Fastenal: A Nuts & Bolts Success Story - [Business Breakdowns, EP.191]

26:04And the final pillar is technology. technology that's technology to dispense items to monitor and control supplies that can be anything from rfid bins or it can even be what they call fast crib which is almost like a canteen inside that's managed by fast nor's employees and they can dispense supplies they can cut metal working tools and other custom components for the customer in that crib and the other aspect of technology which is becoming increasingly important is to give customers data and analytics on their inventory availability, on what they're using, and recommending how they can improve their supply chain practices.

26:47And you mentioned to give an example of an onsite facility. The trick with the onsites is every onsite is different. Every onsite is customized for what a particular customer facility needs. And an Amazon warehouse in Sydney, Australia, may actually operate quite differently to an Amazon warehouse in Seattle, and different customers consume supplies in different ways. For instance, some may not have the space on site for a vending machine, so the supplies are delivered instead from a local branch. Or it might be important for a specific component to be located close to part of the manufacturing line, and they manage around that.

27:22So no two on -sites are alike. But the key to the on -site is the proximity to the customer, the intimacy of the customer relationship. You have Fastenal employees that really act like your customer's employees and they're there to help with whatever the customer needs. It's been quite an evolution. Basically, customers that may have been served out of a local branch previously, once they get to a certain size, it justifies investing in dedicated people and inventory. And Fastenal will move them onto an on -site program. It doesn't always budget the way they expect. Some customers don't grow into those resources, so it's a test and learn process.

27:57But those on -sites have grown steadily over time. When you think about those customer accounts and the importance of choosing true partners, I'd be curious kind of like what an average account looks like, the amount of business they're doing. If you have a sense of if there are some extremely large accounts that are just the 80 -20 rule, or is it pretty normally distributed? What does it look like? Am I doing $5 ,000, $10 ,000, $100 ,000 with them? I just am curious what the relationships are economically. Fastenal has a very, very broad range of customers. And I would guess that even its largest customer, which is Amazon, would only be a low single -digit percentage of revenue at most.

28:33If I think about the average spend per customer, a good way to give you some context around that is that the average on -site does about $100 ,000 per month of revenue. So that's dedicated to just one customer. So you can imagine the average customer spends a lot less than that per year. so it can afford to serve really small customers with its frugal cost structure. And the hope is that that spend grows over time. Maybe a customer expands into more of their facilities across the country. But you can imagine to justify dedicating a whole full -time employee to the customer, that has to meet that minimum spend to make economic sense for Fastenal.

29:13At the branch level, and I mentioned there's still about 1 ,700 branches across the US, they earn about $200 ,000 revenue per month. So you might have a dozen or so customers per branch, some of those quite small, some of those a bit larger. And as the customer gets large enough to justify on -site resources, then a fastener will pull people out of the branch and give them to the customer. It's a really common sense approach. And as I mentioned, it's way down to the branch managers. They get to run the business as they see fit, whatever makes sense to them. whatever they think will be better for the customer and more profitable for Fastenal.

29:54So there's no one could you try to model. I imagine every branch might look quite different depending on the mix of customers in that area and how the branch manager decided to service them. And so when you think about the relationship with their customers, clearly there's a bit of a secret sauce here. But the basic blocking and tackling is to service your customer as well, have the parts available when they need them, keep inventory level stocked. But how would you kind of distill that all down into what the secret sauce is behind their economic success? I think the secret sauce for fastening is first its value proposition.

30:30It delivers real value for customers and they're willing to pay for that. And I think it's a good place to be in a world where the working age population is shrinking. In many developed countries, customers have to navigate labor shortages and inflation themselves. And they can outsource those burdens to fastening. It can help them run their supply chains more efficiently. So I think it delivers value and that's what helps it grow. It has a reason to be, so to speak. I think its focus really helps that it doesn't want to be everything to everyone. Its main peer, which is Granger, stocks a much, much poorer range of SKUs than Fasten does.

31:07So Fasten's selective about what it does. I think its culture is a real advantage. so empowering people to make whatever decisions are necessary to provide the best possible service to the customer they're hungry to grow to do more for the customer and that's really special i think frugality is special it creates business opportunities like operating in these small markets profitably to put some numbers around that i think about a quarter of the u .s population lives in cities with less than half a million residents but fastener earns half of its revenue from those areas so over indexes to these small towns and cities and then there's lots of other local distributors that Fasten competes with day -to -day it actually doesn't come up head -to -head that much with the likes of Granger and MSC sometimes it's tempting to limit competition to just what you can see in the public sphere but a day -to -day Fasten is competing with local distributors they might also have relationships with a local branch and most of its customers use multiple suppliers and Fasten's job is to maximize its share.

