Good day, ladies and gentlemen and welcome to the Fastenal Company Third Quarter 2016 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to introduce your host for today’s conference, Ms. Ellen Trester. Ma’am, you may begin.

Welcome to the Fastenal Company 2016 third quarter earnings conference call. This call will be hosted by Dan Florness, our President and Chief Executive Officer and Holden Lewis, our Chief Financial Officer. Call will last for up to 45 minutes and we will start with a general overview of our quarterly results and 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 call is permitted without Fastenal’s consent. This call is being audio simulcast on the Internet via the Fastenal Investor Relations homepage, investor.fastenal.com. A replay of the webcast will be available on the website until December 1, 2016 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 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.

Good morning, everybody and thank you for joining in on our earnings call this morning. And I also want to welcome Holden to not only the earnings call, but to our organization as well. Holden has been here now for, I believe, about 5.5 weeks, so he is seasoned veteran at the Fastenal organization. When we started 2016, we had a handful of expectations for the year. And I thought I’d run through those expectations and talk a little bit how the year has played out relative to those expectations. First expectation for the year, we are going to open some stores. We hadn’t opened much stores in recent years. We are going to open a few more stores and not a lot, but a few more because that is part of our long-term growth and it’s about always exploring ways to grow in different markets. The second thing we were going to do is we are going to reinvigorate our store network. We talked about the CSP 16 at our Investor Day last November. Essentially, we injected about $75 million of inventory in our store network to be a better supplier, a more efficient supplier and a better same day supplier. And we are pretty good already, but let’s get better. Third item, let’s reinvigorate our vending. We have created a wonderful vending business in the last 5 years. But in the last 2 years, we have lost some steam. In 2014 and 2015, we had – we were signing about 4,000 a quarter, so we had run-rates of about 16,000 a year and really saw there is a lot more potential there and our capabilities are strong and this naturally works with our store and onsite network. Let’s go back to this more aggressively. The fourth, speaking of…

Great. Thank you, Dan. Yes, I will cover the numbers and try to give a little bit of color into what we saw that generated them. In terms of the revenues, total and daily sales in the third quarter were both up 1.8%. That’s the third straight quarter where we have seen daily sales growth between that 1.5% and 2% range. We did like that the quarter finished in September with a daily sales rate up 2.8%. But as you all know, the comparison did get quite a bit easier and that’s a pattern that’s going to continue into the fourth quarter. Qualitatively, it’s not clear to us that the tone changed much in the third quarter. We saw that the sales of fasteners into heavy manufacturing construction end markets were relatively weak as we have seen before. The same could be said of our largest customers. Our top 100 was flat to maybe down slightly during the period. But again, these are the same dynamics that have persisted throughout 2016. If there was any incremental change, it may have been that the U.S. business grew a little less quickly while Canada and Mexico actually strengthened. But at the end of the day, it all blended in what we thought was a fairly consistent quarterly sales performance. This sluggishness does mask the progress we are making on our growth drivers. Dan alluded to some of this, but we did sign over 4,700 vending machines in the third quarter. Our total installed base rose by more than 2,000 units. We now have 60,000 – more than 60,000 in the field. That’s a figure that does not include the machines that are related to our leased locker program, which is being rolled out as we expected it to be. We also signed…

[Operator Instructions] Our first question comes from the line of Ryan Merkel with William Blair. Your line is open.

Thanks. Good morning guys.

Good morning, Ryan.

So first, can you talk a little bit more about September, which to me it looked like sales stabilized at a low level, but how did the month start and finish and I know you said that not much has changed with the end markets, but are you seeing any signs that the industrial economy is bottoming?

I can’t say that we are, Ryan. I can tell you that with the two weeks left in the month and I am looking at where I thought the momentum is going to finish and how it played out, there were no surprises in the last ten days, which says as much about our large account performance as it does our small account performance, just the dynamics of timing during the month. And – but I can’t say that we saw any kind of inflection. Holden, I don’t know if you have any comment to add to that.

