Greetings, and welcome to the Fastenal 2022 Annual and Fourth Quarter Earnings Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the call over to Taylor Ranta of Fastenal Company. Thank you. You may begin.

Welcome to the Fastenal Company 2022 annual and fourth quarter earnings conference call. This call will be hosted by Dan Florness, our President and Chief Executive Officer; and Holden Lewis, our Chief Financial Officer. The call will last for up to one hour, and we'll start with a general overview of our annual and 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 March 1, 2023, at midnight Central Time. As a reminder, today's conference call may include statements regarding the company's future plans and products. These statements are based on our current expectations and we undertake no duty to update them. It is important note that the company's actual results may differ materially from those anticipated. Factors that could cause actual results to differ from anticipated results are contained in the company's latest earnings release and periodic filings with the Securities and Exchange Commission, and we encourage you to review those factors carefully. I would now like to turn the call over to Mr. Dan Florness.

Thank you, and good morning, everybody, and welcome to our fourth quarter earnings call, and Happy New Year. If you -- some highlights on the quarter. I'm on Page 3 of the flip -- of the flipbook. So, our daily sales grew 10.7% in the quarter, eased a bit from what we've seen in recent quarters, primarily because of tougher comparisons to what we were seeing in the fourth quarter last year, but also some moderating demand. I'm pleased to say that our fourth quarter operating margin remained stable at 19.6% and our ability to generate cash. So, we're looking at our cash conversion, it returned to historic levels. And that's really a sign of moderation and the level of inflation that we're seeing in the marketplace. But also, a more stable supply chain and the ability to not need -- that for a double negative, not need to expand our stocking levels to ensure a reliable supply line for our customers. So, it gives us some flexibility as we go into 2023. We're very pleased to see that. 2022 was a year of milestones and they all centered on $1 billion. So, in October, our e-commerce revenues surpassed $1 billion for the first time ever. Our -- and that's on an annual looking at annual milestone. Our international sales exceeded $1 billion. We hit that milestone in the month of November. And as noted in the release this morning, our company-wide net earnings topped $1 billion for the first time ever and that was for calendar 2022. When I look at that chart on the upper left, it's hard to decide where do you start explaining all the noise you have really over the last three years, as we went through COVID, as we emerged from COVID, as we went through supply chain disruptions and inflationary period. So, I chose to not and just compare to 2019 from the standpoint of what was our cumulative sales growth in each of the quarters of this year, because I think it tells a more stable story and talks about the things that we've built. So, in the first quarter of 2022, we were 28.1% larger than we were in the first quarter of 2019. This expanded to 30% in the second quarter, expanded to about 31% in the third quarter and in the fourth quarter, we're about 35% larger than we were in the fourth quarter of 2019. Now you shouldn't conclude from that, that, geez, that expanded 7 points from Q1 to Q4. Because in all -- in full disclosure, 2019 was weakening a bit as we went through the year. I would see this as ignoring COVID, ignoring supply chain, ignoring inflation, we're 30% bigger than we were three years ago, and I think that's a testament to the business model and to the team executing the model and the marketplace, recognizing Fastenal for what it is, a great supply chain partner to their business. If -- and I'm pleased to say, I think we're exiting the pandemic stronger than we entered. The -- we experienced margin pressure in the fourth quarter, and Holden will touch on that in more detail later in the call. Fasteners were challenging, but we understood what's going on there, and we knew what was coming. The safety, I would say the same thing, it's challenging like anything is challenging, but we knew what to expect there. And I think on these first two buckets of Fasteners and safety, we understood it, and we managed through it quite well. The remaining clients, a lot of those products, aren't as prevalent in the recurring pattern, the planned spend component of our business, whether it be through the vending portion of FMI or the BIN or the FASTStock portion of FMI. And so, it takes different tools and different means to manage that. And we had some challenges there. And again, Holden will touch on a little bit more later in the call. When I look at the final piece and the reason we were able to maintain a stable operating margin, we've done a really nice job with headcount. We did add a few more people in the fourth quarter than I would have liked to have seen. I suspect some of it is after a period of being really difficult hiring and as it eased throughout the year, there are some spots that we needed to fill, that were filled. But when I look at it in totality for the year, we've really done a nice job. And I'll touch on it a few more -- a little bit more in a few minutes, but we've done a nice job in the last three years as well. Flipping to Page 4 of the flipbook, the Onsite, we had 62 signings in the fourth quarter and finished with 1,623 active sites, so up about 15% from a year ago. If you ignore the sales at transfer over when we opened an Onsite, where it's an existing customer, we grew our Onsite-based revenue in the high teens and reiterate our goal for 2023, our intention is to sign 375 to 400 Onsites next year. And I'm pleased to see, for us, we often talk about participation inside the organization. Just over 80% of our district managers signed an Onsite back in 2019, and when society closed up and folks weren't as excited about us moving in to stay with them during the day, our -- that participation dropped dramatically as our Onsites dropped in both 2020 and 2021. I'm pleased to say, in 2022, 80% of our district managers signed at least one Onsite. Now