Fastenal Company - Earnings Call - Q3 2011

Transcript

Speaker 0

Good day, ladies and gentlemen, and welcome to the Fastenal Company Third Quarter 2011 Earnings Results. At this time, all lines are in a listen-only mode. Later, we will conduct a question and answer session, and instructions will be given at that time. If anyone should require assistance throughout the conference, you may press star and then zero on your touch-tone telephone. I would now like to turn the conference over to our host today, Ellen Stolts, Investor Relations. Please begin.

Welcome to the Fastenal Company 2011 Third Quarter Earnings Conference Call. This call will be hosted by Will Oberton, our Chief Executive Officer, and Dan Florness, our Chief Financial Officer. The call will last for up to 45 minutes. The call will start with a general overview of our quarterly results and operations by Will and Dan, 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, 2011, at midnight Central Time.

As a reminder, today's conference call includes statements regarding the company's anticipated financial and operating results, as well as other forward-looking statements based on current expectations as defined by the Private Securities Litigation Reform Act of 1995. Forward-looking statements may often be identified with words such as "we expect," "we anticipate," "upcoming," or similar indications of future expectations. It is important to note that the company's actual results may differ materially from those anticipated. Information on factors that could cause actual results to differ materially from these forward-looking statements are contained in the company's periodic filings with the Securities and Exchange Commission, and we encourage you to review those carefully. Investors are cautioned not to place undue reliance on such forward-looking statements as there is no assurance that the matters contained in such statements will occur.

Forward-looking statements are made as of today's date only, and we undertake no duty to update the information provided on this call. I would now like to turn the call over to Will Oberton. Go ahead, Mr. Oberton.

Speaker 3

Thank you, Ellen. Good morning, everybody, and I want to thank you for joining us on the call today. Dan and I are going to both give some brief comments, and we're going to open it up for questions. I'd like to start by saying I think we had another good quarter. Our sales came in at 20.4% for the third quarter. Year-to-date, we're at 22%. For the third quarter, we were a little lower than the first two quarters, but we're still above the sequential trend, our historical sequential trend, so we're very optimistic about that. Our manufacturing customers, as was stated, grew at 18.3% as compared to 18.5% in the second quarter and 15.5% in the first quarter, so there has not been a lot of change, but if anything, it's remained strong, so we're very optimistic about that.

Non-residential construction grew at 15.8% in the second, the same as the second quarter, and that's an area that there isn't a tremendous amount of activity. Most of that's coming in energy jobs and larger construction jobs and infrastructure, but you don't see much as you drive around in this tower cranes and things like that, so I think our team's doing a nice job digging it out wherever they can. Overall, the sales trends are good, and we remain optimistic in somewhat of an uncertain time. We don't have a tremendous amount of visibility, but the anecdotal stuff that we're getting from our people in the field is still quite positive, although there are a few signs of things slowing a little bit, but for the most part, it's very positive. On the earnings growth, we grew our earnings at 29.1%. Very good number. It's interesting, though, about perspective.

I was looking at it and going, "Boy, we didn't even grow over 30%." Because we've had such a good run, 29 is still a strong number. I feel very good about our expense control. I think that the team did a nice job. We picked up 140 basis points of pre-tax earnings over the last year. Our goal of Pathway to Profit is to pick up 100 points, so we've been able to exceed that goal, and I really feel good about the job the team did on controlling expenses. Pre-tax profit at 21.4% of sales, that's a record, and net income north of 13% at 13.3%. That's a number I think we can also be proud of. There's only been, I think, the last quarter's the only time we've ever exceeded 13% on a net income basis. Switching gears, talk about store openings a little bit.

Our store openings came in lower than we had planned and thought we would earlier in the year, but I'm not overly concerned with this, because at this point, I'd rather see our, if we can only get so many things done, which is really the case, I'd rather see that our people put more energy into our automated supplier of vending solutions because it's more timely. Our competitors are not out opening stores in the markets that we plan to open in the future, but they are talking about automated supply and vending, so I think the faster we can move that project along, long term, that will be a better long-term strategic decision, and the store openings and the opportunities will probably be there in the future, I believe will be there in the future. We're working very hard on the automated supply.

Talking about automated supply, I stated to anyone that would listen, I think that I thought we could do, or I wanted to do 2,500 signings in the second quarter, or excuse me, in the third quarter. We fell short of that. We came in at 2,260, so I was disappointed with that. When I look at the 2,260 and I compare it to where I thought we would be a year ago, it's a great number, and by any other measure, it's a very good number. We're going to continue to push hard. What really happened is we dug a hole for ourselves in July. We didn't have a very good month of signings in July. We got behind in the first holiday week and never made it up for the rest of the quarter. On a very positive note, the team did a great job on the installations.

