Category: Competitive Strategy Series

How is Dollar General Only in the “Fourth Inning”? $DG

Reading Time: 6 minutes

“We have turned the clock back. We’re actually now only in the fourth inning. We see a tremendous runway ahead of us there”

CEO Todd Vasos didn’t mince his words. I’ve never invested in Dollar General stock before (to my detriment) because I thought the growth and reinvestment story had come to a close. That was wrong.

Despite being brick-and-mortar focused, they continue to excel in basically any operating environment. Their unique real estate strategy, where they set up low-cost buildings in rural towns as the one-stop-shop at affordable prices, is key.

I’m filing this post under my competitive strategy series because clearly Dollar General is a stellar retailer with unique strategy – and the stock has delivered excess returns.

Since the beginning of 2015, I’ve watched store count grow from 11.8k to ending 2020 with over 17.1k stores. That is a 46% increase!

Dollar General stock benefitted from this growth despite being an “old school” business — no FANG here, but with FANG-like returns. Coming from brick-and-mortar retail, no less.

They don’t appear to be overloading the system either. Going back to 1993 – Dollar General hasn’t had a year when SSS comps have declined.

So if you invested in Dollar General, you’d have benefitted from

  1. Growing stores
  2. SSS Comp increases
  3. Margin enhancement from this operating leverage
  4. A high ROIC / highly cash generative model (even now, Dollar General mgmt estimates the stores are a 2-year payback)

Ok, again. I missed all of that growth. How could one possible invest in Dollar General stock now? Especially with the dawn of e-commerce, is it rational to expect the company can continue to perform?

There are still a bunch of reinvestment opportunities at very high rates of return. I will outline six different ones the company is targeting:

  • DG Fresh – Increasing stock of perishable & frozen items. Self-distributing these products as well to control costs
    • This really started in earnest back in 2013 as DG increased the amount of cooler doors in their stores.
    • At the end of 2012, DG stated they had about 11 cooler doors per store. By the end of 2018, they had 20 doors per store. They expect to install 60k in 2020!
    • Dollar General continues to view this as the #1 sales driver going forward (again driving that one-stop shop mentality).
    • DG Fresh also entails distributing these items themselves to help lower production costs and improve in-stock position, enhancing their competitive positon.
  • The Non-Consummable Initiative (NCI) – Selling such as home decor products, seasonal items, or party items just as some examples.
    • These are higher gross margin and increase transaction amounts, which helps operating leverage on stores.
    • Seasonal items that rotate also helps the “treasure hunting” aspect in retail shopping.
  • New Store Formats (Popshelf). DG has about 17k locations… but that doesn’t mean it can’t use its infrastructure set in place for a new concept. Popshelf is a new store concept targeting suburban women, with products priced under $5 in the  seasonal, home decor and beauty products, as well as cleaning supplies and party goods.
    • This stemmed from the NCI work the company did.
    • Dollar General doesn’t take any decision lightly, so I think this could be a real opportunity and the US could easily support thousands of these stores.
      • As an aside, and call me crazy, but I could BIG as a DG acquisition target.
      • Popshelf reminds me of Big Lots, though I guess Popshelf doesn’t seem to be targeting furniture.
      • There would be immense synergies, with BIG benefitting from DG’s low cost distribution as well as scale on corporate costs.
      • Big Lots is still smallish with only 1,400 stores, but still has all the public company costs, back-office costs, HR, accounting, legal, etc. All of these could be scooped under the DG umbrella. It would give DG 1,400 more stores in a concept it wants to target.
      • BIG also trades at less than half the multiple DG does, so it would be highly accretive to DG.
  • Smaller format stores (<6,000 sq ft) for urban areas where Dollar General doesn’t currently target
  • Private label / Increased Foreign Sourcing. 
  • Other “Core” continuous improvement items like lowering “shrink” (i.e. theft), zero-based budgeting, etc

These are six items outside of tech-enabled strategies like Buy Online, Pickup in Store (BOPIS) or the ability to scan items on your phone to expedite check-out (both of which DG has been talking about for years).


Let’s put some math behind the go-forward opportunity

DG clearly has been a COVID beneficiary. I mentioned before that DG has had tremendous SSS growth over its history, but with expected SSS of +16% in 2020, I fully expect 2021 SSS may decline for the first time.

