Good day, ladies and gentlemen. Welcome to the Fastenal Company Q2 2017 earnings results conference call. At this time, all participants are in a listen only mode. Later, we will conduct a question and answer session and instructions will follow at that time. If you require operator assistance during the program, please press star then zero on your touchtone telephone. I would now like to introduce your host for this conference call, Ms. Ellen Trester. You may begin, ma'am.
Welcome to the Fastenal Company 2017 second quarter earnings conference call. This call will be hosted by Daniel 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 September 1st, 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. 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. We encourage you to review those factors carefully. I would now like to turn the call over to Mr. Daniel Florness.
Thank you, Ellen, and good morning, everybody, and thank you for joining our second quarter earnings call. Before I turn to the flip book, I'd just like to make a few general comments. One, a message to our team, and that is last December, we sat down, we talked about three simple concepts for 2017. One was grow our sales, second one was grow our earnings, and the third one is to think big. On the grow sales front, it was all about focusing on our growth drivers and your team. I'm pleased to say, in the first quarter, our internal goal of system, we came in at 100.7% of our internal sales goal. In the second quarter, we came in at 102.6%. I'm very pleased and proud of the execution put forth by our team thus far in 2017. The second one was about grow earnings.
Biggest message there is have a plan. Gross margin, know your levers. Know the trends of our business, but more importantly, know the levers you can pull in the short term to help your gross margin. I think we executed well on those in the current quarter. The second one is our biggest component of operating expenses is payroll. 2017 is going to be a tough year for managing payroll from the standpoint. We were very bullish coming into the year on what our prospects could be. We had great momentum, I felt, coming from 2016. One of our biggest expense growth in the current year would be incentive comp. I've talked about that in previous calls and at investor conferences, that a high percentage of our payroll is incentive-based, whether that be at the branch level, at the distribution level, or in the manufacturing or support areas.
We reward our people based on our ability to accomplish goals. I felt we'd have somewhat of a reloading of the incentive comp in the current year, and we've seen that in the current quarter. Finally, on the aspect of occupancy, frankly, it just can't grow outside of vending. Vending we include in occupancy expense because it's just another shelf within our network of distribution. Being very mindful of where our costs can go, I think we did a nice job of that in the current quarter as well. Finally, think big. I think Onsite's an example of us thinking big over the last five years of how we can grow the business faster.
Vending is another of the last 10, The challenge we put forth to ourselves is always looking for what's next in that think big category about growing the business, growing our service to our customers, and growing the opportunities for our employees and our shareholders long term. On the gross margin front, I believe it's been, You can correct me if I'm wrong on this one, I believe it's been since the last time we had gross profit improvement year-over-year on a relative basis was the third quarter of 2013. I believe we were up two basis points that quarter. I would suspect in the last 14 earnings calls, 12 out of every 10 questions have centered on gross margin and why it's down. I'm thankful we won't get that question today, Maybe a variation of that.
Holden will provide some more insight on that as he goes through his notes, I would ask you to indulge me with a few thoughts here. One is about human nature. When an organization is struggling to grow, within each of our customers, there's a universe of spend that we typically play in, That universe has the gross margins you've grown accustomed to. Oftentimes, we will step out of that portion of the spend and go deeper into their supply chain, Not all that product has the same margin profile. I'm sure some of the improvement of our gross margin in the current quarter is the economy. Our growth drivers gave us a little bit more lift, Maybe we don't have to dig quite as deep. One aspect where we are digging deeper and continue to dig deeper is our Onsite strategy.
That's the core strength of that, is you go into a broader range of products because you have a different cost structure. We have a better stocking plan. In 2016, we rolled out what we call CSP 16. That's our customer service project. It's helped our in-brand sales. It's helped our construction business, both of which have helped our margin. We've also done a nice job with hub stocking. Nick Lundquist and his team have done a wonderful job balancing inventory dollars to advantages for our branch personnel on what to sell to drive their gross margin. We've gained some traction on that. It took some inventory dollars to do it, but we're generating a great return on that investment. Frankly, better analytics.
