Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following is management's discussion and analysis of certain significant factors that have affected our financial position and operating results during the periods included in the accompanying consolidated financial statements. (Dollar amounts are in thousands except for per share amounts and where otherwise noted.)

BUSINESS AND OPERATIONAL OVERVIEW

Fastenal is a North American leader in the wholesale distribution of industrial and construction supplies. We distribute these supplies through a network of approximately 2,500 company owned stores. Most of our customers are in the manufacturing and non-residential construction markets. The manufacturing market includes both original equipment manufacturers (OEM) and maintenance, repair, and operations (MRO). The non-residential construction market includes general, electrical, plumbing, sheet metal, and road contractors. Other users of our product include farmers, truckers, railroads, oil exploration, production and refinement companies, mining companies, federal, state, and local governmental entities, schools, and certain retail trades. Geographically, our stores and customers are primarily located in North America.

BUSINESS DISCUSSION

We are a growth-centric organization focused on identifying 'drivers' that will allow us to get closer to our customers and gain market share in what we believe remains a fragmented industrial distribution market. Our current growth drivers will be discussed throughout this report. Our growth drivers have evolved, and can be expected to continue to evolve, over time. However, what has always been true, and what we expect to remain true, is the key to the success of any of our growth drivers is our employees and the services they provide to our customers in the field.

The table below summarizes our store employee count and our total employee count at the end of the periods presented. Later in this document we discuss the average full-time equivalent ('FTE') headcount to help explain the expense trends in more detail. The final three items below summarize our investments in industrial vending machines, Onsite locations, and store locations.

Q4 2015Q4 2016Twelve-month % Change
End of period total store employee count13,96112,966-7.1%
Change in total store employee count(995)
End of period total employee count20,74619,624-5.4%
Change in total employee count(1,122)
Industrial vending machines (installed device count)55,51062,822(1)13.2%
Number of active Onsite locations26440151.9%
Number of store locations2,6222,503-4.5%

(1) In February 2016, we signed an agreement to lease a significant number of industrial vending lockers to one of our customers. As of December 31, 2016, we have deployed approximately 15,000 devices under this agreement. These devices do not generate product revenue and are excluded from the count noted above.

Several items worth noting with respect to our results:

(1) During the last twelve months, we have reduced our headcount by 995 people in our stores and 1,122 people in total. These reductions can be primarily attributed to natural attrition rather than an active headcount reduction program. We continue to add headcount where necessary to support our growth initiatives, notably our Onsite business (defined as dedicated sales and service provided from within the customer's facility). However, the continued softness of the North American industrial economy has caused us to more intensively scrutinize our full- and part-time staffing levels outside of these initiatives. Indeed, after increasing our total headcount every quarter during 2015, it has declined during every quarter of 2016. Our current staffing levels approximate those at the end of 2014.

(2) We opened 40 and 41 stores in 2016 and 2015, respectively. Our store network forms the foundation of our business strategy, and we will continue to open stores in 2017 as is deemed necessary to sustain and improve our network and support our growth drivers.

(3) We closed or consolidated 144 stores in 2016; about 90% of these stores were in close proximity to another Fastenal store, and about 85% had leases expiring within 18 months. We closed or consolidated 50 stores in 2015; about 80% of these stores were in close proximity to another Fastenal store, and about 90% had leases expiring within 18 months. The store closings did not have a meaningful impact on sales in either period. We intend to continue evaluating markets for closures and consolidations in 2017 as part of our ongoing efforts to optimize our store network.

(4) We continue to see a very strong pace of national account signings (defined as new customer accounts with a multi-site contract). In 2016 and 2015, we signed 190 and 167 new contracts, respectively. Beyond signings (or growth activities), we look at the health of our large customer market, and by extension our overall market, by watching the trends of our top 100 customers (which represented approximately 26% of our sales in 2016). For several years beginning in 2011, the typical ratio of growth versus contraction in the sales of our top 100 customers was 3:1 (75 grew and 25 contracted). That performance has weakened in recent periods, more typically approximating 1:1 since the fourth quarter of 2015, including the fourth quarter of 2016 when 51 customers grew (33 with growth of 10% or more) and 49 customers contracted (31 with contraction of 10% or more).

(5) We have continued to expand our Onsite business. Our goal was to sign 200 Onsite customer locations in 2016, and we signed 176; 130 were operational as of December 31, 2016. All of the 80 Onsite customer locations we signed in 2015 were operational by the end of the second quarter of 2016.

(6) We have converted most of our United States stores, approximately 2,000, to the CSP 16 (Customer Service Project 2016) format as of December 31, 2016. This merchandising footprint involves expanded inventory placement at our store locations to enhance same-day capabilities. At the end of the fourth quarter of 2016, our inventory of CSP 16 items at our stores was $42 million higher than the level at the end of the fourth quarter of 2015 (including inventory at our distribution centers, this value was $46 million higher). From the end of the third quarter of 2015, before we began this initiative, to the end of the fourth quarter of 2016, our inventory of CSP 16 items at our stores increased by $50 million (or $54 million when including inventory at our distribution centers).

The following sections contain an overview of the following:

1.Sales and sales trends – a recap of our recent sales trends and some insight into the activities with different end markets.
2.Growth drivers of our business – a recap of how we grow our business.
3.Profit drivers of our business – a recap of how we increase our profits.
4.Statement of earnings information – a recap of the components of our income statement.
5.Cash flow impact items – a recap of the operational working capital utilized in our business, and the related cash flow.

The most important thing to note before you read this is to remember Fastenal is several businesses within itself; a fastener distributor (35% to 40% of our business) and a non-fastener distributor (60% to 65% of our business). Within the non-fastener component, approximately 25% is distributed through a vending machine.

FASTENER SALES

First and foremost, we are a fastener distributor. We have been in this business for almost 50 years. We are good at it. We have strong capabilities at sourcing and procurement, at quality control, at logistics, and at local customer service. Each of these capabilities is focused on the customer at the end of the supply chain. This business is split about 60% production/construction needs and about 40% maintenance needs. The former is a great business, but it can be cyclical because about 75% of our manufacturing customer base is engaged in some type of heavy manufacturing. The sale of production fasteners is also a sticky business in the short-term as it is expensive and time consuming for our customers to change their supplier relationships. While our customers value the capabilities we bring to the table, in the last two years this group of customers has seen its growth prospects weaken. In fact, the daily sales growth of the fastener product line peaked at over 10% in the second half of 2014. The rate of growth decelerated in the first quarter of 2015, began contracting in the third quarter of 2015, and continued to experience contraction throughout 2016, including contraction of 2.4% in the fourth quarter.

