Good morning and welcome to Fastenal 2023 Second Quarter Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. At this time, I would now like to hand the call over to Taylor Ranta of Fastenal Company. Thank you. You may begin.

Welcome to the Fastenal Company 2023 second 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. The call will last for up to 1 hour and 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 the proprietary Fastenal presentation and is being recorded by Fastenal. No recording, reproduction, transmission or distribution of today's call is permitted without Fastenal 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 September 1, 2023 at midnight Central Time. As a reminder, today's conference call will 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 our second quarter earnings call. Before I start on Fastenal matters, I'd like to share a message. When I joined Fastenal back in 1996, one of the things that was unique in my joining is that I stepped into the role of Chief Financial Officer, Bob Kierlin offered me the opportunity. And so, I joined in an unconventional way in that I didn't start in a branch or in a distribution center and work my way up through the organization. And sometimes when you join an organization that promotes from within, you're not sure -- kind of reception you'll get when you join. One of the first people I met was Colleen Quad [ph], it was Bob Kierlin sister. She had retired in a retirement. She worked for Fastenal a few years in sales support. One of the nicest ladies I ever met and we lost Colleen [ph] earlier this year. And to her children and grandchildren, you have my condolences and as well as to Bob on the loss of your sister. What a wonderful lady and we were all blessed to know her. We started back in 67. So our 5 founders aren't in their 20s anymore. And Van McConnon -- Henry McConnon [ph], he goes by Van, he was our first employee. In fact, I think that's how he earned his stake in Fastenal, did well with that stake and I'm proud of them. He lost his wife Wilma earlier in the year and the same message. Van was -- could not have been more of a welcoming person to me when I joined the organization and here is my condolences in the loss of his wife to spring. With that, I'll move on onto the Fastenal quarter. Second quarter…

Great. Thanks, Dan. One loose thread there perhaps to pull a little bit. Last time we had cash conversion of this level. It was actually in the second quarter of 2020. For those who don't remember the second quarter of 2020, there was an event occurring at the time that we now know as the pandemic. But I really think it reinforces the point. It took a once-a-century event to create a second quarter that despite several tax payments, produced cash conversion in that 100% range. And the fact that our teams are able to do that in a quarter where thankfully, there has not been anything remotely looking like a pandemic. Again, I think really gets to the success of the teams in managing kind of the post-pandemic environment. So yes but it does take a condition of that sort. Jumping into the details on Slide 5 of the deck. Daily sales increased 5.9% in the second quarter of 2023. Since March, we have seen overall business activity moderate which culminated in June daily sales growth of up 4.7%. The most meaningful change in trend has occurred in our manufacturing customer. This segment grew 10.4% in the period despite sustained sub-50 PMIs and flat to negative industrial production. This reflects the impact of our investment in Onsite and greater sales focus on key account plan spend which tends to be significant within manufacturing. Even so, we did experience weaker sequential in May and June that represents a macro-driven change from the long string of strong sequentials that we had from 2021 to February of this year. As it relates to pricing, they contributed 190 to 220 basis points to growth in the period, declining approximately 470 basis points from the second quarter of 2022 and approximately 100 basis points…

[Operator Instructions] Our first questions come from the line of David Manthey with Baird.

Dan, Holden, I hope you guys are having a great summer. So I have a clarification and then one question. Clarification, Holden, when you're on Slide 5 and you're talking about price contribution, you said this will continue in the second half of '23. And I'm wondering what you're referring to there, first. And then second, the question, I'm hoping you can update us on KPIs relative to your CFCs [ph] and the Focus 5 initiatives.

Sure. The clarification is we continue to expect moderation in the overall contribution from price in the back half, really just a continuation of what we've been seeing over the past few quarters. Does that help?

Yes.

Okay. Then -- yes, if you -- the CFC continues to experience very strong growth. I believe in the second quarter, if you think about the books of business that our CFC or hunter program has, the growth in those books in the current quarter relative to what those books did the prior year, it's actually up north of 50%. So, we continue to see good success in particular with the CFC program. And I don't have specific numbers on the target 5 for you, Dave. CFCs to some extent, have their own target. So I think you can get a sense of how that growth is occurring. But the -- yes. I don't have specific on target 5. The CFCs continue to grow well in excess of our business. And I think the CFCs are a manifestation of the same key account approach that the target 5s are feed into as well.

Our next questions come from the line of Michael Hoffman with Stifel.

