快扣 (FAST) 2017 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Fastenal Company 2017 Third Quarter Earnings Conference Call.

(Operator Instructions) As a reminder, this conference call may be recorded.

I would now like to turn the conference over to Ellen Trester, Investor Relations.

You may begin.

Welcome to the Fastenal Company 2017 Third Quarter Earnings Conference Call.

This call will be hosted by Dan Florness, our President and Chief Executive Officer; and Holden Lewis, our Chief Financial Officer.

The call will last for up to 45 minutes and will start with a general overview of our quarterly results and operations, 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, 2017, at midnight Central Time.

As a reminder, today's conference call may include statements regarding the company's future plans and prospects.

These statements are based on our current expectations, and we undertake no duty to update them.

It is important to note that the company's actual results may differ materially from those anticipated.

Factors that could cause actual results to differ from anticipated results are contained in the company's latest earnings release and periodic filings with the Securities and Exchange Commission, and we encourage you to review those factors carefully.

I would now like to turn the call over to Mr. Dan Florness.

Thank you, Ellen.

Good morning, everybody, and thank you for joining us on our third quarter earnings call.

Holden asked me to stay pretty tight to the script today, so I'm going to be going through the slide deck, first couple of slides of that.

But I will preface the -- my comments with just a few thoughts, and this is as much a shout out to our Fastenal team as it is to our Fastenal shareholders.

My first comment to the team is job well done in the quarter.

For 9 consecutive months in 2017, we have exceeded our internal goals for sales growth.

I'm proud of the team, and I'm happy for the team.

Last December, I challenged them at our annual gathering of the leadership of Fastenal with 3 simple messages as we approached 2017.

One is let's just grow -- let's just go out and grow our sales.

Let's get the business growing.

We have a lot of growth drivers.

Let's execute and grow our sales.

Secondly, let's manage the business well and grow our earnings because long term, the rewards we can create for our customer, our employees, our shareholders and ourselves are centered on our ability to grow our earnings and our returns long term.

And if we grow it faster than other companies that you can choose to invest in, the market will reward us from the standpoint of valuation and our employees will benefit from that because a fair number of our employees are also shareholders of the company.

Finally, I challenged them to think big about the business.

We're going through a massive transformation in the business right now.

We've talked about it in previous investor days.

We've talked about it in our filings.

In the last 10 years, we've grown a tremendously supportive business within Fastenal called vending.

In the last 3 years, we've grown a tremendously supportive business to Fastenal and to our customers called Onsite.

They're complementary to each other.

There are also businesses that Fastenal is uniquely qualified to be successful in and to think big about our future and how the business is going to morph.

As you noticed in the release, our sales growth accelerated in the third quarter '17.

Year-to-date, our daily sales growth is 10.1%.

That's the first double digits we have seen since 2014.

And as I called out in the quote in the release, we ended the quarter with 15.3% daily sales growth in the month of September.

Again, very pleased with top line performance in the quarter.

Our growth drivers continue to gain traction.

We have record signings in the third quarter as it relates to Onsite, putting us on track for a very aggressive goal of 275 to 300 signings.

Recall, if you go back 4 years ago, 5 years ago, 6 years ago, on average, we were signing about 10 a year.

In 2015, we began to move the needle and we began to challenge our team to sign more, and we improved the number to about 75 -- about 175 the next year.

And our goal this year was to add another 100 again and do at least 275.

I feel very good about us being on pace to accomplish that.

Year-to-date, we have signed 213; 64, 68, and now 81.

In all that, we've been investing behind the scenes in additional infrastructure to support the Onsite business.

That includes IT infrastructure.

That includes implementation infrastructure.

Despite those investments, we've continued to obtain operating expense, leveraging our business.

Our incremental margin was 21% in the quarter.

And one thing about the quarter, we -- it's a 63-day quarter versus a 64 last year.

For us to lose a day in a quarter is kind of unusual.

We do just over $18 million a day in business.

If we would of had a more normal quarter, 64 to 64, most of that incremental gross profit dollars would've gone to the bottom line and our incremental margins on that business would have been about 25%.

So feel very good about the expense management we were exercising as we grow and invest in the future of our business.