However, DG currently has more cash than ever on its balance sheet ($2.2BN). The next highest the company has had pre-COVID was $600MM back in 2011. It’s basically been around $200MM since then.

This tells DG has $1.6BN-$2.0BN of cash to invest. It means that they can pull forward many projects they have planned.

I estimate the unit economics for a new Dollar General branch based on what they’ve disclosed (the 2016 Investor Presentation was a big help) and what I know about other retailers. Clearly the returns are pretty good.

But what this really tells me is that each $1 that Dollar General invests is worth about $10 at maturity. This assumes no growth after year 10.

Said differently than above, $1.6BN to $2.0BN invested in the company’s growth will likely translate into >$16BN of value. The current market cap is $51BN.

Coincidentally, DG’s pre-tax ROIC on tangible capital averages >50% over time based on my numbers.

If they invest $1.6BN to $2.0BN at these kinds of returns (perhaps a big IF), that could mean a $800MM-$1.0BN uplift in operating income (estimated by assuming a 50% ROIC). For a company that did $2.3BN in operating income in 2019 – that is very meaningful!

Sure, they could also use that cash for share repurchases or dividends, but like my post on Big Lots, clearly the optionality for DG, and growth, has been enhanced.

While they do have 17k stores, their goal is 25,000 locations. So $1.6BN investments, when a new location just costs $250k to open, leads to 6,400 stores right there…

Remember, DG performed very well during the great recession due to a trade down effect as the consumer wanted to save costs. This led to them having more cash than competitors to expand and reinvest in the business.

As you can see in the chart below, this is when EPS really started to ratchet up.


DG doesn’t look optically cheap today. Currently it trades at roughly 16x 2021 EBITDA and 21x EPS. That’s what used to be called a “growth” multiple. However, they have several growth avenues and you’re backstopped by earnings that actually go up in recessions. So you have growth + stability in cash flow, which drives a premium valuation.

One thing I like to look for in a stock is a doubling of EPS over 5 years. It helps me gain comfort in the multiple I am buying in at (the multiple can be cut in half and I still wouldn’t lose money). This would be tough given where we are buying in at DG (coming off of a peak COVID earnings), but they will have so much capital to deploy with many avenues. I have EPS 70% higher from where it will end 2020 due to store growth, modest SSS growth, modest margin expansion over 2019 levels and share buybacks. Assuming shares trade at 20x FCF in 5 years, I think you can earn a 14.5% IRR. 


I can’t talk about a retailer without addressing e-commerce. If you think about Dollar General’s footprint, it is immense and its generally where e-commerce is still underpenetrated (i.e. rural areas).

However, that also means DG is best positioned with their distribution capabilities to attack that market. Much like they segmented rural areas for brick-and-mortar retail, they could do the same thing in e-commerce. They are the anti-Whole Foods, if you will, which many believe Amazon acquired to enhance their platform.

Why has AutoZone stock been one of the best compounders of all time? $AZO

Reading Time: 8 minutes

I’ve been tardy in my Competitive Strategy posts – living in a global pandemic really disrupts a routine. The focus of this article is on AutoZone stock which would have been a tremendous winner to buy and hold over time.

AutoZone fits the exact mold for my Competitive Strategy Series: auto parts retailing isn’t a sexy business and it’s competitive, but I wanted to dive into any strategic choices the company has made and why that translated into such strong equity returns.

If I could sum up AutoZone stock in one phrase I would say it is: “perennially underestimated.”

Quick Background

AutoZone started as “Auto Shack” in 1979 and quickly expanded from 1 store in Arkansas, to 23 stores by 1980, to greater than 250 by 1985. The company also sold a majority stake to KKR around this time (which may be part of the firm’s culture of understanding of capital allocation priorities and its capital structure). By 1989 they exceeded $500 million in sales and opened the 500th store. The company went public in 1991.

Focus on the Customer

AutoZone’s core strategy was to offer low price automotive parts with high quality customer service. Similar to Amazon, it seems as though AutoZone figured out early on if the customer is happy, they’ll keep buying from you, and that will translate into good outcomes for shareholders. In other words, customer interests and shareholder interests are aligned.

