Good day, ladies and gentlemen, and thank you for standing by.
Welcome to Fastenal.
Welcome to the Fastenal Company third quarter 2013 earnings 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 be given at that time. As a reminder, this call is being recorded. I would like to turn the conference over to Ellen Trester of Investor Relations. Ma'am, please go ahead.
Welcome to the Fastenal Company 2013 third quarter earnings conference call. This call will be hosted by Willard Oberton, our Chief Executive Officer, and Daniel Florness, our Chief Financial Officer. Also present for today's call is Leland Hein, our president. The call will last for up to 45 minutes. The call will start with a general overview of our quarterly results and operations by Will and Dan, with the remainder of the time being open for questions and answers. Today's conference call is a proprietary Fastenal presentation and is being recorded by Fastenal. No recording, reproduction, transmission, or distribution of today's call is permitted without Fastenal's consent. This call is being audio simulcast on the internet via the Fastenal Investor Relations homepage, investor.fastenal.com. A replay of the webcast will be available on the website until December 1st, 2013, at midnight Central Time.
As a reminder, today's conference call includes statements regarding the company's anticipated financial and operating results, as well as other forward-looking statements based on current expectations as defined by the Private Securities Litigation Reform Act of 1995. Forward-looking statements may often be identified with words such as "we expect," "we anticipate," "upcoming," or similar indications of future expectations. It is important to note that the company's actual results may differ materially from those anticipated. Information on factors that could cause actual results to differ materially from these forward-looking statements are contained in the company's periodic filings with the Securities and Exchange Commission, and we encourage you to review those carefully. Investors are cautioned not to place undue reliance on such forward-looking statements as there is no assurance that the matter contained in such statements will occur.
Forward-looking statements are made as of today's date only. We undertake no duty to update the information provided on this call. I would now like to turn the call over to Willard Oberton. Go ahead, Mr. Oberton.
Thank you, Ellen, and thank you, everyone, for joining us today for our third quarter 2013 conference call. Thinking about the quarter, overall, I believe that we had a good quarter considering the challenging environment that we're into. I need to get warmed up here. Starting out with sales growth. Sales growth came in about where we thought it would be for the quarter. On a sequential basis, we showed improvement over our historical numbers in two out of three months. July was a tough month, but we came back nicely in August. Had a good growth month in September. In three out of the last four months, we're over the sequential pattern that we look at the historical pattern. We're moving ahead nicely, although there's still low growth numbers in the mid to high single digits. On the margin, at 51.7%, we were very disappointed with the margin.
Saying that, I do believe the team is doing a very good job. They're working very hard on the margin. There are several factors that weighed into this quarter's margin and are weighing into the year that I'd like to talk about. The first, in no particular order here, are slow growth in fasteners. Fasteners are in a difficult market this year. We've seen basically no inflation in the product. We've had very slow growth in the product line. It is the highest margin product that we sell. We had growth of 1% in the quarter. That's hurting. It's a mix issue. On the other side of that, our non-fastener products grew about 12% roughly. They're traditionally lower margin products, there's a mix issue going on there. Another mix issue that we're facing right now is the customer growth.
We're getting better than average growth or better growth out of our large customers and slower growth out of our small customers. The large customers, again, are the lower margin customers. Smaller customers producing the higher margin. We have that going on. Another thing that we're seeing in the market right now, I've actually spent a lot of my time traveling. Over the last two months, I've spent quite a bit of time traveling to customers, visiting with customers on many issues, and our customers are becoming more creative every day at pushing for lower prices and better deals. If you look at the first and second quarter reports of the industrial companies, many of them are hitting their numbers, but they're not doing it on the top line. They're doing it by squeezing on the bottom line.