Finally, if I look at it from the standpoint of how much of that converted into cash, our operating cash flow in the third quarter was a record for any third quarter in the history of Fastenal, both from the standpoint of absolute dollars and as -- relative to our earnings.

Very pleased with the team.

And that requires a big effort from both our supply chain folks as well as our branch and Onsite personnel just of managing the inventory growth because that is the biggest wildcard when it comes to our working capital needs.

Touching on the Onsites again, going to the second slide.

81 Onsites signed.

We have about 555 active sites.

That's up almost 48% from a year ago.

And again, I reiterate, our goal is 275 to 300 signings.

A sidebar I'll throw in as it relates to Onsite.

As we've ramped up our Onsite in the last several years, it's translated into our ability to grow and take market share faster.

In yesterday's meeting I had with our Board of Directors, I was walking through with them that concept of the growing sales component.

Last year, in the second -- in the third quarter, excuse me, about 25% of our district leaders -- so we have about 250 district leaders in our business, about 25% of them grew their business double-digit.

It's no coincidence -- or it is a coincidence that in the prior year, in 2015, about 25% of our district managers signed in Onsite, and that translated into 75 signings.

Last year -- and I've shared this on calls before, last year, we more than doubled our signings because roughly 54% of our district managers signed in Onsite in 2016.

Interestingly enough, in the third quarter of 2017, 54% of our district managers grew their business double-digit.

Year-to-date, in 2017 -- and our goal for the year in establishing the 275 to 300 Onsite signings, our goal was to keep improving the participation of our leaders in this growth driver.

And I challenged the team, can we get to 80%?

So we've gone from 25% to just over 50%.

Can we add another 30% and get to 80%?

Year-to-date, 64% of our district managers have signed in Onsite.

Success for us in vending 5 and 6 and 7 years ago came from more participation across the organization.

Success for us in Onsite follows the same path, a greater portion of our business engaged with their customer, and a manifestation for us is vending and Onsite signings, year-to-date at 64%.

I don't know if we'll accomplish 80% by year-end, but I'm really impressed with what we've done in the first 9 months of the year.

Total in-market sites today, 2,973.

A year ago, we were at 2,921.

So that continues to grow as we morph a piece of our business closer to the customer.

As you see from our filings, we've closed some branches in the last 12 months as we've done in the last 5 years.

Think of it as not a closing, but think of it as a consolidation.

We've consolidated 2 branches because part of the business of one has moved Onsite, but our local presence continues to grow.

We signed 4,771 vending devices, basically on par with what we did in the third quarter of last year.

To me, the most meaningful thing is our business there continues to grow double digits, about -- just over 20% growth, 21% on a daily basis, just under 20% on an absolute basis because 1 less day.

But our number of devices we're removing is down as we've gone through the year and is down in the third quarter.

So very pleased from the standpoint.

It feels like our signings are better and our performance on the existing base is better.

Finally, our National Accounts business grew about 17% in the quarter, which means our non-National business grew just over double digits for the first time in quite some quarters to give us our combined growth.

So very pleased with the quarter.

Our growth drivers are moving the needle.

We're managing our operating expenses through that.

And one thing you'll notice, I've been completely silent about our gross margin.

Holden's going to touch on a few points of that.

I'm sure there will be a question or 2 on gross margin, but I'll throw one piece out to the group in the for what it's worth category.

If you look at Onsite, if you look at vending and if you look at our Mansco acquisition, add these 3 components of our business up and they account for about 2/3 of our growth from the third quarter of last year to the third quarter of this year.

We've previously said all 3 of these operated at a gross margin below our company average but have very attractive operating margin and return characteristics.

And at the end of the day, that's what you pay us for.

With that, I'll turn it over to Holden.

Thank you, Dan, and good morning.

So before jumping back into the slide deck, I did want to call on a few items that made the third quarter 2017 unique.

The first is, I just want to call your attention to the last page of the supplemental deck.

This quarter, we did take a fresh look at the market exposure of our business and made certain adjustments that affected our end-market mix and slightly altered the growth rates versus what we've reported in the past months and quarters.

So please feel free to take a look at that last page.

Secondly, as Dan indicated, we did have 1 less selling day in the third quarter than was through the prior year.