would I prefer to see that go to 85% or 90%? Sure, I would. But 80% is a nice threshold to get above again because we have done it once before, and that was in 2019. So, my congratulations to the team. FMI Technology: we signed 4,730 weighted devices in the fourth quarter, that's 76 per day. A year ago, we were signing 64 per day. And the activity through our FMI Technology platform represented almost 39% of sales in the fourth quarter. That was 35% a year ago and 27% two years ago. For 2023, our goal is to sign between 23,000 and 25,000 MEU devices, whether it be FASTBin or FASTVend. E-commerce, the next piece of our, what we call, digital footprint, daily sales rose 48% in the fourth quarter. Again, incredible traction in that area. We've really seen that traction move in the last three years, partly a function of COVID, and I think a lot of people are seeing those kinds of patterns, but also -- we've gotten better as an organization and our ability to execute on e-commerce, and that's times through the numbers as well. So, EDI and punched out catalogs and really large customer-oriented e-commerce was up 45% and our web sales was up almost 60%. Looking at our digital footprint. So that's looking at FMI plus the piece of e-commerce that doesn't come from FMI was 52.6% of sales in the fourth quarter, and that was 46.5% a year ago. Our goal is 65% of net sales going through our digital footprint next year. In the interest of full disclosure, that's an aggressive goal, but it's our goal nonetheless. If I flip into Page 5, we put this table in the release last January as well. And it's really intended to show over time what's really happening to our network. And that is, as FMI becomes a bigger piece of our business, as our mix of customers changes, as e-commerce becomes a bigger piece, you rationalize your footprint because you need for a footprint change. So you can see in 2013, we peaked out, and I'm going to start at the bottom of this set of bullets and work my way up. So in 2013, looking at our data, we had a 30-minute access to about 95% of the U.S. manufacturing base. And this is just looking at the U.S. branch network because the Canada follows a similar trend as far as what you've seen in the number of branches, whereas the rest of the planet are continuing to open locations because we're quite young there. Looking at the 1,450, which we think is the ultimate number we get to for branch count, the -- in the U.S. and Canada, the U.S. piece of that where we have really good data, we think that 95% drops to about 93.5%, which we think is incredible coverage and puts us in a great position to be a great local supply chain partner and still have a really efficient network. And you're seeing that in our operating expenses over the last few years. If you look at our headcount numbers -- and I touched on it earlier, and I thought I'd share a different view rather than the year-over-year view you have on Page 5 of the earnings release. And that is, again, a 3-year view of what's happening. So our in-market locations from an absolute basis since 2019, our headcount is down about 567 people in the branch and Onsite network, which is about a 4% drop. And again, things like FMI and rationalizing locations have really allowed us to leverage that. However, our sales headcount is up because every headcount we've reduced has moved into some type of sales role supporting the branch and Onsite network. So, I'm pleased to say we were able to realign our resources in that time frame and really be a better growth-driving organization for the long term that aligns with our strategy of a branch and Onsite network. The other thing that should stand out is a year ago, we had 377 more branches relative to Onsite. So, we had 1,416 Onsites. We had 1,793. So, 377 delta between the two. At the end of 2022, that delta has contracted to 60. So, we have 1,623 OnSites. We have 1,683 branches. I don't know what quarter that flips. But it won't be too much -- too far into our future that we'll actually have more Onsites than branches which has been very much a planned thing within our business over time. Again, the FMI digital footprint helped us leverage our headcount and our rationalization of branches. The other piece that's an important and growing component, we've talked about our LIFT initiative, and we ended the year with just over 17,000 of our vending machines being resupplied out of our LIFT facility, which really allows us to operate more efficiently, ultimately allows us to rationalize some working capital, and our sales team can focus on selling more than managing some of the back-office items in a branch. The final thing, if you look at our headcount over the three-year period is we've been able to really rationalize our support labor. So, we have added folks in the distribution because of LIFT. However, in the -- if I look at DC and manufacturing, we're up 98 people in the last 3 years. So again, that team has done an incredible job of managing their headcount. And if I look at our support areas in general, 51% of our headcount increase in the last 3 years has been focus going into IT. That's how we're able to do things like FMI, how we're able to do things like LIFT and build the technology to support it. 35% has gone into either a growth driver or into our international team or supporting our sales team and 14% has gone into all other categories combined in the last 3 years. I think that's an organization that dramatically improved itself in the last 3 years as we prepared for the future. One last item -- when you see our release in February, I usually don't get ahead of myself on what's going to be in a future release. One thing to note is in 2022, our team in India added approximately 50 interns, and we ended up hiring 54 of them because a number of those interns told their friends about Fastenal, and they joined the Blue Team and they added to our IT group. We saw such great success with that. It's a very efficient way to add folks. Here in early January, we added 96 -- or 98, one of the two. So, you're going to see the number grow by about 100 in the month of January in our support infrastructure. Don't conclude from that Fastenal is not managing its headcount. Conclude from that Fastenal is investing in resources to support its technology side. With that, I'll turn it over to Holden.