My guess is that's going to come true again this quarter. When that happens, companies like Fastenal and our competitors are the ones that are helping support those lower operating costs. The customers are pushing us very hard, and many of our competitors are responding to that just as Fastenal is. If you look at the margin in a macro view, our fastener growth is not doing well. Our non-fastener lower margin products are growing faster. The large customer is up, small customer is not growing as well, and then the pressure, just the competitive pressures out there. Putting that all into perspective, I think 51.7% is probably, yet disappointing from where we thought we would be, a very good effort by our Fastenal team. On the expense control side, I think Lee, Dan, and the team or their teams are doing a very good job.
They seem to have a great handle on what we can afford to spend, where to put the money, and they're making the right investments and managing our expenses very well, not just this quarter, but over a longer period of time. I'm very happy with what they're doing there. Another area I want to talk about is vending. Before I go into the vending performance for the quarter, I just want to clarify a point that I made last quarter, and I know it was misunderstood by some because I've had several questions on it. I do not feel that we have over-invested in vending. I believe that we under-invested in supporting vending because several people, when I talked last quarter and said that we were pulling back the pressure a little bit, they took that to believe that we were over-investing, and that's not true.
If we had the people in place in the stores, we would be pushing harder than ever on vending, and we still believe it is a fantastic way to deliver product to our customers. It's a more efficient vehicle system to deliver product and provide a high level of service. Our goal is when we have better staffing in the stores, and I'll talk more about that in a minute, we plan to introduce new incentives that basically in the early part of 2014 to the vending program with a goal of ramping up the signings in 2014. It's really about get the people in place and then put the hammer out back or put a little more selling power back into the vending program. If you look at the numbers, you'll see that we still have good growth in the vending customers, just over 15%.
Not as good as we're doing, but compared to almost any other measure that you see for industrial customer growth with us or any of our customers, it's about the best number out there. We're very happy with the program. Although the signings were down from where we want them to be, we believe we're moving in the right direction. One comment on the signing, just a side note. It has dropped as you saw, that is a very natural number. It's a number that's coming without putting a lot of pressure on our field. That's the number that's just happening because it's a great system, not pushing very hard. On a positive note, we've made very good progress on adding additional support into our stores. On a quarter-to-quarter basis sequential, we've added 4.6% more FTE, which puts us on track.
Our long-term goal is to be at 15% plus or around the 15% number. On an annualized basis, we're slightly ahead of that, we do have some ground to make up. We are making good progress. Reports from the field is that it's hard to find the right people, if you work hard at it, they are out there and there are a lot of good people looking for great opportunities. As a company, we are very focused on growth. That's what we're talking a lot about, I believe that we are taking the right steps to make this happen over the next several quarters. With that, I'm going to turn it over to Dan to give you some more color on other areas of the company. Thank you.
Thanks, Will. Good morning, everybody. Also want to thank you for joining in on Fastenal's earnings call today. Just want to touch on a few items. The store headcount, we go through quite a bit of discussion of stats, probably sometimes you might argue too many, on page 11 of our release, go through stats of headcount in various pieces of the business. Some things that I think are worth noting, as Will touched on, we added just over 400 people to the store, or FTE to the store in the fourth quarter, 4.6%. One thing that probably isn't as well known as in addition to supporting our store, because really what we're doing is our goal here, we want to support every store, every vending machine, every key account, grow our business.
In addition to the headcount we're putting into the store, we're adding resources behind the store to support the sales leadership of the store. That is, we went from having just over 220 district managers throughout our organization, we added 50 during the quarter. Those are folks that are stepping into expanded roles, reducing the number of stores per district manager to put more selling energy, more attention on each and every store every day, every week of every month. In addition, we expanded our regional VP pool by three, went from 18 to 21 during the quarter. We put in a lot of selling energy to support our store. Again, it's all about supporting every store, every vending machine, every key account, every day, week, and month.