Yes. And what I will say about that Ryan is when we look at sort of our customers by category or end market grouping, we didn’t see a lot of changes in September. We might be lapping some of the issues around the energy side, but that would be one month in hand with that. We will see how that plays out through fourth quarter. But there may have been some indication on that in some of those customers. We probably saw a little bit of incremental weakness in the heavy-duty truck customers that we might have. But beyond those two items, there is not a lot more to add in terms of end markets. Regionally, we indicated the U.S. was a little bit weaker than the international. Some of that might simply reflect changes in currencies more than anything else. But there wasn’t a whole lot of change beyond those fairly minor sort of differences in the quarter or in the month.

Okay, fair enough. And you could see a little bit more evidence before you are willing to call it bottom, I understand. Then, moving to incremental margins, I think in the last call, Dan, you said that the new level was 20% to 25% just given the onsite business that’s ramping, but what level of sales growth do you need in 2017 to get there?

Well, if you look at our expense growth right now, we are running – and I am assuming in this discussion that gross margins, the drain that we have seen in the last five, six quarters moderates. Our fasteners as a percentage of our business moderate to a certain degree. And there is a better shine through of the revenue growth or maybe I could just answer to the context of gross profit or the growth we need. Right now, our operating expenses are up about 5% year-over-year. Some of that because of the investments we have made. We need to structurally lower that probably closer to 3.5% to 4%, so that at 3.5% and 4% revenue growth, we can let that shine through. Obviously, one thing that’s inherent in our numbers right now is of the accordions that are within the – if you think of the cost structure of Fastenal, our incentive comp is at an incredibly low point right now. So, we would be very mindful of the structural expenses we are adding as we look into 2017 and ‘18, because we know there will be some expansion in that cost pool as we want the ‘17 and ‘18 and that’s frankly a good thing. That was also – I am not going to paint the picture of the DOL rule changes were the only reason we closed some stores. They were recently moved pretty quickly, but we do need to be mindful some structural costs that we can remove from the business, especially in an environment where onsite is a bigger part of our growth driver going forward.

So next year, you need mid single-digit top line maybe a little bit better to see some meaningful earnings leverage, is that fair?

Yes, yes. I think it’s also fair, Ryan, to suggest that coming into this year, we sort of took it for granted that we grow mid single-digits and plan to invest around that. I am not sure that we are making such – that we are making any such assumption about the go forward market given that we haven’t seen any meaningful improvement in the markets. And so we are not necessarily going to assume that we are going to make those same investments for that same level of growth. We maybe prudent if we don’t begin to see the revenue growth rates begin to tick up.

Right, makes sense. Okay, thanks. I will pass it on.

Thank you. Our next question comes from the line of David Manthey with Robert W. Baird. Your line is open.

Thanks. Good morning, guys. Could you remind me the math on vending? You asked that customers have an incremental spend of about $2,000 a month I believe it is, is that a net goal after the reduction in usage of the products that are in the vending machine?

Yes. And it does not – it does not need to be vending revenue and again that’s based on the machine itself and different machines have different requirements. The FAST 5000, which is roughly, I think, 40% of our fleet, that’s that $2,000 number. But for lockers, which have a lower cost basis than the FAST 5000, the number might be $1,200 or might be $1,000. That’s why we have disclosed historically, we have talked about both our absolute device count, but then our weighted average count, because the weighted average is more akin to the $2,000 number.

Okay, got it. And if I recall your realized incremental revenues was something less than that $2,000, is that still the case?

No, our realized historically, if you look at that as far as growth with those customers, that was realized, again, not all that through the machine, because our average machine runs closer to $1,100, $1,200 versus that $2,000. But we do achieve growth outside the machine and that’s why you see our vending direct – our business with the vending machine continues to grow. And our non-fastener business, which – about 25% of our non-fastener business goes through a vending machine and that’s why that business continues to grow mid single-digits in an environment where the peers in that business are contracting.