AutoZone likely also took cues from Wal-Mart, which focuses on low everyday prices, given the company’s founder sat on the Wal-Mart board several years before starting “Auto Shack”. The Chairman & CEO of AutoZone, William Rhodes III is also a board member at Dollar General. Both tremendous retail equity stories… is it any wonder that AutoZone stock was destined for greatness?


As a quick aside, seeing these company associations made me think about my own experience of seeing AutoZones. When I drive through a small town I don’t know, there are two stores I typically see front and center… a Dollar General store (or something similar) and an AutoZone. Dollar General specifically targets these towns because a “dollar” store becomes the one-stop shop for many of its consumers. I went back to AutoZone’s original prospectus to see what they said about store strategy. It seems to me that they must also target areas where (i) there are plenty of older vehicles on the road that need maintenance and (ii) a high population of DIY-ers.


Back in the 1980s, the company began using an electronic catalog to help employees determine which parts were needed for specific vehicles quickly. This system helped pave the way for AutoZone to launch an e-retailing site relatively early on – in 1996.

Second, it trained employees to have general knowledge of cars so that they could answer customers’ questions in an educated way. Then, it would even install some parts for the customer. Think of windshield wipers, or running a diagnostic on the car for free to see what’s wrong without visiting a dealer, or replacing a battery for the customer.

Resilient business driven by aging vehicles on the road

AutoZone is a surprisingly resilient business. If you think about it, this makes sense. There will always be a base group of customers that repair their own cars (either to save money or because of interest in cars).

In a recession, AutoZone probably gains a few more customers that would’ve taken it to a repair shop. People may not buy that new car either in a recession and instead opt for fixing the old one they own. This plays exactly to AutoZone’s benefit:

Here is a graph of the vehicle age over time:

I don’t know of many companies that kept same-store sales growth up during the financial crisis, but you can clearly see they started to quickly grow low-to-mid single digits after that as well (likely because it was a long, slog of a recovery).

Recall, 2009-2011 was a period of high unemployment. People weren’t buying new cars and were repairing existing ones. That could play out again.

Thinking about post-COVID for AutoZone: One thing I am thinking about is that new car sales, pre-COVID, were at record levels for the past few years. AutoZone will likely see a recession benefit post-COVID as well, but then those new cars sold the past few years will start needed repairs. In other words, cars sold in 2015 will start to be 7 years old in 2022, which could buoy results for some period of time.

How has AutoZone warded off competition – isn’t it ripe for Amazon to steal share?

Yes and no. First, AutoZone has been in the online retail business for a while now. As of writing, it doesn’t offer two day, free shipping like Amazon does, but that may not matter right now.

Why? Because when something isn’t functioning on your car (and you are part of AutoZone’s core customer base as a DIY-er) then you probably are going to go fix it soon.

Imagine driving in the rain and one windshield wiper stops working. You pass an AutoZone store and understand from their commercials that they’ll even put on the new one for you. Why wait 2 days and risk getting caught in the rain again, being unable to safely drive? Sure, Amazon is moving closer and closer to same day delivery, but so far that has been AutoZone’s capture. AutoZone has nearly 6,500 stores, so it’s hard to miss one!

Like I said though, AutoZone clearly tries to focus on the customer and this is called out almost upfront in its 10-k.

Another reason: comfort knowing the part will actually work with your car. I’m somewhat of a DIY-er myself and, while AutoZone isn’t perfect either, sometimes you buy a part for a car that ends up not working on your specific model. That’s frustrating. Imagine a similar example to the above but now you need to return the item and buy a new one.

Supply Chain is the key

You can already start to piece together that the thing that drives Autozone’s business, the reason why people shop there and the reason why they win your sale, actually comes down to having the part and having it for a fair price.

AutoZone has a very efficient supply chain and this is really what keeps other competitors out of the business. In reality, I would venture to say that the do-it-yourself (DIY) market has developed into an oligopoly now – AutoZone, O’Reilly, Advance Auto, NAPA dominating the market, with Amazon also in the works.

AutoZone has an interesting store concept that reminds me of what Fastenal did, which I described in a prior post. They have satellite stores, which carry around ~24k SKUs, as well as “hub stores” which carry 40-60k SKUs and deliver to the satellite stores 3x a day. This ensures if someone orders a “tail-end” SKU, AutoZone can have it available either that day or the next. Lastly, they’ve deloveped “MegaHub” stores, which have ~100k SKUs. These stores deliver to both satellite stores and hub stores.

