Greetings, welcome to the Fastenal 2019 Annual and Fourth Quarter Earnings Results Conference Call. At this time, all participants are in listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] Please note this conference is being recorded. At this time, I'll turn the conference over to your host, Ellen Stolts, Assistant Controller. Ellen, you may now begin.

Ellen Stolts - Assistant Controller

Welcome to the Fastenal Company 2019 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 1 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, 2020 at midnight Central Time.

As a reminder, today's conference call may include statements regarding the Company's future plans and prospects. These statements are based on our current expectations and we undertake no duty to update them. It is important to note that the Company's actual results may differ materially from those anticipated. Factors that could cause actual results to differ from anticipated results are contained in the Company's latest earnings release and periodic filings with the Securities and Exchange Commission. And we encourage you to review those factors carefully. I would now like to turn the call over to Mr. Dan Florness.

Daniel L. Florness - President and Chief Executive Officer

Thank you, Ellen, and thank you everybody for joining us for our fourth quarter earnings call. Last, we'll be filing our Annual Report here in the early part of - first half of February. And so, last weekend I was drafting the letter to shareholders and employees for inclusion in that Annual Report. And one of the observations contained in that letter is a comparison of 2019 and 2015, because when I was - when I'm writing that letter, I typically will go back and re-read a few letters and one reason you do that is, you're not too repetitive. Another reason to do that is to see what observations jumped out at the time. Back in 2015, we started out the year with a PMI Index of 52.6%. That's the average of the first three months of the year as we disclosed back then. I'm not sure if there has been adjustments to the PMI since then. We ended the year just shy of 49%, I believe it was 48.6%. And in 2019, we started the year a little bit higher. It was at 55.4% in the first quarter. In Q4, we were at 47.9%. So - and we've been sub-50% since August.

If I look at it using an internal benchmark or an internal yardstick, I looked at our top 100 customers and this group represents about 25% of our revenue historically. In the first quarter of 2015, about 72% of those 100 customers were growing. By the fourth quarter, that number was 49%. And given our size of our relationship with each of these customers, the change in trends in a window like that is using more about their underlying business than Fastenal gaining or losing market share with that customer. If I look at that same statistic in 2019, we started the year at 81%. We finished the year at 57%. Again, just looking at the percentage of our top 100 customers that are growing with us and I think that's a great barometer on the marketplace.

If I - yesterday in our Board meeting, one of our Directors asked if you're looking at Q4 and the question was about Q4, my comments to you a second ago was on 2019 in general, what would you give for a grade on the quarter. And without giving it a second of thought I looked at them, I said, you know what, I'll give it a B. And the biggest reason for the B is, we did not leverage our earnings. In other words, our operating income growth was less than our sales growth and I just can't give an A to that performance, so I agreed to the B.

However, if I look at our team, leaders throughout Fastenal and the execution of the team throughout the organization, I think given the subdued activity, as indicated externally in the PMI Index as well as internally in our Top 40 or Top 100, I believe the Blue Team executed well in the fourth quarter. December, as you all know from reading our release, December was a tough month. We grew 1%. The mid-week holiday over Christmas was not our friend. The January and - been doing this, I've been at Fastenal now for 24 years, and that means they have done just shy of 100 earnings calls. And there's one thing we don't do and we don't talk about current month in the current-month. I'm going to break that rule. January started with a mid-week holiday, the Thursday and Friday, the second and third was not our friend and we really haven't recovered from that. And I expect at this point January will feel a lot like December. I don't know if that means we'll be 1%, but I think it's going to feel like December did.

Our sales team is adamantly opposed to that. They see reasons why we'll do better and time will tell. I genuinely hope they prove my expectation wrong at this juncture in a month, but I'm just sharing that. This has absolutely no bearing on my thoughts for February or for 2020 in general. Time will tell what the economy is going to is going to provide for us and what headwinds are created or tailwinds are created, but December ended with a mid-week holiday and January started with one, so I want to make that observation.

Flipping over to Holden's flipbook, I've touched on that second bullet, where we really talk about December weakness and the impact of the holiday timing. Despite everything that's going on and my comment about my belief in the Blue Team and being impressed by their executability, we leveraged our operating costs in the fourth quarter. We continue to focus on controlling our costs, not as a means just for the expense, but to put us in a position where we can continue to invest in our growth drivers, because we still have incredible opportunities for growth. We have a relatively small market share and I truly believe we have a better supply chain model for our customers. As we talked about last quarter, moderation and challenges of inflation and tariffs and our ability to manage through it has stabilized the price cost. Holden violated a rule last quarter and that he talked about his expectations for gross profit. I suspect he won't do that again, but the time will tell.

But one observation I'd have for everybody listening to this call, don't get caught up in the minutiae. The real issue in Q4, our sales fell off a bit more than we expected and we have an incredibly large fixed cost trucking fleet that operates and one that we're bringing one palate or a three-fourths of a palate product to a branch, we're running a truck, it's still a stop. And that de-levered more in the fourth quarter than we expected. To add a little bit to that pain, our freight revenue also weakened. That's a short-term execution issue. If I were to attribute to anything, I think there is a bit of fatigue in the organization from all the tariffs and pricing and inflation energy that we had expelled in the summer and fall months and I think it showed up in our fourth quarter. That's an execution issue on Fastenal and that's on me, but don't get caught up in the minutiae of a gross profit 0.1% or 20 basis points. It's deleveraging of the freight network and that happens always in the fourth quarter. This year was a little bit more acute.