We set up and we installed and turned on more than 1,700 machines in the quarter, and that's just a lot of hard work going into those customers, setting it up and getting these machines up and running. I like the signings, but the install is really where the revenue starts, and that's a positive. As Dan noted in the release, the overall sales growth, a year-over-year sales growth of the customers that have implemented vending automated supply remains strong at 49%. It's been 49% right at 49 each quarter. That's a very positive note. We just need more customers to have automated supply is kind of what we're thinking. Other initiatives that we've talked a lot about, our government sales initiative continues to do well. We had very strong sequential growth in the state and local business.

Most of our government business that we're focusing on is state and local business at this point. In the future, we would look at doing more federal, but right now, our focus is state and local. We think with our branch network, we're better positioned for that type of business, and so far, it's proving to be correct. On the metalworking initiative that we talked about, we feel very good about where we are. We've added a lot of product into our distribution system. That's part of our inventory growth. We've continued to work at signing up strategic partners, the partners we need to fill out our product line, and that's gone very well. We had said we were going to put in 42 trained specialists.

We have 37 in place, and 34 of them have gotten through our level two training, which is a training designed by an outside firm, again, working with our suppliers, and it's a very intense training. Our people are coming back with great feedback. We really hope to see the results of this effort, probably late, probably in the late in the first quarter, end of the second quarter of next year. These people are out selling now, start gaining some traction, and start seeing the results into 2012. We're very optimistic. We met with our product development lead yesterday, and he gave us an update, and things seem to be moving in the direction that we had planned for them to move. On the personnel side, we've continued to invest in people.

I believe this will flatten out in the fourth quarter, really due to normal seasonal slowdown that we see in our business. The majority of our efforts go into the sales effort. On the administrative and warehouse side, where we've added more people, if you notice that, our manufacturing business is doing very well, and we've added more people in there. On the administrative side, most of those additions have been people that we've put in to help push the vending system, so it's really more of a sales service effort, the people setting up the machines and those things. I'm really proud of this. As a leader, I'm proud of the fact that Fastenal is in a position to be adding employees.

When you listen to the news and you see the slow economy and all the things that are going on, and I tell our employees this, I think we should be very proud of the fact that we've added about 2,000 great opportunities this year to people out and trying to push the economy forward. With that, I'll turn it over to Dan, and he'll make a few comments, and we'll open it up for questions.

Speaker 1

Thanks, Will, and good morning, everybody, and thank you for joining our call. Reiterate a few things that Will touched on. First off, sales trends continue to follow or exceed our benchmark, our trend line. If you look at history, history would indicate that we should be at about 16% growth from our daily average in January to our daily average in September. This year, we're actually up 20.8%, so we're running about five points ahead of that trend line, which has given us a nice launching pad as we go into 2012. Digging along deeper into the release, one thing I wanted to add on the end market trends Will touched on already is that we've been in a situation where the ISM index has been moderating now for about five months, and we continue to perform well.

As we mentioned in the second quarter, we really think our vending and our international is helping, giving a nice boost to this, but our domestic, our North American business is doing just fine in and of itself. On the non-residential side, Will touched on some of the energy projects that we're supplying into. I think at the end of the day, it's that, and it's the fact that our store employees are just resourceful at turning over stones to find business. We're really well positioned to go after a lot of the small projects that a lot of other companies either aren't as aggressive with or aren't as interested in going after. Our stores sell on smaller projects all day long, and that's really a lot of little dollars are really what's driving our non-residential construction.

The vending stack, I'll touch on a few things that Will mentioned as well. I guess the two things that jumped out for me when we were pulling together the earnings release was the fivefold increase in the number of installs from Q3 2010 to Q3 2011. My comment there would be a nice job to Russ and his team in wrapping up not just what we're doing to promote vending, but what we're doing to install, because Will is right. The revenue starts after the machine's installed and after the contract is signed. The other item is, taking a step back and thinking for a second, we have 13% of our sales now going to customers that have vending as part of their operation, and that customer base is growing at 50%, at basically 50%.

To me, the part that's most meaningful there is the fact that this is a predominantly manufacturing customer base. It's medium-sized customers. It's not small customers or large customers. It's been driven by a broad brush, but the dollars to move the needle on those kind of dollars and the way we're moving it is quite staggering. The fact that this business becomes very sticky because we're really providing a better solution than the competitor down the street. Pathway to Profit on page seven of the release, we hit a new high on the average store size, $83,000 a month.