At this point, AutoZone notes that all of its hubs and satellite stores get touched at least 1x a day so adding more hubs or MegaHubs doesn’t increase coverage…. However, adding more of these stores reduces the amount of time it takes for deliveries to make it to the end customer.

New Growth Focus – Commercial

AutoZone has historically sold mainly to folks like you and me, not garages and professional networks. Now, its new growth strategy is focused on supply garages and local shops with parts using its sophisticated supply chain. The shift is Do it Yourself to Do it for Me.

Think about this from a garage’s perspective: AutoZone will now house the inventory I need to get more jobs done quickly. This solves 2 issues for me: 1) lowers my need to hold inventory and 2) helps me turn customers which should increase my sales.

So far, the company has seen some success. In its earnings call in early March (pre-COVID impacts), it noted:

We also grew our commercial sales per store at mid-single-digit rate versus last year’s second quarter [which was up 12.9% so a tough comp]… We averaged $9,400 in weekly commercial sales per program this past quarter, up 5% over last year. We have grown our sales with mature customers and mature programs at substantially improved growth rate the last 2 years versus previous years, indicating our offerings. Products, coverage, customer service and ability to enhance the customers’ overall shopping experience are improved and have been recognized and rewarded by our customers.

I can’t prove this trend, per se, but it seems to me that the older generations felt more comfortable working on their cars whereas the younger generation would like to “outsource” that work. “Do It For Me” must be what AutoZone is seeing too and I think that is why they are targeting this market.

AutoZone generates a surprisingly high ROIC

We’ve talked through some of the pieces of the business so far, but it is astonishing to me how high of a ROIC AutoZone generates.

Yet despite this high ROIC, resilient business model, I think one reason the stock has performed so well is that it is perennially undervalued and underappreciated.

This will be hard to read (maybe click to expand), but it’s a trailing FCF yield over a long period of time. Consistently in the high single digit range as a % of market cap. The interesting thing is they plowed in excess of 100% of that FCF back into repurchasing stock.

So clearly, that increased debt of the company slightly over time if they’re spending more than 100% of FCF.

But the way I think about it is: high-single return from FCF yield (which was all plowed back into AutoZone stock) + using capex for high-return projects (new stores). That’s the formula for solid returns. Here is a chart of share count over time – they were early in the share buyback game, in my view, buying massive amounts in the 2000s.

What about the competitors in the space? What have their returns been like?

So Pep Boys is no longer public (no owned by Icahn Enterprises), NAPA is owned by Genuine Parts, so we can really only compare O’Reilly, Advance Auto and AutoZone stock now.

What’s interesting is O’Reilly underperformed AutoZone stock up until about the early 2010s (depending on your starting point). Why did they start closing the gap? They started doing massive share-buybacks. Unlike IBM, where buybacks failed, the automotive parts retailing industry clearly has benefitted from doing this.

Advance Auto actually paused share buybacks and you can see the divergence in equity performance there as well.

Now the real question: who has the best jingle? AutoZone or O’Reilly?


But seriously, I like AutoZone’s business model. It’s a segment of retail that I think will continue to perform well over the next 5 years. I also like AutoZone stock because, compared to peers, management’s decisions have been very consistent over long periods of time. As of writing, its actually a lower multiple as well.

The question from there is obviously electric vehicles. What happens when these auto retailers lose sales related to the internal combustion engine? It’s a million dollar question. I will say, however, that penetration could be overestimated.

Overall, there are 263.6 million registered vehicles in the US. The number of battery electric vehicles sold in the US was 245,000 in 2019 and the total number of cars sold was 16.9 million, which was around cyclical peak.

Let’s say tomorrow, every new car is electric vehicle and each new car replaces an existing vehicle. So 16.9 million is 6.4% of the existing base… that would take ~15.5 years to replace the entire existing fleet.

Sure, we’d have to factor in autonomous cars next, which would drive down car ownership, but I also think that is far off.

If that gets overly priced in to AutoZone stock, I would view it as a buying opportunity.