Flipping to the Page 4 of Holden's flipbook, Onsites, we signed 362 for the year. Our stated goal was 375 to 400, came in just shy of that. We ended the year with 1,114 active sites, about a 25% increase from end of last year. Sales growth with this group and this is excluding transfered sales, so this is looking at peer growth. So if we have $30,000 customer that pulls all of our branch and we go Onsite, it's looking at dollars above $30,000, it was up in the low-double digits.

As you can appreciate, in our more mature onsites, we did see some degradation and at that's a sign of the economy. Going into 2020, our goal remains 370 to 400. We're really excited about this growth driver in our business. Total end market locations were 3,228 versus 3,121 at the end of last year. We closed or converted 36 locations, traditional branches. We also closed 26 Onsites in the fourth quarter. Now, that probably raises a few questions in many of your eyes. Here's a couple of things to always keep in mind about Fastenal. Some organizations prefer only showing pretty picture. Some organizations only prefer talking about good things. We talk about the real, we talk about the things that - the change. We address today's issues today, one of the things the team at Fastenal has learned to live with over the last five years is, every year I share with them, what I consider my Top 10 suggestions on life.

Things that I learned from friends and family as a kid and that includes - and where I grew up, family was also your neighbors. It includes teachers and coaches I was blessed to have in my life. It also includes the people you associate with in your adulthood. It starts with your spouse, extends to your kids, but it also extends to friends and associates you come across. Number 5 on that Top 10 list is, make great decisions, share the reason why, and start today. If we have an Onsite location where that customer's business is downsized, maybe they closed that facility, maybe the economics don't work and we decided to take that relationship and move it to back into the branch, that's not a sign of failure. That's a sign of wisdom. That's a sign of saying, how are we allocating our resources and what's the best resource allocation for our customer, for our next customer, for our people and for our business, and I consider those decisions to close an Onsite that doesn't meet the requirements, to be a good decision, provided we don't think it's going to recover in a reasonable timeframe.

Exiting an Onsite doesn't mean you don't come back. It doesn't mean you lost the customer relationship. It just means the economics for being Onsite aren't holding true right now, you take a step back. I think that's a great decision, and we will make those decisions every day. From a vending perspective, we signed 5,144 devices in the fourth quarter, essentially in line with our - and 21,857 for the year, essentially in line with our goal of 22,000 devices. Our installed base ended up at 89,937, an increase of about 11% from last year and our product sales, through those devices, were up in the low double digits.

In the order of avoiding confusion, earlier in the year we celebrated vending machine number 100,000. This 89,937 includes machines that are principally reducing product sales. We have another 15,000 devices out there that are leased out to customers for check-in/check-out purposes, just to clarify that.

Finally, e-commerce. Our sales grew at 25% Q4 to Q4. For the full year, we were up 32% and this includes a 35% increase with our national account customers. The way we think about e-commerce is about making our business a little bit more efficient every day, because as our supply chain partnership with our customer grows, most of our business activity is coming from vending, from bin stocks where the customer really isn't ordering the product and we keep stepping deeper and deeper into the business. Today, those two pieces are about 30% of our revenue. I believe in the future, that number will more than double as a percentage of our business as we come more entrenched in our customers' business. This is really a reflection of stop the customer's order outside of that supply chain window, the non-recurring stuff.

With that, I'm going to turn it over to Holden.

Holden Lewis - Executive Vice President and Chief Financial Officer

Great. Thanks, Dan. Good morning. Let's just jump right into Slide Number 5. Total sales were up 3.7% in the fourth quarter, which included a particularly poor December growth of just 1%. December was affected by holiday timing and extended customer shutdowns, but even setting these aside, business activity was generally soft throughout the quarter. This was reflected as well in the macro statistics with the leading US Purchasing Managers' Index averaging a contractionary 47.9 in the fourth quarter and printing a 47.2 in December. US industrial production swung to a decline of 1.1% in October and November. Manufacturing was up 5.1%, heavy equipment lagged at 1.4% growth with weakness as well in oil and gas, metals and transportation. Construction was up 3.1% in the fourth quarter, consistent with the third quarter. Our larger construction customers again outgrew smaller ones, though we have seen a moderation in the rate of contraction in those smaller customers. In the fourth quarter of 2019, we sustained the pricing that was implemented and realized in the third quarter of 2019 as a means of offsetting general inflation and tariffs. Clearly things could change, but as we enter 2020, weaker end market demand in a more encouraging tone around trade policy has reduced inflationary pressure. From a product standpoint, non-fasteners continued to lead, but did decelerate with 5.1% growth in the third quarter, while our more cyclical fastener line was up 1.8%.

From a customer standpoint, national accounts were up 8.2% in the quarter with 57 of our Top 100 accounts growing. Non-national account sales actually contracted in the period, with just 54% of our branches growing in the fourth quarter. November and December can be difficult months from which to draw conclusions about the future and that is certainly the case this year. However, business conditions clearly remain sluggish and the feedback from our regional leadership remains cautious on the early part of 2020. It remains our intention to take advantage of this environment to continue to invest in our growth drivers, even as others pulled back.

Now to Slide 6. Our gross margin was 46.9% in the fourth quarter, down 80 basis points versus last year. This annual decline is primarily a function of product and customer mix. With 30 basis points decline sequentially, it was in line with normal seasonality, though we were a bit shy of our expectations that gross margin would be at least 47%. This was primarily attributable to freight as Dan commented on. While the cost of maintaining our captive truck fleet is fairly stable quarter-to-quarter, our ability to charge for freight to partly offset those costs can vary depending on market conditions. In the fourth quarter of 2019, our freight sales declined 7.5%, which resulted in less absorption of our fleet cost than anticipated. With our pricing sticking from the third to the fourth quarter and with weakening demand causing inflationary pressures to moderate, price/cost was not a meaningful variable one way or the other, affecting gross margin in the fourth quarter of 2019.