32:11But it has scale relative to those local providers in procurement. It can negotiate better terms with its suppliers. It can invest more in technology, things like the vending machines and the bins and online ordering systems, more sophisticated than what local distributors can provide. They can invest in a denser network of branches and onsites, distribution centers, operate its own trucks. they can get products to the customers quickly and reliably to have more control of its infrastructure and being close to the customer that's valuable i think it benefits from its national multinational reach a local distributor probably can't serve a customer with the sophistication of amazon and today about half its revenue comes from national accounts fastnell is an approved supplier for all the customer sites in the country.

33:05A tool has to win the business branch by branch, but it's on that approved supply list. And these customers don't want to deal with thousands of different suppliers. So there's a limited number of distributors that can meet the needs of those national customers and try as soon as one of them. But it has to earn its customers' business every day. There's not really any contractual obligation the customers sign. They do agree on pricing, but customer spend can fluctuate and that's what leads to this agile culture where fastener can disrupt itself and it looks very different to how it did a few decades ago and it may look different again 20 years from now it may have no branches i can see a future where it just has on sites and the customer site and distribution centers for shipping customer orders and it doesn't have walk -in branches i can see that being the future and that's actually how it operates its business outside the U .S.

34:00where it had the benefit of starting with a plain sheet of paper. Just to better illustrate how powerful the economic model of this business is, I thought it'd be an interesting exercise to highlight how things have trended over the last, call it decade. Obviously, there have been some speed bumps along the way given the pandemic, but just to really show just how remarkable of a business model this is from a purely economic standpoint. So if you consider that Fastenal serves broadly the industrial economy. 70 % of its revenue is from manufacturing businesses. At least in the US, the industrial economy has grown about 2 % to 3 % on a nominal basis, so below the rate of a normal GDP growth.

34:44And against that benchmark, Fastenal's organic growth has averaged about 8 % per annum, maybe even a bit higher, 8 .5 % per annum over the last decade. So really impressive and consistent outgrowth of the industrial economy, which comes from winning new customers and winning greater share of customer spending and doing more for customers, more services, greater variety of products, and so on. Interestingly, many of Fastenal's customers are grappling with labor shortages. You know, a key proposition here is that Fastenal outsources some of these services, so it relieves customers the burden of having a procurement manager or someone restocking shelves.

35:24And those labor shortages have hit the industrial economy. These frontline workers, blue collar workers, harder than other industries. So Fastenal's outsourcing of those employees is increasingly valuable to its customers and it can charge a premium for that service. So that's the growth line. As I mentioned previously, its margins have been very consistent. Internally, the target is to keep a 20 % operating margin. and managers are told, we want you to stick to that target. As soon as you lose the purse strings and lose some of your discipline around margins, then you start giving away business at uncompetitive rates.

36:01We also don't want you winning business where the customer doesn't value what we do. We provide customers a lower total cost of ownership. So they should be willing to pay a premium on the retail price of the product, given it incorporates all these other services within that price. So that 20 % margin they've been very disciplined with, and even through industrial downturns, they've held that level. So economists draw a straight line through the operating margin over the last 10 years. And as evidence of the value that Fastenal provides, it's large to publicly listed peers, which are Granger and MSC Industrial.

36:36Their EBIT margins range from about 10 % to 15%, and they're really the largest peers in the public domain. I'm curious, whether it be market share or expanded services, what are other paths to growth for a business like this? And what are some examples of things they have done to broaden the addressable market in a way that means that there's a lot more to the story? It's a good question, Zach, because it serves a very fragmented market. Even in the category that it's best known for, which is Fasteners, the company only has a 7 % market share in the US, let alone overseas. There's still so much room for Fastenal to grow and grow in excess of the industrial economy.

37:17By signing new accounts, by growing its share of their spending, most of its customers use multiple suppliers. So Fastenal can demonstrate it does a better job and can deliver a lower total cost of service. Then it should be able to grow its share of customer spending by broadening into new categories of products, by growing overseas. international is still only 17 % of its revenue, still quite early in that journey. And I think many of its customers from the US that have operations overseas with value are having the same service delivered overseas. And then beyond that, Fasten can also grow with local clients as it establishes a relationship, Salesforce, people on the ground.