What Differentiates McDonald’s from Other Restaurant Players? $MCD

Reading Time: 3 minutes

Many know the history behind McDonald’s, but if you don’t I highly recommend the movie The Founder. It details how McDonald’s started as a simple restaurant business, but Ray Kroc took it over to expand the business and eventually takes it over. It also gets into the groundwork for McDonald’s strategy it would use for decades to come.

McDonald’s is not in the restaurant business, per se, it is in the real estate business.

As a reminder, this Competitive Strategy series I am doing is trying to unravel why some businesses do better than others, even in highly competitive industries. This post will be brief and mainly focus on this real estate point – to me, it is a truly differentiated strategic decision from McDonald’s.

Why Does McDonald’s Own or Lease the Real Estate?

Typically, McDonald’s will own or lease a restaurant site and lease or sublease it to a franchisee. McDonald’s return on that real estate investment is derived from a fixed % of sales as rent payment from the franchisee. McDonald’s also earns a royalty fee, but the bulk of earnings is actually tied to this “rent” payment.

As you can imagine, this is a unique relationship between franchiser and franchisee.

Here is a comparison of gross PP&E on a group of restaurants balance sheets compared to the number of locations they have. The only names that come even close are Chipotle, which has no franchisees so isn’t really comparable, and Starbucks, which also is mostly company-operated stores.

Think about if you were a landlord and received rent plus a fixed percent of the tenant’s sales. You want the tenant to do well and may even kick in funds to help them (if you think the returns will be favorable to you).

This is the case with McDonald’s. When a restaurant unit needs to be remodeled or needs new capital investment, McDonald’s will typically share some of the expense, which helps relieve some of the burden on the franchisee, while also allowing the company to cycle through new looks and new menu items. This keeps McDonald’s menu relatively fresh and restaurants looking up-to-date.

McDonald’s also does not allow passive investors. This aligns incentives for the store owner to maximize sales and profits (because that is how they derive most of their income) which in turn boosts McDonald’s profits.

As a result, McDonald’s has posted a powerful financial track record over the past couple decades. As shown below, its same-store sales results are pretty impressive when you think about how mature McDonald’s is as a business.

But doesn’t this make McDonald’s more capital intensive?

Yes!

Here is a chart of capex as a % of sales for each of the players:

But that actually doesn’t hinder the company much. Look at its return on assets compared to peers. It actually stacks up quite well, which is surprising when you think about how much more in assets the company has.

What could be the driver of that? Profitability. McDonald’s is just much more profitable than most of its peers. Part of this is scale (can leverage corporate fixed costs well with the number of branches), but also part of it is the way the company has established its fees.

Breaking Down Fastenal’s Moat in 3 Points

Reading Time: 8 minutes

Fastenal is a company that sells nuts, bolts, and other industrial and construction supplies. Pretty simple business – and definitely not sexy. How then has Fastenal stock created so much value? In keeping with comparisons to other high-flying stocks on sexier businesses (like my post on NVR) Fastenal stock has beaten both Microsoft and Apple since the 1990s!

FAST Total Return Price Chart

FAST Total Return Price data by YCharts

 It all came down to a certain way they decided to operate – its Competitive Strategy. There probably have been hundreds of fastener businesses that have come and gone over the past 30 years, and many probably never created much value. So what gave Fastenal their competitive advantage? What drove their staying power? And how did they compound earnings so effectively? Clearly, something must be going right to translate into Fastenal stock being such a long-term winner.

One thing I’d like the reader to do is think actually how similar Fastenal’s strategy is to Amazon’s (I think the latter borrowed some things from the former’s playbook).

First, some history to shed a light on the business.


Fastenal was actually dreamt up by its founder, Bob Kierlin when he was just 11 years old.  His father ran an auto supply shop in Wisconsin and Kierlin noticed customers typically drove from store to store looking for fasteners they needed for particular jobs. If a hardware store didn’t have the right nut or bolt, the store would send the customer to Kierlin’s store, and vice-versa. Bob noticed a lot of customers had to resort to buying the part, one-off, via a special order and wait.

Kierlin and four other friends started Fastenal in with $30,000 and rented a store in Winona, Minnesota. They opened a store as a one-stop shop with thousands of fasteners for retail customer needs.

But the idea was a flop and the company almost went bust.

Instead of focusing on the retail customer, Fastenal decided to pivot and focus on the commercial customer. It turned out that price was much less of a factor than timeliness for that market segment — contractors and companies often lost money searching or waiting for a particular part. Kierlin and his partners discovered that there was a great need for a service that could quickly provide the fastener or part that a buyer needed.