Based on our September daily sales rate, that cost us more than $18 million in sales during the period.

That was known, of course, but keep in mind that many of our costs, notably the employee-related expenses, are not days dependent, and that does affect leverage.

Third, we estimate that the hurricane that hit the Gulf, the Southeast and Puerto Rico shaved 20 to 30 basis points from revenue during the quarter.

It's hard to estimate the impact of post-storm recovery on our volumes, but we do believe that some of that was present in September, particularly in the Gulf, though not at a level to -- not at a magnitude to offset the original lost sales.

In addition to the top line impact, the hurricanes also were a very slight drag to gross margin due to the write-off of damaged assets and an increase in sales of low-margin, storm-related products like water and generators.

Now with that said, let's look back at Slide 5. As Dan indicated, total sales were up 11.8% in the third quarter, but on a daily sales basis, they were up 13.6%, which is an acceleration from up 10.6% in the second quarter.

Mansco contributed 130 basis points to this growth, which is consistent with the prior quarter.

The third quarter finished strongly, with September's daily sales growth coming in at up 15.3% or up 14% excluding the impact of Mansco.

In terms of end market tone, the third quarter felt a lot like the second quarter.

Macro data remained favorable, with the PMI averaging a healthy 58.6 and industrial production continuing to grow at a low single-digit rate.

As a result, we saw broad strength and further acceleration in our manufacturing markets, while construction sustained a mid-single-digit growth rate.

From a product standpoint, we experienced acceleration in both fastener and non-fastener lines.

And from a customer standpoint, National Accounts accelerated again, up 17.3% in the quarter, with 71 of our top 100 accounts growing.

Growth to the smaller customers also accelerated in the quarter, and it's notable that our non-National Account customers grew better than 10% in September.

This contributed to 64% of our branches growing in the third quarter, which is up from 62% in the second quarter and 58% in the first.

So based on sustained strength in most of our end markets and strong momentum in the growth drivers that Dan covered on Slide 4, we feel good about our top line momentum entering the fourth quarter.

Now to Slide 6. On a year-over-year basis, our gross margin was 49.1%, down 20 basis points versus the third quarter of '16.

If I look at our organic fastener and non-fastener product categories, there really was very little change in the gross margin.

The very driver of the annual decline was the effect of product and customer mix, the inclusion of Mansco and the very slight drag afforded by the hurricanes.

We think that these combined probably provided about 30 to 40 basis points of drag to the annual gross margin figure.

On a sequential basis, our gross margin was down about 70 basis points.

Again, the organic margin for our fastener and non-fastener categories were mostly unchanged, and the price/cost dynamic was mostly stable.

Seasonality and storm effects did play a role, but the single largest cause of the sequential drop in the period was the behavior of what we call the organizational variables.

In the quarter, this includes things such as more third-party shipping, foreign exchange adjustments, lower vendor freight credits as a result of really good inventory control in the period and other items of that sort.

Which of these variables move in which direction can be hard to predict in any single period, that in most quarters, it winds up being a series of pluses and minuses that even out.

But in the second quarter, these skewed heavily in favor of gross margin.

And in the third, that favorable skewing completely reversed.

Given these movements over the last 2 quarters, frankly, we look at the best representation of our gross margin probably being the fact that our year-to-date 2017 gross margin of 49.4% is broadly comparable to our year-to-date 2016 level of 49.5%.

So year-to-date, we're down about 10 basis points despite the mix effects, the acquisition and those sort of factors that we've talked about in the past.

Our operating margin was 20.2% in the third quarter, up 20 basis points year-over-year.

The 20 basis point decline in gross margin was more than offset by the 40 basis point of leverage over operating expenses.

Consistent with how our model works, we've leveraged operating expenses every quarter of 2017, and that's resulted in our year-to-date operating margin expanding to 20.5% from 20.3% in the third quarter -- I'm sorry, year-to-date in 2016.

Employee-related costs were up 12.3%.

130 basis points of this increase relates to Mansco's headcount plus the incremental expenses related to implementation of last year's DOL rules.

Having 1 fewer selling day also had a slight negative impact.

The remaining increase is a function of the reset of incentive comp throughout the organization given our return to selling growth in 2017 and an increase in overall staffing.