Again, Nick and his team have done, I believe, a better job supporting the branches, our district managers, and our regional VPs on understanding their business, understanding the levers to pull in their gross profit. There's a whole bunch of them. Finally, I'll touch on about greater execution. The one thing that I think is really great about our gross margin this quarter isn't the fact that it's up. It's the fact that the improvement came in five basis points here and five basis points there from about a dozen different places. That gives me more comfort in our ability to execute and our ability to hang on to some of that, because the long-term trends that Holden has talked about in previous calls are intact, and that is our growth drivers related to non-fasteners, related to on-site and related to vending, don't raise our gross margin.
Execution steps is what we need to do to offset some of that impact over time. Now switching to the prepared flip book. Sales growth returned to double digits in the second quarter of 2017. Underlying demand improved, but we outpaced the market due to the continued momentum in our key growth drivers. One other item I'll point out is that we did see some improvements in the underlying economy, and again, Holden will touch deeper on that in a few minutes. One point that jumped out for me, in previous calls, I've talked about our national account business representing just under 50% of our revenue, and that our top 100 customers represent about a half of that number. Both of those groups, our overall national account and our top 100, have been performing well for us.
With one exception, our top 10 customers have been negative for us all year long, and in June, flipped to positive. That improvement from May to June from those top 10 customers, represented about 20% of our improvement in the growth numbers from May to June. That's a sign of what the economy did when I look at the May to June numbers that I can tangibly put my finger on. A piece of that 20 obviously came from things we're doing with that customer group, but their activities improved. The other 80, I'm sure, has elements of the economy in it too, but a lot of elements of just pure execution by the Fastenal team and praise for their efforts. We continue to control operating costs, despite having the growth-related compensations or opportunities, depending on how you want to look at it.
As a result, our incremental margins topped 25% this quarter. That number was reduced by somewhere between 25% and 30% because of the expansion of incentive comp. Earlier, I touched on thinking big, and we can't emphasize that enough. We're encouraging all of our leaders, and we have 20,000 of them within Fastenal. We're encouraging all of our leaders to think big about our long-term planning and our future. Finally, as we mentioned in last quarter's call, we acquired a company in Michigan, Mansco. I'm very pleased to say have exceeded our expectations in the first three months. We're learning quickly and really well how to play in the sandbox together. We don't do a lot of acquisitions. That's a learning curve for us, and they haven't been acquired a lot. That's a learning curve for them.
I'm pleased to say both teams have gelled really well, and I want to say thanks to the Mansco team for pushing us over the 10% mark and into double-digit territory for sales growth for the quarter. On page four of the flip book, we signed 68 Onsites in the quarter. We have 486 active Onsites today. We've stated earlier that our goal, it's a lofty one, our goal is to add 275 to 300 signings this year versus the 176 we did last year. I'm pleased with the 68 because in the quarter, we had a very slow April on signings. We have our big customer show. I'm pleased to say we had in excess of 500 on-site candidates at that show. A very good showing from our team of inviting great customer opportunities.
When you take your entire group out of commission for a week of the month, you have a weak month. Despite that, we still signed 68. Year to date, two years ago, we had 30 signings. Year to date in 2016, we had 92 signings. Year to date in 2017, we have 132. That's four times our 2015 number and a 43% increase over prior year. Very good. Very pleased with the trends we're seeing there. Because of the expansion of on-sites, one thing you probably noticed reading through our release is we've removed a term from our release, and that term is store. We've replaced it with the term branch, a term that we would have used prior to 15 years ago when we did the first CSP because we thought it described our business well. We also talk about on-sites and in-market units.
Holden's better with words than I am, and I like the way he's presenting the data. It's really talking about our market presence and the fact that our branches and on-sites are an extension of our distribution network. We're not a store. We're not a retailer. We're a service organization that's part of our customer supply chain. We signed 4,881 vending devices. Frankly, a little disappointing from my perspective. We didn't break 5,000 like we did in the first quarter. Similar to the on-sites, we saw a slowdown in April around the show. The May and June numbers snapped back nicely. I feel really good about that. Our goal remains 22,000. That's a lofty goal, similar to our onsite goal, but that's part of our thinking big. The final piece is we still are removing a few more machines than I'd like to see.