NON-FASTENER SALES

Second, we have a non-fastener maintenance and supply business. We have actively pursued this business in the last 20 to 25 years. The capabilities we developed as a fastener distributor, described above, provide a backbone to growing this ‘newer’ business. This backbone has been enhanced in recent years with our added capabilities in industrial vending, where we believe we have a structural advantage given our local customer service. There is more to industrial vending than the device or the financial resources to deploy; we believe the ability to replenish with a local team from an integrated supply chain network (i.e., the 'Team behind the Machine') is critical to the long-term success of this channel. Because of these capabilities, the non-fastener business remains more resilient. However, similar to our fastener business, growth in our non-fastener business has generally weakened in the last two years. In fact, the daily sales growth of the non-fastener product line peaked at over 17% in the second half of 2014 before beginning to decelerate in the first quarter of 2015. Daily sales of non-fasteners did not contract as fasteners did, but did slow to a growth rate of just 1.2% in the fourth quarter of 2015. Daily sales of non-fasteners rebounded in 2016, growing about 5% in each of the first three quarters of the year, with 5.9% growth in the fourth quarter of 2016.

One particular non-fastener product line, safety supplies, has benefited significantly from our initiatives with industrial vending. We introduced the safety supplies product line in 1999 and, at 15.3% of total sales in the fourth quarter of 2016, it represents our second largest product line after fasteners. Daily sales of our safety supplies product line experienced growth of

about 27% in the last six months of 2014, declined to about 6% growth in the fourth quarter of 2015 and improved to 9.3% annual growth in 2016.

Please read through the detailed Sales and Sales Trends section later in this document for additional insight.

Our gross profit decreased from 49.9% in the fourth quarter of 2015, and increased from 49.3% in the third quarter of 2016, to 49.8% in the fourth quarter of 2016. The relationship between sales and gross profit depends on our success within our large account business (an area that is still under-represented in our customer mix). Larger customers produce a below-company average gross profit; however, they generally leverage our existing network of capabilities which typically allows us to enjoy strong incremental operating income growth. This customer mix change (large versus small), as well as our product mix change (from fasteners to non-fasteners), over time places sustained pressure on our gross profit. We continued to face these headwinds throughout 2016 as the daily sales to our national accounts customers and of our non-fastener products grew approximately two percentage points and three percentage points faster, respectively, than total company sales growth. Against this backdrop, we believe we did well to hold the gross profit in the fourth quarter of 2016 relatively stable versus the fourth quarter of 2015. The meaningful sequential increase in our gross profit in the fourth quarter of 2016 relative to the third quarter of 2016 is not attributable to any single item. Rather, it reflects modest positive contributions from a handful of sources, including favorable product mix, lower freight costs, increased sales of Fastenal brands (private label), and the absence of certain costs related to growth initiatives (e.g., costs related to setting up CSP 16) in previous quarters.

Our operating income decreased from 19.4% in the fourth quarter of 2015 and from 20.0% in the third quarter of 2016, to 19.3% in the fourth quarter of 2016. For the year, our operating and administrative expenses in 2016 have increased primarily as a result of the following: (1) an increase in industrial vending equipment, (2) an increase in average FTE headcount, (3) an increase in health care costs, (4) an increase in information systems costs, and (5) an increase in the number of vehicles for sales personnel. These increases were partially offset by a contraction in our performance bonuses and commissions, in our profit sharing contribution, and in fuel expense. Our fourth quarter 2016 operating income was relatively stable with the fourth quarter 2015 level as an increase in occupancy expenses as a percentage of sales (expansion of our vending devices) was mostly offset by a decline in payroll expenses as a percentage of sales (reduced headcount). The sequential decline in our operating income in the fourth quarter of 2016 relative to the third quarter of 2016 is consistent with historical norms and related to the lower sales volume that is typical of the period.

Using a quarterly average, the FTE headcount grew as follows for the periods ended December 31 (compared to the same period in the preceding year):

Twelve-month periodThree-month period
2016201520162015
Store based average FTE headcount3.4%5.4%-3.7%10.2%
Total average FTE headcount4.6%5.3%-1.8%9.0%
Note – Full-time equivalent is based on 40 hours per week.

Our signings and installed device count of vending machines were as follows for each period:

Q1Q2Q3Q4Annual
Device count signed during the period20164,6474,8694,7833,76018,059
20153,9625,1444,6894,01617,811
Device count installed at the end of the period201656,88958,34660,40062,822
201548,54550,62053,54755,510

In 2016 we executed a strategy of optimizing our vending machines, evaluating our devices for utilization, throughput, and product mix. By improving the efficiency of our installed base, we were able to remove about 9,300 units from service, which has the effect of artificially depressing our net installs in 2016 (a similar, less formal, effort existed in 2015, resulting in the removal of about 7,700 units). These removed units form a pool of ready-to-deploy machines that should reduce the capital necessary in the short term to continue growing our industrial vending device count. While this discrete initiative is substantially complete, efforts to incrementally optimize our growing installed base will be continuous.

SALES AND SALES TRENDS

While reading these items, it is helpful to appreciate several aspects of our marketplace: (1) it's big, the North American marketplace for industrial supplies is estimated to be in excess of $140 billion per year (and we have expanded beyond North America), (2) no company has a significant portion of this market, (3) many of the products we sell are individually inexpensive, (4) when our customer needs something quickly or unexpectedly our local store is a quick source, (5) the cost and time to manage and procure these products is meaningful, (6) the cost to move these products, many of which are bulky, can be significant, (7) many customers would prefer to reduce their number of suppliers to simplify their business, and (8) many customers would prefer to utilize various technologies to improve availability and reduce waste.

Our motto is Growth through Customer Service®. This is important given the points noted above. We believe in efficient markets – to us, this means we can grow our market share if we provide the greatest value to our customers. We believe our ability to grow is amplified if we can service our customers at the closest economic point of contact. For us, this 'closest economic point of contact' is the local store or the customer's facility; therefore, our focus centers on understanding our customers' day, their opportunities, and their obstacles.