Reading through the analyst reports that have come out during the course of the month, I think this is generally well understood, but I thought I'd just touch on a few aspects of the quarter from the standpoint of calendar. July, as Will touched on, a weaker daily sales growth number. One thing to always point out, extra business day in the month, and with July 4th being on a Thursday versus with that one orphan day, that really negatively impacts that month. Rest of the month played out pretty much as expected. Seeing some good trends. Also, we had in our sequential pattern, two consecutive beats. August and September, we beat the historical pattern. We haven't had two consecutive beats since the spring of 2011. If you're looking for some positives, that's the biggest positive in our release, is that there's some positive trends going on.
The ISM Index, I'll be honest with you, it makes me scratch my head. It's been +50 for four months starting in June. It's been in mid-50s for the last three months. The ISM historically was a pretty good indicator of our business as far as trends. It tended to lead the industrial distributors in general by about three or four months. Since spring of 2012, that relationship, in my opinion, has been broken. Given what we're seeing with a strong ISM right now, I hope that old friend returns. It is positive for what we see going into the tail end of this year and into the early part of next year. Hope isn't a strategy. Our strategy is putting energy into the store to grow our business, and it's about growing our top line. FAST Solutions, I would echo Will's comments.
Without the pressure on every day, we saw a natural number emerge. The energy in reinforcing that as we go into 2014 will be strong. One other thing that occurred during the quarter, and I know there's some knowledge of this out there just from the standpoint of discussions on previous calls. Our T-Hub facility turned on July 22nd. We started picking product for our first store. Currently, we have 15 districts that are live on the system. We are rapidly rolling it out. The concept of T-Hub, it's a centralized facility. It's located in Indianapolis, adjacent to our Indianapolis facility, and it is picking product for our vending machines. It's a highly automated, highly efficient picking area where we are picking and containerizing a shipment to the machine level that goes out to the store.
This will free up a tremendous amount of time at the store and probably is more important than our FTE growth right now as far as the energy it's creating at the store when you look at the next 12 months. I don't want to discount our FTE growth because that's a huge plus. This really doubles down on that and says we're adding available selling energy into every store. This will be rolling out over the next six to nine months, and a lot of that in the first part of that timeframe. Profit drivers, 22% pre-tax in the quarter. I think very good performance given the fact that earlier in the year, we had the added impact of gross margin expansion. We really didn't have that. We really had to rely on what's our gross profit dollars, what are they growing.
Our gross profit dollars grew about 7% in the quarter. They grew about 6.6% in the second quarter. Very proud of the fact that we produced a 22% pre-tax in the quarter. Gross margin, as Will touched on, I don't want to beat a dead horse. It's a tough market out there, a very competitive landscape. Product mix continues to challenge us. Within the product mix, though, we continue to eke out month by month, day by day, additional progress in our private label products we refer to as exclusive brands, and vending is a big piece of driving that. That's a piece, that's a wave that's coming through. Again, vending is a big driver of that. Operational working capital, as you saw in the second quarter, we continue to generate good cash flow.
Year-to-date, for every earnings dollar we've generated after paying for working capital needs, we have $0.90 left over. After paying for capital expenditures, which are significant this year and next year, as we've discussed in the past, because of our Vending Initiative, because of our Distribution Automation Initiative. After paying for all that, we still had 50% of earnings year-to-date left over in free cash flow. I think very powerful reflection of the pathway to profit and where that positions our business for investing into the future. Most of you probably saw last night, we announced our fourth quarter dividend consistent with our third quarter dividend, $0.25. Takeaway message I have is grow the business, grow properly, step back, and look at your return on assets. Will touched on earlier the fact that one of the gross margin challenges is the mix.
One thing we always have to take a step back, Bob Kierlin reminds us this every time he talks to us, it's about your operating margin and your return on assets. Sometimes the optics are the gross margin is struggling a little bit because of product mix, but if we're managing the expenses below that and we're generating good operating margins and a good return, or I should say a great operating margin and a great return, that's going to make you successful long term. With that, I'll turn it over to Q&A.