Our previous high was in the third quarter of 2008 when we were at $82,000, and it's no coincidence that our record high for pre-tax earnings is this quarter because the Pathway to Profit, the mechanics and the fundamentals of it are just kicking in, as we've seen in prior quarters. If I look through some of the mix of employees, our store FTE is up about 16% on a year-over-year basis. Since we started the Pathway to Profit, we've added 35% more employees on an FTE basis into our store. On the non-store selling side, we've added 44 people in the last 12 months. We've added 44% in the last 12 months, 49% since the first quarter of 2007. You can really see the energy that's being invested into the growth drivers of our business over the last 12 months.

Those are the types of things that are driving the vending, that are driving the government, that are driving our strength in manufacturing business. On the DC side, up about 16.7%. Since we started the Pathway to Profit, we're up 19.5% FTE. Five points of that came from the Hollisborne acquisition. We've done a nice job leveraging that side of the business over the last since 2007, and believe we have the ability to keep leveraging that into the future. Finally, as Will touched on the support side, we've added about 11.7% in the last year. A good, meaningful piece of that is centered on back-office support for our initiatives. Since 2007, we've added 5.7% more people, but we have 42.5% more sales dollars flowing through our stores today than we did back in 2007.

All those are really for most of the Pathway to Profit leverage and the improvement in profitability of the business. On page nine, there's a few paragraphs. We talk a bit about gross profit margin. Bottom line, I'd say there's a lot of noise in the numbers right now. We're kind of in the middle of that 51%, 53% zone we've always cited. We still look optimistically at that number as we go forward because some of the things we talked about on our second quarter call, opportunities with our Fastenal exclusive brands, how those opportunities are enhanced with our vending machine solutions because they really go hand in hand. We really see over the upcoming quarters our ability to move that gross margin north and enhance the operating leverage of the business. We're optimistic. Right now, there's a lot of noise in the numbers.

One of the things that probably we don't talk about enough is the fact that with the strong growth in our large OEM business, both domestically and internationally, that puts quite a dampening effect on our gross margin. It doesn't hurt our operating margin at all because it's an attractive operating margin business, but it does put a dampening effect on gross margins. If anything, if you compare gross margin to a year or two ago, it's probably a little bit understated in that regard. With that said, the number is what it is, and we believe we have growth drivers to move that number north in the future.

On the operating administrative expense side, our payroll increased about 17.4%, and you see a dynamic going through the numbers now, whereas last year, our quarterly number was quite a bit higher growth than our year-to-date number because we were in a pattern of bonuses and rising. Now we're in a situation where we're anniversarying some of those higher bonus numbers from a year ago, and that's why you're really seeing that payroll growth moderating quite dramatically because we're getting back to the point of growth for activity growth rather than moving out of easier comparisons. While our growth is our net earnings are slightly below 30%, it's a powerful statement because we had a pretty good third quarter last year. The final item I'll touch on, working capital, we continue, I believe, to manage it well.

We still believe we have opportunities in inventory to keep tightening that and tightening that. All things considered, I think we're operating that well. Most of you probably saw this last night, but we announced our fourth quarter dividend, our third quarter dividend payable in fourth quarter, of $0.14, and that'll be paid out here in November. With that, I will take some questions, and we'll go from there.

Speaker 0

Thank you, ladies and gentlemen. If you have a question at this time, please press star and then one on your touch-tone telephone. If your question has been answered and you wish to remove yourself from the queue, you may press the pound key. In the interest of time, we are asking that you please limit yourself to one question and one follow-up. Again, ladies and gentlemen, if you have a question, please press star and then one at this time. Our first question comes from Holden Lewis with DVNT. Please go ahead with your question.

Speaker 2

Great. Thank you. Good morning. I'm curious, I guess, first, if you could maybe expand on some of those anecdotes that you cited in your preamble about maybe some signs of slowing. Along those lines, how are you viewing sort of your margin break-even at this point? I mean, what level of revenue growth do you feel that you can continue to expand margins versus seeing margins begin to maybe come down a little bit just cyclically? Do you have some comments about sort of break-even on margins and earnings as it relates to revenue level?

Speaker 3

I'll take the first question. I'll give the second one to Dan. The anecdotal stuff is what all of our Regional Vice Presidents are in town this week for meetings, and I was talking to them over dinner last night. It sounds like some of the larger consumer products companies are saying, "Yeah, pull back just a little bit." The heavy metal guy, you know, people producing more of the metal parts, they haven't heard much of that. I think the consumer goods probably not going to pick up much. Overall, the tone was positive with the group, and I spent several hours with them. There are, yeah, this one backing up a little bit. Our sales are down 8% or 10% from last year on this one. They're cautioning the tone.