The concept of growth is simple, find more customers every day and increase our activity with them. However, execution is hard work. First, we recruit service-minded individuals to support our customers and their business. Second, we operate in a decentralized fashion to help identify the greatest value for our customers. Third, we have a great team behind the store to operate efficiently and to help identify new business solutions. Fourth, we do these things every day. Finally, we strive to generate strong profits; these profits produce the cash flow necessary to fund our growth and to support the needs of our customers.

SALES GROWTH

Note – Daily sales are defined as the total net sales for the period divided by the number of business days (in the United States) in the period.

Net sales and daily sales were as follows:

201620152014
Net sales$3,962,0363,869,1873,733,507
Percentage change2.4%3.6%12.2%
Business days255254253
Daily sales$15,53715,23314,757
Percentage change2.0%3.2%12.7%
Impact of currency fluctuations (primarily Canada)-0.4%-1.2%-0.5%
Impact of acquisitions0.6%0.2%0.2%

The increase in net sales in 2016, 2015, and 2014 came primarily from higher unit sales. The higher unit sales resulted primarily from increases in sales at existing store locations and to a lesser degree the opening of new store locations in the last several years. The growth in net sales at the older store locations was due to the growth drivers of our business (discussed throughout this document). Net sales were also impacted by slight inflationary price changes in our non-fastener products and some price deflation in our fastener products, with the net impact being a slight drag on growth. Our growth in net sales was not meaningfully impacted by the introduction of new products or services, with one exception. Over the last several years, our industrial vending initiative has stimulated faster growth with a subset of our customers. The rates of growth in net sales in 2016 and 2015 were hindered by weakness in the industrial production and non-residential construction industries served by us. The added growth in 2014 was largely related to two things – the expansion, which began in the latter half of 2013, in the number of our store employees and the number of district and regional leaders supporting our stores, all in an effort to generate more selling energy within our stores, and a stabilization in our OEM fastener business.

The impact of the economy is best reflected in the growth performance of our stores opened greater than ten years ago (store sites opened as follows: 2016 group – opened 2006 and earlier, 2015 group – opened 2005 and earlier, and 2014 group – opened 2004 and earlier) and opened greater than five years ago (store sites opened as follows: 2016 group – opened 2011 and earlier, 2015 group – opened 2010 and earlier, and 2014 group – opened 2009 and earlier). These two groups of stores are more cyclical due to the increased market share they enjoy in their local markets. The stores opened greater than two years ago represent a consistent 'same store' view of our business (store sites opened as follows: 2016 group – opened 2014 and earlier, 2015 group – opened 2013 and earlier, and 2014 group – opened 2012 and earlier). The daily sales change for each of these groups was as follows:

Store Age201620152014
Opened greater than 10 years0.5%2.7%10.5%
Opened greater than 5 years0.6%2.5%10.9%
Opened greater than 2 years0.9%2.5%11.5%

Note: The age groups above are measured as of the last day of each respective year.

Stores opened in 2016 contributed approximately $14,900 (or 0.4%) to 2016 net sales. Stores opened in 2015 contributed approximately $36,619 (or 0.9%) to 2016 net sales and approximately $8,745 (or 0.2%) to 2015 net sales. The rate of sales growth at store locations generally levels off after they have been open for five years, and the sales generated at our older store locations typically vary more with the economy than do the sales growth rates of younger stores.

SALES BY PRODUCT LINE

The approximate mix of sales from the fastener product line and from the other product lines was as follows:

201620152014
Fastener product line37%38%40%
Other product lines63%62%60%

The decrease in our fastener sales as a percentage of total sales arises from two factors. First, we believe non-fastener products represent a larger market opportunity than fasteners, and that we are relatively under-represented in this market. Over time, this has led to faster growth in the non-fastener product lines, a trend amplified by the growth of our industrial vending program through which we sell primarily non-fastener products. We believe this factor will continue to promote a lower mix of fasteners in our total sales over time. Second, a weak industrial production environment, such as was experienced in 2015 and 2016, has a disproportionately negative effect on fastener sales relative to non-fastener sales (which relates more to plant operations than production). This weakness is more cyclical than secular, and it is possible that a better economic environment could at least partially mitigate the first factor discussed.

MONTHLY SALES CHANGES, SEQUENTIAL TRENDS, AND END MARKET PERFORMANCE

This section focuses on three distinct views of our business – monthly sales changes, sequential trends, and end market performance. The first discussion regarding monthly sales changes provides a good mechanical view of our business based on the age of our stores. The second discussion provides a framework for understanding the sequential trends (that is, comparing a month to the immediately preceding month, and also looking at the cumulative change from an earlier benchmark month) in our business. Finally, we believe the third discussion regarding end market performance provides insight into activities with our various types of customers.

Monthly Sales Changes:

All company sales – During the months noted below, all of our selling locations, when combined, had daily sales growth rates of (compared to the same month in the preceding year):

Jan.Feb.Mar.Apr.MayJuneJulyAug.Sept.Oct.Nov.Dec.
20163.3%2.6%0.0%3.8%1.1%0.0%2.1%0.3%2.8%3.9%1.2%3.2%
201512.0%8.6%5.6%6.1%5.3%3.7%3.2%1.6%-0.3%-0.8%-1.1%-3.8%
20146.7%7.7%11.6%10.0%13.5%12.7%14.7%15.0%12.9%14.6%15.3%17.4%

Stores opened greater than two years – Our stores opened greater than two years (store sites opened as follows: 2016 group – opened 2014 and earlier, 2015 group – opened 2013 and earlier, and 2014 group – opened 2012 and earlier) represent a consistent 'same-store' view of our business. During the months noted below, the stores opened greater than two years had daily sales growth rates of (compared to the same month in the preceding year):

Jan.Feb.Mar.Apr.MayJuneJulyAug.Sept.Oct.Nov.Dec.
20162.2%1.4%-1.4%2.5%-0.2%-1.2%0.9%-0.7%1.6%2.7%0.7%2.9%
201511.2%7.8%4.8%5.4%4.6%3.2%2.6%1.0%-0.9%-1.1%-2.1%-5.0%
20145.5%6.5%10.2%8.4%12.1%11.4%13.4%14.0%11.8%13.5%14.0%16.5%

Stores opened greater than five years – The impact of the economy, over time, is best reflected in the growth performance of our stores opened greater than five years (store sites opened as follows: 2016 group – opened 2011 and earlier, 2015 group – opened 2010 and earlier, and 2014 group – opened 2009 and earlier). This group, which represented about 90% of our total sales in 2016, is more cyclical due to the increased market share they enjoy in their local markets. During the months noted below, the stores opened greater than five years had daily sales growth rates of (compared to the same month in the preceding year):

Jan.Feb.Mar.Apr.MayJuneJulyAug.Sept.Oct.Nov.Dec.
20161.7%1.3%-1.7%2.1%-0.4%-1.8%0.5%-0.7%1.1%2.1%0.3%2.7%
201510.8%7.2%4.8%5.6%4.6%3.1%3.1%1.3%-1.1%-1.0%-1.8%-5.3%
20144.6%5.4%9.5%7.7%11.5%10.8%12.9%13.4%11.7%13.3%13.6%16.2%

Summarizing comments – There are three distinct influences to our growth: (1) execution, (2) currency fluctuations, and

(3) economic fluctuations. This discussion centers on (2) and (3).