We removed quite a few in 2016 because of our optimization process. I think that's the right move. In the first two quarters of this year, we still are removing some underperforming machines. Our average revenue per machine continues to improve. We still challenge ourself on how to get better at the signings, the installs, and identifying on day one that 10 is the right number versus eight, versus finding that out a year or two years later and reducing to eight. Eight's the right number. It's just knowing that sooner is key. That ties back to our letter to shareholders, where we talked about recognizing the facts of our business and figuring out how to improve the business going forward. National accounts rose 13% in the second quarter versus second quarter of 2016.
We've done a wonderful job of growing our business and making promises. Our branch personnel, our district personnel, and our regional personnel are doing a great job of honoring those promises we've made. Finally, the CSP products that we rolled out, CSP product continues to grow nicely faster than the company and has brought new life to our construction business. With that, I'll turn it over to Holden.
Great. Thank you, Dan, and good morning, everybody. Thanks for joining the call. Just to hit on what Dan covered on slide three, our total and daily sales in the second quarter were up 10.6%. That's an acceleration from up 6.2% in the first quarter. The timing of the Good Friday shift into April from March this year did cost the quarter about 50 basis points. On the other hand, we included Mansco this quarter, which we acquired on March 31st, and that added about 130 basis points. If you adjust those two factors, the second quarter daily sales rate was around 9.7%. Either way, growth accelerated through the quarter. Even better than that, in June, the daily sales were up 13% or up 11.6% excluding Mansco.
As Dan covered on page four, our growth in the quarter results significantly from customer adoption of our services and growth drivers. However, as demonstrated on page five of the book, some of our improvement clearly reflects a favorable macro backdrop. The Purchasing Managers' Index in the U.S., which represents 88% of our revenue, that averaged a healthy 55.8 reading. Industrial production growth was still modest in the quarter but did speed up a bit over the prior quarter. These metrics underpinned improvement in our industrial and construction end markets in the second quarter, as well as acceleration in both our fastener and non-fastener lines, as you can see from the charts in the presentation. In fact, it's difficult to identify a major market that is acting particularly poorly at this point, and the feedback that we're getting from our RVPs remains overall very favorable.
Our national accounts growth accelerated up 13.1% in the quarter, with 68 of our top 100 accounts growing. We saw a similar pattern in our branches, with 62% of our locations growing in the second quarter, which is up from 58% in the first quarter and from the 54% level that we saw through much of 2016. The market improvement that began in the first quarter solidified in the second, momentum on our growth drivers remains healthy. We feel pretty good about our top line entering the third quarter. Flipping over to slide six, our gross margin was 49.8% in the second quarter. That's up 30 basis points versus the second quarter last year. Again, we're pleased to point out that this breaks a significant string of consecutive annual declines in this measure.
The combination of product and customer mix, as well as the inclusion of Mansco in our results, that still had a 30 to 40 basis point negative impact on the number. This quarter, that was more than offset by a basket of positive variables. For instance, we did leverage our asset-heavy parts of our business, like manufacturing and freight. Our sales of private label brands grew by 30 basis points in the mix versus last year. Efforts to put more product into the field, such as the CSP initiative, has improved the product decisions and sourcing of both our purchasing operation and our field personnel. None of these variables were individually particularly large, but they did combine to push our margin up for the quarter.
In a nutshell, organizational factors skewed heavily in favor of gross margin in the second quarter, though none of those factors would seem to be one-time or unsustainable in nature to us. As it relates to pricing, the combination of good demand and an inflationary environment did provide the branches with some modest pricing lift in the second quarter. On a year-over-year basis, this did not meaningfully add to sales and was only a modest contributor to gross margin. Price in excess of cost was a bit more of a factor behind the sequential improvement in gross margin, however. We expect favorable price and cost dynamics in the third quarter as well, before costs begin to catch up in the fourth quarter. Our operating margin was 21.2%, up 60 basis points year over year. 30 basis points of this improvement relates to the gross margin increase.
