Fastenal's Q2 results could predict trouble for manufacturing sector

Sure there are a lot of construction cranes swinging and news of more open jobs than unemployed people. But before concluding the economy must be booming, perhaps we should consider the latest financial results from Fastenal Co.

The company remains a top performer, but that was not the headline off Fastenal's second-quarter earnings report. "Here come the earnings disappointments," said Bloomberg, in its analysis article following the release of its financial results.

Sales increased just under 8% for the quarter, 7% in June. "After eight quarters where quarterly growth averaged 12.9%, our current rate is clearly disappointing," Chief Financial Officer Holden Lewis told investors and analysts on last week's quarterly conference call.

So as of last week, there seems to be more than enough reason to say manufacturing really has slowed down.

Fastenal reported sales of $1.37 billion in the quarter, but the company's size is not why investors follow it so closely. How it's doing turns out to be a great indicator for how a broad slice of the industrial economy is doing.

Fastenal is still known for selling nuts, bolts and screws. But it has grown beyond its roots to also include lots of other industrial products, such as safety products — yet still sticks to things that get consumed, not capital equipment that might be around for a while.

The Winona-based company has evolved how it sells, too, and now has lots of industrial vending machines inside its customers' facilities. In fact, it just passed a major milestone, placing its 100,000th vending machine at a firetruck factory in Wisconsin operated by Oshkosh Corp., one of the first users of Fastenal's clever machines.

You can see the appeal of these vending machines for customers, as items can be bought only when they are really needed. No need to order, no need to stock up. So when Fastenal sales lose momentum, that means that customers might have cut the production rate or idled a manufacturing line.

Fastenal CEO Dan Florness has an informal style on the quarterly conference calls for investors, and last week he once again started by telling a story. This one was about a six-step process he learned from the previous generations of senior leaders at Fastenal about what to do in times like these.

It's mostly what you would expect, from reminding staff to keep working on what everyone has agreed are the priorities to finding and trimming expenses for things that don't seem important. "Six really simple steps, but they're really effective, in a time when all of a sudden your business has slowed down and you're not sure how long," Florness said.

What the analysts later wanted to ask mostly about, though, was a decline in the gross profit margin. That is the basic measure in business — how much is left over from a sale after subtracting what the item cost you.

When there are price increases from suppliers, a distributor like Fastenal generally tries to pass that on to the customer and maintain the gross profit rate. In this case the cost and margin story gets complicated by the tariffs put in place in the last couple of years.

Florness said the plan all along was to share some of the pain of higher costs from tariffs rather than try to get them all back through price increases. "We're not a business that just sells products and the customer goes away and we don't really care what they do with it," he said. "We are a supply-chain partner, and that's what we represent to our customer."

It's clear the company ended up bearing even more of the tariff burden — and other additional product costs — than planned, not raising prices enough or on enough products.

As Florness explained in the Q&A session, more than half of the steel made in the world is made in China, and fasteners are made out of steel. It won't really matter which brand of fastener American customers buy, or from which distributor, as the odds favor that these fasteners were made in China.

"The reality is even in a 10% or a 25% tariff environment, they oftentimes are still the lowest-cost producer of an item," Florness added.

It's hard to peel apart the explanation for the sales slowdown and isolate the impact of tariffs. Just how much are the cost increases due to tariffs showing up in higher prices charged to customers of American-made products, and thus slowing demand throughout the manufacturing economy?

Fastenal had a better than 20% operating margin in the quarter — and an equally impressive return on capital — so please set aside any worries that this mini-Blue Chipper might somehow be struggling. It's anything but.

The analysts who follow Fastenal may have trimmed their estimates of future earnings a bit but generally suggested that it's too soon to panic, as the headline on one research note put it. Even in the tone of questions asked of Florness and Lewis on the conference call, it's easy to see how deeply respected this company is by investors.

But the fact is even at Fastenal, they have no better than an educated guess how their customers will fare the rest of the year and into 2020.

So if you understand what has been happening at Fastenal, you can better understand why the same week this company released earnings, Federal Reserve Board Chairman Jerome Powell appeared before a congressional committee and managed to use the words "uncertainty" or "uncertainties" more than two dozen times.

Powell doesn't have the same gift for muddying the waters at congressional hearings that some of his predecessors had, but uncertainty is still an aggravating word to hear all the time from people paid to know what's really going on.

To be fair to Powell, he maybe wanted to go share with Congress deep insight into the current industrial slowdown, but the outlook this month seemed a little too uncertain.

lee.schafer@startribune.com 612-673-4302