The change in currencies in foreign countries relative to the United States dollar impacted our net sales growth over the last several years. During 2016, it lowered our net sales growth by 0.4%. During the years 2015 and 2014, it lowered our net sales growth by 1.2% and 0.5% respectively.

In the first quarter of 2014, our sales growth was hampered by a weak economy, foreign exchange rate fluctuations (primarily related to the Canadian dollar), and a severe winter in North America that impacted our customers and our trucking network. This was partly offset by favorable holiday timing in March. The headwinds from the economy and foreign exchange rates persisted in the second quarter of 2014 and the favorable holiday timing in March reversed in April, but the weather effects faded. By May and June results were significantly less 'noisy' and sales to customers engaged in heavy machinery manufacturing, which represents approximately one-fifth of our business, improved.

During 2015, our business weakened. This initially involved customers tied to the oil and gas sector, but grew during the course of the year to include customers across additional industries and in geographic areas not typically associated with the oil and gas sector. November and especially December experienced a greater frequency and duration of customer plant shutdowns than is typical of these holiday-affected periods.

During 2016, business activity remained generally weak, but stable, throughout the year. In the first quarter of 2016, we returned to growth with a 3.5% increase in net sales over the first quarter of 2015 as the impact of seasonal plant shutdowns in the fourth quarter of 2015 subsided. The period did include some 'noise' related to changing business day counts. For instance there was an extra day in February and March which tends to 'understate' the daily sales growth percentage, and one fewer day in January which tends to 'overstate' the daily sales growth percentage. There was also one extra business day in the period and the Easter holiday shifted into March. Overall, during the first quarter of 2016, daily sales grew 1.9%. There was 'noise' throughout the second quarter of 2016 as well (one more day in May, one fewer day and the absence of Easter in April), but daily sales growth nonetheless came in at 1.6%. Business conditions looked similar in the third quarter of 2016, with daily sales growth of 1.8%. The fourth quarter of 2016 did show some improvement with daily sales growth of 2.7%, though this more likely reflected an easier comparison than substantive improvement in overall demand. For most of the year, we saw relative weakness from non-residential construction and heavy manufacturing customers and in demand for our fastener products, speaking to the sustained softness in heavy and general industrial markets. Business with our largest customers was also relatively weak, with sales to our top 100 customers rising modestly in the first half of 2016 and falling modestly in the second half of 2016. While these weaknesses were representative of conditions in the United States and Canada, total sales outside of these geographic areas were relatively strong and improved over the course of 2016.

Sequential Trends:

We find it helpful to think about the monthly sequential changes in our business using the analogy of climbing a stairway – This stairway has several predictable landings where there is a pause in the sequential gain (i.e. April, July, and October to December), but generally speaking, climbs from January to October. The October landing then establishes the benchmark for the start of the next year.

History has identified these landings in our business cycle. They generally relate to months with impaired business days (certain holidays). The first landing centers on Easter, which alternates between March and April (Easter occurred in March 2016, in April 2015, and in April 2014), the second landing centers on July 4th, and the third landing centers on the approach of winter with its seasonal impact on primarily our construction business and with the Christmas/New Year holidays. The holidays we noted impact the trends because they either move from month-to-month or because they move around during the week (the July 4th and Christmas/New Year holiday impacts are examples of the latter).

The tables below show the pattern to the sequential change in our daily sales. The line in the first table labeled 'Benchmark' is an historical average of our sequential daily sales change for the period 1998 to 2013, excluding 2008 and 2009. We believe this time frame serves to show the historical pattern and could serve as a benchmark for current performance. We excluded the 2008 to 2009 time frame because it contains an extreme economic event and we don't believe it is representative. The '2016', '2015', and '2014' lines represent our actual sequential daily sales changes. The '16Delta', '15Delta', and '14Delta' lines indicate the difference between the 'Benchmark' and the actual results in the respective year.

Jan.(1)Feb.Mar.Apr.MayJuneJulyAug.Sept.Oct.Cumulative Change from Jan. to Oct.
Benchmark0.8%2.2%3.8%0.4%3.1%2.7%-2.1%2.5%3.7%-1.2%15.9%
20160.4%-0.8%1.5%1.7%0.6%-0.2%-2.3%2.4%1.5%-0.9%3.6%
16Delta-0.4%-3.0%-2.3%1.3%-2.5%-2.9%-0.2%-0.1%-2.2%0.3%-12.3%
2015-3.6%-0.1%4.2%-2.1%3.4%0.9%-4.3%4.1%-0.9%-2.0%2.9%
15Delta-4.4%-2.3%0.4%-2.5%0.3%-1.8%-2.2%1.6%-4.6%-0.8%-13.0%
2014-1.4%3.0%7.1%-2.6%4.2%2.5%-3.8%5.8%1.0%-1.5%16.2%
14Delta-2.2%0.8%3.3%-3.0%1.1%-0.2%-1.7%3.3%-2.7%-0.3%0.3%

In 2017, we will begin to utilize a more recent time frame (a trailing five year average) as our 'New Benchmark'. Our business has changed meaningfully over time, and we believe a benchmark that places greater emphasis on more recent patterns is likely to better reflect potential conditions in the future. For the sake of comparison, we have included in this second table a comparison of 2014, 2015, and 2016 to the new benchmark (2011-2015).