Total headcount growth remained modest, up 1.9% or up 3% on an FTE basis, but we have added personnel in 8 of 9 months this year.

It does remain a goal of ours to leverage the employee-related expenses over time.

Occupancy-related expenses were up 1.5%.

Branch costs are slightly lower, reflecting closures over the past 12 months, more than offset by growth in our vending installed base.

Selling transportation-related expenses were up 2.7%, reflecting our ability to leverage our vehicle-moving activities even while we support the growth of our business.

Total incremental operating margin in the third quarter was 21.3%.

If you exclude Mansco, that incremental margin was 22.1%.

And frankly, we think that, that value was likely reduced by more than 200 basis points by having 1 fewer selling day in the period.

Turning to Slide 7. We generated $163 million in operating cash in the third quarter.

That's a record amount for any third quarter, and it's 114% of net income.

Year-to-date, we've generated $456 million, which represents 107% of net income, an improvement on the 100% in the first 9 months of 2016.

These improvements are primarily a function of better earnings.

Net CapEx in the third quarter was $24 million, down 67% due in large part to the absence of spending on vending machines related to the leased locker program.

Our anticipated capital spending target for 2017 is unchanged at $127 million.

In the third quarter, we spent $92 million on dividends and $26 million to repurchase shares of stock.

Our level of debt was mostly stable at $440 million.

And at 17.8% of total capital, we view our balance sheet as conservatively capitalized with ample liquidity to continue to invest in our business and pay our dividend.

In terms of working capital, we were particularly pleased with the inventories.

If you exclude Mansco, our inventories were up 7%, which significantly trails the growth in sales.

This reflected the ability of the field to leverage the heavy investment in branch inventory in 2016 and just more energy enterprise-wide on this line.

Receivables growth excluding Mansco was up 15% in the quarter.

As in the second quarter, that it grew faster than sales reflects the acceleration in growth that we saw as the quarter progressed as well as the relative growth of National Accounts.

Payables excluding Mansco were up 23%.

Last year's third quarter was unusually low in the wake of high CSP 16-related purchases in the prior quarter, a dynamic that's likely to repeat in the fourth quarter this year.

That's all we have for our formal presentation.

And with that, we'll turn it over for questions.

(Operator Instructions) Our first question comes from the line of Robert Barry of Susquehanna.

So I just wanted to understand what's happening with price/cost.

I know you've talked in the past about benefits of the long supply chain, but I think the inflation would be upon you.

Are you getting priced to kind of fully offset the inflation?

Yes, I'd answer that in a couple of ways.

In terms of the price that we referred to in the second quarter, we felt like in the second quarter, that resulted in a positive price/cost dynamic.

As you roll into 3Q, we feel like we got a little bit of incremental price, but we also began to see a little bit of the incremental costs flowing through.

And frankly, those probably balanced out relative to where we were in Q2.

So, yes, we feel like the price that we envisioned getting, we got.

The costs have begun to come through.

We talked about that perhaps hitting in Q4, that will certainly be the case, but we saw some of that hit in Q3 as well to result in sort of a stability in that dynamic, if you will.

There is still inflation.

That hasn't changed.

And I think I would probably answer the question of how we address that the same way I've answered in the past, which is that if at some point we determine that we can't protect our level of profitability without resorting to some sort of price action, then we will take that step, and we believe that we would be successful on that.

But we didn't do anything along those lines in the third quarter.

Got you.

And just as a follow-up, I think 4Q gross margin is typically down quarter-over-quarter, right?

And then you also had a tough comp this year.

So should we expect that sequential pattern to hold maybe something in the high 48% ballpark?

Is that kind of how we should calibrate 4Q?

We try not to predict, obviously.

I do think you're right that we have a very difficult comp versus the gross margin that we put up last year.

And I think that that's certainly going to be a feature of the fourth quarter.

In terms of what we expect for gross margin in the fourth quarter, there is typically seasonality.

On the other hand, we did have some minor drag related to the hurricanes in this particular quarter.

It's difficult for me to kind of give you a number, but we're -- yes, we would just -- we're not going to go towards the number.

I think that there's some puts and takes that at the end of the day, the seasonality is usually fairly minor -- fairly modest, and we'll see the degree to which there are some things that offset that.