Okay. So what you are saying is that per weighted average machine, you are achieving $2,000 of total net growth, again yet realizing that’s not just through the machine, that’s all in for the customer, correct?

Correct.

Okay, alright. Thank you for that. And then how much higher were your occupancy costs due to the closures in the current quarter. And then you mentioned the reserve for future closures that you took in the third quarter, I think you said it wasn’t that meaningful, but could you just give us an idea of what that was?

I believe it was just over – just under $1.1 million that we booked during the quarter. And again what that is, once we make the – and this is the – Dan thrown his CFO hat on for a second, sorry, some habits are hard to kill. What you accrue when you are closing locations is you look at future expenses you will incur that do not have a future benefit. And so in the third quarter store closures, there is some real estate that we need to contend with. And in the fourth quarter locations, there are some real estate costs we will need to contend with and those we accrue a lot based on assumptions of similar closures in the past, but it’s about $1.1 million.

Alright. And then final question on pricing, you have been seeing some pressure on the fasteners side recently, has that alleviated at all [indiscernible] fasteners, non-fasteners and then your outlook for 2017 on pricing?

I don’t know if we have an outlook, a generic outlook for fasteners and non-fasteners. My earlier comments were from Q2 to Q3, our gross margin on fasteners ticked up nominally. I look at that and say that probably should have occurred structurally just because some of the weakness usually occurs that we are seeing most acutely is in the OEM fasteners and so mix should be helping fasteners a little bit. So I would look at that and Holden characterized it as treading water. Our non-fasteners, we improved a little better than 20 basis points from Q2…

Yes. But from a pricing standpoint, Dan?

From a pricing standpoint, not much going on there Dave, that’s – the non-fasteners is as much about us doing a better job of managing the mix.

Okay.

To the extent Dave, that in prior quarters, there was any confidence from our people that there was a little bit of pricing pressure they were seeing on fasteners, I would say that the confidence is not as high that they are seeing that pressure at this point. So it was never huge on fasteners to begin with. And whether we are anniversarying it or what have you, it doesn’t seem to be a big factor in what we saw this quarter. And again I think that’s reflected in part by the fact that we had relatively stable margins on our – when you look at the category specifically.

Alright. Thanks guys.

Thank you. Our next question comes from the line of Hamzah Mazari with Macquarie. Your line is open.

Good morning. Thanks for taking my question. Just a question on the onsite business, maybe Dan if you could frame for us, how should we think about the ramp period associated with the new onsite store either in revenue per month or however you want to describe that, just trying to get a sense of how the onsite business ramps over time and against critical mass and I realize that would vary depending on the customer, but just any sense of that would be helpful?

What we talked about a year ago, I will answer it in two components, we talked about a year ago was and what Chris talked as he had studied a lot of our existing onsites is that you could take a $20,000 or $30,000 a month relationship and grow it to $120,000 or $130,000, $150,000 relationship in 12 months to 24 months. We still believe that to be true. We have ramped so many, the 80 and then the ones we have signed this year, many of which we are turning on at different times last year and different times this year. In our earlier commentary, we talked about in January, given a little bit more insight what we have seen from this first group of 80 how we will have a calendar year under our belt and then what we are seeing in the new group coming in that have turned down as we have gone through the quarters. I just soon hold the answer to that for that point in times we will have more succinct data to share with you. What I can tell you is our assumptions initially we have not seen evidence that causes us to think that assumption should be different going forward.

Okay, got it. And then just a follow-up question, on the gross margin, anything you can quantify around freight and also the CSP 16 startup costs, just trying to get a sense of the margin degradation regarding those two items. It’s not like margins coming in your expectation was probably flat to up slightly given some of the inventory you pulled out last quarter. Is that fair?

