FAST

Business Context and Reporting Period

Company: Fastenal Company
Filing Type: Form 10-Q (Unaudited)
Reporting Period: Six months and three months ended June 30, 2006
Business Overview: Fastenal is a North American leader in the wholesale distribution of industrial and construction supplies, operating over 1,800 company-owned stores. The customer base includes construction contractors, original equipment manufacturers (OEM), and maintenance, repair, and operations (MRO) sectors.

Key Financial Metrics

Note: All amounts in thousands except per share data. The company had no outstanding debt on its $10 million line of credit as of June 30, 2006.

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 20.8% for the six months and 19.7% for the quarter compared to the prior year. Growth was driven primarily by higher unit sales from new store openings and same-store sales growth, with a minor contribution from price increases.
• Margin Expansion: Gross profit margins improved to 50.1% (six months) and 49.9% (quarter) due to a new freight model and improved direct sourcing operations.
• Expense Pressure: Operating and administrative expenses grew faster than sales (32.2% of sales vs. 31.7% prior year). This was attributed to the CSP2 store conversion initiative, rising fuel costs (diesel costs increased ~31.7% year-over-year), and occupancy costs.
• Working Capital: Accounts receivable grew 16.9% and inventories grew 18.4% year-over-year. While these increases lagged sales growth, they were necessary to support new store openings and the CSP2 expansion.
• Accounting Change: The company adopted SFAS No. 123(R) effective January 1, 2006, recording $279,000 in stock-based compensation expense for the first six months of 2006, which was not recorded in the prior year.

Guidance, Outlook, and Risks

• Store Expansion: Management expects to open approximately 228 to 316 new stores in 2006 (13% to 18% growth). New stores typically take 10 to 12 months to achieve profitability.
• CSP2 Initiative: The company is converting stores to the "CSP2" format (expanded inventory and sales personnel). 93 stores were converted in the first half of 2006, with more planned for the remainder of the year.
• Capital Allocation: In June 2006, the Board authorized an additional 500,000 shares for repurchase. The company purchased 250,000 shares in late June at an average price of $37.73. Dividends paid totaled $30,211 for the six-month period.
• Financial Goals: Management aims to improve the Annual Sales to Accounts Receivable and Inventory ratio to better than 3.0:1 (currently 2.8:1 as of Dec 31, 2005) to achieve a 20% after-tax return on total assets.
• Risks: Key risks include economic downturns affecting construction and manufacturing, rising fuel costs, disruption from the CSP2 implementation, and the ability to pass through commodity steel pricing increases to customers.

Investor Verification Checklist

• Working Capital Efficiency: Verify if the company can achieve its target 3.0:1 Sales-to-AR&I ratio given the current growth in receivables and inventory.
• Fuel Cost Impact: Monitor the sustainability of gross margins given the significant year-over-year increase in diesel fuel costs and the company's ability to pass these costs to customers.
• CSP2 Execution: Assess the profitability timeline and expense leverage of the 93 stores converted to the CSP2 format in the first half of 2006.
• Same-Store Sales: Confirm the trend in same-store sales growth for stores older than five years, which are more cyclical and sensitive to economic conditions.
• Capital Expenditures: Review the $39 million in property and equipment purchases to ensure alignment with the planned store opening schedule.