Our operating margin was 18.7% in the fourth quarter, down 30 basis points year-over-year. We believe the blue team did a good job controlling expenses as SG&A as a percent of sales of 28.2% was better by 60 basis points and a record low for a fourth quarter. However, as we have commented before, given our intention to continue to invest in growth drivers, even if condition slow, it will be difficult to defend the operating margin when growth eases into the low-single digits. Our inability to leverage occupancy costs in the fourth quarter of 2019, are a perfect example of this with current growth not being sufficient to produce leverage over the vending investments to drive our market share gains.

Looking at the other pieces of SG&A, we achieved 20 basis points to 30 basis points of leverage over employee-related costs, which were up 2.4%. This was largely due to reduced FTE growth of 1.4% combined with lower performance-based compensation in the period. In the current environment, we would expect further low-single-digit growth going forward. We realized 30 basis points or 40 basis points of leverage over general corporate costs with lower bad debt expense in the absence of certain legal and structural expenses incurred in the fourth quarter 2018 offsetting higher IT spending in the fourth quarter of 2019. Putting it all together, we reported third [Phonetic] quarter 2019 EPS of $0.31, up 5.4% from $0.29 in the fourth quarter of 2018.

Turning to Slide 7, looking at cash flow. We generated $252 million in operating cash in the fourth quarter or 141% of net income. Higher earnings combined with lower working capital needs produced the cash flow. Full-year cash conversion was 107%. Net capital spending in 2019 was $240 million, exceeding our targeted range of $195 million to $225 million. The sources of higher capital spending in 2019, vending, trucks and hub capacity were planned. The overshoot related to our addressing a number of facilities in 2019 as a means of managing a sharp increase in our volumes over the past three years and a couple of those facilities simply costing more to complete than we anticipated. In light of weaker macro conditions, we expect net capital spending of $180 million to $205 million in 2020. We paid nearly $500 million in dividends in 2019 and increased our dividend for the first quarter of 2020 by 13.6%. We finished the quarter with debt at 11.5% of total capital, below last year's 17.8%. Inventories were up 6.9% in the fourth quarter of 2019. Nearly three quarters of this growth related to inventory to support Onsites. Hub inventory growth slowed sharply, a function of both deliberate efforts to reduce inventory as well as weaker demand, while field inventories were slightly down. Setting aside the impact of demand, we believe there remains further opportunity to improve our inventory days in 2020. Accounts receivable grew 3% in the fourth quarter of 2019, the slowest rate of increase in more than three years, which largely reflects slowing demand. Mix and customer behavior will likely continue to influence AR days in 2020 with our expectations being flat to slightly higher days. We believe these factors will continue to produce good operating and free cash flow in 2020. That's all for our formal presentation. So with that operator, we'll take questions.

Question & Answers

Operator

Thank you. At this time, we'll be conducting a question-and-answer session. [Operator Instructions] And our first question is coming from the line of Ryan Merkel with William Blair. Please proceed with your question.

Ryan Merkel - William Blair & Company - Analyst

Hey, thanks. Good morning guys.

Daniel L. Florness - President and Chief Executive Officer

Morning.

Holden Lewis - Executive Vice President and Chief Financial Officer

Morning.

Ryan Merkel - William Blair & Company - Analyst

So, first off, in terms of price capture, you said it was consistent with last quarter. So, I just want to confirm, does this mean pricing was up 90 basis points to 120 basis points. And then, sort of a related question, I recall that you thought you'd get some incremental price into fourth quarter. Did this not materialize and why was that if that's the case?

Daniel L. Florness - President and Chief Executive Officer

No. So, what I'd say is, if –the impact of price in the fourth quarter was probably in the neighborhood of 70 basis points to 100 basis points, which would have backed off a little bit from where Q3 was. But again, much as we saw much of the year that reflected having to grow above some increases from last year. If I look at the overall price level in our business in fourth quarter, it was slightly up from where we were in the third quarter. So, we look at the overall pricing activity from Q3 and for the most part, I would characterize Q4 as living up with our expectations as it relates to the price side.

Ryan Merkel - William Blair & Company - Analyst

Okay. So, the bottom line is, I was maybe picking up. There was maybe a little price pressure starting to materialize, but that doesn't seem to be the case just yet.

Daniel L. Florness - President and Chief Executive Officer

We aren't seeing price pressure materialize. Now, what we're commenting on has more to do with inflation. Remember, what we've said is we've had two things affecting us over the past 12 months. One was the generalized inflation. The second was the tariff and frankly the generalized inflation was a much more significant impact on us than the tariffs were. What we are seeing is, with some of the activity around tariffs of late, I mean, with the overall sort of slower demand level, some of those inflationary pressures that have been a part of our business for the past 12 months to 18 months have begun to moderate, but that shouldn't be read to suggest that we haven't maintained our pricing that we achieved in Q3 because we have.

Just to add a slight color to that, when I - first off, there is always price pressure, that's a constant in life and it's intense now. If I - but, I'd make that comment again any quarter. The one element that does exist in the fourth quarter, that does exist in the first quarter is keeping the facts straight in the confusion at a minimum. And what I mean by that is, we've talked in prior calls, and we've talked internally, continuously about the tariff and anti-dumping duties that are out in the marketplace. You have the 232 anti-dumping as it relates to steel and aluminum that was put in place. And then you have the 301 tariffs. So the 301 tariffs - and I get an update on this every two weeks and even that's not enough in many ways, because there's a lot - there are so many pieces that are flying around. I suspect if I'm in a branch in Fastenal, I'm having a customer talking to me in December, and saying, jeez, the tariffs were just eliminated. Now the List 4B that never went into effect that was - had been postponed was canceled on December 13, but that never went into effect, and that was largely consumer goods, so that - the impact of that is less than our world.