In short, Fastenal segmented out its buyer base and identified what their key purchasing criteria was. They focused on industrial and commercial buyers and they realized they didn’t need to be the lowest price, they just needed to have the item in stock.

At the end of the day, you can see why this makes sense.

  1. Fasteners make up a small portion of project costs (e.g. building a home, building a car), but are crucial pieces in the process that can hold up work.
  2. If Fastenal increased price of a particular fastener by 3%, their customer probably wouldn’t even notice in their project and could likely pass it on to the end customer if needed
  3. Fastenal’s customers are many in size but also small in size, so they have limited bargaining power.

Fastenal further segmented based on geographic locations.

Fastenal opened its first branch in Minnesota and continued to target very small towns. Why? By targeting small towns that had healthy construction and manufacturing industries, but were also small towns that were underserved by big distributors, Fastenal could be the only game in town.


Finding New Segments

One thing a business can do to improve its competitive advantage is find new product segments. Think about Arm & Hammer expanding baking soda into a refrigerator deodorant – that was a creative decision to target a market and improved the overall market size.

In some cases, you can find new segments by broadening and you can find new segments by narrowing focus.

Fastenal actually did both.

Narrowing Focus (and Not Being Afraid to Try Something New)

This is from Fastenal’s 1996 10-K. Satellite stores weren’t a major success, but the company did expand to 71 satellite stores opened by 2001. The key was that Fastenal was focused on improving the customer relationship. Fastenal already was getting some business from these customers in smaller areas, but they wanted to make it even easier on the customer to get their Fasteners – and it preemptively did so. Sure, it would cost resources and no one else really saw the returns from doing it, but the customer sure would be loyal. Sound familiar to Amazon?

In fact, do you know what Fastenal says its goal is? “Growth through Customer Service.”

It also reminds me of Dollar General’s strategy of serving rural America. Carve out a niche where you know your customers well and others choose not to serve and that can payoff well.

In 2014, Fastenal identified a new growth driver: Onsite locations. These are sites that are not open to the public, or a wide variety of customers, but instead serve one customer at their location.

In essence, the customer (typically a very large one) might consume enough fasteners that it could source them themselves, but they’d rather benefit from Fastenal’s scale and expertise so they hire them to serve all their needs.

Fastenal had locations like these since the 1990s, but they expanded following 2014 – growing from 214 locations to over 1,100 by 2019 and represents roughly 30% of the company now.

The company really started to build a vending solution in 2011, choosing to do so while industrial activity was still weak from the Financial Crisis.

They would give a customer a vending machine, essentially for free (estimated to be a $10,000 value), but in return it would essentially become a “mini-branch” at the customer’s site. The machines were also available to the customer 24/7 – not just when a supply room is staffed. It also helped the customer track consumption data, in some cases improving their ability to see which of their plants were consuming more or less of certain parts.

Early on, Fastenal learned that it actually cut customer consumption (2011 conference call):

As we talked about on the Amazon review, if I were to distill differentiation with a buyer into two factors it would be: cut their cost and/or improve performance.

In this case, Fastenal cut the costs for its customers buy reducing spend, but it also differentiated Fastenal as a solutions provider. It also resulted in a share shift as customers looked favorably at the vending machines (quid pro quo) and Fastenal “locked” the customer into purchasing from them.

The company now has 105,000 vending devices in the field and generate $1.1BN of revenue.

Expanding Breadth

Fastenal decided in the mid-90s to test out new products. If a customer came into the store for fasteners, they might want to pick up something else why they are in the store. Convenience outweighs price.

In 1995, threaded fasteners were ~70% of sales. By 2000, it was just 51% of sales. Now, Fastenal has 9 different product categories it sells and targeting further product diversity:

The company also decided that in some cases, it made sense to manufacture tools for a customer. This would be rare, but in some cases it would pay off royally (and gain customer loyalty).

In one instance, a Ford plant’s assembly line was shut down by a breakdown that required a few dozen special bolts. Ford’s regular supplier told the company it would have to wait until Monday—three days later. “Meanwhile, it’s costing them something like $50,000 an hour to have this line not operating,” Slaggie [one of Fastenal’s founders] said in the March 11, 1992, Successful Business. “They called us and the part is an oddball, something we don’t have in stock. We had them fax us the blueprint for the machine and we determined we could make it…. We had them finished Sunday afternoon.”