Yes, that’s a fair characterization of what we talked about in July. If you look at the CSP from a gross margin perspective, the stuff we were seeing earlier wasn’t about CSP 16 so much. That was about – we were introducing some new tools into our business inventory by location and some other aspects like that and we were aggressively moving on some inventory from a clearance standpoint. The CSP 16, those – the margins on those projects are nicely above the company average. That has much to do about the mix of who that business is going to as it is about the actual products. Because in the CSP 16, there is a fairly strong mixture of tool categories etcetera that don’t necessarily have higher gross margin, but the mix of customers is beneficial in that business. So, that CSP 16 has a positive influence overall to gross margin albeit relatively small impact on the relative dollars. In terms of the freight, I mean, our gross margin declined 20 basis points sequentially from Q2 to Q3. I think it’s fair to suggest that freight was a significant piece of that 20 basis points, if not all of it.

Great. Very helpful. Thank you, guys.

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

Hi, guys. Good morning.

Good morning.

Just sticking with that freight theme for a second here, we have talked about fuel and execution behind that. I am wondering if you are seeing any changes in how the market approaches freight, because obviously a lot of consumer markets, consumers expect free shipping. And so maybe you could talk about how much of your revenue base you already have free freight with certain customers and then maybe talk a little bit more about the pushback with the execution issues that you are seeing there?

Well, two things going on here, Adam. One is if you think of our growth drivers both short-term and multiyear, our growth drivers lend themselves towards things that really don’t have a freight component to them. Vending, there really isn’t a freight component to vending, so that business, that growth, that $600 million plus business a year is freight free, because it’s part of the offering we have. If you think of CSP 16 by placing it in the store, those products don’t really lend themselves to having freight charged on them, whereas perhaps in the past some of that revenue again, that’s a relatively small impact. One of the selling impacts or selling philosophies of the onsite is that we are by moving in onsite to your facilities, there are certain costs we can strip out. One of them is some of your working capital costs as we can stock that inventory because we are a more efficient supply chain. Some of that is because we are more orderly in what we are ordering in our visibility to when we see – we learn about transactions before they become quotes and purchase orders. And so we can be more efficient on how we manage our freight costs. So, those are structural changes over time that aren’t necessarily detrimental in the true sense of the word. I think one of the things that can happen when you are going through this environment of some of the structural changes don’t necessarily have a freight component to them is that you can convince yourself that maybe the other pieces don’t have as great propensity to have freight on them as they did in the past, maybe that piece of that is the tone of the leaders of the organization and I look at myself when I say that. Maybe I am not pushing it hard enough. But it’s the case of, sometimes, you can convince yourself on why you can’t do some stuff and you need to convince yourself on why you can, why you should. And I think that’s probably the bigger culprit in this equation than the marketplace, because the marketplace doesn’t change that abruptly to explain some of the degradation we had.

Okay, thank you. And then if we could just switch gears back to the revenue growth trends, the non-res construction sales have been weaker sometime and I think Holden, you mentioned that we are starting to cycle against some of the oil and gas headwinds that we had last year. Maybe could we dig into that a little bit more deeply? What have you been seeing by region, any pickup in oil related customer growth recently? Thank you.

It would probably be premature to get particularly excited about what we are seeing. As I said in September, it looked like maybe a couple of our national accounts within that energy piece should begin to see some of their annual rates have changed become less severely negative, but they are still negative. And we will see how the next couple of months, couple – the next quarter plays out on that space. But I think that the real emphasis that we would make and I guess, this came about the question of bottoming. We are not seeing things getting a lot better. If those customers get better, it’s because the comps are getting easier. Maybe we will be pleasantly surprised and demand will actually improve from here going forward. But it’s a little bit early to make any such declaration in any of those markets.

I will throw one comment and I had the opportunity early last week to reach out to our regional leader in the Gulf Coast. Steve and his team have gone through a pretty ugly period in the last 1 year, 1.5 years. And that business grew in September. And it was fun making that call and congratulating them because I know from a first hand basis some of the discussions I personally had with them as well as other individuals in that business unit, they have had a really ugly period and I was really happy for them to see their business grow in the month of September.