Then the next comment might be, well, List - I thought went from 15% to 7.5%. Well, it was just announced that List 4A is going from 15% to 7.5%, and it's taking through that piece. For us, the bigger one was frankly List 3, nothing has changed on List 3. So our biggest challenge internally is to make sure that an individual in a branch, a branch manager, a district manager, a regional leader, a national accounts person is as familiar with these pieces as what I just laid out, because when you're familiar with the facts, you can have a discussion. If you're not, it's very difficult to have a discussion about it. So that pressure is there primarily because of all the noise and confusion that can come into the marketplace and a lot of the misinformation that can float around, but the fact is 4B never went into effect, 4A was just announced that it's dropping and - but List 3 is where the dollars are, at least for our marketplace. List 1 and List 2 are less meaningful.

Ryan Merkel - William Blair & Company - Analyst

Yeah, that's helpful color. Yeah, I think we're all sort of interested to see how that materializes if tariffs are removed, what happens if pricing and such, but guess TBD on that.

Daniel L. Florness - President and Chief Executive Officer

Yeah.

Ryan Merkel - William Blair & Company - Analyst

And then on the Onsite, you mentioned the closings, and you mentioned the economics. I'm curious, is the reason for the worst economics is due to the slowing economy or is this more of the local team didn't assess the opportunity correctly? And this is something you can fix?

Daniel L. Florness - President and Chief Executive Officer

I think it's typically economic. I'm sure there's examples of ones that we decided either to pull it back because it didn't materialize is what we thought. Keep in mind, and I've used this example before, I remember traveling with the District Manager several years ago and he had an Onsite, that when we were driving to the Onsite, he said, yeah. And this individual knows as much about Onsite as anybody in our company. He is based in Wisconsin and he said, I'm taking you to this one, and I'm not really sure if it was a good idea or bad idea, but here's why I did it. And he talked about going Onsite and he talked about what the relationship was and he talked about where he thought he can get it to and he thought he can get it to $75,000 a month, which is a small Onsite for us, but he has had a real frank discussion with the customer that I'm only going to be able to staff it this many days a week, but again the freedom to move the branch a little bit further north and it was a better location for the branch.

There, he was looking at and saying, if it doesn't work out, I pull that back into the branch. As it turned out, he got it to $75,000 and a couple months later, he sent me a message and said, hey, we picked up some OEM parts and we are going to get it over to $100,000. That change occurred because the customer loved what we are doing and they figured out ways to buy more from us. That doesn't always happen and so sometimes you might have one where you're going in Onsite and you think you can get it to X and you find out that you can only get halfway there. That $30,000 got to $80,000, but you can't get to a $130,000, and you pull it back. I don't consider that a failure, we took a $30,000 relationship, grew it to $80,000. We're having - and we're having a frank discussion with the customer, it's easier for us to service it from the branch. I consider that we're engaging with that customer and it's a win and if that's one of the 26, I'm fine with that.

Holden Lewis - Executive Vice President and Chief Financial Officer

I'll add a little color to that as well. I mean, I think looking at the causes of the closures this quarter, there were really no differences versus the ones that we covered with you last quarter, right. So, it's all sort of the same reasons, and we have to remember that in those, as Dan alluded to you, some of those are simply taking business that we had in Onsite and moving it to a branch. So, I - we didn't see anything different in sort of the character of those closures and I think you have to think about the larger installed base.

Once you get to a certain level, you do review that base for underperformers. And, again, as Dan was saying, I think that's a healthy transition. But I think you should also think a little bit about the culture of the business. I mean, if you think back to vending, I think we started that initiative in 2009. It really began to get legs in 2011. And in 2016, we sort of went through and we looked at all the machines we put in and said, should this machine really be here, right. And in that year, we had a higher than normal sort of removal rate than we had seen in previous years, as we sort of evaluated the installed base. And we're in the fifth year of this Onsite push and I think that our culture in some respects is to sort of find these growth drivers, run fast, grab ground and clean up a little bit later.

And at the end of the day, what you're seeing right now is we built a good installed base, we're evaluating what we have, the churn has gone up a little bit. It's down from Q3 and frankly, I think we're expecting a lower rate of churn in 2020. We'll see how that plays out, but in the end what you wind up getting much as you did with vending is a great business where we're ahead of the field in terms of being able to implement it and it contributes to gaining market share and we're looking at this very much the same way.

The other thing to your point about opportunity, this past quarter the Onsite team actually sampled 400 locations. I'm not sure which 400 those are, but they wanted to sort of get to the same question that you're asking and these were decently sized 400 Onsites in terms of the average, but they found that in the products that we currently deal in, there is still more than 2 times the revenue potential than we already have in those Onsites. And, again, these are smaller Onsites. So the potential - we don't see any diminishment in the potential for this business and I think what you're seeing us transition to, I would say, is historically consistent with how we execute our growth drivers and is leading to have a great business.

Ryan Merkel - William Blair & Company - Analyst

Makes sense. Thanks. Pass it on.

Operator

Our next question is from the line of Robert Barry with Buckingham Research. Please proceed with your questions.

Robert Barry - Buckingham Research - Analyst

Hi, guys, good morning.

Holden Lewis - Executive Vice President and Chief Financial Officer

Good morning.

Daniel L. Florness - President and Chief Executive Officer

Good morning.

Robert Barry - Buckingham Research - Analyst

Did you say or could you how much the freight was a headwind to gross margin?