The other 30 basis points reflects our organization, again, doing a nice job leveraging total operating expenses. If I look at the employee-related costs, they were up 9.3% in the quarter. Roughly three-quarters of this increase can be attributed to Mansco's headcount, as well as incentive-related expenses stemming from our return to growth, such as profit sharing and even more significantly, as Dan alluded to, bonuses. Absent these impacts, we believe the subdued growth better reflects the fact that our headcount is down slightly year-over-year. We did add 352 new employees in the second quarter over the first quarter, and if demand remains strong, we would expect our headcount to rise. However, we're still committed to leveraging the employee-related cost line. Occupancy-related expenses were up 3.4%, reflecting the impact of 29 net branch closures, offset by growth in vending. Selling transportation-related expenses were up 3.2%.
That this line grew reflects growth in our business, while the tapering off of that growth rate from the first quarter reflects stabilization of fuel prices and easier year-over-year comparisons. It all rolled into an incremental margin in the second quarter that was at 26.4%. If you exclude Mansco, the organic incremental margin would've been 27.5%. We view this as being consistent with past statements we've made with respect to incremental margin potential. Shifting over to slide seven, we generated $83 million in operating cash in the second quarter, which is 55.7% of net income for the period. Bear in mind that second quarters are typically poor for cash generation, as we typically have two tax payments in the period.
In the first half, in total, we generated $293 million, which represents 103.6% of net income, an improvement on the 98.4% that we had in the first half of 2016, primarily as a result of better earnings. Net CapEx in the second quarter was $33.7 million, down 41%, due in large part to the absence of spending on vending machines related to the leased locker program that was ramping up in Q2 last year. We did increase our anticipated capital spending target for 2017 to $127 million. That's from $119 million last quarter, which reflects some investment we're opting to make on the IT and logistics sides of our business. Our free cash flow for the quarter and year-to-date was $49 million and $249 million, up a healthy 43% and 64% respectively. In the second quarter, we spent $92.5 million in dividends.
We also spent $56.7 million to repurchase 1.3 million shares of Fastenal stock, which closed out our most recent authorization. We had an announcement last night noting that our board approved the company to buy back up to 5 million in additional shares at our discretion. This spending in the quarter, combined with low seasonal free cash flow, pushed our debt up to $445 million, as compared to $365 million in the first quarter and $430 million in the second quarter last year. At 18.3% 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 comfortable with where the numbers came out. Receivables growth, excluding Mansco, was up 13% in the second quarter.
That it grew faster than sales really just reflects the acceleration in growth that we experienced as the quarter advanced. Inventory, excluding Mansco, was up 4.5% in the second quarter, and that reflects the ability of the field to leverage the heavy investment in branch inventory in 2016 and more energy enterprise-wide on this line. Payables, excluding Mansco, were down 12.5%. Last year's high payables reflected the aggressive inventory investment we were making for CSP2016. That's all that we have for the formal presentation. With that, we'll turn it over for questions.
Ladies and gentlemen, if you have a question or a comment at this time, please press star, then the one key on your touch tone telephone. If your question has been answered and you wish to remove yourself from the queue, please press the pound key. Our first question comes from Robert McCarthy with Stifel.
Good morning, everyone. Congratulations on a great quarter. Great gross margin. I guess the first question I'd have is, maybe you could just walk through and give a little more complexion around the pricing environment, what you're seeing, a little maybe color around fasteners and then MRO and how you're approaching that.
Yeah. I think what we said in the past is, if we continue to see demand get better and the environment remains somewhat inflationary, then a window would probably open for us to take advantage of a little bit of pricing that the market affords. We sort of deemed the second quarter to be consistent with those themes. We saw the opportunity out to be a little bit more prudent with price, knowing that we were going to see costs coming down the pike in the latter half of the year. We went forward with that. The environment remains consistent, I think, with that sort of take on it, and we would expect, or we've seen the pricing that has come into the market stick in the market at this point.