Great. Thanks, Dan. Starting on Slide 6. Total and daily sales increased 10.7% in the fourth quarter of 2022, which included an up 8% reading in December and represented further deceleration from prior quarters. We attribute this deceleration to slower industrial production, which shouldn't surprise anyone that tracks the purchasing manager index and more difficult growth and pricing comparisons. But even so, significant elements of our business continue to perform well. For instance, manufacturing, which was roughly 73% of our sales in the fourth quarter of 2022, grew 16% and slightly exceeded normal quarterly sequentials. In addition, our largest customers, as reflected by our national accounts program and which approximated 59% of our sales in the fourth quarter of 2022, grew 15%. We believe continued healthy performance in these areas reflect our investments in Onsite and changes to our branch structure and sales roles. Feedback from our regional leadership on the outlook entering 2023 remain constructive and largely unchanged from the third quarter of 2022. There are a few areas where we have seen incremental weakness, however. For instance, a handful of our large retailer customers tightened their belts regarding facilities and labor and our non-North American sales softened on a strong dollar and geopolitical events. Now we've made significant investments and seeing enormous growth in these areas over the last few years and the current weakness in our view relates to market-specific factors. Construction revenues were also softer, which reflects the conscious decision we have made to position our branches to focus on larger key accounts, which is contributing to better labor leverage. These 3 areas, large retailers, non-North American markets and construction together, represent more than 15% of sales and went from double-digit growth as recently as the first quarter of 2022 to declining in each case by the fourth quarter of 2022. As always, we have limited visibility as it relates to future demand. However, we do believe that our sales initiatives continue to gain momentum and expect good outgrowth in 2023. Now to Slide 7. Operating margin in the fourth quarter of 2022 was 19.6%, flat from the prior year. We continue to manage operating expenses effectively, producing 120 basis points of SG&A leverage in the fourth quarter of 2022. Occupancy costs are being restrained from strategic branch closures, while initiatives such as digital footprint, LIFT and the changes we've made to our brand strategies are contributing to improved labor leverage, which accelerated in 2022. As Dan indicated in his opening remarks, we were a bit more aggressive with headcount adds that might be prudent given the cloudy manufacturing outlook heading into 2023. However, we think that can adjust quickly, and it is likely annual FTE growth peaked in December or will peak in January before decelerating through the first half of 2023. Although the ultimate level of growth in the marketplace will have it say, we do believe that we can continue to leverage operating expenses in future periods. SG&A leverage was offset by a matching 120 basis points decline in gross margin, which was greater than anticipated. Certain factors were familiar. The drag related to product and customer mix widened as non-fastener growth began outpacing fastener growth, which was expected. The price cost drag widened slightly, which is a little more than expected, reflecting some improvement on the fastener side but incremental challenges in other products offsetting this. In fact, we experienced broader product margin pressure in our non-fastener and non-safety products. These categories tend to have a less centralized supply chain and the spend tends to be more unplanned, which when combined with slower demand and a better stock marketplace resulted in broader discounting. We believe this relates more to our actions than the state of the market and have plans to address it in the first quarter of 2023. On the positive side of the margin ledger, we continue to have healthy freight revenues and narrower losses related to maintaining our captive fleets. We had a higher tax rate, reflecting the absence of certain favorable reserve adjustments that benefited the fourth quarter of 2021 than higher non-deductible payroll and state income tax expenses in the fourth quarter of 2022. Our fully diluted share count was also down 0.8% from share buybacks for the last 2 quarters. Putting it all together, we reported fourth quarter 2022 EPS of $0.43, up 7.1% from $0.40 in the fourth quarter of 2021. Now turning to Slide 8. We generated $302 million in operating cash in the fourth quarter of 2022 or approximately 123% of net income in the period. This reflects a typical fourth quarter conversion rate in contrast with the preceding five quarters where our conversion rates lagged. This is due to comparisons in the second half of 2021, we began to finance significantly more working capital to navigate supply chain constraints and inflation. We do not expect to have to make a similar incremental investment in 2023, which should produce better cash flow. Year-over-year, accounts receivable was up 12.6% on higher customer demand and an increase in the mix of larger key account customers, which tend to have longer terms. Inventories rose 12.1%. The supply chain has largely normalized. Inflation is moderating. And our fulfillment rates are at healthy levels, which is causing our inventory growth to align more closely with growth than was true earlier in the year. Our days on hand was 161.5, more than 4 days better than the fourth quarter of 2021 and more than 13 days below the fourth quarter of 2019 despite the challenges in the last 18 months. We continue to identify sustainable efficiencies in how we manage our inventories. Net capital spending in 2022 was $162.4 million, a bit below the $170 million to $190 million anticipated at the end of the third quarter, mostly related to project and equipment deferrals. Those deferrals, combined with higher spending on hub investments, fleet equipment and IT equipment, resulted in an anticipated net capital spending range for 2023 of $210 million to $230 million. We finished the fourth quarter of 2022 with debt at 14.9% of total capital, up from 11.4% in the fourth quarter of 2021 and unchanged at 14.9% in the third quarter of 2022. Though we had strong cash generation in the fourth quarter of 2022, we were also, again, more aggressive in returning cash to shareholders in the form of $177 million in dividends and $93 million in share buyback. Last night, we announced an increase in our quarterly dividend from $0.31 in the first quarter of 2021 to -- I'm sorry, of 2022 to $0.35 in the first quarter of 2023. Now before the questions, one quick note. This week, we released our inaugural ESG report, which is accessible through the ESG link found at the bottom of fastenal.com. This report highlights the strong alignment of Fastenal's culture and mission with the environmental and human capital objectives of our stakeholders. I want to congratulate and thank the community of Blue Team members that work to pull this outstanding piece together. And with that, operator, we'll turn it over to Q&A.