Dan and Holden, the trend data that you share so generously, can you -- again, I get that you have limited forward visibility but do you think you're hitting bottom?

I guess I'll just reinforce, we have very little visibility to what the market is going to hold. Here's what I'll say. I've always respected the PMI as an indicator of future activity levels. I tend to think it has a forward look of 3 to 5 months. I think we all know that the PMI in June hit 46 which is not a meaningful new low but a new low nonetheless. And I think the message that we gave to our people internally was that, that would seem to suggest that the back half of this year is going to remain soft. So I don't have an indicator internally that would give you any real insight into what's going to happen in August, September, October. But the PMI has always been a good indicator and the PMI remains relatively low and suggesting the back half is going to be weak and that's what we sort of take our cues off of.

Okay. And then on the digital transformation, one of the things that I think I understand correctly, as you tend to gain a greater percentage of wallet of the individual customer over the life cycle of that penetration, how do you -- how would you characterize where you are in that journey and how that's influencing some of the share gain.

I think -- so if you think about it at the digital foot -- well, I'll talk about the FMI component of the digital footprint. It's about 40% of our business. And internally, the number we've always talked about is we think we can get that to about 65%. A good chunk of that is converting existing customers to the new platforms and it allows us to share insights with our customers in ways that historically you couldn't. It brings efficiency to the business. And the efficiency isn't just for efficiency's sake which is nice. It's the free up time to engage in the marketplace. And so ultimately, we see that time freed up as a means to grow the business faster because you can engage more. The other piece is, it's a separator in the marketplace. There is -- we have a customer event each spring where we bring in thousands of customers and meet -- they meet with suppliers, engage with different tools of the business. And the -- we are winning business because of the capabilities. When I said in a customer discussion last summer and our national account person was speaking to the purchasing team from a bunch of locations within a conglomerate and they were explaining how the -- how our RFID program worked. And that's essentially a compound system with an embedded RFID chip. So in that bin is empty, instead of somebody having to walk around and check things and find stuff and see what needs to be replenished, that bin is placed on the top shelf. The top shelf has a simple RFID reader. It sees bin 14 is empty, oh, okay, I'm hungry, I need to be fed. And that's how replenishment works. And her response when she learned about it,…

And I might add as well that I think that those 2 actually interconnect in the sense that to the extent that it helps to reduce our overall cost of operations than it does, that actually allows us more flexibility in bidding processes and I think makes us more competitive in the marketplace and contributes to our ability to win and gain market share as well. So it really plays -- it plays really strongly in both our ability to leverage as well as our ability to grow.

In February, I think it was February, I was down in Indiana visiting, speaking to a group of branch managers and visiting with Randy Miller, our most senior Regional Vice President. And they asked me if I want to go up and visit a customer and the customer that took me to was a large Onsite. They've contacted us in the fall of, I believe, it was 2020. I might be wrong on the year but I believe it was 2020. And they need some help and we set up an Onsite in there. And the incumbent had been staffing the Onsite 24 hours a day. And our folks really studied the activity and said, if we put out a handful of -- if we put our product in a handful of lockers in a way that we wouldn't typically do it, we could give you better service and staff 10 hours a day instead of 24 and you'd get better service than you were getting before. And we'd have a better -- it would be easier for us to recruit and we could ramp up faster the business because finding folks to work 24 hours a day is sometimes challenging. Finding folks to work 10 hours a day or a 10-hour window, especially when it's during daylight is less challenging. And again, it was a case of -- that separated us in that instance. And I visited that customer, I had a great visit with them. And they were showing me some of the stuff that we were doing that they just loved about our model.

Our next questions come from the line of Chris Dankert with Loop Capital Markets.

Holden, you had a kind of mid-teens growth in IT spend and an FMI investment. As we're thinking about kind of SG&A spending and investment going forward, can you kind of give us a sense for how you would trend in the back half of the year as you kind of keep investing for growth here?