Ladies and gentlemen, if you have a question at this time, please press star followed by the number 1 key on your touchtone telephone. If your question has been answered or if you'd like to remove your line from the queue, you may press the pound key. Again, if you do have a question, please press star and then 1 at this time. Our first question comes from the line of Ryan Merkel from William Blair.
Hey, guys. Good morning.
Hey, Ryan.
On the last call, you talked about average daily sales growth potentially improving back to a double-digit pace at some point during the next few quarters, and this was primarily based on adding sales FTEs, which it sounds like you're on track for that. If I also start to look at the, if you hit the normal sequential math, which you have the last two months, this also implies that average daily sales could start to pick up from here. I guess I'm wondering, is there anything you see out there today that would change this outlook?
No.
No.
Okay. Care to elaborate any more or?
The market doesn't seem to be changing a lot, Ryan. It's a soft industrial market. We don't believe it's getting any worse. We don't see signs that it's improving, but our attitude internally is we have to deal with the environment out there and go take share, and we're adding the people. Our comps in October are softer than September. We have good opportunity to improve our growth nicely in October and going out through the rest of the year, setting ourselves up for a stronger first quarter.
Okay.
The only thing I'd echo in on that is, if you think of trends going forward, we're adding selling energy, we're adding vending quality to the organization, and I don't know if this third one will prove indicative or not, but the ISM is improving.
Right. Okay. On gross margin, I understand the mix headwind, but I guess I'm wondering if you believe further sales re-acceleration might come at the expense of gross margin, unless the macro improves. What's kind of the outlook there?
No, we don't think that our gross margin results are a reflection of our hard push around sales. Really believe it's the normal environment that we're in. We're probably overly optimistic going in.
We're still confident or comfortable with our 51%-53% range, and believe that's what we have to work with. We have to try and stay in that range. We see nothing that would push us out of that. If sales really took off, could it affect our margin? Yeah, but we'd be happy with that problem. If we had unusually great sequential growth.
Thank you.
We're not pushing so hard to reduce it.
Thank you. Again, if you do have a question, you may press star and then one. In the interest of time, we ask that you limit yourself to one question and one follow-up. Our next question comes to the line of Hamzah Mazari from Credit Suisse.
Good morning. Thank you. The first question is just on the production side of your business. You guys highlighted mix as a negative, also some competitive pressures. I'm just curious if you're seeing any impact of some of your larger, publicly traded peers getting more aggressive on the manufacturing and market side, particularly on production consumables. I realize the market is big enough for a lot of players, just any sense of, is that leading to increased competitiveness in the industry? Any thoughts?
I think the competitive aspects we're talking about really relate to more what our customers are expecting and asking of us, more so than what competitors are doing, other than the fact that we are all reacting to the competitive marketplace. It's really being driven, I think, not so much by everybody else taking shots at us. It's really being driven by what customers need. We're squeezing our expenses tremendously, as you can see when you look at our operating expenses. Our customers are doing that, too. In the absence, as Will mentioned, of sales growth, I need to squeeze expenses if I want to get profit growth.
We're seeing that from the large public companies, and we're seeing it from the small private companies. Everybody is out to keep the business they have and try and grow the business the best they can. I agree completely with Dan. It's customer driven, and we're all reacting to the pressures.
Got you. Just a follow-up question on the vending. Clearly, you are taking a more measured approach on the vending side. Could you give us a sense of maybe what inning you are in terms of moving towards higher quality vending, trying to get a sense of, out of your installed base in vending, what % of that do you really need to prune? How much is low quality in that installed base? Any sense of that?
I do not know if we know the quality answer yet, Hamzah, because one of the things that we are seeing, and I touched on earlier, the T-Hub rollout. The quality is not about T-Hub. I do not want to confuse the issue. The T-Hub is about efficiency behind the scenes. Some of the steps our stores are taking to implement T-Hub support expanding the quality, in addition to what we are doing with our vending improvement program. For example, looking at the activity of the actual machine and are there tweaks you could make to it. You go to our warehouse, or I go to a place with a lot of younger folks, and you might see, in a soda machine, five out of six offerings are Mountain Dew. It is because that is what is turning in that machine, and that is what that marketplace wants.