I would expect that you'd probably see a little bit more incremental benefit in the third quarter before you get into the fourth quarter when some of the costs are starting to step up. I will tell you that initially, I think that the market was more supportive on the non-fastener products. I think going forward, you'll see it become more supportive on the fastener products, given what we've seen out of steel. As I said, it's just the market opened up a little bit in the second quarter. Should remain open a little in the third quarter, and by the time you get into the fourth quarter, you'll probably start to see the cost move through our supply chain and begin to catch up a little bit with what the market has allowed from pricing.
The second question is on the oil and gas side. Maybe you could talk through the Gulf regions, the Dakotas, what you're seeing there, maybe Canada as well, and just give us some sense of how you're thinking about ring fencing exposure, as we're seeing another oil swoon, and we could see a repeat of 2014, 2015.
Yeah. I can tell you that those regions of our business that we typically associate with oil and gas, they continued through June to outgrow the business as a whole. Those regions still, certainly the facts on the ground are favorable. I think in terms of the tone, talking to the RVPs from those regions, the tone is still fairly encouraged as well. That's an area that's been strengthening over the past, call it five to six months, and at this stage, I didn't really note any real change in sentiment from folks internally around that end market.
Final question is just on onsite deployment. Have you gained any incremental knowledge about how Yes.
Bob?
Yes.
I'm going to move on to the next one. We try to limit it to one and maybe a related follow-on. Otherwise, we won't get to quite a few people in queue.
Congratulations on the quarter.
Thanks, Rob.
Our next question comes from Andrew Bisciglia with Credit Suisse.
Hey, guys. Congrats on a good quarter.
Thank you.
Thank you.
Just looking at your gross margin. It was a great quarter there. Things are pretty good now on that front. How sustainable are some of the initiatives that you called out that help that line item? Going forward, do you see a path back to 50%, especially if we get some pricing at some point down the road?
What we'll say about the gross margin is, it can be hard to say quarter to quarter what's going to happen. The mix elements that we've called out before are still very much there. To the extent that we are successful with our onsites and safety and things of that nature, the mix elements we've called out are still there. They're not going away if we're successful with our growth drivers. If you think about the second quarter, it's not unusual for there to be a little bit of seasonality to keep margins flat, maybe slightly down. Frankly, I think this quarter, everything just kind of went our way. That's not necessarily the norm, if you will. We'll just have to kind of see what Q3 and Q4 look like in that regard. That said, I guess there's two things that are working our favor.
One is, I do think in Q3, you might get a little bit of incremental contribution from price that you didn't get in Q2, again, before that begins to get worked off in Q4 from cost. The other thing is there was really nothing unsustainable in the pieces that pushed up the gross margin, right? When you think about the shop leverage, when you think about the success that we're having with the CSP and the exclusive brands and things of that nature, there's nothing that's unsustainable in there. Will they all move in the same direction in Q3 as they seem to in Q2? We'll have to wait and see. We think that the fact that we have an opportunity to have a quarter like this really reflects a lot of good things that we're doing in the field with a lot of initiatives.
We think that those things will certainly carry forward, not just into the next quarter, but sort of beyond that. That's how I'd characterize the gross margin environment.
I'll just add a piece to that, and that is a fundamental thought about how we think about the business now. I'll go back to how we started the call. Grow your sales, grow your earnings, think big. From what you know about Fastenal for the last 50 years, or actually the last 30 years that we've been public, gross margin's an important part of our business because it funds our ability to do the things we do and to grow the business. It's very important to that matter, during the start of April, even tweaked the way our regional leaders are paid to include a component for gross margin, dollar growth, not %, dollar growth.
It's about our growth drivers really center on helping us grow the business faster, knowing that some of the offshoot of that is the gross margin environment over time is challenging. We have to look at it and say, "Where do our cost structure need to be two and five years from now?" That's what we're obsessing about. Day to day, we're working on all the levers, and as Holden mentioned, those levers went our direction. What makes me feel better about sustainability is the fact that we picked up five or seven or eight basis points from a bunch of different places, and that makes it a little stickier. It's still a challenging environment, and our growth drivers are still going to have the drain.