Was the hurricane about 10 bps?

I just wanted to clarify what the hurricane impact was on the gross margin.

Yes, it was probably 5 to 10 basis points.

This is Dan.

I'm going to chime in a quick comment.

This is part of the call that always drives Holden probably a little crazy, but he's getting used to it.

But if I think about the comments he made earlier and I think about our July call, there was quite a few questions that really we're asking.

What lifted gross margin?

Because Holden's message over time has been one of, when you think about the growth drivers, the math of the growth drivers should lower our gross margin each year, optimistically, 20 basis points; pessimistically, 25 to 30.

And that's just the fact that the growth drivers, the vending, and in the case of this year, our acquisition, tend to weigh down.

And then over time, the growth of our non-fasteners relative to fasteners, which are obviously influenced by the growth drivers, weigh it down a little bit.

And organizationally, what can we do to work back, to grab back some margin in our sourcing, our logistics, our selection of products, everything.

So in the second quarter, we stumbled over ourselves a little bit trying to explain to you all in your questions why we weren't confident that gross margin wasn't a new normal because we talked about a lot of the puts and takes, and everything was a put.

This quarter, as Holden mentioned, a lot of the puts and takes leaned towards takes, not puts.

Our fastener gross margin was down about 10 basis points.

Our non-fastener gross margin was completely unchanged from Q2 to Q3, and I think that's an important component.

And so it was really the organizational, the other stuff all worked against us this quarter.

History has told me -- and my history perspective is 20 years, 4 quarters a year, so that's about 80 quarters.

History has told me that you don't get things that go all your way, or mostly against your way, typically in a quarter.

So going into the fourth quarter, and I don't like making predictions, but going into the fourth quarter, I'm not looking for our gross margin to be below 49% from the standpoint of sequential weakening.

We'll get a little bit benefit from the hurricane number.

Now, in all honesty, there could be 5 basis points of hurricane in the fourth quarter because in Puerto Rico, we don't know all the answers.

We do know that all of our employees are safe in the Gulf Coast, in Florida and in Puerto Rico.

And in Houston, we had 2 store -- 2 branches that were destroyed by the hurricane.

What we know initially about Puerto Rico is we had no branches damaged.

It sounds like we came through it reasonably well.

Our business suffered, but our assets did not.

And more importantly, our employees came through it safely.

Our next question comes from the line of Ryan Merkel of William Blair.

First question is on incremental margins.

Just given the 12% top line, I would have expected incremental margins at 25% plus.

So my question is, is this still an achievable target if we adjust for restoring incentive compensation, hurricanes and 1 less day?

Yes.

I mean, we -- organically, the incremental margin came in around 22%, and we believe that the day itself probably cost us the rest of the gap between that number and about 25% in the quarter.

If you think about it, that extra day cost us about $18 million in revenues.

Now bear in mind, of course, we know about that in advance, of course, the day is not a surprise, but it still does cost us year-over-year $18 million in revenues.

We don't get a discount on our base salaries, which are a significant portion of our total employee-related expense, and there's other elements within the operating expense category that we don't get a discount on just because we have 1 fewer day.

And so we do believe that the organic incremental was around 22%.

And if you -- if it weren't for that extra day not being there, we think that it would've been in that 25% range.

Okay.

So no change really long term to high single-digit sales growth.

You can get 25% or so incremental margin.

Yes.

In the short term, I would agree to that.

The real question, Ryan, is when you look out to the future, what percentage of our growth is coming from the Onsite model.

And again, in the quarter, it was about 30% of our growth.

What percent of the growth is coming from Onsite?

And what does that do to weigh down that incremental margin?

But we're very mindful of managing the expenses around that.

And I don't know if Holden touched on this, sometimes the discussion at the board meeting yesterday and discussion on the conference call get muddy for me, but I don't know if he touched on it, so if I repeat, I apologize.

But right now, we're anticipating Q4 branch-level occupancy -- by occupancy, I'm talking about rent.

Utilities change with the season, but I'm talking about rent expenses.

Right now, we're expecting Q4 will be lower than Q1, and I don't know if that's ever happened in the history of Fastenal.