Speaker 2

On the second part, if you're just looking at our third quarter operating expense increase, it was at about $15.7 million. You could break that leverage point down to $15 million really fast and with some energy get it down closer to $12 million or $13 million.

Speaker 3

Okay, go ahead. I say because we haven't added a lot of stores, we could drop it well below that just through our payroll system because of the bonuses very quickly. I mean, if things really hit the wall.

Speaker 2

Overall, you think if your revenues grow 12% to 13%, you can still expand margins and below that, maybe you get some contraction. Did I understand that correctly or no?

Speaker 3

I would say we could hold margins at the 12% to 13% rate.

Speaker 2

Got it. Okay, thank you.

Speaker 0

Our next question comes from David Manfrey with Robert W. Baird. Please go ahead with your question.

Speaker 1

Hi. Good morning, guys. First of all, on the vending machine solutions, I think you said historically that the products that go into the vending machines are used less. With the growth at 50% overall from the customers that have these automated supply solutions, I assume that most or all of that growth is coming from adding lines that you didn't have before. Am I assuming that correctly?

Speaker 3

That is correct.

Speaker 1

Okay. When you look at that 50%, I'm interested in the dispersion around that. Are there some customers that are up 300% and some that are flat-ish, or is it pretty consistent at 50%? As you look out, I guess the number that we're looking at here is aggregate. If you just isolate the vending machine solutions you put in a year ago or longer ago, does that 50%—I would imagine it goes down, but does it remain above the corporate average for customers with vending machine solutions after year two, year three?

Speaker 3

We really don't have any good data for year two. Year two, we do, but not year three because we only had a handful of machines out there. Yes, the customers that are in their second full year of vending, and I have to qualify this. This is information from second quarter because I haven't looked at this for the third quarter data. It just had a lot going on. Those customers were growing at about 30% versus the 50. The customers that are in their first year are growing at 70%. That's the 30 plus the 50 balances out to the or plus the 70 balance out to the 50. Yes, the growth slows, but the growth is still greater than the company average with that group. These are larger customers. It's still.

Speaker 1

It is meaningfully above the company average of that group.

Speaker 3

Yeah. Still exceptional growth for that group of customers. It's all about taking a bigger share of their wallet because we have very few customers that we have, you know, the majority of their wallet that are sizable customers. The small ones, that's different.

Speaker 1

Okay. Great. Thanks. Just one quick one on the end here. Could you discuss pricing on the fasteners you're purchasing in Asia today?

Speaker 3

You know, we haven't seen a lot there. It's been kind of a roller coaster year with small bumps, meaning if we hear that it's going to go up, then we don't see much. One of our largest fastener suppliers out of Taiwan was here this week, and I spent some time talking to them. You know, there's just not much going on. I think it has more to do with a slower, you know, somewhat of a slower economy than anything else. Especially the Taiwanese are very concerned about capacity. They want to run the machine wide open, so they're willing to take a little hit, even if steel's up, to keep the machines running. That's a historical pattern. We haven't seen much, a little bit here and there, but it's probably pretty easy or pretty soft to your fly here.

Speaker 1

All right. Thanks, guys.

Speaker 0

Our next question comes from Tom Hayes with Piper Jaffray. Please go ahead with your question.

Speaker 4

Oh, thanks. Good morning, gentlemen.

Speaker 1

Morning, Tom.

Speaker 4

Just a question on back to the vending machine. If you're gaining a larger share of the current customer's wallet, which I think is a great idea, is there a transactional margin benefit where it's not as the pricing is not as competitive as you're delivering a better service and a cost savings for them?

Speaker 1

I guess I'm not quite following your question, Tom.

Speaker 4

Is there a meaningful margin benefit for the customers or to you for the customers that have the vending machine solutions versus your non-vending solution customers?

Speaker 1

What do you mean a need for more margin?

Speaker 4

Are you thinking of a bigger discount?

Speaker 1

Are the customers that you have the vending solutions in, is your margin profile better than the non-vending solution customers?

Speaker 3

No, it's not. Actually, when we match up by customer size, we match up. What I really do is I look at the customer last year and this year. Even with the growth, the margin in most cases hasn't moved much. If they were a low-margin customer, we might be up or we might be down. The trend is basically the customer margin changes very little when we add vending. The sales just go up. It really, I think, has to do more with the pricing habits of our store. The store looks at this customer. In many cases, they were a customer in the past. The store looks at the customer and they're a, say, a 40% margin customer. When they bid the vending product, they're probably bidding it in that range because it's just incremental business for the store. It's actually very consistent.