Holden Lewis - Executive Vice President and Chief Financial Officer

It probably impacted us by 10 basis points to 20 basis points relative to the expectations.

Robert Barry - Buckingham Research - Analyst

And you think now that just goes away or that persists as long as the sales growth is low-single digits?

Holden Lewis - Executive Vice President and Chief Financial Officer

Well, I think as long as sales growth is low-single digits, there is going to continue to be some pressure there for sure, and that's not new and that's not necessarily unexpected. I think Dan also talked about, we just have some focus to bring to that, right. We spent a lot of effort in the last 12 months on pricing discipline on the product side of our business. And the degree to which you've seen us not really have to talk about price cost is a direct result of the success of that, right. We've been able to mitigate some of those inflationary pressures. We need to bring some of that discipline to the freight side of it as well and that's going to be a focus and a goal for 2020. And the degree to which it is or is not a drag will depend on our level of success. But again, we always have to put this into perspective, we're talking about 10 basis points to 20 basis points. Now, we want those 10 basis points to 20 basis points, right, but we're not talking about 100 basis points or riskier 150 basis points. And then, we're also talking about something, which is related to an asset that being our captive fleet, which is a huge competitive advantage for us. So, there's things that we have to do better. It's - focusing on that will be something we do in 2020. We do have to address the market, that doesn't make it easier, but there are some things that we can do from a self-help standpoint and that's probably how I'd characterize the situation with freight.

Daniel L. Florness - President and Chief Executive Officer

Hey, Rob, the only element I'd add to that is, part of it is about year-over-year growth, but part of its about sequential. So, if you think about where we were in October to November, December, the delever that occurs because you have this infrastructure to support that, then it falls off. History has shown where January is relative to October and depending on what the start of January will be in that normal landscape, will still come into play. But once you emerge from that slowdown that you get around the holidays, and you get further away from that and the dollars climb back, then that delever that occurs from our distribution, our trucking freight - the trucking fleet, that dissipates, because we not only want that 10 basis points to 20 basis points back. Message to our team is, here is when we expect to get it back.

Holden Lewis - Executive Vice President and Chief Financial Officer

And then, to Dan's point, don't forget seasonality as well, right. Again, the crux of the issue is that you have relatively stable costs in your fleet and seasonality, as you get into Q2 and Q3, you get a seasonal uptick as well just naturally. So, Dan's right. Part of this reflects simply the seasonal nature exacerbated by the cyclicality. So that is an element of it, but we're going to work on executing it better as well.

Robert Barry - Buckingham Research - Analyst

Got it. I guess, bigger picture, where do you see price costs going from here? It sounds like if the non-tariff inflation was actually the bigger piece and we're seeing commodity deflation, I don't know, how do you think about the puts and takes, because I think you said the tariff inflation will peak in 2Q. But if you're seeing some meaningful commodity deflation like steel, I mean, could you see price costs, I don't know, even be modestly positive? Do you see any line of sight to that or how should we think about it tracking?

Daniel L. Florness - President and Chief Executive Officer

Hey, Rob, I'll make a deal with you. If you can tell me what tariffs are going to do in the next six months, I'll tell you what I think our reaction is going to be. I've had numerous times over the last year where I have a discussion on Friday and by Monday what we just talked about had completely changed and the discussion became irrelevant.

So, I'm going to respectfully decline to answer that, only because I don't know sometimes from week-to-week and month-to-month what's going to happen with tariffs and if it makes it - the economy I can look at trends and look at prior years in Fastenal and I could at least give an informed thought on tariffs, we really can. I mean, all I know is we focus every day. I'm setting the best light we can for our customers and building the best supply chain for our customers and where appropriate, moving sources of supply and that we've done quite aggressively in the last 10 months to 15 months.

Holden Lewis - Executive Vice President and Chief Financial Officer

And the only thing that I would probably add to that is, over the past 6 to 9 months, the pricing teams, the way they've been sort of structured, the work they've done to sort of surface a lot of our challenges, the tools that they deployed to allow us to react to events, we are in a far better position today than we were a year ago to manage whatever happens, right.

So, to the extent the tariffs go up or go down, we'll be able to adjust to that in the way that we promised our customers that we would, and that would be with an eye towards maintaining that price cost dynamic. Inflation, deflation and again, we'll just have to see how that plays out, but I think that it really is, it's the other side of the same coin, right. I mean, many of our national account contracts have terms in it that are linked to specific steel price indices or what have you and so those conversations get add [Phonetic].

In the end, the question that we have to deal with with our customers is, what's the right action to again be able to neutralize the impact on gross margin. We're not trying to take advantage of our customers, but at the same time, we're just looking to deploy the tools that we developed in the last few months, last couple of quarters, just to essentially neutralize the impact and that would be the intention. But, again, we'll have to see how things play out as the year goes on.

Robert Barry - Buckingham Research - Analyst

Got it, okay. Hey, just lastly, could you say how December was [Speech Overlap].

Daniel L. Florness - President and Chief Executive Officer

Hey, Rob, [Speech Overlap].

Robert Barry - Buckingham Research - Analyst

Yeah. Okay, I'll stop with that. No problem. Yeah, no problem.

Holden Lewis - Executive Vice President and Chief Financial Officer

Thanks.

Robert Barry - Buckingham Research - Analyst

Okay. Thanks, guys, yeah.

Operator

Our next question is from the line of David Manthey with Baird. Please proceed with your questions.

David Manthey - Baird - Analyst

Hey, guys, good morning.

Daniel L. Florness - President and Chief Executive Officer

Good morning, Dave.