Before we start Q&A, my adder to the Holden's comment on the ESG report, I encourage to focus on this call to read it. Don't wait for the movie. It's a -- I think it's a well-written story in the context of how Fastenal tell its story about how our business and our team have addressed this topic really throughout our history, but communicated in a way that is conscious of the formatting in the structure that society has grown more accustomed to. The other piece that I wanted to highlight is another announcement went out last night, which was, we announced that our international team has surpassed $1 billion in revenue for the first time during 2022. My congratulations to everybody listening to this call as part of our international team that spans the Americas, Europe and Asia. And to our team in China, where -- your society has opened a bunch more in recent months, recent weeks, I would like to wish you a Happy Chinese New Year. I believe it's the year of the rabbit. And I hope you since I -- sincerely hope you have a nice opportunity to visit with family as the societies opened up a little bit more. With that, we open the Q&A.

[Operator Instructions] Our first questions come from the line of Ryan Merkel with William Blair.

So, Holden, as you might imagine, I'm getting a few questions on gross margin this morning, obviously, a few moving parts. Should we think about, for '23 a typical 30 basis points to 50 basis points of pressure from mix? Or could it be a little bit greater, just given this price cost dynamic, lower rebates, any other pressures?

Yes. Well, from a mix standpoint, 30 basis points to 50 basis points is probably a low number now versus where it was in the past, primarily because our strategies have changed, right? I mean we have shifted towards really prioritizing key and larger accounts. Now that might be a larger regional account at a branch level. It might be national accounts. But I mean we've shifted our strategy to prioritize those, as you know. And so, I think that you've probably seen a bit of a widening in the expected mix impact from gross margin. Again, there's nothing that's surprising about that. And I would again point you to the improved labor leverage that we've been seeing in the last few years has been the flip side of those decisions, right? So that's deliberate. So, I wouldn't be surprised if the type of leverage that we're looking at from a mix standpoint is more in the 50 basis points to 70 basis points range. But again, as I said, I think that's expected. And I think that it's offset by the labor leverage that we get from the and strategy. And I think that we're product -- where mix is concerned, you have to balance both what's happening at the gross margin with the offsetting impact on operating margin.

Right. Got it. Okay. And then next, moving to incremental margins, your kind of exit 4Q at about 20%. Is this a level you think you can achieve in '23 on mid-single-digit sales growth? It sounds like FTEs will be down. You'll have the incentive comp that's down. Anything you can add there would be helpful.

Yes. I think that you're hitting on important elements from an OpEx standpoint, and we do continue to expect good leverage there, right? And I think we've seen on the labor side, wage inflation has moderated a bit. You're right, incentive pay. Look, I'd love to be paying greater levels of incentive pay. But if the market slows down, that wouldn't happen. So, you wouldn't see that kind of growth there. And I think we'll continue to control headcount and the mix will shift as well, where a lot of the headcount that we add will be part time as we rebuild those ranks or -- so the mix will shift that way. So, I think that there's still good opportunity to leverage labor in 2023. And I think the same for occupancy. End of day, the question though, is what's going to happen on gross margin. And if we can limit the decline in gross margin to our mix, I expect that we'll be able to grow our operating margin year-over-year, which would get you more than that 20% incrementals and would get you, I think, solid into the 2025. I think the question, and I'm sure there'll be additional questions coming up, but I don't want to just leave this hanging out there, ultimately, is how do you think we execute some of the pressure that we've seen in the other product side and any level of deflation that may occur down the road if it occurs? And I think those are variables that are harder to sort of judge. And I think get down to whether or not you believe that we're going to execute effectively on some of the things that we cited that pressured the gross margin this quarter. And obviously, we believe that we're going to execute effectively that we're going to find ways to kind of offset some of the pressures that we saw in 4Q. And when we do that, I think that in a mid-single-digit growth environment that we can defend or improve the margin. But I think there's some -- there's probably more variables or questions on the gross margin going into 2023 than we have answers to right now.

Our next questions come from the line of David Manthey with Baird.

I have one 2-part question on OpEx. The first part is related to labor. The initiatives that you put in place have clearly driven better labor efficiency overall. But I'm wondering, in general, is the Fastenal cost structure more or less variable today than it had been in the past because of some of those structural changes? And then the second question is related to branch rationalization. By the chart you show here, where you're extending it out to 2025, it appears that you're materially complete with that transition. And I'm just wondering, are there any costs related to that transition that you've eaten over the past many years that will go away in 2023? And what I'm referring to is any sort of rationalization costs that a less conservative company might have flagged as nonrecurring or restructuring?

