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By Josh Peters, CFA | 03-20-2015 02:00 PM

The Nuts and Bolts of Fastenal's Attractive Dividend

The industrial distributor--a recent addition to the Morningstar DividendInvestor portfolio--has plenty of headroom for earnings and dividend growth, says Morningstar's Josh Peters.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Josh Peters. He is the editor of Morningstar DividendInvestor newsletter and also our director of equity-income strategy. He recently picked up some shares of Fastenal (FAST). We're going to talk about what attracted him to the stock. Josh, thanks for joining me.

Josh Peters: Thanks for having me here, Jeremy.

Glaser: So, for investors who might not be familiar with Fastenal, can you give us a little bit of background about the firm?

Peters: Sure. It is an industrial distributor into what's called the MRO industry--maintenance, repair, and operations. It's kind of an invisible industry. It's actually worth maybe $150 billion a year in North America. That's a pretty big number even in a multi-trillion-dollar economy. But most people don't see it because it's mostly factories, manufacturers, and other commercial customers--contractors and whatnot--that are interacting in this field.

Fastenal: The name actually refers to fasteners, literally nuts and bolts and things like that. That's how the business got its start. That's still a big piece of the business, distributing nuts and bolts, but they've added on more product lines, they've grown their store base dramatically over the years. It's been a terrific growth stock for a couple of decades. What's changed here just in the last couple of years, though, is that now you can actually pick this up with an above-average dividend yield.

Glaser: So, why has the company been shifting in terms of more of a dividend-paying strategy? Are they seeing a slowing of growth?

Peters: The growth has slowed somewhat, and the pattern of that growth has changed a little bit. For a long time, they were out there just opening new stores, expanding across the country. Now, it's been more of a story of expanding existing locations, adding more salespeople, adding more products that they can push through this distribution system that they have--and they are still maintaining a good rate of both top- and bottom-line growth as a result.

But what you have here is what we think of as a wide-moat company. A distributor like this is dealing with hundreds of thousands of customers and thousands of vendors for individual products. And Fastenal, as the middleman, can actually make for a very efficient relationship connecting the vendor or manufacturer to the person who is ultimately going to use it. And that, in turn, has enabled them to earn very good profit margins and returns on capital. And with high returns on capital, as the business grows, it doesn't have to put quite as much back [into the business] in order to expand. So, Fastenal, even as it is continuing to grow, is generating a fair amount of free cash flow, converting about 60% of earnings to free cash flow. The other 40% goes back into support of the low-double-digit rate of growth.

Now, with that other free cash flow, what really makes Fastenal distinctive is that they've chosen to make the dividend the primary means of returning cash to shareholders. The vast majority of companies that are out there, frankly--whether they are fast growing or not--really prefer to emphasize share repurchases. But Fastenal, instead, has made the dividend the top priority. They do some buybacks, but mostly just to offset shares issued through employee plans. And as earnings have grown, the dividend has grown at a very good rate, too. I expect that to continue going forward.

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