And so we're being very mindful of managing that expenses because we do believe we can get, in the short term, incremental margins in the mid-20s.

I can't speak to 4 and 5 years from now if they're mid-20s or if they're closer to the lower 20s, but I know that we'll be growing our returns and our cash flow handsomely at that time.

Yes.

I would just chip in 2 things.

One, that math is basically correct.

Bear in mind again, the difficult gross margin comp in the fourth quarter, however, will make it difficult on a single quarter way basis to do that.

But to Dan's point, I mean, we're trying to grow this business.

We're doing a fairly successful job of it given where our revenue growth rates are compared to the marketplace and things of that nature.

And we are going to continue to grow and outgrow the market and gain market share.

And so whereas we are going to manage our expenses to be able to achieve a very healthy incremental margin, and we do think about that double-digit growth in that 25% type of incrementals.

Sometimes we get questions of why it can't be more, why it can't be more.

And the answer is because we not only manage our expenses, but we also manage our expenses to be able to grow.

And so I think the math that you're talking about makes some sense to us.

Our next question comes from the line of Scott Graham of BMO Capital Markets.

So earlier this year, we were talking about how we sort of wake up in the morning with a 20 to 30 basis point gross margin drag that you are -- that you were -- at that time, you said you were confident in being able to backfill, owing to mix and what have you.

It sounded to me, and maybe I'm just reading too deeply into this, but the growth drivers now do seem to be that 20 to 30 basis points, and that does not include what would seem to be product mix, which has been running negative.

And I'm wondering if the growth drivers include customer mix.

So is it still 20 to 30?

Or maybe is it now higher than that?

Yes.

So a couple of things.

First, I don't think we ever said we were confident that we backfill.

I think what we've said is that we were going to have a 20 to 30 basis point headwind, just as you say, waking up in the morning at the beginning of the year, and that we'll certainly work very hard to try to backfill that.

But over an extended period of time, we would not be surprised if our gross margins are lower, but that is on the back of significant growth in market share gains, right?

So I never said confident, but we certainly do wake up every day knowing we're in a hole and making an effort to try to fill it up.

But there is certainly never any guarantee that we would do that year-after-year.

With respect to the mix question, no, the mix is not different.

When we talk about the 20 to 30 basis point drag, that really does fill in the product.

It fills in the customer.

That is really trying to take into account all the variables.

And the reason it does that is because I look at that mix relative to how our margins are performing across the product set, which would encompass everything that we're doing from a growth standpoint.

So no, I think that 20 to 30 basis points that we wake up to every year, I think that's the number.

Now we talked about how 3 quarters of our revenues are fasteners and Onsites and National Accounts and vending, that we believe that we have a significant moat in, and those also happen to be our growth drivers.

They're going to become a bigger part of the mix, and they also have even lower gross margin.

If in a year or 2 that 75% becomes 80% or 85%, if that 20 to 30 become 30 to 40, maybe, but that's a function of very defensible revenue and market share gains.

And we'll try to fill in that hole too, but we certainly would not guarantee it.

Understood.

And I apologize if I misquoted you there.

So it does stay at 20 to 30...

Scott, hold on a second.

Dan will chip in before we move to the next topic.

I'm going to just chime in.

If your definition of backfill is at the gross margin line, the answer is different than if your definition of backfill is at the operating margin line or operating income line because in the last 12 months, if I look at Q3 to Q3, we gave up 20 basis points of gross margin.

We picked up 20 basis points of operating income.

And so I read that as we backfilled the 20 with 40 basis points of operating expense leverage from a backfill perspective because at the end of the day, the numbers that really matter on the income statement are further south than the gross margin line, and we backfilled that 2x over.

And that's the key to the business.

And that was done in an environment where -- as you know from reading our proxy or if you read through our proxy, you'd see that our incentive comp is really centered on paying out a piece of our profit dollar growth in the case of our leadership team, and that's true of many of our support areas as well as our logistics costs in the case of distribution and gross profit dollar growth or sales and gross profit dollar growth at the branch and Onsite location.

So in the current quarter, our incentive comp is up between 25% and 30% because we're reloading incentive comp.

So that -- in that environment, we picked up 40 basis points of expense leverage.