38:00That's an exciting long -term opportunity. And so one of the things I find is that when a company suggests that its point of differentiation is its people and its culture, as an outsider, it's tougher to really appreciate how that can truly be a point of differentiation. And so I was wondering if there's a way that you can best capture the more qualitative nature of what makes this business so special. If you were to speak with the management team, the way they would describe Fastenal is, is not one single business, although there's a lot that ties Fastenal together in its values and its mission, but it's more like a collection of 3 ,700 locations that's across branches and onsites.

38:39And each of those managers has full autonomy to run their business subject to the guidelines set around expectations for growth and profitability. So they're in charge of their hiring decisions, they're in charge of which customers they choose to serve, what business they choose to chase, what services they choose to provide, even what products they stock and provide their customers. I've read a statistic that about 40 % of revenue from fastener locations is not procured centrally. So it's actually the branch manager choosing what to provide its customers. If a customer really needs a TV to set up their conference facility or to have quality metrics show up on the manufacturing line, we'll go and procure TVs for them.

39:20So really it's whatever the customer needs. and that's inherent in the business from day one when Fastenal set up its second store outside Winona, Minnesota in the 1980s. They gave the store manager a few hundred dollars worth of inventory, an old recycled desk and chair and told him to get on with it and it was really his domain how he grew that business and then the managers are rewarded and incentivized commensurally based on the business outcomes that they can drive. So it's a business that empowers people to make decisions, to serve customers. And it's not the right model for everyone. So within the first one to three years of joining Fastenal, the attrition rate for new employees is reasonably high because that model doesn't work for everyone.

40:05Some people need more direction, more guidance, and that's fine. But once you stay with Fastenal for a few years, you stay with the business for life. And it's a deeply entrenched culture. It was one of the first businesses, it's something that's in vogue these days, but one of the first public US companies to build out a corporate university in -house. So there are four or five dozen staff that work full -time training employees. And last year, every fast and all full -time employee received on average 25 hours of training at this university. So people can upskill, they can move into different areas of the business and work on something that's more interesting to them.

40:44They're really given the freedom to do whatever they think is best for themselves and for the business outcome. So that's quite special. I think it's a lasting legacy of this culture that the founder instilled decades ago, which is Persevered. And so this is a business that produces a ton of cash flow. It's not particularly capital intensive. They've had little in the way of M &A historically. And if you look at the returns on capital that they have enjoyed, which exceed 30%, how do you think about the reinvestment runway here and what do they do with excess free cash flow as it relates to a broader capital allocation strategy?

41:20In the same way that Fastenal's mission is to deliver simplicity to its customers, it likes to keep things simple in its own business. So it operates with zero net debt. It's all internally funded its operations. It doesn't really make acquisitions. Largest acquisition it's made was acquiring its manufacturer of vending machines a few years ago, but that was small. So it's all organically driven growth. That's quite important. It means Fasten can keep doing things its own way rather than having to accommodate, integrate the cultures of other businesses. It doesn't really repurchase its shares regularly.

41:57Every now and then if there's a period of abnormal share price declines, management become a bit opportunistic with the share of purchases, but really it pays out most of its excess earnings as a dividend after accounting for stay in business investment needs and growth investment needs. So it's dividend yield is about 2 % today. But really what you want as an investor is the growth in value of the business. That's what you're participating in, that 8 % organic revenue growth. So yeah, it's about your confidence in the durability of that growth. That's what's going to make the business more valuable.

42:29And then I guess as a corollary to that question, what does the balance sheet look like and how has the business been asked itself historically? It's always had a conservative balance sheet. Actually, in its early history, it operated with a net cash balance sheet. It goes back to this frugal culture that we've been discussing. And today it has effectively zero net debt. So its debt is equal to its cash balance. And I expect that to continue. This is a no -nonsense, blue -blooded Midwest business. They recognize that they do operate in cyclical markets and they don't want the business to come under balance sheet pressure and for that to limit what it can do in a downturn.

43:06So it's important for Fastenal to sustain that conservative balance sheet. It also allows it to be opportunistic in investing more in inventory through periods of supply chain challenges and build goodwill and market share gains with its customers. And the pandemic was a great example of that. Fastenal built more inventory, not just of the stuff that it already did for customers, but it went out there and bought more COVID testing kits and hand sanitizer and face masks and whatever customers needed to help them stay in business and run their operations. It outsourced some of that burden for them and customers were very grateful for that.