David Manthey - Baird - Analyst

Over the past couple of years here, your gross margins pretty consistently have been down 100 basis points year-over-year and some of that is secular, some cyclical. I'm just - as we look ahead to 2020, it gives the decline is less than that. What would be the factors you would see is driving a better outcome?

Holden Lewis - Executive Vice President and Chief Financial Officer

Yeah. So, I think there's two things to think about next year in terms of big sections and assuming that the price cost dynamic remains neutral, as it has been the last couple of quarters. And that's, obviously, depends on anything that occurs that we have to react to, but we don't know what that looks like. Based on what we know today, I think that with the slower, small customer business where we have fairly good margins and the expectations for growth on the Onsites, I think you're looking at mix probably being a 50 basis points, 60 basis points, 70 basis points drag next year.

Now, that could change depending on the relative growth between the small customer and the large customer, but that's - that seems like a decent range to me. I think that we also have to think just about the cadence of the price trend from 2019, right. I think in the first half, we did not do a great job addressing inflation and addressing tariffs, actually we did better job on tariffs than we did inflation, but in the second half, I think we did a very good job on that. And I think that success will carry over into the first half of 2020, so you might have some easier comps in the first half of 2020 before that sort of normalizes in the back half. And I think those are the two big things to think about when you're thinking about how to model our gross margin next year. And then, yeah, I think those are the two big things to think about at this point.

Daniel L. Florness - President and Chief Executive Officer

What I would add is, if we're able to channel that out, it's from things that we're doing specifically inside the organization related to some of the products. For example, we're challenging - and this is ongoing. We're always challenging our folks from the standpoint, if I think of our vending platform, so that's highly repetitive transactions. How do we channel as much of the spend to our - to a select group of preferred branded suppliers and our own exclusive brands, our private labels from the standpoint of it, it's not just about the cost of the product, it's about the cost of the whole supply chain, because it's product we have on the shelf.

If it's on the shelf, our distribution centers operate more efficiently, our trucking network and our freight costs are more efficient, our local labor costs are more efficient and the first two of those three pieces impact our gross margin and the third obviously is in operating expenses, the branch labor, but it allows us to have the product offering in that machine or in our ongoing supply chain offering where we can offer a better price to the customer, because our cost structure's inherently lower and that typically helps our gross margin. So, we're sharing some of the benefit with the customer, so it's a win-win scenario and we're driving more spend to our preferred suppliers.

David Manthey - Baird - Analyst

Thanks guys.

Daniel L. Florness - President and Chief Executive Officer

Thank you.

Operator

Our next question is from the line of Nigel Coe with Wolfe Research. Please proceed with your question.

Nigel Coe - Wolfe Research, LLC - Analyst

Thanks, good morning guys. Great color on the gross margins, Hogan. Just thinking about - you normally give forward quarterly guidance. We normally see gross margins in 1Q pretty flat. It feels like a cue [Phonetic], it sounds like that holds true in 1Q '20. Any comments on that?

Holden Lewis - Executive Vice President and Chief Financial Officer

Well, a couple of things. First, I would dispute the idea that I normally give forward guidance.

Nigel Coe - Wolfe Research, LLC - Analyst

Okay.

Holden Lewis - Executive Vice President and Chief Financial Officer

Dan commented on how we rarely talk about the current month in the current month because it's hard for us to know what's going to play out till it's all said and done, but sometimes things are moving in a direction where you deserve a little bit of guidance.

And for the last two quarters, I've given you a little bit of forward guidance on the next quarter because we had a lot of moving pieces as it related to the inflation, the tariff, the success around pricing etc., and when your second quarter gross margin is down, I think it was 180 basis points. I think you all needed a little bit of guidance about what we were seeing and expecting. And so, I provided a little bit of that color, but the idea that we usually provide that color I would disagree with and I'm not going to get into that game, now that, frankly, I think most of these moving pieces are kind of stabilizing out.

So, I'm going to remove myself from that game until a future period where there is a lot of volatility that you need a little bit of guidance on. But you asked about the seasonality. At this point, if I assume that the trends in the back half of 2019 are sort of the ones that will carry over into 2020 with sort of a neutral price/cost dynamic and then our usual mix piece and all that, I think that - judge what you think the seasonality is going to look like and I think that's a reasonably - that's a reasonable way to approach the cadence of the quarters.

Nigel Coe - Wolfe Research, LLC - Analyst

Okay, got it. I didn't mean to put words in your mount, but thanks for the color, Holden. Just my questions around the attrition on the Onsites and I'm just - now that we've got to a base of over 1,000, some level of attrition is normal and should be expected. So, I'm just curious if you can think about what do you consider to be as a CEO, CFO, a normal rate of attrition going forward. Is it - is 2% per quarter the right number, is it lower than that, but maybe, also, can you just clarify the freight issue? It sounds like that's - I understand the seasonality and the absorption, but that sounds like it's more of a price - obviously we've seen LTL and TL rates obviously down. So, I am just curious if we should be tracking price of freight volumes as a proxy for what's going on that side of your business, but my real question is on the attrition on the Onsites.

Holden Lewis - Executive Vice President and Chief Financial Officer

I'll touch on the Onsite attrition and the cycle on my count is a third. So I'll let [Speech Overlap]. We'll think through that one, Nigel.

Yes. If I think of - I'm going to answer first in the context of vending and then I'll transition to Onsite. So, if I go back a few years ago, Holden mentioned in '16, the number of vending machines we were removing. It actually started before that. So in 2012, our vending really took off and we pulled out - if you look at the number we had at the end 2012 and when we pull out 2013, it was 20% some of the devices we pulled out because we had gone from a handful of district managers doing vending to a big chunk of district managers doing vending and a big chunk of our branches doing vending and we did really have it dialed in where they should go and because it was a new industry we are creating.