I've spent some time looking at that. I wish it was higher, but it's not. The opportunity we have is as we put in more Fastenal exclusive brands in those machines, we will see a margin improvement. In many cases, we start out with a lot of branded product because that's what they were using. Over time, we plan to convert that.

Speaker 4

Great. Thanks for clarifying my confusing question. I guess this last is a follow-up on the CapEx or the meaningful increase in the CapEx year-over-year, just kind of a thought on the balance of the year and going forward.

Speaker 2

Yeah. You know, if you think about where our CapEx dollars are centered this year, they're really centered on the vending equipment. Unlike a lot of our CapEx in most years, a lot of our CapEx centers on construction. You know, we're expanding a distribution center, we're adding onto a distribution center, we're doing things like that. Even with store additions, those tend to be maybe back-end loaded from the standpoint of they really don't get going as fast in the spring until the frost is out, and then those types of projects take off. They push into the November timeframe, maybe early December, depending on geographically where you are. Whereas our vending dollars, that was much more first three quarters loaded. I think we cited $95 million, $100 million in our annual report as far as our CapEx for the year.

That was going to be more front-end loaded than our traditional year.

Speaker 4

Okay, you're still comfortable with that for the dollar or whatever for the $95 million?

Speaker 2

We're going to be in that $95 to $105 million number, I suspect. One item that we're doing that I probably didn't have as much dollars planned on for this year just because we're running a little ahead of schedule is we're doing a meaningful expansion of our distribution center here in Winona. We're adding a mini load system, an ASRS type system that we've done in Dallas and Indianapolis in the past. They're actually doing groundwork on that right now.

Speaker 3

We pushed that forward because our Midwest region has shown very good sales growth this year, and they're pushed to the wall. We moved that up a few months, trying to beat the winter, which we're not going to do.

Speaker 4

That makes sense.

Speaker 2

You bet.

Speaker 0

Our next question comes from Ryan Merkel with William Blair. Please go ahead with your question.

Speaker 4

Thanks. I wanted to start with September sales. Can you just talk about how the month finished, and then maybe speak to end market and geographic strength?

Speaker 2

Month played out well. We saw it was going to be a solid month, even with a week or two weeks left in the month. The month played out well. Pleased with the trend pattern. End market, I don't think anything jumps out. With one exception, I continue to be pleased with what we're seeing in our manufacturing number. Just from the standpoint of, we're all sometimes guilty of reading the newspapers too much or reading stuff too much and letting that taint your view of the world or of life. The ISM, we didn't make a big deal of it back in May and June when it split, but we also noticed it. To see that we're able to grow our manufacturing despite, again, it's still north of 50. I think people got a little accustomed to that 60 number, which really wasn't sustainable.

Pleased with what we're seeing in the end market. Geographically, I guess nothing jumps out outside the norm.

Speaker 0

Okay. I wanted to clarify a question. Go ahead, Will.

Speaker 3

I said geographically, the oil patch remains strong, but that's been strong all year long. If there's one area of the country that we're doing better, it would be Texas, Oklahoma, Louisiana.

Speaker 0

Okay. Appreciate the color. I wanted to flip in a question on vending. The growth rate for the vending customers remains very impressive, and it's clearly a wallet share gain. Am I right that vending is not only a wallet share story, but also a tool to help you win new customers?

Speaker 3

Actually, that's been coming in very strong from the field is that we're getting calls and opportunities from customers because they want this solution. Large companies, and again, talking to our Regional Vice Presidents this week in meetings, the thing that I ask our Regionals every time when I talk to them is, "Hey, is this solution as good as I believe?" What I tell them is I don't want to be the crazy guy running around with the flag and everyone's laughing at me. They're saying the solution is better than I believe because of that reason, Ryan, because it's getting us indoors we would have otherwise not had a chance to go in. We're signing up new customers every day because of that, because we really do have a better solution from a cost standpoint.

There are some other good solutions out there, but the machines themselves and the systems are far more expensive. The fact that we built the machine behind the machine, all these install people, all these technical people, we inherently have a more value-oriented system to deliver products than most of our competitors at this time.

Speaker 2

The other thing I'll just add to that, I think some of the calls we're getting and some of the energy we're seeing from the customer inquiry side is coming from the fact that we have a lot of machines out on the road. We have our trucks that are out on the road that are demonstrating the equipment. There have been a number of articles written in recent months about our vending machine solutions, both in local newspapers as well as some national newspapers. One comment I'd make to the analysts listening to this call, on your next report, put a nice big bold headline about how much vending machine solutions save manufacturers in North America. If you need a copy of the flyer, we'd be happy to send you some.