Maybe moving backwards and to your first question. I do think that we will have additional closures this year as we move towards that target. And I think beyond this year, you'll begin to see those closures begin to moderate, right? And so I think part of your question is how long does this -- the sort of this closure process go? And I think we have another year of it before it becomes a little bit less part of the story. But one of the things that we've done in closing the branches is, on top of that, we've sort of shifted the priorities of the branches, which ultimately make those branches more scalable in the future than I think they have been in the past. And so as we grow as a business, I expect that we will -- even if we're not closing branches, I think that as our average branch size grows, we're going to get good leverage out of that. To your point of, are there some expenses that were in there regarding closing? Sure. There's branches that we may have closed where the lease wasn't up and there's a buyout. We haven't scrutinized that spend meaningfully. It's been within the overall results for the last 5 or 6 years that we've been doing this. But there'd probably be some of that, that would also taper out of the model as we move from a branch closing mode to sort of a branch sustaining and leveraging mode 12 to 18 months from now. So, there'll be something in there. But again, I don't -- it's not a massive number. If we were prone to breaking things out, which we're not, I don't know that necessarily would have been that big a number to begin with. So, I wouldn't make too much out of that. As it relates to the underlying leverage -- yes, go ahead, Dan.

Yes. So, you talked about more variable, less variable. That answer will change over time, Dave. If I think of 2022, a big chunk of our compensation programs, whether that be to our district leadership, the leadership in a lot of support areas, our regional leadership, our executive leadership. If you look at all those groups, a big driver of pay is growth in pre-tax. And if you think about that from the context of -- you look at it from the last -- the five years prior to 2022, we're growing our pre-tax ex. And in 2022, we grew our pre-tax ex times two. So, there was a very sizable increase in incentive comp that was paid out in 2022 versus the prior years. And that actually aid into quite a bit of our efficiencies during the year if you look at it just from a P&L perspective and a labor efficiency, because that's a meaningful payout. Depending on what you conclude our earnings growth will be in 2023, I suspect it will be a smaller number than 2022. And that will cause in the 2023 timeframe variable to actually be higher than it had been in the last few years because of that swing. If I look at things that we have done historically in the model, if you're opening branches every year, you're adding a fixed layer of expenses every year. If you're adding people into those branches, you're not getting a lot of revenue and gross profit dollars for those ads. There's a fixed layer that you're adding. That really isn't part of our model anymore. And -- because when we're adding labor into new units, it's going into an Onsite, and we're going into Onsite, because we're -- we have an understanding with the customer of what's going to ramp up, and that ramps up a lot faster than historical branch network would. So, from that standpoint, in 2023, more variable. As we move out over time, it's going to depend on what the economy is doing, and is it pulling us up or pushing us back as far as our ability to grow our earnings. And -- but I think you also have our ability to manage headcount in a much different way today than we could have. If you're adding 100 branches, you need 200 people to go into those branches on day 1. And that element has changed. And so, it gives us the ability to manage the P&L in a fundamentally different way. The other piece is, while this doesn't tie right to your variability question, as we're growing things like LIFT, it allows us to create efficiency, the leverage that Holden talks about. And that's going to keep building over time because we're at about 17% of our devices today are supported through LIFT. That was about 5,000 a year ago and that's going to continue to grow over time. And that just allows us to either remove a layer of expense as well as a layer of assets or invest in selling energy faster or accommodation of the 2. So, I hope that answers your question, and -- but it's about the year you're asking it to, but in 2023, there's a little bit more variability.

Yes. But I would say looking over the course of the cycle, Dave, I don't think our variability has changed. I think what we've done is we've reduced the level that our SG&A as a percentage of sales over time can decline to without impairing our levels of service, our ability to grow, et cetera. So I think we've reduced our floor of operating expenses to sales. I don't think the variability of our cost structure has changed much.

Our next questions come from the line of Josh Pokrzywinski with Morgan Stanley.

This is actually Gustavo for Josh -- earlier on the gross margin front and mix headwinds heading into '23. I think just looking a little bit more near term, can you sort of quantify the margin impact from price cost, maybe the improving supply chains? And then how does that sort of trend from here from what you saw in the fourth quarter?

So price cost, the -- I think last quarter, we talked about it being about a 30 basis point impact. This quarter, that was probably more like 40 basis points. So it widened a little bit more than I expected. I will say though, one of the reasons we expected that it would be flat to better this quarter because we expected the dynamic around fasteners to improve. And we, in fact, saw that happen. The drag from a price cost standpoint on the fastener side was narrower than what we saw last quarter, where we saw the more than offset was when I alluded earlier to sort of the other product side, I think we saw a greater impact on the other products that sort of moved that number from where I would have expected it to be to about a 40 basis point drag.

Got it. That’s helpful. And then I guess just sticking with fasteners. And obviously, it’s been a margin headwind here in the fourth quarter as well. I guess with steel deflation coming into the fold now, how should we be thinking about P&L impact from fasteners deflation over the next couple of quarters? And maybe any historical context on what you’ve seen previously would be helpful?

I’ll take historical context first, and I’ll -- yes. So I mean, thinking about the current, as you know, I don’t have the same historical context that Dan does. But the – this is one of those variables on gross margin next year where it comes down, Gustav, to your belief in our ability to execute, right? I mean the -- we do expect that at some point in 2023, there will be requests to adjust fastener pricing down based on the cost of steel. Now you have to --

Or the cost of transportation.