Doing some simple math, $50,000 a day is $1.2MM in cost… for 3 days that would cost the company $3.6MM. Fastenal could make a part and charge $50,000 for it, and I’m sure Ford would pay for that all day…  I have no idea what Fastenal charged in this case, but you can see why Fastenal created differentiation here as a service provider.


Decentralized. By the time Fastenal stock became public, they put out some interesting color on how they decided to manage new branch openings:

By reading the company’s filings, you can tell they first want to train their employees to understand the business and industry and then give them the power to make decisions on their own.

I’m a relatively cynical person, so I wonder to myself how the employees could possibly know more about what to stock than people who have been operating the business for 20+ years. Two words: Smile & Dial.


Putting it together

I could go on about Fastenal — there is a lot I didn’t touch on about how frugal the company chooses to be — but its performance as “just a fastener distributor” has been truly amazing.

I opened this series saying that I was tired of the terms “asset light” or “high margins” being used to say why a business is “good”… instead, you need to understand what the company has done to make its business sustainable and why they will create above average shareholder value in the long run.

Here are some summary financial metrics for Fastenal compared to other distributor peers.

What jumps off the page to me is (i) its gross margins for a distributor, (ii) its EBITDA margins and (iii) EBITA / Assets (a proxy for ROIC).

High Gross Margins: Its high gross margins relay to me that they truly have targeted their customer in a way that isn’t just based on price – otherwise I think the margins would be much lower.

EBITDA margins: Its EBITDA margins are high, which makes sense given the gross margins. But the delta between gross margins and EBITDA margins is nearly 23% of sales — meaning they spend 23% of sales on selling costs and general and administrative expenses. That’s definitely in the upper half of the group and tells me that they are spending a lot on service for the customer.

EBITA / Assets: One might look at this comp set and say, “hmmm, Fastenal’s metrics are good, but its FCF conversion (rough proxy using EBITDA – Capex over EBITDA) isn’t great because capex is so high.” That’s ok for me – when I look at EBITA / Assets, what Fastenal earns on every dollar of capex it spends is much higher than what I could go out and earn! It also will likely lead to above-average sales growth.


I hope you’ve seen from what I’ve outlined above that Fastenal is very similar to Amazon – relentless focus on the customer. But Kierlen also appreciated hiring the right people and giving autonomy, as shown in this interview I found with some hard-hitting reporters.

“I admit things I never knew how to do well – I admit I was never a good sales person, so I hired a good salesperson.” In some ways it reminds me of Steve Jobs (though it was later learned he had a tendency to micromanage), he did have a great quote:

“It doesn’t make sense to hire smart people and tell them what to do; we hire smart people so they can tell us what to do.”

How has NVR stock outperformed Microsoft?

Reading Time: 6 minutes

NVR stock has absolutely crushed the competition. The company is a homebuilder, which isn’t a very good business, but has a differentiated strategy than its peers. Below is a chart comparing NVR to other builders.

This may surprise some people, but investing in NVR in the 1990s would have outperformed buying Microsoft!

Note, the starting point differs a bit from the chart above, but you get the idea. $10,00 invested in NVR stock would be worth $2.8MM today compared to only $1.1MM in Microsoft stock.

Quick overview of the homebuilding industry

Homebuilding is pretty simple — essentially acquire land and subcontract most parts of the building process out.

Therefore, if you had the capital and time, you could probably enter the industry. That’s probably why most homebuilders do not create much value for shareholders in the long run. There are several other reasons as well.

Trusting them to be good asset managers. Homebuilders want to acquire cheap land, so they acquire in areas outside of where they currently operate – going where they think the growth will be. This land is typically “raw” and needs to be  zoned & entitled, roads paved and sewer installed, etc. Now, builders typically let a land developer handle this, but enter into a contract to purchase that land when it is developed. By the time the land is developed and the builder is prepping to build homes, they are praying that demand will hold in or has moved in their direction, otherwise the investment in the “raw land” may not be fruitful.