Speaker 3

We can send you pictures.

Speaker 0

Thanks for the color, guys.

Speaker 4

You bet.

Speaker 0

Our next question comes from Sam Darkatesh with Raymond James. Please go ahead with your question.

Speaker 4

Good morning, Will. Good morning, Dan. How are you?

Speaker 3

Hey, Sam. Doing well.

Speaker 0

Hi, Sam.

Speaker 4

Two questions. First off, you mentioned ratcheting lower the store count expectations due to both the PMI and also the vending initiative. Are there other actions or plans that you're either undertaking or considering based on the prospects of a lower growth period? What are the next things you would do from an operational standpoint? My second question would be, you mentioned the payroll or the labor leverage expected on the OpEx line. Can you talk about occupancy and selling and transportation also? I'm guessing that occupancy would continue to grow faster because of the vending and the selling transportation would come off because of where diesel is. If you could throw a little color on that, Dan, that'd be very helpful.

Speaker 3

I think that's like six questions, Sam.

Speaker 4

Go ahead, Dan.

Speaker 3

I'll kind of go as far as the steps. In addition to the moderating of store openings, I think if you look at kind of where we were trending and where we came out, I can't take a number to the right off the cuff, but I know we have fewer employees at the store level today and fewer employees in the organization in general because of the moderating ISM. We're very decentralized, and we try to share a lot of information with our regional and district leaders about what we're seeing. With the moderating ISM, our folks pay attention. They're smart business people. They know not to get ahead of themselves. We're working diligently to add staffing where we need it because we don't want to hamper our growth.

On the flip side, you have to be careful not to get ahead of yourself on certain things when there's uncertainty when you look out the next 6 to 12 months. As far as some of the other expenses, if I look at occupancy, about one point, I think it's 1.3% of our, of our we grew at about 8.5%. 1.3 points of that came just from vending. The other one thing that did pop our occupancy up a little bit more than I would have expected is energy prices are meaningfully higher than they were a year ago. I don't know how it was nationwide, but we had some warm weather here in the third quarter, so we're probably doing a little more cooling than we normally had. Still, look at our occupancy in general, that we still have legs on that.

When I look out to 2012, we have, we typically will have 600 to 700 leases up for renewal in a given year. One thing that you still have is there's still empty spaces out there. There's also willingness on the part of the real estate community, if you will. I mean, if you look at the value of money and borrowing costs or incremental borrowing costs, the need for a 10% return on real estate that you might have seen five years ago, people are willing to take a lower return, A, to keep the building occupied, and B, because their costs have gone down in many cases, or the alternate use of that cash, probably a better way to say it, isn't as attractive as it might have been four or five years ago.

On the transportation and product movement, we've done a very nice job of that in the face of higher diesel prices. Now the diesel and gasoline prices are, you know, coming down over the last four to six weeks. Going forward, we think we'll be in a good position in product movement. We're actually launching some new initiatives, kind of stirring the pot, believing we can do better on transportation, turn it into a meaningful profit center over the next two years. You'll hear more about that because that's kind of my path. We have some good initiatives going there. A couple of other things to note as far as how do you pull expenses back. Maybe just not grow them as fast. If you look at 2012 or 2011, we built the machine behind the machine, the vending group, which is well over 150 people.

That group is in place, and we believe that they can do well over 1,000 machines, both sell and install at their current level. We have some built-in headroom per month, excuse me, yes. Government sales, we've put that in place this year. We're really not seeing the benefits yet. We have nice growth, but not big dollars. Our metalworking team, we spent a lot of money there putting these people in and training them. In our District Managers and Regional Vice Presidents, we won't be adding many because of the, you know, lower store counts. If you look at this group, these are higher-paid individuals. Also in that group, you would put our National Accounts group. We've overinvested in the last 12 months in all of these groups. The real benefits will come in 2012.

We'll continue to invest, but not at even close to the level that we did in 2011. We should really see the benefits of that and drive our incremental profits.

Speaker 2

Now, if you recall, earlier when we touched on the non-sales FTE growth, 90% of our growth since 2007 occurred in the last 12 months.

Speaker 4

Very helpful. Thank you, gentlemen.

Speaker 0

Our next question comes from Robert Barry of UBS. Please go ahead with your question.

Speaker 4

Hi, guys. Good morning.

Speaker 1

Morning, Robert.

Speaker 4

It looks like in each of the last few quarters, the conversion rate has ticked down. Dan, I think you mentioned something in your prepared remarks about how you could see the margins starting to tick back up. I was wondering if you could just expand on that and what the drivers will be.