Or the cost of transportation. Now certain costs are still higher labor, things of that nature, right? And so we have to balance that. But in the end, it’s the same question during a period of inflation is can we time the reductions in the price of our product with the lower cost coming through our P&L? And as we have had conversations with customers, that’s been the message that we’ve conveyed is – we understand when our cost is going to come through and these conversations will sort of occur in lockstep with that. And to the degree that we execute that effectively, then we would target neutral from a gross margin standpoint in terms of price cost. But it comes down to your belief in our ability to execute it effectively. I think that with the new tools that we’ve put in place the last few years, I think our ability to manage that process has improved significantly. And I think you saw that during a period of a fairly aggressive inflation. And – so we feel good about that prospect. But our goal would be to really time the cost and the price effectively so that price cost is neutral in 2023. But it comes down to your belief in our ability to execute that effectively.

From a historical perspective, and I’ll use an extreme time frame because, quite frankly, over the years, there hasn’t been a lot of significant inflation or deflationary periods. In the late 2000, so 2008, 2009 timeframe, you saw a period of pretty heightened inflation followed by not only deflation, but the economy getting pounded pretty hard in that late ‘08 and ‘09 timeframe. So, what you saw is if you think of our business in 2 components, large production-type environments and then maybe some of the smaller customer base departments, you – the one is driven more by conversations with customers about pricing. And there, we tend to do a pretty good job over time of maxing it and some you get a little bit ahead of it depending on the turn of that product. But our fasteners turn a lot slower than our – turns slower than our overall inventory. So generally speaking, on the way up, you get a little bit of margin profit in there. And you’ve see an expanding gross profit margin. You saw that back in ‘08, and that’s over that turn of inventory. In ‘09, it was amplified obviously because the economy was weak, but you saw the inverse of that, and we’ve got squeezed pretty hard. But again, it was for a turn. So it’s about understanding what’s happening in the turn versus what’s happening in the long term. What’s changed in today’s environment is that piece that is the more the production center element is a larger component than it would have been back in 2008. And so that piece where the marketplace is raising prices affects a smaller piece of our inventory, and it’s more of these direct conversations. And so – and I think we have better tools to manage through it and have a more sophisticated conversation with our customer on the way up and on the way down. But you know it is it’s easier to slow things down on the way up because your customers arguing that direction, then it is to slow things down on the way down because your customer actually has a different incentive there. So you have those challenges. It will be challenging in the cycle of this turn of inventory, but I believe our team and our tools, we have a means a disciplined way of managing through it.

Our next questions come from the line of Tommy Moll with Stephens.

Wanted to start off with some of the end market -- end market commentary you offered, particularly around what appears to be continued strength in manufacturing tied to industrial capital goods. At the same time, I think, Holden, your word characterizing the outlook for this year on manufacturing was cloudy, obviously, PMI is sub-50 now. Have you seen any softening there? Or would you characterize that end market is just as strong as it was, say, a quarter ago?

Still feels pretty strong. And again, I tend to try to rely on the regional Vice Presidents and kind of their feedback to me. And honestly, the feedback over the last 2 or 3 quarters really hasn't changed that much. We clearly down shifted from first quarter to second quarter. But since then, it's kind of been the same kind of feedback from the RVPs. They still feel good about what we're doing. They feel constructive about the cycle. Their customers are constructive, but nervous. And RVP might cite something that's worrisome, but on the other hand, another one might sort of change their tune quarter-to-quarter. And that's why I look at it net-net, the overall tone and tenor of what the RVPs are describing to us about the marketplace, frankly, it hasn't changed a whole lot as it relates to that manufacturing and the dynamics are fairly similar. So if we look at the same stuff that you do and I've always had a tremendous amount of respect for the PMI and its ability to sort of point directionally to what industrial production is doing. I think if you look at industrial production, that's still growing, but it's -- but that growth has moderated. But we still feel pretty good about what we're doing with focusing on this customer set and really being able to spend more time and grab wallet share at a faster clip. And I think a lot of things that we're doing is making us feel pretty good about a market that, as you pointed out, there's a lot of signals that are suggesting it should be softer than it feels to us right now.

So I have the opportunity throughout the year with 240 district managers. And throughout the year, I'm having conversations with 4, 5 or 6 DMs every week. And our conversation with each one going through learning a little bit more about them, learning about their business, where they think their business is going and just hearing about what they're saying. And we were stuff on our chart sleeps. If you feel like -- if you're nervous, that anxiety manifests itself and how you think about stuff. I think a couple of things are going on. And again, put that in the category, this is from talking to a lot of people and this isn't from studying a lot of numbers. I think what's helping manufacturing is a really healthy backlog that existed through much of 2022. So let's just say you're a manufacturer and your backlog is 100 units and whatever that revenue is because, say, it's 100 units. And because of supply chain constraints, because of just demand in the marketplace from the last several years, maybe some deferred maintenance, whatever it might be, that backlog goes from 100 to 150. And then we get into the latter third of 2022. And let's say that backlog goes from 150 to 120. It's still a really good backlog. And the question is, is the PMI reflecting the 120? Or is it reflecting the concern, the angst that comes with, well, the backlog went from 150 to 120? And is the PMI giving us a head fake or is the PMI really telling us what's going to happen? We honestly don't know. But to Holden's point, the activity we're seeing feels okay. But we are -- we, like everybody else, are a bit nervous about where things are going. The last 3 months and for the next 6 months, I'll be pushing our leadership pretty hard on what we're doing as far as adding headcount and being really thoughtful about it. I feel good about -- set aside the economy for a second, I feel good about the fact that we have 350-plus new Onsites that will be given us juice as we go into 2023, and we didn't have that kind of number coming into 2022 or 2021. And so there's some positives there. But as far as the underlying economy, we're not really sure if the PMI is right or wrong, but we're playing it, assuming it's right.