In homebuilding, you are rebuilding the factory each year. Builders are constantly acquiring lots for growth. Think about it. What other business are you constantly selling your asset base down? In manufacturing, typically your factory creates products that you sell, but at the end of the year you still have the factor. In farming, I sell the fruits of my labor, but I still have the land for next year.

I liken homebuilding to oil & gas – if I drill one well, it will produce cash but for me to keep my earnings power constant, I’ll need to reinvest that cash into other wells.  Typically this means they are burning cash in the good times, as demand looks good in the future so they continue to acquire future inventory. In bad times, the builders need to generate cash, but do so at the worst time. They have illiquid assets that need to move quickly to generate liquidity so they have to take a haircut.


As you can probably tell, I think homebuilding is a bad business. But as I said when I launched this series, you can have a bad industry, but a great company. Oftentimes investors will write-off sectors and leave gems out like NVR stock.

So what sets NVR apart? NVR actually filed for bankruptcy in the 1990s have a debt-financed merger went sour as the economy went into a recession. They came out of that will a new, safer business model that is quite differentiated.


NVR Options Land

Summing up NVR in one picture: The company takes very limited land risk.

So for an initial deposit, NVR keeps flexibility of whether or not it will buy the lot. This helps it keep flexibility in a downturn so that its not still acquiring things that may be bad investments or it can divert capital elsewhere when needed (in fact, NVR is the only builder right now that can confidently buy stock on the cheap due to its flexible model and strong balance sheet). This also means it keeps very little land on the balance sheet compared to peers because it doesn’t own it.

This is very different than the rest of the industry:

Let’s compare how the cash flows then look for a traditional builder. Pay attention to working capital, which is mostly inventory movements (may need to click on picture to see better):

As you can see, Lennar generated cash in the financial crises, but it came from liquidating inventory. It then needed to replenish as the market came back. It was forced to sell when you’d want to be a buyer and forced to buy when you’d want to be a seller. 

Let’s compare that to NVR’s cash flows. It too sold down inventory, but as a % of earnings, it was much lower and emerged much stronger. It also didn’t need to impair large portions of its book like Lennar did.

NVR Builds Only After the Home is Sold. NVR does not typically take ownership of a lot until it has pre-sold a home and the buyer has qualified for their mortgage and then it begins construction on the unit. This also reduces risk that the company spends capital today for no reason.

NVR ships pre-cut materials to the job site at specified requirements. This speeds up the building process for quick & efficient assembly. The company is one of the few builders to maintain manufacturing facilities for framing products as well as windows & cabinets. This type of vertical integration helps control costs and provide efficiency.

Maintains leading market share on a local level. I shudder whenever a homebuilder acquires another where it doesn’t currently build. Think about it – what benefit does the transaction bring? Yes, it brings lots in a new region. Some would say diversity is good. But M&A is typically done at 1x book value or above. So how does that create value? You won’t get any purchasing scale or scale on labor used unless you expand your market locally. It’d be much better to buy a player where you already operate. Lower competition plus gain regional scale.

NVR’s strategy is to gain leading market share where it operates and growth areas stem from places its operated before. NVR has a dominant 20%+ share in its core markets — much higher than peers’ typical share of 7-10% when they have a leading position.

Combining the last two points translates into similar margins to peers. NVR did about 35% of the sales that Lennar did in 2019. Yet compare their financials. NVR is lower GMs (which is a byproduct of their business model), but also much more efficient with SG&A, as discussed. This leads to comparable margins to peers.

Land is the most capital intensive part of the business, so they (i) are earning similar margins as peers but also (ii) turning inventory much faster than peers. This translates into much higher ROEs… higher ROE in the long-run helps NVR stock outperform peers.

Breaking this out – look at NVR’s historical ROE!

Why doesn’t everyone operate this way?

  • Not all geographic areas offer options like the ones NVR uses, so it may inhibit NVR in the long-term. But also many builders in other areas simply don’t have this option.
  • In times of growth, NVR’s top line will typically lag peers as its business model acts as a governor. Through cycle though, we can clearly see the benefits
  • Gross margins, in the good times, can also be better because you are selling low cost inventory into higher prices

NVR’s sales and earnings aren’t the largest, but its differentiated strategy aimed at limiting risk has obviously helped in a cyclical industry. As you can see by NVR stock, slow and steady wins the race.