Yes. Well, I mentioned the IT and the FMI spend because those are investments in our business that we're making that are wise investments to make. And I don't necessarily anticipate where we're making investments in those areas that we're going to pull meaningfully back in those areas. The areas we were talking about more had to do with expenses that we had for travel, both sales and non-sales and related type expenses. When we think about how we're using our part timers and the fact that hours among our part timers are up, 12% in June in a marketplace where revenues are up less than 5%, there's just a number of things that we talked about that are variable that we weren't really treating those expense lines as though we're in an environment that's growing at 5%. And the message is we need to get there. Now what was the impact of that? If I think about the -- if I think about the travel, meals, supplies, et cetera, that's about a 10 basis point impact on our business in terms of overall profit impact. If I think about the increase in base pay that comes from higher absolute headcount that comes from higher part-time hours, those sorts of things. That would have been about a 450 basis point impact to margin. Now that was offset by the fact that incentive compensation was down because last year was such a strong year relative to this year. But those are areas that as an organization, we need to tighten up a lot of our behavior and patterns to reflect more of the environment that we're in. And again, I expect that we'll make progress on that in the third quarter.

Let me add on and I'll put on to that as it relates to IT is when I stepped into this role, back in 2015, one of the first things that I said to the Board and I said to our team is, everybody is going to get lower pay next 12 months because we're going to -- because we're paid off of earnings growth. If you read our proxy, you'll see how our compensation programs work. We're all going to take a pay cut because we are going to increase the investment in IT and I tapped the senior leader who had grown up through our branch network, was a district manager, who was a regional vice president, has led our government sales, our vending business and his name is [indiscernible]. I tapped him and I said, John, I know you know nothing about IT other than you show me apps you download on your Android device. But you're a great leader of people. We have great folks in our IT group. I don't think they're connected well enough to the business and I think we're underinvesting and we increased our spend on IT by 50 basis points in 2016 and we've held that number in there ever since. And I told them we will not sacrifice our investments in the short term. If it's longer term, we have to be pragmatic. But last year, we added 50 people into our Bangalore tech center. In January, we added another 100 people. We're not there yet but I suspect at some point in time, we'll have more people in our India technology group than we do in our 4 U.S. -- 3 U.S. technology groups and that's partly about availability of recruiting because we have great folks here. We can't add them fast enough. But we will continue to make those investments. And because we made those investments today, we have a digital footprint. This 55.3% of sales and the productivity gains over the last 3 years would not have happened without it. I think it's a wise investment and we'll continue that.

Our next questions come from the line of Ryan Merkel with William Blair.

I had a couple of questions on margins. So first off, on gross margin. How should we think about the rest of the year. Is normal seasonality, the right framework for 3Q and 4Q?

I think in the first quarter, we sort of talked about normal seasonality would apply but at a bit more of a muted rate and I think that's still appropriate. I mean, second quarter was down about 20 basis points from first quarter. I typically think of it being down 30. 3Q is fairly typically flat with 2Q and I think that's a reasonable ballpark. And 4Q is usually down about 30 basis points from 3Q. And again, maybe to be a little bit more modest than that. I mean I think about the mix question is still an open one, right? Because the reality is, in a weak cycle, your fasteners weaken more and that winds up sort of having a bigger impact on gross margin and mix than you would normally expect. And you saw that this quarter just as you've seen in the past. And so to some extent, Ryan, part of the question is, well, what's going to continue to happen with the cycle and the gap between fasteners, non-fasteners? And such a cyclical question, I can't answer. But if I think about the transportation piece of it. I think that's going to continue to have a sustained beneficial impact for a number of quarters. If I think about sort of the timing elements that the gap stuff that I talked about, I don't think that that impact is as great in Q3 and Q4 is what we saw in Q2. I think we'll still be price mix neutral just as we were this quarter, right? So when I put all that in together, I think the seasonality is reasonable but I would mute it against history for the next couple of quarters. That's my expectation. And like I said, the wildcard really in my mind is what happens in the cyclical element of seasonality related to fasteners.

Yes, makes sense. Super helpful. And then on OpEx, Holden, you mentioned you're going to tighten that up a bit and then you're also going to invest in IT for the long term which I agree with. I guess is there any metrics you can provide? Is there a goal for FTE growth in the second half? And I guess, ultimately, what I'm getting at is, can you adjust SG&A fast enough where you can hold operating margins flat year-over-year in the second half? Or is that maybe optimistic?

It will depend how aggressive we are. The part of the operating margin is going to be a reflection of the gross margin. So again, I will perhaps comp out a little bit in your question about SG&A and a part of the answer to your question is going to rest in what happens to the cyclical element of mix, right? Step that aside and just focus on the SG&A, I think that the -- we need to reduce the cost in our SG&A relative to Q2 by $2 million, $3 million. And we need to do that through tighter control of headcount, through tighter control of those expenses. And I feel comfortable that we'll be able to do that. I think the organization is already sort of responding to the messages and responding to the natural signal of their growth slowing down. So I do believe that we will have better leverage opportunities in the back half. Again, with the wildcard being what happens to the underlying demand environment and what impact does that have on fastener-related mix?