When we get through 2016 -- 2017, excuse me, that reload is largely complete.

We have a little bit of reload in the first quarter, but in the second quarter, our incentive comp had dramatically expanded.

So we have the benefit of that when we get into the second quarter of 2018 and partially there, in the first quarter of 2018.

Got you.

That's great color.

My follow-up is a little simpler.

The acceleration in sales in September was impressive.

I was just sort of wondering if you maybe could parse out the piece of, let's say, of sales that you recaptured from Harvey.

My guess is that, that would be a smaller piece of it.

And instead, I'm hoping that you can answer the sort of which end markets look like they accelerated in September.

Yes.

So to take the first question about Harvey, it was fairly modest, and it was primarily in Houston that we would have regained some of what we lost in August.

But that regain was probably about 1/3.

I mean, we're probably talking about $0.5 million, maybe a little more than that in terms of what we recaptured.

I will tell you, going forward, it's a difficult number for us to really understand, so we'll do our best, but it's a hard number to refine.

But I'm fairly comfortable at this point that we actually lost more in revenue in September from Irma and Maria than we gained in recovery in Houston.

So the hurricanes were a net negative in both August and September.

That's what I would say with regards to that.

And then in terms of end markets, it really -- it gets down to the manufacturing end markets, right?

If you look at our heavy equipment, it accelerated.

If you look at heavy manufacturing -- but honestly, our manufacturing business as a whole accelerated across the board.

And you talk to the RVPs, and they still talk about oil and gas is still doing fairly well and all the flow-through that comes with that.

So the manufacturing complex, in general, I think, continues to accelerate.

The transportation complex for us, which doesn't include a lot of automotive, bear in mind, but that continues to expand for us.

So it's -- there weren't a lot of areas that I could point to that were soft or weren't getting better.

Our next question comes from the line of Luke Junk of Baird.

First question on Onsite.

I realized we're still early stage here relative to when you really put your foot down on the accelerator in terms of signings.

But what I was wondering is, how was the revenue run rate tracking on average relative to the numbers that you've laid out at 2015 Analyst Day?

That is the about $1 million of year 1 market share gains and $1.8 million in average annual spend over time.

The reason I asked is with the -- pace of signing we're seeing right now, just doing the math on those numbers alone, that would certainly speak to some really sustainable top line momentum coming from that business.

Luke, if I look at what we're seeing, I have a few observations.

One is we're feeling -- we're continuing to see really good trends in the numbers.

Averages are in line with what you're seeing.

Averages can be deceiving.

You have some that are well above it, some that are below it.

That's the nature of averages, I guess.

But very pleased with the run rates we're seeing from the standpoint of what we would have expected.

One thing that's a tremendous positive for me, when I look at the layers of Onsites we're signing, we're actually seeing better performance out of the 2016 signings that we've been implementing in the latter half of '16 and early half of '17 than we saw in the 2015 signings that we were signing 12 months earlier.

Now how much of that is a rising tide?

As you all know, the ISM has continued inch up.

That's usually a leading indicator.

So I'm optimistic that's a sign of things to come.

But we're definitely seeing strength in our end markets, but we're also seeing underlying better performance in the Onsites we have signed, again, in '16 versus what we did in '15, which is really positive from the standpoint of the quality versus our historical perspective.

So I feel very good about that.

I hope that answered your question, Luke.

And the only thing I'll add to that is we continue to see the Onsites contribute more and more to our growth rate.

I think this quarter, if you take out what moved from branches to Onsite, if you remove that element of it, the Onsites contributed close to 3.5% of our growth year-over-year.

And that is an increase from where we were in Q2, which itself was an increase from where we were in Q1.

So it continues to contribute more.

And then follow-up question, just as it relates to the operating leverage looking into next year.

Dan, you already touched on this to some extent, but I just wondering if you could put a finer point on the benefit to your growth and pretax income as growth in the incentive comp normalizes to get into the second quarter next year and beyond.

I think in the past you've maybe put this in terms of how much pretax earnings growth that the growth incentive comp is consuming, say, right now, where we're in this adjustment period versus a period next year where that's going to normalize to some extent.

Yes.

I'll let Dan provide some historical perspective on these numbers since he has it given his 80 quarters, I think, he counted.