Jan.(1)Feb.Mar.Apr.MayJuneJulyAug.Sept.Oct.Cumulative Change from Jan. to Oct.
New Benchmark-1.2%1.4%5.6%-1.1%2.7%2.2%-3.5%3.6%2.2%-2.1%11.2%
20160.4%-0.8%1.5%1.7%0.6%-0.2%-2.3%2.4%1.5%-0.9%3.6%
16Delta1.6%-2.2%-4.1%2.8%-2.1%-2.4%1.2%-1.2%-0.7%1.2%-7.6%
2015-3.6%-0.1%4.2%-2.1%3.4%0.9%-4.3%4.1%-0.9%-2.0%2.9%
15Delta-2.4%-1.5%-1.4%-1.0%0.7%-1.3%-0.8%0.5%-3.1%0.1%-8.3%
2014-1.4%3.0%7.1%-2.6%4.2%2.5%-3.8%5.8%1.0%-1.5%16.2%
14Delta-0.2%1.6%1.5%-1.5%1.5%0.3%-0.3%2.2%-1.2%0.6%5.0%

(1) The January figures represent the percentage change from the previous October, whereas the remaining figures represent the percentage change from the previous month.

A graph of the sequential daily sales change patterns discussed above, including the 'New Benchmark' period of 2011 - 2015, starting with a base of '100' in the previous October and ending with the next October, would be as follows:

fast123120_chart-29966.jpg

End Market Performance:

Fluctuations in end market business – The sequential trends noted above were directly linked to fluctuations in our end markets. To place this in perspective – approximately 50% of our business has historically been with customers engaged in some type of manufacturing, a significant subset of which finds its way into the heavy equipment and oil and gas markets. The daily sales growth rates to these customers, when compared to the same period in the prior year, were as follows:

Q1Q2Q3Q4Annual
20160.9%0.7%1.0%3.0%1.4%
20156.9%3.8%1.1%-2.2%2.3%
20149.0%11.2%13.7%13.8%12.0%

Our manufacturing business consists of two subsets: the industrial production business (this is business where we supply products that become part of the finished goods produced by our customers and is sometimes referred to as OEM - original equipment manufacturing) and the maintenance portion (this is business where we supply products that maintain the facility or the equipment of our customers engaged in manufacturing and is sometimes referred to as MRO - maintenance, repair, and operations). The industrial business is more fastener centered, while the maintenance portion is represented by all product categories.

The best way to understand the change in our industrial production business is to examine the results in our fastener product line (35% to 40% of our business) which is heavily influenced by changes in our business with heavy equipment manufacturers. From a company perspective, daily sales growth rates of fasteners, when compared to the same period in the prior year, were as follows (note: this information includes all end markets):

Q1Q2Q3Q4Annual
2016-1.7%-2.4%-2.9%-2.4%-2.3%
20155.5%0.0%-4.4%-6.2%-1.4%
20141.6%5.5%9.9%11.4%6.9%

By contrast, the best way to understand the change in the maintenance portion of the manufacturing business is to examine the results in our non-fastener product lines. From a company perspective, daily sales growth rates of non-fasteners, when compared to the same period in the prior year, were as follows (note: this information includes all end markets):

Q1Q2Q3Q4Annual
20164.7%4.7%4.9%5.9%5.0%
201511.7%9.0%5.9%1.2%6.8%
201414.2%17.1%17.6%19.0%17.2%

The non-fastener business demonstrated greater relative resilience over the last several years, when compared to our fastener business and to the distribution industry in general, due to our industrial vending program. However, this business was not immune to the impact of a weak industrial environment.

Our non-residential construction customers have historically represented 20% to 25% of our business. The daily sales growth rates to these customers, when compared to the same period in the prior year, were as follows:

Q1Q2Q3Q4Annual
2016-0.4%-1.7%-1.9%-1.6%-1.2%
20156.2%1.6%-1.7%-6.1%-0.2%
20142.9%7.5%9.3%12.6%7.8%

Our non-residential construction business is heavily influenced by the industrial economy, particularly the energy sector. The volatility and weakness of energy prices has weakened this business, particularly beginning in the second quarter of 2015 and throughout 2016.

A graph of the sequential daily sales trends to these two end markets in 2016, 2015, and 2014, starting with a base of '100' in the previous October and ending with the next October, would be as follows:

Manufacturing

fast123120_chart-32645.jpg

Non-Residential Construction

fast123120_chart-34924.jpg

GROWTH DRIVERS OF OUR BUSINESS

Note – Dollar amounts in this section are presented in whole dollars, not thousands.

We grow by continuously adding customers and by increasing the activity with each customer. We believe this growth is enhanced by great people located in close proximity to our customers. This allows us to provide a range of services and product availability that our competitors can't easily match. Historically, we expanded our reach by opening stores at a very fast pace. These openings were initially in the United States and expanded beyond the United States beginning in the mid 1990's.

For a little perspective, we began our business in 1967 with an idea to sell nuts and bolts (fasteners) through vending machines. We soon learned the technology of the 1960's wasn't ready, and also learned a lot of products didn't fit, so we went to 'Plan B': sell to business users with a direct sales force. It took us a number of years to 'work out the bugs', but ten years later we began to pick up the pace of store openings. After another ten years of expansion we had approximately 50 stores and sales of about $20 million. Our need for cash to fund our growth was growing, as was our desire to allow employee ownership. This led us to a public offering in 1987.

In our first ten years of being public (1987 to 1997), we opened stores at an annual rate approaching 30% per year. In the next ten years (1997 to 2007), we opened stores at an annual rate of approximately 10% to 15% and, since 2007, at an annual rate of approximately 1% to 8%. We opened 41 stores in 2015, at an annual rate of approximately 2%, and 40 stores in 2016, at an annual rate of approximately 2%. Our store network forms the foundation of our business strategy, and we will continue to open stores in 2017 as is deemed necessary to sustain and improve our network and support our growth drivers.

During our almost 50 years of business existence, we have constantly evolved to better serve the market (as is described in the paragraphs below) and have always been willing to challenge our approach. In our first 20 to 25 years, we closed several store locations because we felt the market was insufficient to operate a profitable 'fastener only' business. Every one of those locations was subsequently 'reopened' when our business model evolved to serve these markets profitably. During the last 20 to 25 years, we have enjoyed continued success with our store-based model, but we continued to challenge our approach. This resulted in our closing approximately 85 stores in the ten years prior to 2014 - not because they weren't successful, but rather because we felt we had a better approach to growth. Since 2014, we have continued to evaluate opportunities for store closings. We use the term closed; however, we consider them to be consolidated into another location since the vast majority are in close proximity to another store. We will continue to evaluate opportunities for store closings/consolidations in the future.