Our next question is coming from the line of Josh Pokrzywinski with Morgan Stanley.

Also, kudos to the operator for nailing the authentic pronunciation there. We don't get [indiscernible].

I was going to ask. That was pretty close.

Yes, that was old country right there. I like that. The -- just maybe a higher level question for both of you. Obviously, we've seen a huge wave of inflation supply chain tightness. Now going back the other direction at least with this inflation, I guess what would you identify Dan, as the biggest change you saw as a function of that? And the biggest things that are changing now as those reverse. Could be customer-facing, could be kind of margin profiles with the business, deliberately a broad question but just thinking of how [it is going to be priced]?

Well, I mean the biggest change that we saw directly in our business from supply chain element was the fact that we had to add a heck of a lot of inventory in those expensive inventory in 2021 and 2022; container costs were sky high. We were doing a lot of things; we were not going to let people down. And fortunately, we have the balance sheet to do that. And we have a shareholder base that appreciates, we're judicious with their capital but they were supportive of the move. And they were confident that when the need for that extra layer of inventory subsided, we figure out a way to harvested out the balance sheet and move forward. That's probably the biggest thing to how it manifests itself, obviously, on our balance sheet and in our cash flow statement. We talked about that earlier. If I think about more broadly, we are seeing changes. And it's one of the reasons I touched on a bit the 2 elements of our business, the plan spend which I believe we've created over time an incredible ability to serve that market. And the unplanned where we're good at it. We're not great at it. And partly because we haven't built the system to support it whether it's technology or supply chain. And we've been busy building that the last several years and I talked about some of those pieces. And we've seen success on what we've built but it's still a relatively small piece of business but we are seeing that trend. If a buyer is working remote 2 or 3 days a week, or covering a bunch of locations, because with technology, you can do a lot of things you couldn't do in the past and you can do it easily. They're buying in a different way. And we need to make sure our systems work for that different way. I hope that's helpful.

And specific on pricing, if you recall during the period of tariffs, we didn't do a great job sort of offsetting all the tariffs and inflation that occurred during that period of time. And the organization kind of buckled down and developed since then, what we call the pricing review tool, PRT and I think what you've seen over the last few years in a period first of fairly significant inflation and now a period of perhaps modest deflation is I think you've seen that tool and our organization's ability to utilize it, result in a much better outcome. We -- there's the occasional blitz here and there. We didn't quite get all the inflation on fasteners. So that's come back. In fourth quarter, I think we got a little bit behind on a certain area. But for the most part, we've been able to be price cost neutral for the entirety of this period of inflation and deflation. And I think it really is reflective of the organization's ability to deploy technology solutions to problems that we run into every day. The other thing that I would say is, from an inventory standpoint, we talked about how inventories dropped a lot because of the -- we're unwinding or sort of harvesting some of the investments. But we peaked from a days on hand standpoint between 185 and 190 days. We're currently sitting between 135 and 140. That's not just because of buying inventory and then harvesting it related to pandemic. That relates to a lot of things the organization did in terms of how it views branch inventory strategically in terms of what's in our hub versus where should inventory be, improving the velocity. And I think the fact that we're able to improve the overall performance of our assets, even in an environment where we're getting a tremendous amount of pressure because of the needs of the pandemic when it started and as it was fading really reflects the organization's ability to do more than one thing at once. And I think the organization can be proud of itself how it's managed a lot of the things that have come up over the course of the past 4 or 5 years.

Got it. I appreciate it. That's comprehensive. Maybe just a quick follow-up. As you've seen things decelerate and maybe disinflate a little bit, is the competitive landscape change? I know you guys don't really see it maybe some of the way other folks do in the space given your business model but anything you'd comment on competition?