Even though I do not want Mountain Dew, I will take the Dr Pepper, Mountain Dew is what is being drawn. It is taking a step back and looking at the machine and saying, "What coils are really spinning in this machine for the replenishment from T-Hub?" That also optimizes the machine. I think after we get T-Hub turned on, and we have had the opportunity to optimize more of our machines, we have had our vending improvement program in place for a longer period of time, I think at that point in time, we will be able to take a step back and say, "You know what? Here is the portion of machines that were suboptimal 6 months ago, and here is the portion that still are, and we need to scratch our head a little deeper on those." It is, I believe, a small subset.
The machine is just a better way of delivering products. Where we have issues is, do we have too many machines relative to the customer? I think that we will run into more than we have a machine where it does not belong.
Got it. Thanks a lot. Appreciate it.
Thank you. Our next question comes to the line of David Manthey from Robert W. Baird.
Hi, good morning.
Hey, Dave.
First off, I was hoping you could discuss the impact to date of your full-time equivalent additions. Have you seen measurable improvement in stores where you've added them? Also, if you could talk about success you've had in going back and asking customers to make good on the commitment to add an incremental $2,000 per month per machine. You talked a little bit about optimizing the machines, but I understand that some of those are not operating at the level that customers had committed to. Could you talk about those two growth drivers?
On the first one, Dave, as far as the improvement, adding the people, it's too early to tell. If you look over a long period of time, we know when we have more hours, our businesses grow faster, it's very straightforward. We've had very good success on going to visit the customers on the $2,000 per machine. I don't know the exact percentages, but it's a very low percentage where we've decided to take the machine out. In most cases, it isn't about the customer giving us other business, which we would like. It's about resetting the machine so that we have the right product in there. Dan mentioned that with his Mountain Dew analogy. It's really about looking at the customer's needs and understanding what we should put in there.
In our vending team, the team running the system has developed some very good software to look at what's spinning and what isn't, or what's falling out of the machine and what isn't. They have good analytics to go to the customer, identify what we need to put into it. Most customers want that conversation, because if they don't use the machine, they don't save any money, and they don't run their plants as efficiently. We're going down the list. We continue to see very good progress in the quality of each machine, continues to rise basically on a weekly basis. Team's doing a very good job.
Okay, thanks, Will. In terms of this, the emphasis on shorter cycle sales efforts, sort of unclear what the impact there was on growth, it seems like you cited that it had a negative impact on gross margin, clearly. Could you put that in the context of the price guidance system where you've had such good success year to date? It seems like it overwhelmed the benefits that you had there. Just wondering, do you expect future improvement in sort of that underlying gross margin exclusive of mix?
On the last part of your question about gross margin, I'm going to shy away from answering. We're going to hold to the 51%, 53% and the faster it move a little bit, and half of this discussion goes away. In regards to the shorter cycle sales, to me, the best indicator I can point to of everything we're doing, going after some shorter cycle sales, aggressively having some of our national accounts folks work in stores, the FTE we're adding, the district manager energy we're adding. If you look at all those things, I go back to the sequential patterns. In the sequential patterns, we've now strung a couple of months together where we've beaten the pattern. There's positive energy going to that. I don't know if I touched on this earlier. If I did, I apologize for repeating myself.
It must be because I'm almost 50 years of age and I'm
Like next week
losing it a little bit. If I look at it since May, and I'll probably lose the group with this comment. Since May, we've beaten 3 out of 4 months in pattern. If you look at the delta, if we beat the pattern by 0.5%, miss the pattern by 0.5%, cumulatively, our beating has given us a 0.5 point of lift. In the last two years, from May to September, we were down about 0.2% or 0.3%. We've gone from negative. In 2011, it was negative, and that was the stronger year. 2012, it was negative, and that was a negative year. In 2013, if you look at the sequential beats and misses since May, we're up 0.4% and we've beaten 3 out of 4.