Very helpful. As a follow-up, I wanted to pivot to pricing dynamics in gross margin. I guess this is a 2-parter. Holding on gross margin, is there anything quantitative or qualitative you'd offer just to bridge us from 4Q to 1Q? And then more broadly, I forget which one of you referenced the broader discounting in the non-fastener, non-safety SKUs. Is this an early sign of a trend that may bleed over into some of your more core product categories? Or any context you could offer on that discounting dynamic would be helpful as well?

We'll have to put our heads together and decide if a two-part or second question is actually three questions. We'll get back to you, Tommy, on that. The -- so the -- the other products, I think, was the second question that you asked. And the -- there's not a lot more, I think, that we can add to kind of why we think it occurred. We just think that those products tend to be less planned. They tend to be a little less centralized in sort of the supply chain. And when markets change and shift, and we've seen some, right? I mean you go back six, nine, 12 months ago and the availability of products in the marketplace was fairly sketchy. It's gotten much better. Inflation conditions have changed. Demand may be softening a little bit sort of under the surface. I don't know. But in the end, I think that the weakness that we're seeing has a lot more to do with things that we've done. And the good news in that is having identified that, there's things that we can do to sort of mitigate those effects. And those are things that we intend to do over the next quarter or such, right? And so, we have a lot of belief, and this is another element of gross margin for next year. It comes down to your confidence in us and our ability to execute sort of the measures we need to mitigate that effect. Now what was your question about bridging from Q4 into next year, it probably does mean that if you look at traditional seasonality around gross margin, it's probably a little weaker in the first part of the year and a little stronger in the second part of the year as we get our arms around the things we need to do to sort of mitigate the issue around the other products. So hopefully, that gives you a little bit of color you can use.

Our next questions come from the line of Jake Levinson with Melius Research.

On a totally different topic. I feel like that international $1 billion revenue level seems to have snuck up on us and it's certainly been one of the fastest-growing parts of your business. I'm curious, what your longer-term aspirations are there? Because as far as I can understand it, it grew kind of organically out of the domestic business that you built in North America. But clearly, it's getting to a pretty sizable level. So, is there a path to further expansion beyond that traditional legacy model, if you will?

Yes. So first off, yes, it's -- that growth has been all organic as has most -- 99.5% of our growth as a company in general over the last 50-plus years. The -- you milestone, I think, has made ever more impressive by the fact that you look at our international business outside of North America, I mean, talk about a year to get your teeth kicked in. You have the chaos that's going on in Europe between the hostilities in Eastern Europe in Ukraine and the energy situation and all the uncertainty and stuff that's been shut down in Europe because of this high energy consumption, et cetera, and moved to other places. You have Asia where the bigger part of our business is in China. Again, these are both relatively small pieces to Fastenal. But to international, they become more important. And so that milestone is ever more important. In China, they've been enduring lockdowns for an extended period of time, and it makes it really difficult to conduct business. So, I think it's really impressed with what they've done throughout this time frame, and I touched on it in my head count numbers, we've continued to invest in the team. I had the opportunity after not being over there for a number of years, obviously, because of COVID, I was over traveling in Europe in the fall in September, October time frame, spent time with our team in Northern Europe. I spent time with our team up in the Netherlands, really impressed with what I'm seeing from a growth perspective, not top line growth, but from the underlying customer acquisition perspective and the team I met with. And what's exciting about that business is you're seeing examples of customers we're signing and Onsites we're signing or branches that customers that were creating relationships with that aren't strictly an extension of North America. There are businesses we're signing up contracts with that know nothing about our business in the U.S. or our business in Canada, or our business in Mexico. And they were introduced to Fastenal in our team because of our contact on the ground, whether it be in Europe, whether it be in China or down in Southeast Asia. That's the exciting part because it tells me the team there has -- is creating a market presence for themselves and they're being recognized in the supplier community, which makes life a lot easier because when your supplier community is in North America and you're operating in Europe, that's a challenge. The other piece is the -- if you think about the economy, and I'm not telling you anything you don't know, there's more business outside North America than there is in North America, and we're very conscious of that long term. So, depending on what your time horizon is, if your time horizon is the next five or 10 years, most of the growth element of the business is going to come in North America from a pure magnitude perspective. But beyond that, what's exciting is, I think we're unique in our space and that we've found tremendous success moving beyond the traditional geography that your business operates in. And the model works. We go in these new markets. We find great people. We ask them to join. We create an environment where I think they want to be. And I think the comment earlier about our experience with interns in India is indicative of what we're able to do. I think people like this style of decentralized organization, where we respect people for their opinions. And we challenge everybody to be vocal about what you think can make us better. That's how we get better as an organization, and I couldn't be more pleased. In fact, at our April Annual Meeting, I've asked Jeff Watt, who leads our international business, to speak to the group this year. And he was going to do it a couple of years ago and then couldn't make it because COVID hit in the spring of 2020. We had virtual annual meetings for the next couple of years. So it wasn't quite the same. We just kept it to the facts, so to speak. And last year, we had the opportunity to let Terry Owen talk about the distribution and investments we're making on the sales side of the organization, and this year, Jeff is going to cover international. But it's a wonderful business for us because we're finding a whole bunch of folks that are getting exposed to the Blue Team and our supply chain capabilities.