Speaker 2

Probably the biggest short-term one is, we've talked a lot in the last several calls, some of the things we're doing to build our momentum with Fastenal exclusive brands. That takes a while to get that inertia going because it's a huge undertaking. Currently, between 6.5% and 7% of our sales are Fastenal exclusive brands. We have goals to, in the shorter term, in the upcoming quarters, and I'm not saying two or three or four, I'm saying upcoming quarters, to double that. That is very attractive from the opportunity, not only to go after business that maybe you wouldn't go after before because the margin wasn't attractive enough, or to enhance your margin. You can use it to grow a little faster, or you can use it to drive some operating, some gross margin. We believe there's ample opportunity for both.

The question is, what other things are there to drive it? Will touched on a second ago some of the freight initiatives. I think we call it FY 2012. I named everything. Our goal is over the upcoming quarters to, again, turn that into a more meaningful, it's a profit center today, but turn it into a more meaningful profit center and add gross margin because that's all at the gross margin line. Those are two shorter-term things that I think have the ability to move that needle north.

Speaker 4

How about pricing?

Speaker 3

Right now, there isn't a tremendous amount of pricing out there. Historically, we've been pretty steady there unless there's a large upswing where we can get some timing. The opportunity there will be somewhat limited, I believe, because the economy is slow and everybody's a little reluctant to push it. You know, normally where you see good pricing is when things are robust and we're all confident. Our salespeople, because we're decentralized, are going to be somewhat reluctant to go out and push a price increase if their cost doesn't go up to their bigger customers. You know what? We're okay with that because we want to keep that business.

Speaker 4

Yeah. Maybe just finally, on the vending, I'm curious, as you're going through and presenting the opportunity, what's the most common pushback you get on why customers don't want the vending machine?

Speaker 3

Change. The most common problem and mistake we make is calling on the wrong individual. If we call on the purchasing agent, our success rate is relatively low because it's a big change in their environment. It changes their day. If we call on a CFO, a Plant Manager, a CEO, our results are much better because it really, it's new and it changes the way they do their day. The very positive is the customers that have it, it's like 99% of these customers are saying fantastic and they're adding more machines. Change is a difficult thing. I continued to remind our Regionals yesterday that this is just pure hard work to get these things in there. Once we have them, it's very efficient business. To that point, we're developing new and better software for the machines we have that will greatly reduce the workload at our stores.

We implement this to fulfill the machines and get the product out there. It's going to be extremely efficient business to support. It's already efficient, but it's going to become much more efficient going forward.

Speaker 4

Thank you.

Speaker 0

Our next question comes from Hamza Mizari with Credit Suisse. Please go ahead with your question.

Speaker 4

Thank you. The first question is, can you quantify or maybe make some comments as to how much of the slowing in store growth is just economic due to the macro situation and uncertainty that you mentioned relative to growing the vending solutions?

Speaker 3

We really can't break that down. The reality of how it works is the way we get the stores open is by keeping the volume loud because you have to understand our District Managers and Regional Managers are never crazy about it because they open a business that doesn't add a lot of revenue initially and loses them money. That's the way we've set it up.

Speaker 4

Loses the money personally.

Speaker 3

Yeah, personally, boy. We keep the volume high and we open the stores. As vending started picking up, I started changing my message, not saying don't open stores, but really put the pressure on vending. A little back off there, and people came back, "Man, maybe we don't have to open this one." It's really about how much effort, how much energy an individual has at the regional level. There's no way for us to quantify 10 openings were because of economic and 20 were because of vending. It just doesn't break out that way in our business. It's all lumped in.

Speaker 4

Okay. That's fair enough. How big is the % of sales do you expect vending to get? If you could just comment on, just update us on your metalworking and national account initiatives. Thank you.

Speaker 3

On the vending, the percentage of revenue going through vending machines, we're not sure. If the customers that we sell to that have the systems, I would predict that within the next year, it'll probably, or say two years, it'll be north of 60%. 60% to 70% of our customers will have some kind of automated solution, and maybe only 20% of their business will go through that machine. We're really not too concerned about that, whether they vend it or whether we deliver it. We're concerned that they buy from us.

Speaker 4

That's true.

Speaker 3

It's revenue.

Speaker 4

That they buy from us.

Speaker 3

We're not going to pick it apart. What was the second half of your question? I apologize.

Speaker 4

Yeah, the second half was just if you could just update us on metalworking and the national accounts.