I think all those tie together that the focus on just grow the business is impacting our business.
Dave, I didn't mean to indicate that our short cycle sales are affecting our reported gross margin. I'm not saying they are or they aren't, I really think our gross margin is more about the two mix related issues and the customer pressure for them trying to hit their bottom line. Like I said, in the last two quarters, every industrial report I read was short on the top line, We did a nice job on expense control, That affects all of us and all of our direct competitors.
Got it. Thanks, guys.
Thank you. Our next question comes to the line of Sam Darkatsh from Raymond James.
Good morning, Will, Dan, how are you?
Good, Sam.
Hi, Sam.
A couple of quick questions. First off, I noticed that your store count expectations or the store additions were trimmed on the high end, now 55 to 60 instead of 55 to 80 before. Are you rolling those into next year, or what's the reasoning behind the trimming there?
Yeah, I think the reason behind the trimming is we're now nine months through the year, and we have a better idea of where we're going to finish at. You narrow the range down. There's nothing more than that. We also indicated a starting point range for next year. I don't think either one of those are horribly surprising.
Okay. Secondly, Will, you mentioned that you're looking, incentive-wise, to create an environment where you're going to be ramping up the vending signages next year. Could you quantify that in terms of what goals or reasonable expectations might be for installs, both on the FAST 5000 machines and otherwise?
Well, on the overall number, our goal would be to, 2014, we'd like to get to the roughly 2,000 per month signing. We think that's a good number. That's what our incentives are going to be designed to do. It's too early to say whether we're going to get there. But if you look at the fact we're basically, we've signed 18,000 without putting any pressure on or Based on last quarter, it doesn't take a lot more energy to crank that up. We think that we have some built-in energy when T-Hub is up and running because right now, if a store is struggling to serve the machines because it's a lot of work packaging the product and filling the machines, there's a reluctance to go out and sign more machines. I talked to a group of managers this week about that very subject.
If we can get T-Hub up and running the way we believe it will, we reduce the workload at the store, the stores see, hey, this is pretty good business. They're going to go out and work harder to sell them, and they're going to have more time to work harder to sell them. Based on that, based on a little incentive, right now, looking at the year internally, we're saying, hey, we'd like to get the number up around 2,000 machines per month. We sign 23,000-25,000 or 22,000-26,000 for the year. That gives us great growth. It's very manageable, and it doesn't overload any particular area of the company as far as stores and regions.
Dan, if I could sneak one more in if I could. I noticed your accounts payable, this might be nothing, but it spiked, and I was wondering if perhaps you were building inventory late in the quarter as a result of why that was the case.
There's a few things driving that. One is the timing of some of the inventory spend. We were building some inventory, and some of that is inventory going into T-Hub. Another one, which is a relatively minor event, but it's still meaningful dollars, is we changed the organization we use for processing our fuel cards in our vehicle fleet. Their cutoff is five days earlier in the month. There's an added accrual in there for some fuel. That's more mechanical than anything. The third one is all the distribution stuff we're doing. There's a piece of that sitting in accounts payable at the end of quarters, and it will be paid out here in October, but nothing horribly meaningful other than that.
Okay, thanks much.
Certainly.
Thank you. Our next question comes from the line of Adam Uhlman from Cleveland Research.
Hi, guys. Good morning.
Hey, Adam.
Hi, Adam.
Yeah, I was wondering on the fastener mix, the business really hasn't been growing too much, and it sounds like there has been some added pressure to try to increase the company's sales there. I'm just wondering how you think you're doing from a market share perspective on fasteners overall, and then, where do you think over the medium term where that settles out in terms of your mix as you've been addressing non-fastener products more aggressively?