The following table provides a summary of store closings for each of the last three years and the corresponding analysis period used to measure their profitability.

201620152014
Total number of store locations closed1445073
Number of profitable store locations closed953529
Analysis measurement period for closuresQ4 2015Q3 2014Q1 2014

There is a short-term cost for closing these stores, and since we believe we will maintain the vast majority of the sales associated with these locations and most of the impacted employees have a nearby store from which to operate, the cost primarily relates to the future commitments at our leased locations. We have recorded the impaired future costs related to these commitments. The related expense was not material as these locations have relatively short lease commitments and minimal leasehold improvements.

During the years, our expanding footprint has provided us with greater access to more customers, and we have continued to diversify our growth drivers. This was done to provide existing store personnel with more tools to grow their business organically. In the early 1990's, we began to expand our product lines beyond primarily fasteners, and we added new product knowledge to our bench (the non-fastener products now represent nearly 65% of our sales). This was our first big effort to diversify our growth drivers. The next step began in the mid to late 1990's when we began to add sales personnel with certain specialties or focus. This began with our national accounts group in 1995, and over time has expanded to include individuals dedicated to: (1) sales related to our internal manufacturing division, (2) government sales, (3) internet sales, (4) construction, (5) specific products (most recently metalworking), and (6) industrial vending. Another step occurred at our selling locations (this includes Fastenal stores as well as strategic account stores and Onsite locations) and at our distribution centers, and began with a targeted merchandising and inventory placement strategy that included our 'Customer Service Project' approximately fourteen years ago and our 'Master Stocking Hub' initiative approximately nine years ago. These strategies allowed us to better target where to stock certain products (local store, regional distribution center, master stocking hub, or supplier) and allowed us to improve our fulfillment, lower our freight costs, and improve our ability to serve a broader range of customers. During 2013 and 2014, we expanded our store-based inventory offering around select industries (with an emphasis on fasteners, construction products, and safety products).

Beginning in the latter half of 2013, we expanded two key employee groups: (1) the number of employees working in our stores and (2) the number of district and regional leaders supporting our stores. To improve the efficiency, accuracy, and capacity of our distribution centers, we made significant investments into distribution automation over the last several years (a majority of our facilities are now automated, and greater than 85% of our picking occurs at an automated distribution center). Finally, we also added a high frequency distribution center, internally known as T-hub, to support vending and other high frequency selling activities. During 2015 and 2016, we continued to enhance the technology in our automated distribution centers, to sharpen our focus on growing our Onsite business, and to expand our store-based inventory offering ('CSP 16'). This merchandising footprint involves expanded inventory placement at our store locations to enhance same-day delivery capabilities. The theme that shines through in all of these changes is a simple one – invest into and support our sales machine – the local store.

Over the last several years, our industrial vending operation has been an expanding component of our store-based business. We believe industrial vending is an important chapter in the Fastenal story; we also believe it will continue to be transformative to industrial distribution, and that we have a 'first mover' advantage. Given this, we have continued investing aggressively to maximize the advantage.

Our expanded industrial vending portfolio consists of 23 different vending devices, with the FAST 5000 device, our helix-based machine (think candy machine), representing approximately 40% of the installed machines. We have learned much about these devices over the last several years and currently the target monthly revenue ranges from under $1,000 per device to in excess of $3,000 per device. The following two tables provide two views of our data: (1) actual device count regardless of the type of machine and (2) 'machine equivalent' count based on the weighted target monthly revenue of each device (compared to the FAST 5000 device, which has a $2,000 monthly revenue target). For example, the 12-door locker, with target monthly revenue of $750, would be counted as '0.375 machine equivalent' (0.375 = $750/$2,000).

The industrial vending information related to contracts signed during each period was as follows:

Q1Q2Q3Q4Annual
Device count signed during the period20164,6474,8694,7833,76018,059
20153,9625,1444,6894,01617,811
20144,0254,1374,0724,10816,342
'Machine equivalent' count signed during the period20163,6963,9413,5202,95114,108
20152,9163,9313,7693,31913,935
20142,9743,1793,1893,24312,585

The industrial vending information related to installed machines at the end of each period was as follows:

Q1Q2Q3Q4
Device count installed at the end of the period201656,88958,34660,40062,822
201548,54550,62053,54755,510
201442,15343,76145,59646,855
'Machine equivalent' count installed at the end of the201643,32944,70746,39948,399
period201535,99737,71440,06741,905
201430,32631,71333,29634,529

Note: In February 2016, we signed an agreement to lease a significant number of industrial vending lockers to one of our customers. As of December 31, 2016, September 30, 2016, and June 30, 2016, we have deployed approximately 15,000, 11,000, and 3,000 devices, respectively, under this agreement. These devices do not generate product revenue and are excluded from the counts noted above.

The following table includes some additional statistics regarding our net sales and daily sales growth:

Q1Q2Q3Q4
Percent of total net sales to customers with201644.5%44.6%45.0%46.1%
industrial vending(1)201540.5%40.9%42.1%43.9%
201437.8%37.0%37.8%39.3%
Daily sales growth to customers with20163.6%2.7%2.4%3.7%
industrial vending(2)201512.3%8.6%4.8%0.7%
201419.7%20.9%21.9%20.0%

(1) The percentage of total net sales (vended and traditional) to customers currently using a vending solution.

(2) The growth in total net sales (vended and traditional) to customers currently using a vending solution compared to the same period in the preceding year.

A significant number of our customers utilize a Fastenal vending machine. Indeed, the percent of net sales to customers with industrial vending, at 46.1% in the fourth quarter of 2016, is approaching half of our sales base. Customers utilizing vending have continued to grow faster than our overall business: in the first, second, third, and fourth quarters of 2016, daily sales to these customers grew 3.6%, 2.7%, 2.4%, and 3.7%, respectively. However, the relative growth of these customers has moderated over the last couple of years as customers taking advantage of the service have grown to be an increasingly significant portion of our total customer base. Put another way, penetration of our customer base with vending solutions has risen to the point where macroeconomic variables that affect the customer increasingly affect machine throughput as well. We believe our installed base of machines and our penetration of our customer base will continue to grow and be a catalyst to

gaining an increasing share of our customer’s MRO spending. This was evident in 2016: our installed machine base increased 13.2% and the daily sales growth of product moving through those machines similarly increased at a rate greater than 10%. Daily sales of our safety product line, which is heavily vended, increased 9.3% in 2016. We believe these factors point to our gaining increasing wallet share with our customers through vending.