They're going to drag on our gross margin that we've talked about for the last year and a half, two years, and that reality hasn't changed. As far as the last part where it starts with a number that I'm not going to mention out loud, kind of like Voldemort in "Harry Potter." I'm not going to mention it out loud because that's not where our head's at. Our head is at growing sales, growing earnings, and thinking big.
Yeah. Just as a follow-up, you really saw a nice bump in your operating margin line. A lot of this gross margin stuff is somewhat self-inflicted with your positioning and vending and onsite. Would you say this quarter is kind of the start of us seeing some of that stuff finally flow through on that EBIT line, where it is accretive?
Well, I think frankly you saw that in Q1, right? In Q1, I think a lot of questions around gross margin not being where everyone would've hoped that they would be. We levered our payroll. We levered our occupancy. We didn't lever the freight within SG&A simply because the fuel costs were up as significantly as they were, and that stabilized this quarter, and this quarter we leveraged freight. When you think roll and occupancy and selling related transportation expense, that collectively is 85%-90% of our SG&A. We leveraged those pieces nicely in the first quarter, and we leveraged those pieces nicely in the second quarter.
One of the reasons why we're not obsessing over the fact that over a period of time our gross margins are likely to be down is because we do think that the growth initiatives that we have, they may be lower gross margin, but we think they're also inherently easier to leverage. Again, I think we saw that in Q1. I think we saw that in Q2. We have certainly emphasized to everybody within the organization that we need to continue to focus on leveraging that SG&A line. Yeah, that remains a focus of ours. It's certainly not something that has just emerged this quarter.
Okay. All right. Thank you, guys.
Thank you.
Our next question comes from Hamza Mazhar with Macquarie Capital.
Good morning. Thank you. Just a question on the branch network. A few years ago, you guys had said there could be 3,200 or so potential locations in the U.S. Since then, vending has picked up, onsite has picked up. You're closing a ton of stores, you're opening a few branches, I guess. Could you give us a sense of what your updated view is on how you think about the branch network here, and when do you cycle through these closures so that occupancy expenses actually start going down longer term?
First off, on the underlying question of the 3,200 or 3,500 potential locations that we talked about. That was always predicated on the fact that we saw a certain size of market, and that size of market changed as our product lines changed. If you'd have been looking at that company that went public back in 1987, that was basically selling fasteners, we looked at our market as $15 billion, maybe a $20 billion opportunity, and someday we'd have 500 Fastenal locations across North America selling nuts and bolts. As we moved into the mid-1990s, we were expanding our product lines.
Our decentralized nature, we had a chunk of business that was outside that fastener product line, and we looked at that and said, "Boy, if we can really be successful in the non-fastener products, the market's a lot bigger." Over time, that number grew to 1,000 potential and 2,000, and ultimately about 3,500 locations in North America. As I said, included U.S., Canada, and Mexico. I'm not intelligent nor informed enough to give a comment on outside of North America at this time. That number is intact from the standpoint of there's this $150 billion, $160 billion market out there, and we think we can continue to enjoy an ever larger piece of that market. I think the 3,500 number is potentially overstated to our branch network, understated to our, Holden's new term is in-market network, because the on-site strategy really changes that.
I believe ultimately we go well above that number. But it's not exclusively branches. It's branches and on-sites over time, and the vending. The wild card on your second part of the question about occupancy, we categorize both our vending platform and our FMI, which is Fastenal Managed Inventory platform, as part of occupancy. That's principally what's driving to grow now. That will continue to be the principal wild card in there. We're going to keep investing in growing our vending business.
The other thing I wanted to add to that, is bear in mind that what you're seeing in terms of the public branches, those are really decisions that are being made in the field, right? Our people have the ability to decide if they want to open a store or a branch, and there's a good economic reason to do so, then we've done some of that. If they decide that it's more prudent to close a branch, either because they're pursuing other initiatives or whatever, then they can decide to do that as well. The decisions with regards to the stores at this point, or the branches, are really much more being made in the field than they are any sort of corporate initiative. Be aware of that as well.