Yes, I don't think the competitive landscape has changed, if you look at it from a product perspective. And I think one element that's there, too, is while the -- there's more than one element of inflation and there's more than one aspect of cost. There's inflation that we saw in product costs. There's inflation that we saw in transportation, container costs, things like that. Product cost dynamics are different than the container and transportation element. The third element which is really relevant for our customers and for their supply chain is the cost of labor. There is no deflation in labor. I'll guarantee you that. There continues to be inflation in labor. We do have more success in recruiting. We -- but we are not unique. All businesses are seeing inflation in that arena until this day. And part of -- the nice thing about the total cost of ownership approach we take with our customer is we're really able to understand all those cost components and have intelligent conversations with the customers that they're not a motion conversation, the fact and tactic conversations which allows both us and our customers together to make better choices on puts and takes. But there are inflation elements still in the business. There are some deflation elements in the business. Container is coming across the ocean is cheaper today than it was 1.5 years ago or a year ago.

And I would say there's also availability elements in the marketplace as well. During 2020, 2021, there weren't a lot of distributors that had availability of product and we benefited from that. As the supply chain is normalized, the marketplace sort of normalize as well. And I think what you see is it's a little bit more competitive in terms of customers being willing to say, "Yes, we're going to test the market a little bit". Again, I don't think that's unique to us. I think it's fairly typical in the market. And I think it's reflective of the degree to which things have frankly normalized at this stage of the game. And it allows us to really talk a lot about exactly what Dan said which is the supply chain solutions and how that differentiates us in the marketplace.

And Josh, in the interest of full disclosure, I probably would have gotten your last name incorrect.

Our next questions come from the line of Tommy Moll with Stephens.

Can you give us an update on fastener product margins? And I know that associated with those, there's potential for some renegotiation just on pricing that has given some of the volatility around steel and shipping. Any update you could give there would be helpful as well.

Yes. I mean product margins, when you break fasteners into OEM versus MRO fasteners, product margins are fairly stable. When I think about price cost in the fastener arena, it's fairly neutral at this point, right? So I mean from a costing and margin standpoint, I think things are fairly as expected. Now I will say, I do believe that we have had circumstances where again, there's contracts that require some adjustment based on end markets where I do believe that we've begun that process. But that is in -- that is really aligned with what we've talked about before as we see our costing improve and we have on imported product that we have certain agreements with certain very large customers that we'll adhere to and I think that you're seeing that happen. So it's largely, I think, as we expected. I don't think they were having any adverse impact on our overall profitability level. And that's probably how I'd characterize it. Does that help?

Indeed. I also wanted to talk about supply chain and in the prepared materials this morning, you talked to the reduced inventory is aided by a shorter product ordering cycle for Fastenal. I'm curious, though, with the better supply chain, do you see some of the same for customers? And is there any impact on your daily sales trends from that?

If you think about what we do for our customer, we're the buffer. If we're supplying product to them. And again, I'm really talking about both sides of our business, whether it be plan spend or unplanned spend. If supply chains are taken 30 days longer, we build that inventory so we get it to them when they need it. So I don't know that there would be a destocking element downstream from us. I'm sure there's examples of it. If there is a destocking element, it's because a customer had built up finished goods because they had a strong backlog. And that backlog has been worked down, their finished goods has been worked on. And as they're in that process, that impacts us because they lower their production. And so it isn't so much because the supply chain change is because downstream, their needs finished goods changed. Where we typically see a supply chain impact the most is when we take on a new customer relationship. It's not uncommon for us stepping into the new customer relationship will though have elements of inventory that we're going to be managing now for them where they have a 6-month, 12-month, 15-month supply, 4-month supply. The extreme examples are usually niche [ph]. But they -- as we illuminate what they have in their inventory and/or how their predecessor supply chain partner was supplying and I'm not throwing in a predecessor under the bus because it could have been there's a bunch of different suppliers supplying this in and there's not a coordinated effort. And so you have months of inventory on something that is ridiculous to have months of a customer a few years ago. First off, it was a part that I thought was fairly unique. I discovered that we had a regular supplier for it. But it was an item where the customer discovered, they had 14 months of inventory and they had no idea. They were appreciative of it and we worked out an arrangement with them to manage it down and they paid us something for helping manage it down but we didn't have product sales for a period of time but we had a lot of other sales. It was an Onsite doing 130,000 a month, it just wasn't doing 160. But then when we burn through it. And that's what a supply chain partner does. But that's not about supply chain time. That's about just an inefficient supply chain. I apologize to whoever was in queue. Holden be available for calls, you want to give him a direct call. I'm going to run to a meeting in a few minutes but we hold these calls to 1 hour and we are at 10:00 central time. Once again, thank you, everybody, for attending our earnings call today. And best of luck in July and the balance of the year. Have a good day, everybody.

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation and have a great day.