at what pace we’re going to be able to put it through. As it relates to tariffs, however, if you think about 232, the increase in steel and aluminum, it’s — that would primarily have a direct impact on our manufacturing business which does source that. If I think about the Section 301s —

Daniel L. FlornessPresident and Chief Executive Officer

That’s 5% of our revenues.

Holden LewisExecutive Vice President and Chief Financial Officer

Yes, which is 4% or 5% of our revenue on the manufacturing. If I think about the Section 301 tariffs, we looked into what products are captured in that. And there are some. I think we’ve identified about $ 11 million or $ 12 million in annual COGS that would be affected directly by that.

There’s no doubt there will be some others that would come through in — through masters, but we’re talking about metal nuts, we’re talking about pallet jacks and a few other items. And so there really was no impact on tariffs in Q1 in our business. Most of what would be affected directly seems fairly modest. I think our bigger question is what impact does it have on our customers at the end of the day.

And as I said, in Q1, there really was nothing there. To the extent that it contributes to either a more inflationary environment, we’ll have to respond to that as we talked about. To the extent that it creates issues for our customers, have to respond to that, but no impact yet and I think that the — it’s sort of a wait-and-see kind of situation.

Daniel L. FlornessPresident and Chief Executive Officer

I’ll just chime in a little bit as well to support Holden’s answer and that is, historically, our ability to pass on things like this, a tariff, a duty, etc., the marketplace gets that and is able to pass that through. The wildcard in all of it is what impact it has not to our ability to price, but to volumes. What impact does it have with the customer? Does it impact their ability to export product? Does it impact the profitability within their business on what products they sell? That’s the unanswerable question, but the marketplace gets the fact that price — the costs are going up.

Robert BarrySusquehanna International Group — Analyst

Got it. Thank you, very helpful.


Thank you. Our next question comes from Robert McCarthy with Stifel. Your line is now open.

Robert McCarthyStifel Financial Corp. — Vice President

Good morning, everyone. I have two questions because that’s all we’re allowed in the time we’re allowed, so thank you for taking that. I guess, following up the tariffs, you mentioned 301. Could you just confirm, you just think it’s a very limited set of SKU and product that is going to be affected by this? And could you just let us know broadly how much you do source from China in terms of your underlying COGS or general sourcing?

Daniel L. FlornessPresident and Chief Executive Officer

First off, we touched on that. We have identified what we know so far. Keep in mind that the number Holden cited looks at product we’re directly sourcing that we believe is impacted and — but on top of that is product that we are sourcing from others that would be impacted. That one is a lot more difficult one to quantify because with many of our suppliers, if I think of both branded and some of the non-branded products, many of our suppliers, their source of origin can fluctuate.

So they might — a lot of fasteners come out of Taiwan and China and a lot of that production has moved into China over the last 15, 20 years. No different than 40 and 50 years ago, a lot of that production had moved from Japan into Taiwan and other parts of southeast China — or Southeast Asia, excuse me. So there are other sources of supply, but the issue you run into is the speed at which you can change, other factors that might be going on in other countries within the Pacific Rim. Most of the fasteners sold in this country are made outside of North America.

So it’s not an issue that’s unique to us. It’s an issue that’s unique to that product line. Within our non-fastener product, the percentage would be lower, but still, a sizable piece is made — but, again, I can — I hesitate to quantify it because there are multiple source of supply and we aren’t always privy to upstream those source of supply when we run a product. But the — so the — but the other dynamic is this thing moves rapidly.

Sometimes you have to try to follow it by the latest tweet and we prefer not to manage our business that way

Holden LewisExecutive Vice President and Chief Financial Officer

We actually have seen the list of things that we understand to be affected now, so we have something on which to sort of make a judgment, if you will. And if I look at that list, there’s probably 25 things on it. Iron or steel nuts is 85% of that. And so there is a list of things out there that are supposedly affected by that.

That’s where we’re able to give some judgment based upon.

Robert McCarthyStifel Financial Corp. — Vice President

Yes. No, I have the documentation right here in terms of the list. But the answer to the question, I don’t want to preclude my second question, so this is a follow-up to the first question is, very briefly, yes, that’s the Section 301 that was kind of enumerated, but the fact of the matter is it sounds like it could be a greater effect, kind of similar to oil and gas in ’14, where you had headline exposure mid-single digits, but the penumbra of the effect could be greater, I guess, is my point.