Adam, it's hard to understand because there's not a lot of data out there. If you look at the Fastener Index that BB&T uses, that Holden Lewis sends out. Holden, you're probably on the call, thanks for that. It shows that fasteners are in a pretty tough spot. I think it came out at 46 and change, with 50 being the center point on that index. Very slow growth. Our director of purchasing and a person who heads up our fastener initiative just came back from Taiwan, which was China and Taiwan about three weeks ago, I met with them, and they said that the factories that we support very heavily are very slow. The U.S. imports coming out of Asia are at a very low level, which tells me demand is slow.
The Fastener Index from Holden tells me that demand is slow, we know that there's no inflation in the product. You put all those together, it says that we're probably doing a little better than average with our fantastic 1% growth, sarcastically. We are working very hard at it, we have a lot of small projects and medium projects, things we're working on, better bin stock technology, doing a better job of calling on the large customers. Lee has implemented some new quoting tools, his team has tools to speed up the process to try and turn an inquiry into an order. We had kind of slowed that down with price guidance. They recognized that.
They developed some software that the store managers, I again, spent a lot of time with store managers this week, are high-fiving us for doing this for them, I get no credit back. We're doing a lot of things to speed that up, we're pretty confident that we're going to start taking share when that opportunity for share growth comes back.
Okay. Just to follow up, could you just talk about where we stand with the metalworking initiative, if trends there are getting better or worse overall?
Well, the trends are slow. In the quarter, we grew our metalworking by just over 10%, basically a little, almost double where the fastener growth is. Metalworking is a tough area right now. Two-year pattern, we're up 37%, so we had a great first year. It slowed down this year, but we're still very motivated and believe it's a great opportunity for us. Based on what we're hearing from industry data, from other competitor data, metalworking may be one of the toughest areas out there right now, but we're still growing the business at 10% off a pretty good base. We're not huge, but it's a nice piece of business for us, and we're still very optimistic. Believe the team is doing a nice job of growing that business.
Year to date in that, we're up about 13%.
Okay. Yeah, I didn't have that.
Great. Thanks.
Thank you. Our next question comes from the line of John Baliotti from Janney Montgomery Scott.
Good morning. Thanks for taking my question. You guys have pointed out the correlation you've had or sequential pattern with ISM, you pointed out that fasteners have been growing a little bit slower than you had hoped. I was wondering, do you think that all the points that Will mentioned about the headwinds and tailwinds to gross margin, do you think that customers are still pruning their inventories? Because ISM picked up quite a bit in the third quarter versus the second quarter. In every one of those months, I'm wondering, given your high correlation to that, do you think that maybe they're just working down some inventory in the short term?
No, I don't believe that. Since 2007, 2008, 2009, most of our customers, they don't have a lot of excess inventory in the system anymore. They're all living, part of it has to do with, there's a lot bigger pressure on taking cash out of the business. The other hard thing that's going on is the suppliers are better, we're better, our competitors are better, so you don't need as much inventory. I have been scratching my head just as Dan has over the ISM. Like I said, I've been out with a lot of customers over the last few months. It's hard to find one that's just booming. It'll be interesting to see the reports coming out over the next two weeks from the big industrials.
It doesn't sound like any of them are seeing robust growth. It's hard to understand where that 56 is coming from. Hopefully, it's a leading indicator, as Dan mentioned, we're seeing it in the next two, three, four months. I do not believe it's inventory.
It seems like it's an encouraging number because it did move up markedly from the second quarter. To your point, the things that you flagged about gross margins, do you think that we should expect those to continue through the balance of the year? If we're thinking about your long-term range of gross margin, you think it's smarter for us to be in the vicinity we are now through the year?
We're not going to give guidance on gross margin, unless the fasteners pick up and unless business just picks up in general, unless fasteners pick up, that pressure is going to stay there. If the economy doesn't turn around, the competitive pressures from both our competition and our customer base are going to remain the same. We don't foresee a lot of change over the next three to four months.
Okay. Just finally, Dan, you'd pointed out historically the sequential patterns and how more recently you've outgrown them by about a half a point or so. Do you have any feel of what we should expect that? What would you guys view as a successful delta from, I guess, historical sequential trends?