43:44So inventory grew about 30 % between 2019 and 2022. But that's an investment they were willing to make and they earned a return on it both financially and through goodwill with customers. And then if I look at a business like Fast that all the candidly trades at a pretty aggressive multiple, I think the pushback typically would be their success is highly linked to the industrial economy and the cyclicality of it. How do you consider what the risks are here and how do they try to defend themselves from those risks that are seemingly quite known and perhaps others that are less obvious? There's no doubt that Fastenal is subject to cyclicality in its end markets.

44:26It serves the industrial economy. And in years where the industrial economy is soft, like in 2016, its organic growth was only 2%, quite a bit below normal. In years like 2024, where we expect about 3 % to 4 % organic growth, which is quite below normal. This is a slower year in terms of industrial activity. So there is some cyclicality in its revenue. But I think there's the expectation that it will gain market share every year. It's branch managers are incentivized to grow their business. They don't get bonuses if they don't grow. So even in the down market, there's always more we can be doing for customers.

45:03That's a really important mindset. And its revenue growth actually hasn't been negative a single year since the GFC, which understandably was an extraordinary event. And its margins are also incredibly stable. That even margin of 20%, you can almost draw a straight line through it historically. And that comes from this discipline of only certain customers that value your services, not getting away on price. So even through cycles, it's been remarkably consistent in terms of profitability. And I think it's become a broader business as well. It's a broader range of customers with a broader range of products.

45:38It's slowly expanding internationally. So that creates resiliency as well. But every business is subject to cycles. Every business inevitably goes through challenging periods that we assess the business on a through the cycle basis. It operates with a very conservative balance sheet, basically known at debt. So there's no scenario in which a cyclical downturn can meaningfully impair the long term value of the business because of balance sheet stress. And at the moment, it's probably the slowest period fastener was seen since the GFC. They say that the US PMI, which is a survey of manufacturing activity, it's been in contraction for 22 of the last 23 months.

46:18But its revenue and earnings are much less volatile than what you're seeing in industrial production. Our customary concluding question are lessons that can be learned through your studies of Fastenal and your experience with the business that could then be applied to other prospective investments and also from the perspective of a company, what they can do to better emulate a business like Fastenal and improve their business. I give it to you to help us to better understand those lessons. One interesting one for us was the value of candor and clear communication from management. And I think Fastenal really excels in this respect.

46:57In their annual letters, they even share snippets from their internal communications to employees. If anything is not going to plan in the business, if anything's changing the business, even if there's external conditions that have affected Fastenal's growth, they're remarkably transparent. In the last 24 months, Fastenal's management team, they've spoken openly on their quarterly earnings calls that anyone can listen in, that the sales processes for one of their services wasn't as effective as they'd like. They've made personal changes to their sales force to address the issue, but they've told us that candidly.

47:33They've communicated the closure of the branch network and what invitations that has for the business and how customers are served. They've been very transparent for that whole process. Every business inevitably makes mistakes and goes through challenging periods. And for investors, it can really test your confidence in the quality of the business and the management team. Is this a cyclical issue or a structural issue? Is the market, if the share price is telling you you're wrong, it can be really difficult to stay the course. And so it's been very valuable to us for a business like this to receive honest, balanced feedback on how the business is performing.

48:08And it helps us stay the course and make the right investment decisions through those periods. So that's been a really valuable lesson for us. We've had other portfolio companies, but it hasn't been the case. Another interesting one is just the value of going out to visit these businesses in person. In our case, that's from Sydney, Australia. So it's a long trek. But every time we've made the effort of going out to Winona in Minnesota, it involves a three -hour drive down from Minneapolis. We've been given at least half a day of management's precious time. We've spoken to many of its executives and walked the floor of its distribution facility, packing facilities, and so on.

48:45And we've come away with a deeper appreciation of the cultural attributes of the business, of the service offering, just being there, seeing it in person. And funnily enough, you mentioned it's a $45, $50 billion market cap business. It's in the S &P 500. The CFO told us that the company only gets about a dozen or two investor visitors a year that bother to go out and visit them and learn some of these things. So I think the Zion scuttlebutt we sound. I think after revealing that tidbit, they make an imbalance for a few more visits, for better or for worse. Kelly, and we appreciate it. Fastenal is a fascinating business, one that's been an economic force over the course of the last, call it 40, 50 years.

49:28And clearly growth is going to continue at a steady pace and they'll navigate the cyclicalities of the industrial end markets. but the way with which they're embedded with their customers clearly bodes well for their future success. To find more episodes of breakdowns ranging from Costco to Visa to Moderna or to sign up for our weekly summary, check out joincolossus .com. That's J -O -I -N -C -O -L -O -S -S -U -S .com.