Holden LewisExecutive Vice President and Chief Financial Officer

Yes. Time will tell. There’s still plenty of unknowns. What’s No.


Robert McCarthyStifel Financial Corp. — Vice President

Yes. No. 2 is just a very simple question. I mean, obviously, gross margin, you cited and enumerated the various — listen, growth is good, but the challenge is the mix in gross margin and that structural mix.

Given the last couple of years, you’ve been — the first-quarter gross margin typically is one of the higher gross margins of the year and then typically is above the average gross margin for the year, do you think that’s going to continue according to Hoyle here? Or do you think there’s opportunity for you to expand sequentially gross margin this year? Or have we put in the high for gross margin for this year or particularly versus the average?

Holden LewisExecutive Vice President and Chief Financial Officer

Well, the question of expanding gross margin, I mean, we filled a hole in Q1. Q2, I can tell you is going to be a very difficult comparison based on how we performed last year, but if — so that would be difficult. If we’re talking just sequentially, the — there is a path to be able to achieve a gross margin that is comparable to slightly below where we are in Q1, right? So I think if you look at the history, it’s not uncommon to see 30 basis points or what have you, to sort of down from Q1 or to Q2, etc. There’s a path to do somewhat better than that, but that path, it does rely significantly on our ability to continue to build up our sort of pricing momentum and that’s kind of the wild card that we are going to be playing through in Q2.

Again, we like the signals. We’ve certainly given a clear message as to what we need to do going forward and if we can deliver and execute on that, as we fully expect to do so, there’s a path to have margins that are comparable to maybe modestly below where we finished in Q1 and perhaps do a little bit better than the normal seasonal pattern, if you will.

Robert McCarthyStifel Financial Corp. — Vice President

I’ll follow-up offline. Thanks for taking for taking the questions.

Holden LewisExecutive Vice President and Chief Financial Officer



Thank you. Our next question comes from David Manthey with Baird. Your line is now open.

David MantheyRobert W. Baird & Company — Analyst

Hye, guys, good morning. First question, Dan, you said you’re happy with the return on the investment in your growth drivers, but you were disappointed by the profit growth in the first quarter. When you look at the core expense leverage in addition to the changing secular mix of the business and gross-margin pressure you just mentioned, are we at an inflection point here where we’ll get back to 20% to 25% contribution margin? Or are you happy with faster sales growth and maybe a contribution margin in the teens? It seems like we’ve been leaning that way in the last couple of quarters.

Daniel L. FlornessPresident and Chief Executive Officer

When — as our business was ramping up in 2017, our willingness to invest in our growth drivers expanded. That’s why I touched on some of the headcount we’ve been adding behind the scenes to really support this. And knowing full well that I, frankly, didn’t expect coming into the first half of this year — and I’m talking about operating margin when I talk about this. I’m removing the noise of tax reform — I fully expected our operating, our incremental margins to drop below 20% and into the upper teens.

And if, ironically enough, we had been — if we wouldn’t have this fastener issue in the quarter, the old “would have, could have, should have,” but we would have been in the low 20s. I still firmly believe when I look at this business over a period of years — and we are in a transition period of really investing heavily in a fundamentally different growth driver in our business, as we’re in that, if you look at it over time, there’s no reason why gross margin can’t be in that — the incremental margin within the gross margin line can’t be in that lower half of the 40s, so 43 to 45, and our incremental spend can’t be closer to 20, which would put us into, optimistically, a 25, pessimistically, lower half of 20s incremental margin. And if we’re growing six, seven, eight points faster than anybody else out there and we’re taking market share and we’re doing things that are natural for our business and that create a more defensive of a business from the standpoint of competition from others, I think that’s a win for our shareholders. Right now, like I say, we’re investing heavily in that transition.

And unfortunately, we stubbed our toe on local pricing this quarter, but I think that’s fixable and that’s fixable fast.

Holden LewisExecutive Vice President and Chief Financial Officer

And, David, just so you know, the gross margin is certainly a part of it, but the other piece, if I look at our operating expenses, bear in mind that through Q1, right, the blending in of Mansco, that obviously has an impact on the incremental margins. The reset of incentive comp. I know it seems like we started talking about that a year ago. We did.