That’s good to hear. Thank you.

Our next question comes from the line of Sam Darkatsh with Raymond James. Your line is open.

Good morning Dan, good morning Holden, how are you?

Good. Good morning Sam. Thank you. Good morning.

Couple of questions here, first off, related to back to vending, the spread between the growth in vending customers and non-vending customers is obviously pretty tight right now, I am trying to think about what factors might occur that would create that spread to re-widen in vending’s favor especially with your thoughts Dan that you think the fastener business ultimately for you stabilizes from here?

We had quite a few vending machines that have been running negative and vending relationships that have been running negative. And I asked our team to take a look at this group of vending machines. And it’s a sizable group of vending machines, so population if you look at and you can actually glean some knowledge from it. We took a good hard look at it and what we saw – because one thing – one visibility we have into our customers’ business that we have never had before is the insight into how many unique people are using the device. If there is 100 employees that are in this customer’s facility, you know that because those 100 people are in the database are people that can use the vending platform and it also – of those 100 people can get these products versus those products. If I am in the welding area, I have access to the welding tips. But if I am not in the welding area, I don’t have access to those six buttons, if you will and – or those six products. And one thing that jumped out for us where we had vending machines that were negative and again, it was a sizable number is the number of employees on the database right now versus a year ago had dropped. And that group, the number of employees had dropped about 10%. And I don’t recall offhand how many customer locations this included but that tells me we have a bunch of customers and our fastener business was negative with those customers. We have a bunch of customers who had downsized some operations, maybe they have fewer shifts maybe they have fewer people per shift, but they have downsized in this group about 10% actual headcount. And we were seeing in those machines revenue down in the teens. So that’s the case that there was some serious belt-tightening going on. But there was just a drop in consumption because there was a drop in the workload at that business. And that’s – the economics are such that if there is fewer employees from a year ago, they need fewer safety glasses and gloves and new consumables that go with having people.

Interesting. A couple of more quick questions if I could. What would prompt the resumption of the share repo activity is it just a matter of once you no longer require the capital for the Walmart initiative or is it something else?

I don’t know if we know the answer to that right now, Sam. One of the – personally, one of the advantages of bringing in somebody like Holden into the organization is the perspective of Fastenal has historically been we are boringly conservative Midwesterners and we tend to look at the business probably not as financially as still as we should and that’s probably a reflection of the old CFO. I like the fact that we have a voice at the table that is going to challenge us to think about our business differently. The fact that think about our working capital, think about our capital structure just think about the business, in general, little bit differently, it doesn’t mean we are going to change suddenly on our appetite for doing different things, because we have changed our appetite in that over the last 2 years. But we have been – as you see from the numbers we have been pretty quiet on the buyback and I don’t know that, that will change in the next few months.

When the decision was originally made, part of it was simply the capital structure had been so under – so overly conservative, if you will. At this point with 13% debt-to-cap is certainly not a lot, there was plenty of room to go higher should we choose to do so, but at the same time, we do in fact have debt at this point. So, the same urgency to address our capital structure isn’t quite where it might have been originally and so there maybe reasons to buyback stock in the near to intermediate term, but there is no urgency to do so.

And then the last question...

Sam, I will have to take that one offline. I see we are at 45 minutes past the hour and we have always religiously held to the 45-minute conference call. I realized it’s the start of earnings season and everybody has a lot of demands on their time. I want to close the call by thanking everybody for your interest in the Fastenal organization and learning a little bit about our quarter and about our growth drivers. I am as excited about the opportunities for our business as I was a year ago as I was 5 years ago and really feel we have begun taking two nice steps, 2015 and 2016, into transitioning to an onsite mentality for growth. And I am excited about what that means for our future. Thank you everybody and have a good day.

Thank you.

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude the program and you may all disconnect. Everyone, have a wonderful day.