49:58We hope you enjoyed the episode. Next, stay tuned for our conversation with Katie Ellenberg, head of investment operations and portfolio administration at Geneva Capital Management. Katie gets into detail about her experience with today's sponsor, Ridgeline, and how she benefits the most from their offering. To learn more about Ridgeline, make sure to click the link in the show notes. Katie, begin by just describing what it is that you are focused on at Geneva to make things work as well as they possibly can on the investment side. I am the head of investment operations and portfolio administration here at Geneva Capital.

50:34And my focus is on providing the best support for the firm, for the investment team. Can you just describe what Geneva does? We are an independent investment advisor, currently about over 6 billion in assets under management. We specialize in US small and mid -cap growth stocks. So you've got some investors at the high end, they want to buy and sell stuff. and you've got all sorts of investors whose money you've collected in different ways, I'm sure. Everything in between, I'm interested in. What are the eras of how you solved this challenge of building the infrastructure for the investors? We are using our previous provider for over 30 years.

51:10They've done very well for us. We had the entire suite of products from the portfolio accounting to trade order management, reporting, the reconciliation features. With being on our current system for 30 years, I didn't think that we would ever be able to switch to anything else. So it wasn't even in my mind. Andy, our head trader, suggested that I meet with Ridgeline. He got a call from Nick Shea, who works with Ridgeline. And neither Andy or I heard of Ridgeline. And I really did it more as a favor to Andy, not because I was really interested in meeting them. We just moved into our office. We didn't have any furniture because we just moved locations.

51:50And so I agreed to meet with them in the downstairs cafeteria. And I thought, OK, this will be perfect for a short meeting. Honestly, Patrick, I didn't even dress up. I was in jeans. I had my hair thrown up. I completely was doing this as a favor. I go downstairs in the cafeteria and I think I'm meeting with Nick. And in walks two other people with him, Jack and Allie. And I'm like, now there's three of them. What am I getting myself into? really. My intention was to make it quick. And they started off right away by introducing their company, but who they were hiring. And that caught my attention.

52:27They were pretty much putting in place a dream team of technical experts to develop this whole software system, bringing in people from Charles River and Faxit, Bloomberg. And I thought, how brilliant is that to bring in the best of the best? So then they started talking about this single source of data. And I was like, what in the world. I couldn't even conceptualize that because I'm so used to all of these different systems and these different modules that sit on top of each other. And so I wanted to hear more about that. As I was meeting with a lot of the other vendors, they always gave me this very high level sales pitch.

53:03Oh, transition to our company, it's going to be so easy, etc. Well, I knew 30 years of data was not going to be an easy transition. And so I like to give them challenging questions right away, which oftentimes in most cases, the other vendors couldn't even answer those details. So I thought, okay, I'm going to try the same approach with Ridgeline. And I asked them a question about our security master file. And it was Allie right away who answered my question with such expertise. And she knew right away that I was talking about these dot old securities and told me how they would solve for that.

53:39So for the first time, When I met Ridgeline, it was the first company that I walked back to my office and I made a note and I said, now this is a company to watch for. So we did go ahead and we renewed our contract for a couple of years with our vendor. When they had merged in with a larger company, we had noticed a decrease in our service. I knew that we wanted better service. At the same time, Nick was keeping in touch with me and telling me the updates with Ridgeline. So they invited me to Basecamp. And I'll tell you that that is where I really made up my mind with which direction I wanted to go.

54:14And it was then, after I left that conference, where I felt that comfort in knowing that, okay, I think that these guys really could solve for something for the future. They were solving for all of the critical tasks that I needed, completely intrigued and impressed by everything that they had to offer. My three favorite aspects, obviously, it is that single source data. I would have to mention the AI capabilities yet to come, client portal. That's something that we haven't had before. That's going to just further make things efficient for our quarter end processing. But on the other side of it, it's the fact that we've built these relationships with the Ridgeline team.

54:55I mean, they're experts. We're no longer just a number. When we call service, they know who we are. They completely have our backs. I knew that they were not going to let us fail in this transition. We're able to now wish further than what we've ever been able to do before. Now we can really start thinking out of the box with where can we take this? Ridgeline is the entire package. So when I was looking at other companies, they could only solve for part of what we had and part of what we needed. Ridgeline is the entire package. And it's more than that, in that, again, it's built for the entire firm and not just operational.

55:36The Ridgeline team has become family to us.