Very helpful. I just have a follow-up. I'll turn it over. Just looking at your gross margins improvements that you've made around execution, could you give us a sense of where the low-hanging fruit is here? Is it private label? Is it better purchasing? Is it the supply chain? As you look longer term, is there any one bucket where there's more low-hanging fruit, where you can sort of offset any mix or pricing headwinds? Thanks.
I think exclusive brands is certainly one of those. Right now, I think exclusive brands is probably about 12%-13% of our total company sales. Frankly, we think that over some period of time, that should probably approach 20%. We think that there's significant opportunity still in exclusive brands. We've been very pleased with how CSP has played out for us, and that basically is taking product, putting it into the marketplace and making it available. It's one reason why construction is trending the way it is, and it's one reason why our margins are trending the way it is. What those really come down to is just us managing our supply chain really well. I think that we'll continue to find ways to do that. Absolutely, exclusive brands are going to be a part of the equation.
I think that we're going to do not CSPs the same size that we did last year, but there are ongoing CSPs to continue to tweak and improve the inventory in the field to make it available. I think that's going to continue to improve the market space as well as the margin. Those are sort of the two that come to mind, frankly, as having tremendous opportunity going forward.
Our next question comes from David Manthey with Baird.
Hi, guys. Good morning.
Hi, Dave.
Yeah. First question is on on-sites and the progression. I think that the perception out there is that on-sites are massively dilutive to the overall company forever, and I'm hoping you could discuss the margin progression of the on-sites as they mature. Reason for the question, I noticed you say you have 486 open today. You're opening 68 in the current quarter. At what point does the improvement of the base start to outweigh the dilutive impact of the lower margin relationship to the front end of the pipe?
Yeah. With regards to 68, just one correction is, those are signings. Those aren't necessarily openings in the quarter. Once you sign one of these things up, there is a process that you need to go down before it's sort of open for business, if you will. That's a short period and a technicality perhaps, but just to sort of clarify that. The idea that these will be dilutive forever, we don't believe that, right? We're on the early stage of expanding the signings, expanding the openings, and growing this within our revenue base. It began in 2015. It picked up speed in 2016, and it's picking up further speed in 2017. You're certainly right to say that when you first open these things up, they tend to be a little bit less profitable. As they age, they become somewhat more profitable.
By the way, that speed to profitability is probably faster than people give credit for. This is a business model that, today, sits in sort of the high teens in terms of an operating margin. What'll be interesting to see is as time goes on, as the pathway to profit perhaps applies to this as it has our branches in the past, can these margins exceed where they sit today? We're working very hard to kind of go there. I think in terms of this sort of emerging bump, if you will, right? As we have a high concentration of very new sites today, I think in 2017 and 2018, you probably have the fact that the initiative is so new, dampening the margin.
By the time you get into 2019, 2020, 2021, as these ones you're opening today begin to age, I think they begin to work against that. I think you're going down into the valley of this initiative in 2017 and perhaps a good part of 2018, but by the time you get to 2019 and 2020, I think there's certainly the potential for the margins to stabilize and improve on this initiative.
All right. Thanks, Holden.
Dave, I'm just going to chime in on that, just to think out loud for a second. We've talked about the on-site model and the fact that operating margin-wise, it does have lower operating margins than our business today. When I look at the regional business units within Fastenal that have the greatest concentration of on-site business within their business unit, they also have the highest operating margins in the company. Because if you look at it in a static sense, if we just plopped a bunch of on-sites in our business today and our store network is static, in the short, yeah, it'd be dilutive to our operating margins. Our returns would be just fine because it requires less working capital to support, but it would be dilutive.
The pathway to profit that we have talked about for the last decade, it is still intact, and our branch network is improving every day as the average branch size increases. While it is dilutive, it is no more dilutive than non-fasteners and national accounts have been to our business over the last 20 years. The business continues to evolve. Your average location revenue continues to go up, and that is probably the strongest anti-dilutive or profit-enhancing component we have within the model, is that pathway to profit is still there.