The good news is you get into Q2, Q3, and Q4, and that reset begins to anniversary as well. I take some encouragement from the fact that we got 50 basis points of leverage over corporate and occupancy. We did not get much over the headcount side, but as we do begin to anniversary that reset in Q2 and beyond, I think that there is potential there to get more leverage out of the SG&A than what you’ve seen to this point. And so the growth drivers, we’ll — we’re going to continue to invest in those, but there are pieces of our P&L that we should leverage at a greater — to a greater degree, certainly into the second half of this year, than we have at this point as this cycle and as our growth matures.

David MantheyRobert W. Baird & Company — Analyst

OK. That’s very helpful. And second question is on the freight impact on gross margin. I went back and looked and this has been an issue for you at least back to the — by the end of 2016 and here, it’s in here.

When does this get fixed? Can you fix it? And can you just describe what the source of the issue is? Is it that you’re using third party in that internal logistics? Or what’s going on there? And can it be fixed?

Daniel L. FlornessPresident and Chief Executive Officer

There’s a number of things there. It’s not external versus internal. We probably had a little bit of that in the quarter because of the weather, but that’s not the fundamental issue, Dave. The — if I look at it, we lost about 20 basis points of gross margin strictly on the pricing aspect to where we’re charging it.

I’d say one-third of that is because of our growth drivers pulling it down. The other two-thirds is our propensity to execute. And I think sometimes we fall victim to — we convince ourselves that the marketplace doesn’t allow people to charge freight anymore because that’s what you read in the headlines every day. That’s not true.

The marketplace will allow you to charge freight when you’re providing a value. I believe your propensity to charge freight in this environment goes up because every time I turn around, I read an article about folks can’t add trucks and drivers and capacity fast enough and so freight’s becoming more expensive, and we have a structural advantage there and we need to price for that. So I believe it’s fixable, but the challenging aspect is our growth drivers aren’t our true friend, and so when it comes to this aspect — our great friend when it comes to growing our business, but they do hurt it on the face of it — and there, we need to challenge ourselves with saying, “OK, we don’t charge freight here, bet this customer is shipping product out. Can we ship some pallets of product out for them?” And that’s why when I go to our big cross top [ph] facility down in Indianapolis, I’m always curious what I see when I’m down there because it tells me if we’re engaging in doing that, because if our customers are having a hard time finding capacity to ship pallets and we have capacity to ship their pallets, I think we can marry that up and fix a piece of the problem there, but it’s a component of what Holden’s talked about, the gross-margin impact of our growth drivers.

And the drop — the natural drop we’re going to see each year in our gross profit, that’s a component of it.

David MantheyRobert W. Baird & Company — Analyst

All right, thanks very much.


Thank you. Our next question comes from Adam Uhlman with Cleveland Research. Your line is now open.

Adam UhlmanCleveland Research — Partner

Hi, guys, good morning. Can we start with, Dan, you just mentioned 20 basis points of the impact on gross margin. Could you walk through the remainder of that, the decline in gross margin between mix and Mansco and the rest of it?

Holden LewisExecutive Vice President and Chief Financial Officer

Yes. Mansco was probably about 10- to 20-basis-points impact, right down the middle there. I would say mix this quarter was also sort of in that 10- to 20-basis-point impact. I think the transportation was about 20 basis points of impact.

And those would give you the biggest pieces of the sort of the 70-basis-point decline year over year —

Daniel L. FlornessPresident and Chief Executive Officer

In local pricing of fasteners.

Holden LewisExecutive Vice President and Chief Financial Officer

And so — and then, obviously, local pricing on fasteners and just general product inflation played a role and the fact that we didn’t get as much as we needed to, to begin to offset that, right?

Daniel L. FlornessPresident and Chief Executive Officer

Adam, I’ll add one tidbit there. So I cited when I was talking to Dave the fact that we’ve given up 20 basis points on our propensity to charge. We got about half of that back in leveraging of our network itself. So the gross-margin impact was about 10 basis points for freight, 20 of it in pricing, 10 of it we got back because we still run a great fleet and we continue to utilize that fleet for moving products around the country.

Even though our costs are up there, we’re moving more tons of product.