And that 20% some number was 20% some the next year and then it dropped, I think, to 17%. I don't have the stats in front of me, but then it dropped to 16%. We believe long term that number is going to settle in around 10%. Right now, we're at about 14%. So, 14% of the installed base - that 89,000 we cited a few minutes ago, I would expect would get removed based on history in 2020 and our goal is, can we get that down to 10%. If I looked at Onsite historically, it was back when we had a couple of hundred of them. I'd say, we close about 10 [Phonetic] a year, that's about 5%. I think if Kris Van Dalen were sitting here and Kirs leads our team that really drives and owns our Onsite model, the team that is involved with evaluating our Onsite. I think the number he typically thinks it is about 6%. So, how that plays out quarter-to-quarter is anybody's guess, but it's probably in that neighborhood. History has said it's going to be - it's probably 5%. A person who is more informed than me thinks it's going to be 6%.

In the interest, Nigel, I am not encouraging people to ask one question with 12 parts. We'll address your second question when we talk after the fact.

Nigel Coe - Wolfe Research, LLC - Analyst

Okay, thanks, Dan.

Daniel L. Florness - President and Chief Executive Officer

Thanks.

Operator

Our next question is from the line of Hamzah Mazari with Jefferies. Please proceed with your question.

Hamzah Mazari - Jefferies - Analyst

Good morning. Thank you very much. My first question is…

Daniel L. Florness - President and Chief Executive Officer

Good morning, Hamzah.

David Manthey - Baird - Analyst

Good morning. Dan, a number of years ago, you had something called pathway to profit and 23% op margin was sort of the goal. So, maybe - do you view that as achievable still and any thoughts on that target as you look long term?

Daniel L. Florness - President and Chief Executive Officer

Yeah. So, that was pretty close to that one back in the day. I'll touch on that. In fact I talk about pathway to profit in this year's letter to shareholders. So, there's a little bit more insight you can gain from that in early February, but the pathway to profit was about our branch network and about the fact that as our average branch revenue went from $70,000 to $80,000 - I am talking about the revenue per month, so $70,000 a month to $80,000 a month, to $90,000 to $100,000 and beyond. As that number went up, we had a whole bunch of branches out there that were doing a $120,000, $150,000, $200,000 a month and we already know what the profitability is of that group. So, we talked about in 2007 when we introduced pathway to profit was, we're opening fewer branches today, which means the dilution factor is going to go away and the average revenue per month is going to keep climbing. And as it's climbing, the inherent profitability of our branch-based model will shine through. We had a whole bunch of branches that we're deep into the $20,000s, but a branch that does $50,000 a month, doesn't have that kind of operating margin.

A branch that does $70,000 or $80,000 a month doesn't have that kind of operating margin. So, that $23,000 is still true for our branch network, but branches represent about 70% of our business today and the other 30% is Onsite. For Onsite, that number is down in the upper teens from the standpoint of where the profitability is. There's still a pathway to profit element of it. When we go from having 200 Onsites at the end of 2014 to having just over 1,100 Onsites today, that's a massive take off.

And so, our revenue per Onsite actually dropped because we opened so many new ones. And so, we've been living through that for the last four years of that deleverage of our Onsite business because our average revenue dropped. We're approaching now an inflection point where our steady state of how many we're adding is going to kind of neutralize and our revenue per Onsite when we get later into 2020 and then into 2021, is actually going to start inching up. And so, that will still come into play. On a previous call, I believe, I cited the fact that I think our branch network, over time that branch network moves ever closer to $200,000 a month. Today, it's still in the - I forget the exact number we cited, but it's in the $130,000, $135,000 neighborhood, I believe, but as that moves up, I would expect that profitability piece to improve. As the mix changes, I see a path to an operating margin where you have a 50-50 business of a branch in Onsite, in that low-20s. I've cited a number at 22%. Time will tell if I am right or if I am full of it, but you're - the number you cite, Hamzah, was really about the branch network, which is a subset of our business.

Hamzah Mazari - Jefferies - Analyst

Got it. Very helpful. My follow-up question I'll turn it over is on freight, how much of a cost advantage is your captive fleet and do you view that cost is offsetting execution risk? Just any broad, high level thoughts there. Thank you.

Daniel L. Florness - President and Chief Executive Officer

Look, well, the cost advantage is a constant. So, it doesn't offset execution risk. Execution risk stands on its own, but the cost advantage - we've always felt that running on a highly utilized trucking network, where you have products going - and by highly utilized, I mean, there's products going both directions. The number we've often cited if you contrast what it cost to move it on our trucking network versus shipping industrial products small parcel.

In industrial - and shipping a relatively low value product small parcel is incredibly expensive and that's where the e-commerce world lives and that's why they keep trying to build different types of networks to change that dynamic. We've often cited [Indecipherable] that it's about 90% cheaper. But again, we're moving a relatively low product on a captive trucking network. A third of our products, so if I look at our fastener products, there is a big chunk of that product category that has secondary operations. So it isn't just that we're moving it from supplier to the brands, to the customer - from the supplier to the customer with the Onsite. We might be sending that fastener product out for a secondary operation. It's going to go get heat-treated. It's going to go get plated, and what it means in our fastener industry and the reason we built the captive network to start with is, many of our competitors, because they're using a lot of LTL shippers and other parties, don't have that advantage.

And so their freight costs, in many cases, can become equal to, if not greater than their product cost. And so, one of the reasons we enjoy the gross margins we do in fasteners. And the reason we built the trucking network is we've just built a better means to move product around. But execution risk - they're disconnected in the standpoint of what you're doing and what are your habits and behaviors every day, but I think it's fair to say, Hamzah, that the value that affords to us because of our captive truck fleet is well in excess of one quarter, 10 basis points or 20 basis points lower result than we expected. We get huge dividends from the ownership of our captive fleet. Just speaking of dividend we raised ourselves.