Speaker 3

On the metalworking, we don't disclose numbers. Our goal is to grow the business disproportionate to our other revenue next year. We'll start reporting that as it comes through. What we really spent 2011 doing, building the team, getting the inventory and the suppliers, getting the suppliers lined up, and then the inventory lined up in that order. Now we're out there hitting it. We're working hard to get our store people to start taking the training. Over in just the month of September, we had our store people take 2,000 one-hour classes online. I just got that report yesterday. That's nice forward motion. A bunch of people are out there learning about this product. On the national accounts, we continue to sign accounts at a very nice rate. A lot of that has to do with the vending.

That's what we hear from our national accounts people, that we're getting continued opportunities. We have very good momentum with national accounts. We will continue to invest in additional resources, i.e., people for the national accounts team in 2012 because the ones that we've given them have given us above-average returns.

Speaker 4

All right. Great. Thank you. Appreciate it.

Speaker 0

Our next question comes from Adam Ehleman with Cleveland Research. Please go ahead with your question.

Speaker 4

Hi, guys. Good morning.

Speaker 1

Good morning, Adam.

Speaker 4

I was wondering if you could look at the vending customers a little bit more closely. What % of the customers that you have today were existing customers, and what % would you think would be new?

Speaker 1

I honestly don't know that number off the cuff.

Speaker 3

I look at the report that shows last year's sales. If I were to have to, you know, it shows the two columns, this year's sales and last year's, the ones with zeros are probably only about 10%, no more than 15%. That isn't really a fair representation because many of them were buying from us, but in a very small way. They went from being a $2,000 a month customer to a $10,000 a month customer. We were a spot buy, you know, third choice for them, and we became maybe a first or second. The majority of the customers were buying from us a year ago, and we just ramped this up. With larger customers, that's not uncommon, where we'll sell to a customer for years but never get any real spend from them, meaningful spend.

Speaker 4

Okay. Related to that, have you run into any capacity constraints from your suppliers to do installation?

Speaker 3

No, we haven't. The manufacturer of the machines, we've worked well with them, and that's part of what Dan said about front-loading the CapEx. We have not wanted to get behind. We put these build centers in all of our distribution centers. We trained our technicians, and we overstaffed those groups because the guy who runs it for us, Russ, really a great Fastenal employee, said, "Russ, we need to be in a position from both phone support and installations to do at least 1,000 machines a month. Build the machines, size it that way, build your team and size it that way." They're kind of standing ready, saying, "We're ready to go." The only delay in installing the machines is we need to become better at figuring out what goes in each machine.

We continue to work on ways, but the customers want to be very involved, and many of them are slow. It always takes a little longer than we think. In cases where the customer is just ready to go, many times we'll get an order and they'll be in place in two weeks because our guys can get them in if we can get the data set up or the information about what we're going to sit in and put in the machines. You know.

Speaker 2

One thing I'll add to that is think about when we're coming into this year and this tail end of last year, you know, we're looking at how we believe this would ramp up. I might be over at certain times on what we spend for inventory or spend for fixed capital. My message to both our purchasing group as well as our vending group is don't get caught naked here. We added some inventory early on because we wanted to have vendable products ready on the shelf. We have a backlog of machines, so we are ready to handle it from the standpoint of that product. If we end up having a few months too much because we overstretched ourselves, that product's a great product with all the shelf life. The cost of running out is too high.

A little bit of our inventory, a little bit of our CapEx is there because we were willing to front load because we saw the potential and the opportunity here.

Speaker 4

Great. Thanks. That's helpful.

Speaker 2

With that, I'm going to cut off the call. We're at 45 minutes past the hour. Again, I want to thank everybody for joining in on the call this morning. Just a couple of takeaway items I've jotted down during the call. I probably sound a little like a stuck record here, but maybe in today's world, sometimes hearing the same thing from a company consecutive quarters is a sign of good things rather than being boring. First off, our Pathway to Profit, we're more convinced than ever that it just works. It's a logical progression for our business, and it's working well throughout the organization. Very good sales patterns.

One thing that I noted the other day when I was looking at some of the numbers, if I look at the last six months, so the second and third quarter of this year, on a two-year comparison, our growth is in excess of 45% every month. We had actually one month over 50%. I have to go back to 2006 to see that type of a two-year comparison. 2006 was a pre-Pathway to Profit. We were opening stores at about a 14% clip. What it demonstrates to me is with focus, with energy, and a bunch of growth drivers, we can continue to take market share in a very aggressive fashion in this marketplace. It isn't strictly store-centered. It's all facets of the business. The sales initiatives, we have great traction with them. Very good opportunity with our Fastenal exclusive brands.

Finally, as I mentioned last quarter, the employees of Fastenal continue to perform at a very high level. Thank you to them whoever's on the call. Have a good day, everybody.

Speaker 4

Thank you, ladies and gentlemen. Thank you for your participation in today's conference.