Adam UhlmanCleveland Research — Partner

OK. Gotcha. And then, just secondly, how should we think about the working capital for the rest of the year? I guess I’m a little confused on exactly what’s happening with receivables and why customers are pushing it into the next quarter. Do you have any goal that you can share with us or other process improvements that you’re putting into place to get the conversion to improve?

Holden LewisExecutive Vice President and Chief Financial Officer

Yes. And to some extent, you don’t want to overreact to something because, again, at the end of the day, what we’re looking for is, are we seeing issues with hard-to-collect product? And the fact is we’re simply not. And so in the fourth quarter, we obviously called out receivables being a bit of a challenge. And I may have sort of believed that that was primarily a function of the calendar and, in truth, it may have simply been our customers deciding to push out beyond the quarter.

I don’t know what the reason is for what looks to us to be a recent somewhat change in behavior. It’s something that we’ll have to kind of go back and check on and get our arms around, but I think the important element of it is we don’t have an increase in hard-to-collect receivables out there. Those numbers have remained lean and healthy. And so all we’re seeing is, we’re seeing a pushback which, if it’s about being able to report a clean quarter, as many of our customers are public and do so, you could be talking about days.

At the end of Q4, we saw an inflow of payments at the beginning of January. I haven’t had a chance to sort of look at how the beginning of the first quarter has played out yet and look at that statistic. It wouldn’t surprise me if it’s there. So it’s something that’s worth calling out because, obviously, it impacts those numbers, but I don’t think that there’s anything particularly worrisome there from a — in terms of a corporate-health standpoint, I guess, is how I’ll put it.

Daniel L. FlornessPresident and Chief Executive Officer

I’ll throw a little adder onto that and then we’re coming up on 45 minutes past the hour so let this be the last question. When I think of it and putting my old hat on, you have customers that are growing faster than they’ve experienced in recent years. That growth in their businesses takes working capital. You have interest rates that are rising.

It’s probably not an unreasonable thing to see of people pushing, especially to do a little window dressing at the end of the quarter to see payment patterns slow down. My challenge to our team is, guys, how about challenging a customer? We’re business partners here. And to cut off your payments from the 22nd through the 20th, through 25th of March, creates a lot of pain for us, too. And there’s three assets on our business.

There’s fixed capital, of which vending is typically is placed inside their facility. There is inventory, of which with Onsite, we’re placing dollars inside their facility. And there’s accounts receivable. If I think of the value we bring to their business of those three things, the first two add value, the third one doesn’t.

So don’t do that to us. Let’s push back a little bit using that because every dollar we have there is a dollar we can’t have in inventory and fixed capital long term and we don’t think that’s good for our customers. So if they want to push some other suppliers, they can do that, but don’t do it to us because we have inventory and fixed capital inside your facilities to support your business. We can’t do all three.

With that, we’re at 45 minutes past the hour. Thank you for participating in today’s earnings call. We — Holden is hosting an Investor Day next week. I believe that’s being broadcast on the Internet.

Holden LewisExecutive Vice President and Chief Financial Officer

That will be webcast.

Daniel L. FlornessPresident and Chief Executive Officer

Webcast. And again, thank you for your support of Fastenal. Have a good day.


[Operator signoff]

Duration: 45 minutes

Call Participants:

Ellen Stolts — Financial Reporting and Regulatory Compliance Manager

Daniel L. Florness — President and Chief Executive Officer

Holden Lewis — Executive Vice President and Chief Financial Officer

Robert Barry — Susquehanna International Group — Analyst

Robert McCarthy — Stifel Financial Corp. — Vice President

David Manthey — Robert W. Baird & Company — Analyst

Adam Uhlman — Cleveland Research — Partner

More FAST analysis

This article is a transcript of this conference call produced for The Motley Fool. While we strive for our Foolish Best, there may be errors, omissions, or inaccuracies in this transcript. As with all our articles, The Motley Fool does not assume any responsibility for your use of this content, and we strongly encourage you to do your own research, including listening to the call yourself and reading the company’s SEC filings. Please see our Terms and Conditions for additional details, including our Obligatory Capitalized Disclaimers of Liability.

10 stocks we like better than Fastenal
When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has quadrupled the market.*

David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now… and Fastenal wasn’t one of them! That’s right — they think these 10 stocks are even better buys.

Click here to learn about these picks!

*Stock Advisor returns as of April 2, 2018

Motley Fool Headlines

Related Posts You Might Like: