快扣 (FAST) 2009 Q4 法說會逐字稿

Good day, and welcome to the Fastenal Company fourth quarter and fiscal year 2009 earnings results conference call.

Today's conference is being recorded.

At this time I would like to turn the conference over to Darin Pellegrino.

Please go ahead, sir.

Good morning, and welcome to Fastenal Company's 2009 fourth quarter and year-end 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 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 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 at www.investor.fastenal.com.

A replay of this webcast will be available on the website until March 1, 2010 at Midnight Central time.

As a reminder today's conference call includes statements 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 be also -- 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 matter containing such statements will occur.

Forward-looking statements are made 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, Will.

Thanks, Darin, and thank everyone for joining us today for our fourth quarter 2009 conference call.

Start right out with the sales.

Sales for the quarter were pretty much on plan.

We had a very good November.

It was a little weaker in December, but you average it out, and look at the numbers from where we thought we would be starting the quarter, we really came right on plan.

And we stayed on our sequential trend pattern that we really started back in July.

We're pretty optimistic about numbers.

Looking at our January numbers month-to-date, it appears that when we report numbers -- at this point, it appears when we report numbers in January, we will report a positive number.

Not a lot of growth, but right now it appears that we will have growth.

And any amount would be a real positive for our team here at Fastenal.

Jumping to the margins, we are a little disappointed with the margin where it came in at 49.9%.

Not really surprised because we did make a decision on the rebates to pull back.

We understand where we are with that, and that will be coming back in the first quarter -- or starting to come back in the first quarter and throughout 2010.

There's really three pieces to margin.

The first one, as I mentioned, the rebates, understood what happened there.

We just made a conscious decision to reduce our purchasing, and just basically work towards 2010, and growth in 2010.

We're comfortable that will come back.

Second one that hit was in 2010 was the deflation in the steel products, primarily the fastener products.

We have seen the steel prices pretty much flattened out in the summer.

They've actually started rising through the last four months of the year.

We anticipate continual -- a little bit of inflation in steel.

Is really hard to tell.

It has a lot to do with what happened with the economy and the world or mainly China right now.

But right now, we're anticipating some inflation in steel and some inflation in our pricing as the year goes on.

But that won't kick in until probably the second or third quarter as the product sells through, but that's a positive for our margin.

And the third part of our margin is a POS, what the customers -- or what the stores use to charge and price their customers.

That bottomed out in August.

We have seen positive trends in the POS margin every month since August.

We're very optimistic.

When you look at the margin, rebates, positive deflation, positive in POS positive, we're still very optimistic we'll see improvement in each of the next three quarters.

From an expense standpoint, I think we did a really nice job.

Our expenses were down 13.2%, and in that, we had a -- somewhat of a kick in the health insurance.

Our health insurance jumped.

And the problem with health insurance expense, it's one of the expenses you can't manage short-term.

You set a program up for your employees, and we set up a good program for our employees, then you basically just wait for the claims to come in -- or the experience rating in the claims.

In the last half of the year, we saw our claims go up, but we have also been reading that there are other companies seeing the same thing.

We're not sure if it's people rushing to get things done before changes in health insurance.

We're analyzing it as we speak and hopefully we'll have better information, but we don't foresee this problem going forward into the new year.

We're very confident that we can lower that a little bit as we go into the new year.

But otherwise, our expenses, I think our team did a very good job managing at the point they are.

Earnings, a little disappointing.

We came off one point -- or $0.01, but that's completely explained by the health insurance.

That's almost dollar for dollar there.

Couple of other areas I want to touch on.

Accounts receivable down 12.6%, right where sales were.

That's one area, and I said that in the last conference call, that I was worried going into the year with bankruptcies up and everything going on in the economy.

But we did a nice job actually hanging on to our number, holding the days out flat to down a little bit in a difficult time.

And then the other one is inventory.

Our inventory is down 10% from the beginning of the year.

If you take out the acquisition that we made in December, we would actually be down almost exactly where sales were.

We did bring some inventory in with that acquisition so they did a nice job on inventory.

Overall that's good.

When I step back, and I look at where we are as a company starting out the new year, starting out a new decade, how do I feel about our positioning?

I feel very good about sales.

We're going to start out with a positive trend and the comps get a little easier as we go on.

So I'm very comfortable that we're going to have good sales trends, not only year-over-year, but also sequentially.

Our margin is lower than we want it to be, but we understand the pieces, and there's a lot of positive in that.

Our headcount is right in line.

If you look at where our FTE came in, we're basically from a relative -- related to sales, we're almost where we started the year out so we're positioned very well.

The expense structure, the accounts receivable and the inventory are all in great shape.

When we look at the business, I say, what do we need to work on?

We need to work on margin.

We need to continue to work hard on growth.

We need to make sure the other things that I just mentioned stay in line.

I think we're in a very good position to move forward as a company and get back on to our strategic plan of pathway to profit.

That's why I'm looking at the year.

That's why I'm communicating to our people internally.

And that's -- should be in a good position.

With that, I'm going to turn it over to Dan.

Dan has more information.

I kept mine brief today.

Thank you.

Thanks, Will, and thanks also to the shareholders on the call.

I'm going to touch on a few items highlighted in our earnings release, then we'll turn it over to Q&A after that.

One item I wanted to touch on is centered on page one -- discussion about our end-market info.

As we talked about our last call, in the May timeframe, our manufacturing business appears to have bottomed out.

And it has been improving sequentially every month since May, except for July and December, which we would expect a little bit of a drop-off because of the holiday impact.

But generally speaking, the business has been improving mode since bottoming out in the May 2009 timeframe.

Manufacturing, as you recall, represents almost 50% of our sales.

On the construction piece which is just shy of 25% of our sales -- that business has continued to weaken as we go through the year.

Fortunately the manufacturing has been able to overshadow it through the second half of 2009.

If I look at the remaining components of our end market, and I called them out individually on our press release this quarter.

Generally speaking, those trends are all positive as we look through the second half of 2009.

And I believe will remain positive as we go into 2010.

A new piece that I added to the release this quarter, and hopefully for those of you who have had a chance to read it, it creates more answers -- and a better understanding of our business, rather than a bunch of questions.

But I'll try to elaborate on what I'm really trying -- why I'm highlighting these point.

It really starts on the bottom of page one and continues on to page two.

And what I laid out on page two is something that I have been looking at the entire year as I tried to understand really what happened -- what was happening as we were going along through the year.

Because historically, when we talk internally at Fastenal, we always talk about where we are in September, October timeframe because the daily average in October really sets up in our mind for how the new year is going to start.

Because historically, our daily average has been at or slightly positive to -- in January to the previous October.

Internally, we are setting our goals once we have the October numbers, because we really think we have the benchmark identified.

As you can see in the table I laid out, in that -- in 1998 to 2003 -- and I chose this timeframe as a benchmark because I believe it's a timeframe -- an extended period with an industrial recessionary environment and provides a good basis for comparison.

And in that timeframe, we would see January was again slightly positive than the previous October.

And then we would start climbing the stairway in the new year.

What you saw in 2009 is our January wasn't in line with the previous October.

It dropped about 18.5% and what you saw was our sales went from positive to contraction in that timeframe as well.

In the February, March and April timeframe the erosion continued at a pretty steep clip and we were missing that sequential pattern that we've enjoyed historically.

And then about the April timeframe, things really started to change in our business in that while the sequential growth wasn't as strong as we would like, it was starting to get closer to that historical pattern.

And really since July, we've been in a position where we've been consistently beating the historical trend and are slowly climbing out of the hole that the economy put us in if you will during the first part of this year.

I think it's an important trend to understand because it really serves to guide us as we look into the new year.

And being a mid-westerner and an accountant makes me truly a conservative person, and for me to come out and say something positive into the future is a pretty rare event.

But when I look at the trends, as of last October, the trends would tell me we should be about -- and again, I'm looking into 2010, based on where we are in October.

And I'm doing it based on these trend lines that I have laid out in our press release.

If I were to just plunk it down on a spreadsheet and say, okay, if we're nine-tenths of a percent ahead of October -- in January 2010, I would expect us to see positive growth.

And it would quantify to about four-tenths -- about 0.5% of positive growth.

As Will mentioned earlier, we believe in the month of January we'll see positive growth.

Again, we tend to be on that pattern which we really started on last July where our sequential numbers not only make sense, but are making us more positive in our outlook to our future for our business.

If I were to extend this out and look into 2010 -- and again, I'm merely taking the trend line based on our history, extending into the future.

I don't know -- our visibility into the future is extremely limited due to the nature of our business.

But I can look at history as a guide post.

It would tell me, when we get in to the March, April timeframe, we are looking at double-digit sales growth.

If I were to truly anniversary the numbers -- because of the easing comps as we get in deeper to the year -- when I look at out to July, if we were able to follow this past trend line, our sales growth in July, would just tip over -- would just eclipse 20% -- 20.3% is what it calculates out to.

I don't honestly know if this will happen when I look at 2010, but it does make me optimistic and bullish when I look at the year as far as our ability to continue to grow out of the pattern -- to grow out of the place we have been in when I look at 2009.

I believe for the year, this would provide us the ability to see growth that gets into the teens.

Only time will tell if these trends prove to be a good guide post to our future or if they just prove to be just wrong.

But I believe it gives us a positive bias as we enter the new year.

Will touched on earlier our active account growth.

And there is something that I think is important also to understand when you look at our active accounts.

Our active account growth was weaker in 2009 than we would like to see.

Historically, we like to see our active account growth in the low double digits, so in that 11%, 12%, maybe 13% neighborhood.

And this year, we have been in the single digits.

But when I look at the data from history and I look at what we would expect for frequency of our account base, one thing I do see that's very distinct in our 2009 numbers is our frequency of existing customers.

In other words, how many customers -- what percentage of our customers buy in any given month because we have some customers that buy daily or weekly.

We have some customers that buy monthly.

We have some customers that might buy sporadically, maybe they buy every second or every third month.

We measure a lot of those statistics internally and provide that information to our store personnel.

But when I look at the frequency factor of our customers, I see that in 2009 our frequency is off about 7%.

That tends to -- that dampens our active account number by about 7% and really serves to diminish what I believe is our true active account growth when I look at 2009.

Again, what that does, it provides one more component to what gives me confidence when I look at our 2010 top line numbers.

Will touched earlier on gross margin, and I would echo his comment.

It was tough for us to have to report 49.9% gross margin, because it was a barrier we really did not want to cross.

That's the negative news.

The positive news is this; when you look at the decline, it was really -- when we looked at where we thought our vendor allowance and rebate programs would come in earlier in the year, they did come in weaker than we expected and it tracked a little bit from the fourth quarter.

When I look at gross margin, I really think of it in three distinct components.

One is structural.

What is going on in the environment -- internal and external, but primarily external that influences our number.

The second one would be freight side.

And the third would be just our transactional activity, in other words what is happening at the point of sale level.

What is happening from our ability -- from an importing level, or a direct purchase level.

On the structural side, I see two things that are -- generally speaking have a positive bias going in to 2010 versus 2009.

One would be the vendor allowance which tend to be linked to the calendar year so the program is reset.

And starting in January, I would expect that the rebate we're earning would improve relative to where it was in 2009.

That won't necessarily flow in to the P&L in the first quarter because that better purchasing activity will be sitting in ending inventory at the end of the first quarter.

But I would expect us to start seeing that improvement in the second quarter and that's one of the components to improvement in gross margin when I look at 2010.

The second is what -- the point Will touched on in the last several months of the -- about the last four months, we have seen some inflationary trends.

And having a slight inflation trend versus a marked deflation trend has a significant impact on our gross margin because of the nature of how fast our inventory turns.

The second category I talked about on freight.

When I look at where we are at the start of 2010 versus 2009 and 2008 -- I'll go back two years.

I believe the momentum we had in both of those previous two years, we have still today and we continue to identify opportunities to improve our freight margin.

I see that as a positive bias going to the new year.

The final piece -- the transactional, as Will mentioned, the margin we measure at our point of sale level -- that margin bottomed out in August '09 and we've been above that number since.

And we believe our day-to-day activities -- our transactional activities, we've improved the pattern since that low point in August.

The second component of our transactions is really our direct sourcing margins that we measure and that really is -- the fact that we're able to source in volume.

And that had a negative bias to it in 2009 because of deflation.

Again, I believe will have a positive bias to it in 2010 if the inflation patterns that we have seen in the last several months -- last four months continue.

Finally on the next couple of points, on cash flow, as you saw -- see in our cash flow statement, our cash flow for the year was quite strong.

The big drivers of the cash flow were the changes in working capital and accounts receivable and inventory that Will alluded to earlier.

As a percentage of earnings, for every dollar of earnings, we through off $1.66 of operating cash.

Last year that number was $0.93 on the dollar.

Our long-term number that we really laid out when we started to pass that profit, we felt we could be in a position to be at or slightly exceed $0.85 on the dollar.

We feel very good about our performance on that in the last several years since the (inaudible) profit started.

When I look at free cash flow, again, a very strong number.

Our capital expenditures came in quite a bit less than they were a year ago, as we expected.

And as I mentioned in the conference call, I would expect the capital expenditures to drop again in 2010 because we are complete with our projects in Denton, Texas and Indianapolis, Indiana, and now are in a position to reap the benefit of that hard work over the last several years.

What this did is it provided funding for two items that we did in the current year.

As in prior years, we were able to increase our regular dividend.

And our buyback -- we did buyback some stock late in the year.

We bought back about $41 million worth at $37 a share so feel good about that at this point in time.

And we're continue to look at buybacks in the future and we'll see how that plays out.

Finally, just to touch on a few things on the working capital identified on page nine of the release.

As Will mentioned, accounts receivable we were down 12.5% in line with our sales, actually slightly better than our sales pattern.

And really what we did was identify a structural improvement.

And that structural improvement is -- we have a lot of customers and a lot of customers that buy relatively small amounts.

And what happens a lot of times with billing processes is a lot of stuff gets caught in the chatter.

And invoices -- we have -- most -- generally speaking, our customers are really fair with us on paying their bills.

What happens is the stuff that usually falls through the cracks, it's stuff that's inadvertent.

And we made some structural changes to our billing in 2010.

The team did a great job of automating a lot of processes, e-mailing more invoices, faxing more invoices.

We just improved the structural collection patterns in our business, despite the fact that we had some negatives from the standpoint of some customer bankruptcies during the year that continue to hang over a little bit from the standpoint of increasing our days out, but the other stuff more than offset it.

On the inventory, as Will mentioned, very pleased with what we were able to accomplish in the year.

And it's really an effort of everybody being on the same page and working to be smart about what we're buying, be smart about when we've buying and constantly rebalancing our inventory, and really thinking about the components and challenging everybody.

So very pleased with the team and what they were able to accomplish in 2009.

One last item I'll touch on and then turn it over to the Q&A, and that is we disclosed -- we did a small acquisition late in the year.

We acquired a business called Holo-Krome.

We're very excited about this acquisition.

We think it fits in really well with our business, and quite frankly with our customers' needs.

We look forward to that business being a contributor to us in the future and we welcome the 92 employees in West Hartford, Connecticut to the Fastenal family.

With that, I will turn it back over to the moderator for the Q&A.

Thank you.

(Operator Instructions).

And we'll go first to David Manthey at Robert W.

Baird.

Hi, guys.

Good morning.

Good morning, Dave.

Could you give us -- you thought that pathway to profit -- do you have a new target for when you believe you can achieve the 23% EBIT margin.

And then as you're talking about growing stores 7% to 10%, is that -- should we expect that number for the full year?

Or are you expecting to hit that pace in the second half of this year?

The -- I'll hit the second question first.

We expect to hit that pace in the second half of the year, assuming we stay on our trends and Dan talked about.

We're going to start the year conservatively, building back towards the pathway plan, with our plan -- the goal of being on pace sometime in the second half of the year.

As far as the pathway to profit, it's going to get pushed -- right now, I say it gets pushed back between 18 and 24 months.

And what we base that on is the growth that we had in 2008 we gave back in 2009 so we're really starting over again.

Right now, we're looking at 2015.

Go ahead.

Dan has a comment.

One item I would add on to that -- one of the things that's influencing our thought process here, Dave, is when you look at the pathway to profit, it really is about over time increasing the average store size and letting the inherent profitability of Fastenal business model shine through.

Earlier in the call, I went through what I believe the trends could mean for our business in 2010.

And trust me it was awkward for me to go out on that ledge because I don't normally talk about that that openly.

But even when I look out to the summer, and I look at what I believe will be a good year for Fastenal and our ability to move back into the pathway to profit mode, our sales in the summer will still be down 7% or 8%, and that's -- if those trend lines play out from where they were in 2008.

And for us to get back on the pathway to profit, we need to get the top line moving.

Our projection for fourth quarter would put us right at fourth quarter of 2008.

Those are the two years we gave up.

One thing -- and I did mention earlier, when you look at the pathway to profit, we have learned a lot of things in this slowdown about our expense structure, about what we really need and what we don't need that will improve -- I believe, improve our chances of hitting our goals to pathway to profit because we're just smarter about controlling expenses.

All right.

Thanks a lot, guys.

And we'll go next to Adam Uhlman at Cleveland Research.

Hi, guys.

Good morning.

Good morning, Adam.

You highlighted your high-level view of how sales could shake out in 2010, some teens level in terms of growth.

How should we think about operating expenses coming back on that level of sales growth, given the business is more variable in terms of costs instead of fixed previously?

If you look at it, the real component that's going to increase and I believe one increase similar to our sales growth would be the payroll component.

The real thing that drives that is -- if I look at 2009 versus 2008, what changed.

Our commissions that went to our sales personnel fell off quite dramatically, because our sales fell off quite dramatically.

And that was -- that drop-off was leveraged from the fact that our gross margin fell off so it was kind of a double whammy.

The second piece, most of our employees in the Company are paid on some type of bonus compensation.

And it's really linked to our ability over time to continually grow our earnings and grow our return.

And so our incentive compensation was off dramatically from where it was a year ago.

The third piece, and quite frankly a smaller piece of the three I'm talking about in 2008 -- and really, 2006, 2007, 2008, nice increases to the amount of dollars that we contributed to our employees's retirement plan, 401K and it's a set formula that we do and it's based on a level of profitability.

We did not achieve that profitability in 2009 -- that target profitability.

Therefore, the payout on that was essentially eliminated.

When you look at 2010, that component of our cost structure will act in a very variable fashion.

The other components of our cost structure won't.

The fact that our sales growth -- whether it strengthens our weakens, doesn't influence things like occupancy.

What influences things like occupancy is how many stores we open, what types of stores we open, what do we agree to for rent.

And how do we manage that in the future for other expenses.

I think, Adam, the way I'm looking at it is that the sales growth -- or the expenses will probably grow as sales.

The real earnings leverage will come from the margin improvement.

That's where the real opportunity for 2010 earnings growth comes from, improving the margin as we grow the sales.

Got it.

Thanks.

Very helpful.

We'll go next to Holden Lewis at BB&T.

Good morning.

Thank you.

Good morning, Holden.

Can you talk a little bit about a couple of elements of the gross margin?

First, you talked about rebates and things like that, and there's various costs that spread through there in the course of the year and they require some true-ups.

Were there any significant true-ups in Q4 that might have been a one-time drag on the gross margin?

And then can you also comment -- you went through the details pretty specifically about what was in there.

What about the change in the compensation instruction?

Do you feel that is having an adverse effect on gross margin trends?

I'll take the second question.

I really don't think the change in compensation has made -- has much affect on -- I mean, could there be some, yes.

But we have broken it down and looked at where the lost margin dollars, what customers we lost them from, and it just doesn't play in that the compensation change has made much of a difference because it isn't across the board.

Some stores are doing better than others.

And so what we're really looking at is that there is just a lot of market pressure out there on the POS side and some of our stores gave back more than others.

On the first half of your question, Holden, about components that -- and true-ups and anything during that quarter that really influenced bringing that number down, there weren't any.

Okay.

Okay.

Great.

And just on the follow-up, in the past your gross margin has always been 50% to 52%, at least recent past with the exception being a year where you were getting pretty significant pricing.

Can you comment about what you are thinking about the future range?

Are you thinking that 50% to 52% remains what you expect to see over the course of a cycle because that is what you have done?

Or is your visibility on pricing so significant at this point that you expect to do better than that?

Or operationally better?

Just a little bit of perspective on where you've been and where you see that going.

I think we can do operationally better going forward.

I would say it's more of a range of 51% to 53% and we should stay to the high end of that range.

And a lot of that has to do with our sourcing.

We just continue to find better sourcing for a lot of product and we should be able to retain most of that within the Company and not have to pass it along to the customers.

Because the customer mix hasn't changed a lot.

The market has not changed dramatically so if we're able to buy better, we should be able to retain that and stay, really, within the 52% plus.

But in certain times it could drop below that.

2009 was so unusual with the rebates and incentives, because we just never planned -- and I ran that for a long time, that was my job running operations.

I never planned for a down year and we didn't build it in to our programs.

We gambled for the high side.

It worked out well, and last year it hit us hard.

It works out 40 years and then doesn't work one, you look at it and say, I think my odds are better with the 40.

And I have told our people that.

Maybe we should plan for this.

I go, let's not plan for it right now.

Let's plan for grow going forward, and I'll take it when I can get it.

It's better overall.

All right.

Thank you.

Next we'll go to Brent Rakers at Morgan Keegan.

Good morning.

Just following up on some of the other questions about the SG&A outlook for 2010.

There's some comments in the release about payroll being 60% to 65% of SG&A in 2009.

Wondered if maybe at that mid-teens, top-line growth rate next year, what target do you think we would see for 2010?

I think you would get a little bit of leverage on it, but it would be in the -- just shy of mid-teens.

Okay.

Mid-teens increase, Dan, just to clarify?

Yes, it will increase.

I guarantee that.

Yes.

Sorry.

And just -- again, if I'm looking at 60% to 65% of overall operating costs in 2009.

And I think it was 65% in 2008, does it -- can it creep back to that 65% number it was in 2008?

Yes.

And just -- one -- somewhat related question, just again, revisiting the pathway to profit, you have given a good outline of what you are expecting in terms of range opening strategy for the year.

But I want to say back in 2007, 2008, you opened about -- you added about 1,000 additional sales people as part of pathway for profit in those years.

Any sense for what the plans might be for sales force additions in 2010, over and above the branch openings?

What we plan to do -- our plan as far as headcount additions at the store level is they will probably be close to what our sales growth is, lagging a little bit.

What you have to understand is we have about a thousand stores now -- unfortunately that many that are $50,000 and below.

Those stores we don't have to add much to because they are properly staffed to create growth, at least 10% to 20% higher than they are.

It's the larger stores -- when they start growing, we're going to have to start adding staff to not only grow the business, but also support the business coming in.

Most of the headcount reduction that we saw in 2009 at the store level came out of part-time heads --

FTE in general.

Right.

FTE in general came out of part-time hours and part-time heads so we're really pretty well staffed with the sales and full-time people.

It will be adding part-time hours and part-time people to support the revenue.

And just to clarify on that.

The premise -- it goes along with the same thinking as with the branch openings, you are still waiting on an inflection point in the economy to push forth a lot more aggressively with the sales of that as well.

Is that correct?

I'll chime in on that one.

It's -- there's pieces to it.

We believe we have seen the inflection point and only the future will tell us if we're right or if we're full of it.

But if you look at where the staffing is and the inflection point, part of it is we stabilized -- on the October call we really talked about we are stabilizing our store headcount.

And we were preparing for where we were going to be in 2010.

Because every time I open a store, I'm pulling a very valuable resource out of an existing store and you need to balance those two.

It's really stabilizing and growing the headcount in connection with the store openings, but not letting one get too far ahead of the other.

Great.

Thanks a lot.

(Operator Instructions).

We'll go next to Hans [Amandari] at Credit Suisse.

Thank you.

Just a question.

Is it fair to say that your inventory levels are now where they need to be, given the demand environment you are seeing out there?

How should we think about that?

And could you quantify if possible, the negative gross margin impact you saw this quarter from further deterioration in your vendor rebate which you talk about reversing as you get into the third quarter?

Yes.

The deterioration we saw was about 15 basis points during the quarter.

And if you look at it in total, we're down 70, 75 basis points from where we -- where I would have expected us to be in a normal environment.

As far as the inventory level, our goal internally for -- we will add inventory in 2010 because we're opening stores and because we're beefing up some of our spending patterns.

And really those beefing ups started in November and December.

In fact I wouldn't be surprised to see some inventory growth in the first quarter.

However, when I look at the inventory we need to add in 2010, I'm a firm believer that we have identified in excess of that amount of still surplus inventory that we can continue to rebalance out of our inventory as I look at 2010.

I feel for the year, there's a reasonable chance we can operate the year with very modest growth.

And my goal is to hold it flat.

To me the only wild card in it is depending on how the inflation plays out and what that influences the steel component.

But if there's a little bit of inflation that influences the steel component, we'll take that issue as long as it's manageable for us and our customers.

Perfect.

Thank you.

Next we'll go to Holden Lewis at BB&T.

Great.

Thanks again.

Can you also perhaps touch on some of the pricing versus cost?

We all know what is happening to steel.

I would think that that's probably going to be flowing through in the year of cost of purchasing here very soon.

But when you think about the price versus cost relationship, you just talked about maybe the upcoming few quarters.

Where did the price cost relationship become positive?

Negative?

How should we look at both sides of the ledger there?

I would say right now the price cost relationship is about neutral -- flattened out, middle of the year inventory flows through.

Prices have gone up and we should start seeing the inflation coming through in the March through May timeframe, depending on when the import product hits.

We always lag it because our customers -- most of our steel and Fastenal customers are saavy.

They understand the market so we like the steel indexes.

If steel continues to increase, we should see inflation in our fastener and steel products late fist quarter and through the second quarter.

The other products -- the non-fastener products, we have not been seeing nearly as many vendors showing up, or suppliers with price increases this year.

And I think most of these people are just basically happy to have what they -- hang on to what they have.

And they are probably -- normally they are not timid, but it appears they are a little bit timid with price increases for the first in a long time.

That's the cost to you.

What about when you start to institute price increases to try to offset that?

On the steel, last time this happened we were very successful.

With most of our large customers, we have an index put into our contracts.

As steel goes up, we pass it on.

If steel goes down, we pass it on also in a decrease.

We have been quite successful.

I'm confident that we can pass that along in -- show an increase in sales because of it.

But knowing what is coming down the pike on the raw materials side, are you planning on perhaps putting through price increases as early as the March timeframe, in which case you would probably get a little bit that ahead of the actual inflation?

I'm just trying to get a sense of how timing is going to play out on the price cost.

What really plays out is we have to see what the master distributors in the market do.

We don't determine that for the most part.

We can work to stay ahead of it, but it really depends on what is going on in the market.

History shows that we're able to get some timing out of inflation and that we lose timing on deflation in the downside.

(multiple speakers) I would anticipate it happens the same way this time.

We're very -- we're watching it very closely.

The difference today, Holden, is that -- it's not an abrupt change like -- last time steel spiked up in August or September of 2007, it just shot up.

Right now, it's moving up but it's a little bumpier on the way up.

All right.

Thanks.

And we'll go next to John Baliotti of FTN Equity Capital Markets.

Good morning.

Hi, John.

Just following on Holden's question earlier about gross margins.

The -- Will, you had mentioned that with some inflation, that should help.

And I'm just -- I'm trying to go back historically to see the patterns that played out.

I think the last time that gross margins were in this range, they stayed in the 50%, 51% range for -- up until 2008.

The sourcing sounds like a good opportunity, but are you also hampered by the fact that back then 60%, 65% of your sales were fasteners?

That's down to 50-ish.

How does that mix play out as you try to get back up into the 52% range?

I'll touch on a piece of that, and then turn it over to Will if he wants to add it to.

When you look at our fasteners as a percentage of sales, you have to go quite a few years back to get in to the 60s.

That number has been in the low 50s.

Below 55%.

(multiple speakers) For quite a few years.

In fact, it picked up a little bit in the mid-part of this decade from a couple of things.

One, I think our -- what we referred to at the time as our CSP initiative, where we put more products in our stores.