In addition to the industrial vending operation noted above, which primarily relates to our non-fastener business, we also provide bin stock programs (also known as 'keep fill' programs in the industry) to numerous customers. This business, which relates to both our maintenance customers (MRO fasteners and non-fasteners) and original equipment manufacturers (OEM fasteners), has many similar attributes to our industrial vending relationships. These attributes include a strong relationship with these customers, where we are often their preferred supplier, and a higher frequency of business transactions. This business is performed without the aid of a vending machine, but does make use of the latest scanning technologies, scale systems, and our fully integrated distribution network to manage the supply chain for all sizes of customers. In recent years, we have begun to refer to this business as FMI (Fastenal Managed Inventory).

PROFIT DRIVERS OF OUR BUSINESS

As we state several times in this document, profit is important to us. For a distribution business, profit and cash flow go hand in hand. Cash flow is what funds our growth, provides us with short-term and long-term flexibility, and enables us to create value for our customers, our employees, our suppliers, and our shareholders. Over time, we grow our profits by continuously working to grow sales and to improve our relative profitability. We achieve our improvements in relative profitability both by improving our gross profit and by structurally lowering our operating and administrative expenses.

We also grow our profits by allowing our inherent profitability to shine through - we refer to this as the 'pathway to profit'. The distinction is important. The 'pathway to profit' to which we refer is merely the natural 'per store' leverage that occurs as the average net sales per month of a store increases. There are two diverging trends that occur as a store grows; first, the gross profit percentage at a store generally declines, and second, our operating and administrative expense as a percentage of net sales generally improves. The operating and administrative expense improvement starts on day one, while the gross profit percentage decline typically occurs when the average sales at a store move above $100 thousand per month. Fortunately, the operating and administrative expense improvements typically far outweigh the gross profit percentage declines.

The best way to appreciate this dynamic is to look at the cost components of our business. The cost components of a store include the following: (1) cost of sales and (2) operating and administrative expenses. The operating and administrative expenses can be further split into (listed by relative size): (1) people costs (base pay, incentive pay, benefits, training, and payroll related taxes), (2) occupancy costs (facility expenses such as rent, property taxes, repairs, and depreciation on owned facilities, as well as utility costs, equipment expenses, and vending machine related expenses, excluding leased locker equipment), and (3) 'all other' expenses. The largest component of the last category is the vehicles needed in each store to support selling activities.

The first component, cost of sales, is directly related to sales and fluctuations in sales. However, it is also heavily influenced by product and customer mix. As is true for the company as a whole, many stores are under-represented by, and seeing superior growth from, the non-fastener product category and/or the large customer category. As these tend to contribute disproportionately to a store's growth and increase in scale, we often see a decline in gross profit as the average monthly net sales of a store increase. Over the long-term and in the absence of offsetting efforts elsewhere in the business (which we address below), we expect these factors to continue to exert pressure on our gross profit percentage.

The second component, operating and administrative expenses, does just the opposite, it generally improves as a percentage of net sales. This is due to the fixed nature of our 'open for business' expenses and the attractive incremental profit margin typically realized in our remaining variable expenses. The 'open for business' expenses are the expenses needed to 'just keep the front door open', and they relate to a base staffing level, a base facility cost, and base vehicle costs. These expenses do not generate a profit; however, they create the opportunity for future sales growth that will generate profits. This drives our 'pathway to profit'.

STATEMENT OF EARNINGS INFORMATION (percentage of net sales) for the periods ended December 31:
Twelve-month Period
201620152014
Net sales100.0%100.0%100.0%
Gross profit49.6%50.4%50.8%
Operating and administrative expenses29.5%29.0%29.8%
Gain on sale of property and equipment0.0%0.0%0.0%
Operating income20.1%21.4%21.1%
Net interest income (expense)-0.2%-0.1%0.0%
Earnings before income taxes19.9%21.3%21.1%
Note – Amounts may not foot due to rounding difference.

Gross profit – The gross profit percentage during each period was as follows:

Q1Q2Q3Q4
201649.8%49.5%49.3%49.8%
201550.8%50.3%50.5%49.9%
201451.2%50.8%50.8%50.5%

Important factors that impact our gross profit percentage over the long-term are our mix of store sizes, customer sizes, products, geographic locations, end markets, and end market uses (such as industrial production business versus maintenance business). Given the close proximity of our sales personnel to our customer's business, we offer a very high service level with our sales, which is valued by our customers and improves our gross profit. Fasteners, which is currently our largest single product line at 35% to 40% of sales, is our highest gross profit product line given the high transaction cost surrounding the sourcing and supply of the product for our customers. Any reduction in the mix of our sales attributable to fasteners, and particularly maintenance fasteners, may negatively impact gross profit. Larger customers, whose more focused buying patterns allow us to offer them better pricing, also influence gross profit. Stores typically achieve higher average sales disproportionately by growth in the non-fastener product lines and with large customers, causing gross profit to decline as average net sales grow. One final item of note, our fourth quarter has typically been the season with the most challenges surrounding gross profit. This relates to the decline in sales in November and December due to the 'holiday season' and due to the seasonal reduction in non-residential construction business. This drop off in sales reduces the utilization of our trucking network which can also slightly reduce our gross profit.

Besides the long-term trends noted above, periods of inflation or deflation and sudden changes in business volume can cause short-term fluctuations in our gross profit percentage by effecting product and customer mix, freight, and sourcing strength that can occur as we leverage buying scale and efficiency. Sudden changes in business volume can also impact our gross profit percentage over the short-term by influencing supplier volume allowances. Our gross profit percentage is also heavily influenced by our store-based compensation programs, which are directly linked to sales growth and gross profit, and incentivize our employees to improve both.

During 2016, our gross profit, as a percentage of net sales, decreased when compared to 2015. This decrease was primarily caused by changes in product and customer mix. Our gross profit also decreased in the fourth quarter of 2016 when compared to the fourth quarter of 2015 for similar reasons.The sequential increase in our gross profit in the fourth quarter of 2016 relative to the third quarter of 2016 is a reflection of modest positive contributions from several sources, including favorable product mix, lower freight costs, increased sales of Fastenal brands, and the absence of certain costs related to our growth initiatives (e.g., costs related to setting up CSP 16) in previous quarters.