Okay, I will leave it there. Thanks a lot, Dan.
Thanks, Dave.
Our next question comes from Adam Altman with Cleveland Research.
Hi. Good morning. Congrats.
Adam
Nice quarter, I guess. First, a clarification, Holden. I think you were mentioning earlier your price cost trends that you expect through the rest of the year. Should we read into that that's a good directional read on just the gross margin level overall, that we step up in the third quarter and then step down in the fourth quarter? Are you just explaining a component of the total gross margin, and there should be other things that we should keep in mind?
Yeah, I'm really explaining sort of a component, if you will, because again, we would still expect the mix to be a drag. Seasonality can sort of historically suggest that Q3 margins are flat to maybe slightly down. We did have everything kind of move our way this quarter. As you move into Q3, yeah, I think that there could be some incremental pricing that slips into Q3 before the cost catch up as you get into Q4. How does that seasonality play out this year? Do some of these things that went our way this quarter, is it more of a balanced mix of pros and cons in escrow? It's really difficult for us to say.
I don't see anything that is not sustainable over time with respect to what we're doing with the gross margin, it's really hard for me to look at Q2 and understand the pieces with so much depth at this point, to be able to give you a real concrete indication of where the quarter's going exactly.
Okay. Okay, good. Could you speak through the investment plan for the second half of the year in terms of salespeople and the like? We've seen the sales growth rates accelerate a good deal, and the headcounts remained low for some time. I know the local folks are going to be adding headcount as they need to. When would we really see that big inflection point, or is there a belief that maybe we don't need to ramp up headcount all that much to sustain a higher level of activity?
I'll chime in on that for Holden's benefit. Well, to me, the biggest component, Holden touched on it a second ago when he talked about the signings of the on-sites, and what that means. Those 68 on-sites we signed in the quarter, those will largely turn on in the next three to five months, and some of the signings from the first quarter have yet to turn on. I think it's safe to say you're probably going to see, and I hope you see this because it tells me the on-site's taking off. You're probably going to see in the short term one to three employees, so let's just say it's a couple. That would imply we'd probably be adding 150 people, 140 people, just from the impact of the on-site.
The remainder will be more of a function of what our business is doing from the standpoint of growth and the improvement we saw in the last 30 days in the underlying economy. I believe this can continue to enhance the revenue on a per location basis and will potentially cause that number to be higher, possibly between two and 300. Beyond that, I probably wouldn't go too deep into it because a lot of it's going to depend on the needs. We manage that, not centrally. We manage that locally. What we do centrally is we challenge folks with the facts. We point out our expense patterns. We point out the seasonal patterns of our business. It's really a reminder exercise. Just the fact that we have close to 70 on-sites that we'll be turning on, that's going to cause some headcount increase.
Another thing to bear in mind is we've actually added heads every month this year. It was low initially in January, it's 13 heads, but in June, we added 178, right? You're already seeing the headcount react to the trend in the marketplace and that sort of thing. I would expect that you would continue to see that sort of thing. We have emphasized that we still need to leverage this line, that is our intention. Bear in mind that last year at this time, when the marketplace looked significantly weaker, we were actually letting attrition work our headcount down in the back half of 2016.
What you're going to be entering into in the second half of this year is you're going to be coming up against that sort of attrition in the back half of 2016, even as we're adding now because of better heads. I think that what we've been seeing is an addition of heads all year. I think we'll continue to see that. You will see the year-over-year numbers flip from negatives in the first half of this year to positives just because of the sort of the cadence of how we've treated heads over the last year and a half.
We're up at 9:45 A.M. I would just thank everybody again for your participation on today's call. Say thank you to the Fastenal team. You put up a great quarter. I'll close with two thoughts, they really come from learning some lessons from my predecessors in this role. One is the power of having a fundamental belief in people and their ability to do great things, the value of having a business with structural advantages, I'll keep building on those. Thanks, everybody.
Thank you.
Ladies and gentlemen, this concludes today's presentation. You may now disconnect. Have a wonderful day.
We're off 4%.
We're off 4%?