I believe that helped our fastener business, because we went from being I think, a really, really good fastener distributor to a great fastener distributor from the standpoint that we had a great availability of product -- a wide range of products at the local site.

And we got better at it as the percentage of sales picked up a little bit.

And there was a also a little bit of inflation that helped because we measure it at a dollar level.

And so those two things influenced it, but you have to go back, as I mentioned, quite a few years in to the history to see a fastener percentage in the 60s -- touch on.

On the -- other hurdles that we have, you look at -- we are doing a lot more importing of non fasteners so I think that's a big thing that a lot of people don't understand.

They think we're only importing fasteners.

We have developed lots of other products.

And one thing that everybody has to understand that's a huge motivator for our troops is we had a tough year in 2009 from a bonus standpoint -- district managers, store managers, regional vice presidents.

And we have made it very clear to everyone -- because I've met with all of our districts, all of our regionals and a lot of managers.

If you want to get your payback in 2010, it's going to require that we improve our margin.

And living in the environment we live in, it -- motivation like that really does work.

We have been doing it for a long time.

When you have about 3000 out there saying hey, I need to do this.

It's not about just going out and raising prices on everybody.

It's about making a lot of transactional decisions a little bit smarter.

I can make an extra dollar here.

I can pay -- renegotiate a deal with a supplier here and it all works together where you have a large team of people trying to make an extra dollar or two or three on every transaction.

With a number of transactions it adds up very quickly.

I think probably the biggest thing is a motivated team of trained people that had a pretty tough year in 2009 who just soon have a good year in 2010 from a market standpoint.

The -- Dan sounds pretty optimistic about -- obviously he did mention comps that will help -- but getting back to a nice positive growth rate.

Given the balance sheet that you talked about, given your size, waiting for the second half of the year to add stores of seven to ten, it seems like it puts pressure on the number of stores per month.

It throws them in the 20 to 30 per month range and I was just thinking if non res construction starts to get better, wouldn't it be to your advantage to maybe add more now when those cost would be lower rentals?

And real estate costs would be lower now and you could take advantage of that, and put less pressure on having to add so many stores in the back half of the year to get that rate?

We said a run rate of seven to ten in the back half.

We're not saying we're going to open 7% to 10% more stores in 2010.

Right.

We wouldn't have to double down in the second half.

That's not our plan.

Right.

In the second half, that's like 165 stores, divided by six months is like -- you are over 20 stores a month.

Yes, we can do that.

We have done that for years.

We're really looking at the business and saying, where do we think is the best place to put our investment.

But also understand that we have a lot of stores out there that were 20% and 30% larger a year ago.

Those stores have the built in customers, the capacity to grow very rapidly.

We're going to invest aggressively to grow.

We really believe at this point we want to get our average source size up a little bit before we go aggressive after new stores.

What about (multiple speakers).

You mentioned that in the fourth quarter your non res construction business was down below the average for the year.

Do you expect that to recover in the second half and does that affect what you expect for leasing costs?

I'll be honest with you -- I -- when we look at 2010, we don't give a lot of thought -- I'm just being bluntly honest -- a lot of thought to what construction will do in the second half of the year.

And the biggest reason is because we don't frankly know.

Okay.

What we do know is, we believe -- we're optimists as a group.

We believe the worst is behind us, and time will tell if that is correct.

But we think when we look into 2010, we have a reasonable basis for why we're doing what we're doing.

If construction were to come back in the second half of the year -- keep in mind the store openings in a given year represent a relatively small piece of our sales in that year.

And we have 2300 stores that have business that's down and so we want to turn back on the energy of the Fastenal profit.

We want to turn back on the ability for our folks to have a good 2010, a great 2011 and 2012, and we believe these are the pieces.

We believe in that scenario, our shareholders will do quite well.

Okay.

Thank you very much.

Thanks.

And that does conclude today's question-and-answer session.

At this time, I'll turn the conference back over to you gentlemen for any closing remarks.

Okay.

This is Dan.

I just want to again thank everybody for participating on our call today.

I hope you find it informative.

And thank you again for your support in the Fastenal organization.

Have a good week.

Thank you.

And that does conclude today's conference.

Thank you for your participation.