But I think we usually think about it in the first year of that reset year, if you will.

It probably consumes 25% to 30% of our pretax dollar growth, can sort of go to incentive.

When you get into the second year, that can perhaps get cut close to in half in terms of how much of your pretax it consumes.

I'll take Dan's silence to mean I got it right.

You got it right.

Our next question comes from the line of Hamzah Mazari of Macquarie.

This is Kayvan Rahbar filling in for Hamzah Mazari.

Could you give us a sense on what your hearing on Section 232?

And the duties on semi-finished steel products and whether that's going to have an impact on margins?

We don't know yet.

I think a decision on that keeps getting...

I think it would be helpful to explain to everybody else on the call what he's asking.

Yes.

Section -- so this is basically a question about tariffs on Asian steel, I believe, which could encompass some of our products.

The -- and effectively, a decision on whether or not to enact those sort of tariffs continue to get punted, and I think at this point, the expectation is maybe a decision comes next year, early next year.

What I would tell you is I think that if the costs to procure steel products and fasteners go up because of an act like that, then they would go up for everybody, Fastenal as well as our competitors, and given that it's difficult to procure a lot of product domestically at this point.

And so the typical response would be to try to pass that through the customers, and we expect that the industry would probably take that action if something like that were to occur.

But we're watching it.

Nothing has been decided on it, to our knowledge.

And if something is, then we'll react appropriately.

All right.

And just a quick follow-up.

Could you give us a sense of how much your current business is government and how that's trending, including any exposure to state versus federal?

Our government business is probably about 4% of our total revenue.

It's almost entirely state and local.

We really don't do a lot with federal.

By the way, that's one reason when people want to talk about sort of the recovery element after a storm, we don't necessarily have that sort of FEMA and federal government connection that perhaps some other distributors may have.

But ours is primarily state and local.

It's growing well for us.

What I would tell you is it's probably a small enough piece of our business that we wouldn't be a proxy for the market.

But the last couple of quarters, we've had some nice wins.

We have some energy that we're putting into the state and local government business, and we think it's -- that's providing some benefit to us.

But yes, it's about 4% of our revenue.

Our next question comes from the line of Matt Duncan of Stephens.

The first question I've got is just, Holden, if you look at the -- or Dan, either one, if you look at the top 100 customers, you've got some where you're not growing and some are declining double digits.

Just curious what end markets those customers are serving.

Is there a common theme among them?

And do you see an opportunity to maybe see growth pick up even further if some of those customers do return to growth here?

Yes.

The -- well, if I look particularly at sort of where September was, there is -- within that top 100, I'll tell you, there are not many categories that are declining.

And the 1 or 2 that are -- there's only 1 or 2 companies in each.

And so I'm not sure if that's particularly indicative.

So as I said, I think that the performance for the most part has been pretty uniform across our end markets.

Now, obviously, the largest piece of those 100 is going to be in manufacturing, and that's doing really well, but it's relatively -- there's growth across our landscape, frankly.

I would say if I look at trends, I think that the E&C, the engineering and construction business, has gotten

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questions, but I see we are at 9:45.

I have a

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the incremental margin because we're expanding our team, we're expanding our distribution capabilities, we're expanding the expenses of the business.

But generally speaking, a high piece of the gross profit dollars flow through.

The -- if I look at the expansion of incentive comp -- and Holden was taking a little broader brush when he is looking at his 25% number.

If I look at the expansion of incentive comp at the branch, support and leadership levels across the company, our expansion of incentive comp consumed about 11% of our incremental margin.

History has shown that number is probably in a more typical year -- probably not at 5% but probably in that 7% to 8% neighborhood.

So to Ryan Merkel's earlier question, there's probably about 3 points of incremental margin that are absent this year because of the expansion of incentive comp that wouldn't be there next year because it's already reloaded.

I hope that it clarified that point.

I see we're at 9:45.

So again, I want to thank everybody for participating in the call today.

I hope you find this exchange useful in your understanding of Fastenal business.

And again, to the Fastenal team, nice quarter, everybody.

Thanks.

Ladies and gentlemen, thank you for participating in today's conference.

That does conclude today's program.

You may all disconnect.

Everyone, have a great day.