Our next questions come from the line of Chris Snyder with UBS.

I wanted to talk about the ability to drive operating leverage as Onsite activations ramp. And I understand that a fully mature Onsite can be accretive to operating margin despite being materially lower on the gross margin side. But I guess my question is how long do you think it takes? Or how long should we expect it to take from Onsite to reach that level of maturity and how should we think about that dynamic into 2023 as Onsite activations are ramping?

Functionally, I think it's less about a function of time and more a function of scale. And that being said, it really -- well, on an individual on-site basis, you're going to get a certain degree of variability, right? I don't believe that a $600,000 a year on-site is necessarily margin accretive. But if that $600,000, we believe can lend itself to $1.8 million to $2 million a year, then it's certainly worth being in that setting and that environment and that relationship for the potential upside. And that's part of the point of the exercise. But if it's a function of volume, what I've always said is prior to Onsite becoming an initiative, and we just looked at 215 on sites that have been there, somewhere between 1992 and 2014, they were mature not as a function of time, but a function of scale. On average, those Onsite were doing between $1.8 million and $2 million a year in revenue. And that is when you achieved a margin north of 20% on that group. And what I can tell you is during the period of COVID when our signing slowed down, you had a certain maturation of existing on sites that became a faster percentage of the whole than we would have expected to see in the absence of COVID. And one of the by-products of that was we actually saw a pretty good increase in the overall operating margin of our Onsite business. And I believe that, that increase was to the tune of a percentage point a year between 2020 and 2021 and '21 and '22. Now we signed a lot of Onsite last year. We're targeting signing a lot of Onsites this year. Assuming we're successful with that, and we believe we will be, then you'll sort of see the inverse of what happened during COVID, where you're going to see those newer units kind of stepping up a bit in the mix again. And that might make further progress in 2023 on margin at the Onsite level, a little bit more difficult to achieve. You might see a little bit of a step back, but you're not going to step back to where we were pre-pandemic. We've seen the mix of mature units go up. And I think we'll continue to see that. And our expectation is that right now, your average unit is probably between $1.6 million and $1.7 million. If that steps back a little bit in 2023 because of all the new implementations that we're doing and the greater signings, that's fine. But we do expect that, that average size is going to continue to trend towards that 1.8 to 2 and that those margins will trend towards 20% plus. That's the expectation.

We've talked about over time. It's going to add to Holdings. We've talked about over time how we expect the operating margin of our business to continue expanding. And there's really 2 dynamics going on there. One is we can absorb a greater mix, even if they're below company average operating margin, we can accept a greater mix because the branch network isn't stagnant. The branch network is continuing to grow because we're adding revenue every day, and we pulled some units out over time, as we talked about. So if I look at our oldest regions that have the highest concentration of Onsite, their average branch isn't doing $150,000, $140,000 a month. It's doing $210,000, $220,000. Our operating margins are higher in those areas even though our Onsite revenue might be 50% of revenue. And so it's really a case of the network matures, even if the mix is beating you down, your branch network is actually becoming more profitable. The other thing is elements inside our business, and I see we're almost at talks, I'm going to cut it off with this when we're done, I apologize for that. But the elements of our business are becoming stronger. Now I use vending as an example. Five years ago, I sat down with the fellow that leads our vending business. And if you look at vending as a discrete business within Fastenal, it had operating margins between 13% and 14%. So it doesn't take a lot of math to figure out, hey, you keep growing your vending business, that's not friendly to your operating margin. And my comment to Jeff at the time was, Jeff, here are the pieces we need to work on over time. increased revenue per machine, increased the mix of our exclusive brands, increased the mix of our preferred providing brands lower the cost of our devices. All these things need to occur over time. I'm pleased to say when I look at vending as a discrete P&L, we just looked at it last week, it broke 20% for the first time. And Onsite never had the benefit of organizational investments in it to make it better. Didn't have FMI. It didn't have a point-of-sale system that was built for Onsite. It had a point-of-sale system that was built for a branch network. We're investing in those tools today. That helps the efficiency of the Onsite network, too. So, it helps defend the math, but the network is getting better, and we have demonstrated proof that, that occurs already. With that, it is on the hour. Thank you for your interest in Fastenal. Have a great 2023.

Thank you. This does conclude today's teleconference. We appreciate your participation. You may disconnect your lines at this time. Enjoy the rest of your day.