Hamzah Mazari - Jefferies - Analyst

Great, well, thank you very much.

Daniel L. Florness - President and Chief Executive Officer

Thanks.

Operator

The next question comes from the line of Josh Pokrzywinski with Morgan Stanley. Please proceed with your questions.

Josh Pokrzywinski - Morgan Stanley - Analyst

Hey, good morning guys.

Daniel L. Florness - President and Chief Executive Officer

Morning.

Josh Pokrzywinski - Morgan Stanley - Analyst

Dan, if you might - mind commenting on how we should think about mix in - kind of historical recoveries. Dan, you led off talking about maybe the analog to 2015 that you saw, if I were to look at similar points in time or other periods where you think it feels like today, what is the mix on the way out? Is it that the Onsites recover faster because of our captive, is it that the kind of the smaller customers are non-national accounts where there's higher mix recover faster. Just trying to calibrate how we should think about mix as markets eventually recover?

Ellen Stolts - Assistant Controller

Yeah. So, if I think about my comparison 2015 was more about just a trend in what we're seeing in the numbers. The other observation I'd make looking at 2015 is, in 2019, we started at a higher point and we finished at a higher point and I really attribute that to the success we've enjoyed taking market share at a faster clip, and the backlog we have in energy. I mean in the last three years, we've signed either renewals or new contracts for about 1,500, and that's an incredible tear that we've been on and that builds a certain level of just market share gains you get. And so, when I look at our relative outperformance that in 2019 versus 2015 in a similar PMI Index scenario, it's what the team's done to engage with our customers. And we have a massive footprint. So, to the extent that the percentage of our Top 100 snaps back and it moves into the '60s and it moves into the '70s because of - there's a bit of a lift in the economy, that piece was snapped back pretty fast in our large account - our accounts with a contract relationship would grow disproportionately faster because they have contracted disproportionately faster. And that's just a reflection of recovery in the underlying market. So, I would expect that to play out. The speed at which is going to be dependent on what the market is doing and maybe Holden has more insight.

Holden Lewis - Executive Vice President and Chief Financial Officer

Yeah. Yeah, I mean, I think this is an area that I think can be overthought many times. I mean, the fact is, whether it's an Onsite, whether it's non-fasteners, fasteners, most of our businesses - essentially, all of our businesses are cyclical. And so, when you see an upswing, it's fun talking about an upswing by the way, I hope it happens, but if you see an upswing, what happens is, you see the growth rate at particularly our older Onsites to get better, just as you see the growth rate in our smaller customers get better, just as you see the growth rate in our fasteners and non-fasteners get better. Now, does non-fastener growth coming out typically maybe outpace - I'm sorry, does fastener growth coming out outpace non-fasteners growth? Probably. Just like it outpaces it going in. But if you look at Page 5 and you kind of look at the non-fastener and fastener lines, there is not a difference in how they move, right. They really move in the same direction. The gap may narrow or widen depending on the cycle, but as long as we're successful with Onsites, as long as we're successful with vending, I don't think you're going to get a period where mix works in your favor, frankly. And that's just how the math works out. This is always where I always feel a need as well to - however, to point out that if mix is going to continue to work against us, if we're successful or when we're successful with our Onsites and vending and our growth drivers, you have to remember that we get good leverage over SG&A.

One piece of perspective I might offer you is, if you think about our gross margin, fourth quarter '16 to fourth quarter '19, I think it's down something like 300 basis points - almost 300 basis points. If you think about our fourth quarter operating margin over that same period of time, it's down 60%. There is inherent leverage in Onsites. There is inherent leverage in the pathway to profit asked about earlier. And so, I wouldn't expect that mix is going to start pushing our margins up, because I expect we'll be really successful with our growth drivers. I wouldn't conclude from that, that our operating margins are at risk because there's inherent leveragability in the growth drivers at the operating expense line as well.

[Speech Overlap]. Say, Josh, I am going - we're coming up on the hour. So, I'm going to bring the call to a close. I'll just close with one thought and that is and I often bring a personal touch into this. I apologize for those people that are rolling their eyes right now, but last weekend, I had the opportunity to go to a funeral, a funeral for a very dear individual. Her name was Lillian Peterson. She was known as Till to family and friends. For me, she was both in a way. While she was a neighbor, she was also my godmother and I consider that family. She was 88 years old. She's married to her husband for 67 years. She and her husband had six children. As you can appreciate a multiple that in grandchildren and great grandchildren. She was my Sunday school teacher. She was a giver of great advice and affection. She was the writer of many letters.

Over the years, I've received many letters from her and as did many others. Said simply, she was a second mom. I alluded to earlier, the Top 10 suggestions I share with folks over the years and as I was at her funeral and hearing the story about her life and learning all bunch of things that I didn't know, it dawned on me that she was an incredible influence around three of them. Number 8 on that list is trust people. By exposure, Bob Kierlin put a little adder on that and that is incubate and cherish ideas. Number 9 on that list is cherish, embrace the special words. Say please, and thank you. Always say you're welcome. Be willing to say you're sorry and show respect for all. And finally, enjoy something outdoors in all four seasons. She loved to ride bikes, she loved to go for walks and she loved the cross-country ski in the winter. And if you're foolish enough to live in Wisconsin or Minnesota, you better do all - you better enjoy all four seasons. I'll close on that note, thanks everybody.

Thanks everyone.

Operator

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Q4 2019

Earnings Transcript

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