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.
Glaser: So, what does the dividend yield look like right now and how would you expect that dividend to grow over time?
Peters: Well, on the dividend-growth side, I am looking for, call it, 12% long-run dividend growth--maybe closer even to 15% over the next couple of years where we're expecting still pretty fast expansion in earnings. Over the long run, I'd like to think if the company is growing faster now, it's going to slow down long term. I try to blend those estimates. Eventually, it's more of a high-single-digit growth story, so I'd call it 12% as a blended estimate.
Now, that's a pretty good total return, even if there's just the growth. But "what are you growing?" is always a good question when you're thinking about dividend growth; and in this case, you are growing off of what's a fairly generous dividend yield. Now, my usual minimum for portfolio holdings is 3%, but I'm willing to bend that if I can see a lot of growth front-loaded that's going to take the yield on my original cost basis up fairly quickly. And what really distinguishes the story here from other dividend-growth stories is, yes, there are other companies out there with double-digit dividend-growth rates--in fact, the S&P 500, as a whole, has had a low-double-digit dividend-growth rate over the last couple of years. But that's coming off of such a low base--2% yield for the market overall. Most of these really fast-growing dividends are well below even the 2% yield mark. Those are not dividend-growth stories; they're just growth stories.
To be a dividend story, to have the dividend be relevant, I think you have to have an above-average yield. And with the growth in Fastenal's stock price, combined with the fact that the valuation has become a lot more attractive the last couple of years--it used to be a very high P/E stock, but now it trades just a couple of multiple points higher than the market average--the dividend yield rose into the high 2% range. That got my attention. And the opportunity to pick up such a high-quality franchise that still has a tremendous amount of growth--we're talking about less than 3% of the market, overall, in North America that Fastenal has, even though they are the second-largest player after Grainger (GWW). They have a huge amount of opportunity to leverage those strengths, continue to expand, gain market share, while generating a lot of cash and paying it out not just agnostically, as returning cash to shareholders through buybacks, but directly through the dividend. It's a little different from the utilities and food stocks and things like that that most dividend investors are used to, but I think it adds a lot of growth in exchange for that slightly less-than-customary yield. And just to emphasize one more time: 2.7% on Fastenal is well above the market average down around 2%. So, you're getting a lot of income and you're getting a lot of growth.
Glaser: Josh, thanks for your thoughts on Fastenal today.
Peters: Thank you, too, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
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