I think that'd be called guidance.
Well, I'm just thinking like.
John, to be honest with you, we don't know.
Yeah.
We know what we're doing that we believe positively influences our business, and I would hope to positively influence our performance to our benchmark.
Sure.
What we're doing with adding energy into the store, what we're doing with working to improve the vending, what we're doing to drive our key accounts. Those pieces are ultimately good means to grow our business. The expanding our district manager roles will do two things. A, we'll be better at recruiting, and B, we'll have a higher level of sales energy in our business to support our stores every day, every week, every month.
If the ISM is an indicator of future opportunity, that is going in our direction.
Okay, great. Thank you.
We do have some tailwinds from that perspective.
Thank you. Our next question comes to the line of Eli Lustgarten from Longbow Research.
Good morning, everyone.
Good morning.
Good morning.
Somebody has to ask the obvious question. All the data we've gotten was before the insanity in Washington. Now we have a combination of a government shutdown. We have Obamacare scaring a lot of businesses from hiring, and just wondering whether you foresee or anticipate or are looking for any impact from the environment that nobody chose, but we're sort of stuck with, at least for now?
We're both kind of looking at each other-
Yeah
shrugging our shoulders.
It's not positive.
I think as a nation, and I'll go out on a little limb here, I think as a nation, we've grown a little bit accustomed to the fact that we have a bunch of folks in our nation's capital that a high percentage of the time do things that are pretty damn dumb. That's unfortunate, speaking as a U.S. citizen. With that said, I'm a firm believer if there's core demand for the things that we sell, that core demand will be there. I don't think that distraction is going to be that destructive longer term. We don't know.
I was just pointing out, the Small Business Optimism Index is weakening, there's a lot of commentary coming out of the small business side about Obamacare and their unwillingness to change their business conditions, and that's an important part of the profitability the company would say. At this point, you're not seeing anything that are in the plans for the fourth quarter. Is that fair?
That's fair.
The incremental profitability, we talked about gross margins, the cost going, which really weighted on the incremental profitability that we saw in the third quarter. From the sound of it, do you expect no real material improvement in those metrics as we go toward the end of this year? If volume was better, obviously it would be better. At this point, the conditions you're laying out don't show much improvement in incremental profitability. Is there a distinct movement inside to control costs a little tighter to get the improvement in profitability up for the fourth quarter?
When you're operating at a level of profitability that we are, at 22%, you're in an environment where you're not sure what mix is going to do to your margin, we're heavily investing in selling energy, that does create challenges for us to obtain incremental margin. We've talked in the past about the pathway to profit. Our stated goal, and this was a point-in-time goal, this is an end mark, end place. Our stated goal a good number of years ago was to drive the pre-tax to 23%, which would imply we have another 100 basis points of incremental margin to pick up at some point in time and beyond. Again, that 23% is not a target. It's just a number. It's really predicated on the average size of the store.
The average size of the store right now, I forget what it was in the release.
94,000.
94,000. That's what needs to happen to drive that up, we need the top line to drive that. It gets a little easier if the top line, if we have a good mix of products and our gross margin is giving us a little bit of tailwind. It's good if we're getting a little bit of tailwind in operating leverage. We're investing in a lot of things right now. We're adding folks into the store, great investments, because we focus on long term.
Our main focus is getting our growth back, because if we can do that takes care of most of the other things, pre-tax profit %, all the other things. We have to stay very focused on that, and we believe we're doing the right things to make that happen.
Thank you. That is all the time we have for questions today. I'd like to turn the conference back to Fastenal management for any concluding remarks.
Speaking for Will and Lee and myself, we want to thank you again for your support and interest in the Fastenal business and for participating in the call. Have a good day.
Ladies and gentlemen, thanks for your participation in today's conference. This does conclude the program, and you may now disconnect. Everyone, have a good day.