During 2015, our gross profit, as a percentage of net sales, decreased when compared to 2014. This decrease was primarily driven by changes in product and customer mix. Our gross profit, as a percentage of net sales, also decreased in the fourth quarter of 2015 when compared to the fourth quarter of 2014. We saw a noticeable squeezing of discretionary spending by our customers in November and December of 2015, which produced a noticeable drop in sales of less frequently purchased products. This resulted in all of the drop in gross profit when compared to the third quarter of 2015, and substantially all of the change from the fourth quarter of 2014.

During 2014, our gross profit dropped below 51%. The drop was primarily driven by changes in product and customer mix and our strong emphasis on growing average store sales.

Operating and administrative expenses - These expenses increased as a percentage of net sales from 2015 to 2016.

Historically, our two largest components of operating and administrative expenses have consisted of employee related expenses (approximately 65% to 70%) and occupancy related expenses (approximately 15% to 20%). The remaining expenses cover a variety of items with selling transportation typically being the largest.

The three largest components of operating and administrative expenses grew (contracted) as follows for the periods ended December 31 (compared to the same periods in the preceding year):

Twelve-month Period
201620152014
Employee related expenses2.7%0.7%11.7%
Occupancy related expenses10.1%7.4%6.9%
Selling transportation costs2.9%-13.1%10.1%

Employee related expenses include: (1) payroll (which includes cash compensation, stock option expense, and profit sharing), (2) health care, (3) personnel development, and (4) social taxes. The increase in 2016, when compared to 2015, was caused by increases in full-time equivalent headcount (see table below) and an increase in health care costs. These increases were partially offset by a contraction in our performance bonuses and commissions, and in our profit sharing contribution, primarily due to lower sales growth, gross profit, and operating income (both on a dollar basis and on a relative basis). The slight increase in 2015, when compared to 2014, was caused by increases in full-time equivalent headcount and growth in our profit sharing contribution, primarily due to our expanding growth in operating income. Offsetting factors included lower performance bonuses and commissions due to the decrease in our gross profit percentage, and a focused reduction in overtime hours paid.

Using a monthly average, the FTE headcount grew (contracted) as follows (compared to the same period in the preceding years):

Twelve-month Period
201620152014
Store and Onsite based2.4%6.2%12.5%
Total selling (includes store and Onsite)3.7%6.1%12.3%
Distribution6.4%6.1%11.5%
Manufacturing-6.4%0.1%10.7%
Administrative6.3%6.7%8.9%
Total average FTE headcount3.8%5.9%11.9%

Occupancy related expenses include: (1) building rent and depreciation, (2) building utility costs, (3) equipment related to our stores and distribution locations, and (4) industrial vending equipment (we consider the vending equipment, excluding leased locker equipment, to be a logical extension of our store operation and classify the depreciation, repair costs, and hosting services as occupancy expense). The increase in 2016, when compared to 2015, was mainly driven by (1) an increase in the amount of industrial vending equipment discussed earlier in this document, and (2) an increase in occupancy expense related to rent. The largest impact came from the industrial vending equipment. The increase in 2015, when compared to 2014, was driven by (1) an increase in the amount of industrial vending equipment as discussed earlier in this document, and (2) an increased investment in our distribution infrastructure over the last several years, primarily related to automation. In 2016 and 2015, the industrial vending component represented approximately 66% and 42%, respectively, of the increase.

Our selling transportation costs consist primarily of our store fleet as most of the distribution fleet costs are included in cost of sales. Selling transportation costs included in operating and administrative expenses increased in 2016, when compared to 2015. This was driven by an increase in the number of vehicles for sales personnel, and was partially offset by a decrease in fuel expense. The contraction in selling transportation costs included in operating and administrative expenses in 2015, when compared to 2014, was driven by the decline in fuel costs.

The last several years have seen some variation in the cost of diesel fuel and gasoline. During the first, second, third, and fourth quarters of 2016, our total vehicle fuel costs were approximately $6.4 million, $8.2 million, $8.3 million, and $8.0 million, respectively. During the first, second, third, and fourth quarters of 2015, our total vehicle fuel costs were approximately $8.8 million, $9.1 million, $8.6 million, and $7.8 million, respectively. The fluctuations were a result of: (1) variations in fuel costs, (2) the service levels provided to our stores from our distribution centers, (3) the number of vehicles at our store locations, (4) the number of other sales centered vehicles as a result of store openings and the expansion of our non-store sales force, and (5)

changes in driving conditions. These fuel costs include the fuel utilized in our distribution vehicles (semi-tractors, straight trucks, and sprinter trucks) which is recorded in cost of sales and the fuel utilized in our store delivery and other sales centered vehicles which is included in operating and administrative expenses (the split in the last several years has been approximately 50/50 between distribution and store and other sales centered use).

Income taxes – Income taxes, as a percentage of earnings before income taxes, were approximately 36.8%, 37.5%, and 37.2% for 2016, 2015, and 2014, respectively. The decrease in our income tax rate from 2015 to 2016 was caused by a slight change in jurisdictional income and changes in the reserve for uncertain tax positions. The increase in our income tax rate from 2014 to 2015 was driven by an increase in valuation allowances on deferred tax assets and changes in the reserve for uncertain tax positions. As our international business and profits grew the past several years, the lower income tax rates in those jurisdictions, relative to the United States, have lowered our effective tax rate.

Net earnings – Net earnings, net earnings per share (EPS), percentage change in net earnings, and the percentage change in EPS, were as follows:

Dollar Amounts201620152014
Net earnings$499,478516,361494,150
Basic EPS1.731.771.67
Diluted EPS1.731.771.66
Percentage Change201620152014
Net earnings-3.3%4.5%10.1%
Basic EPS-2.3%6.0%10.6%
Diluted EPS-2.3%6.6%9.9%

During 2016, net earnings decreased, despite our nominal sales growth, primarily due to the reduction in the gross profit percent realized and an increase in operating and administrative expenses (discussed earlier in this document). The contraction of basic and diluted earnings per share was smaller due primarily to the purchase of our shares of common stock in 2015 and early 2016. During 2015, the net earnings increase was greater than that of sales primarily due to the effective management of operating expenses. During 2014, the net earnings increase was less than that of sales primarily due to the reduction in the gross profit percent realized.

CASH FLOW IMPACT ITEMS

Operational working capital – Operational working capital, which we define as accounts receivable, net and inventories, are highlighted below. The annual dollar change and the annual percentage change were as follows:

Dollar change20162015
Accounts receivable, net$31,3416,298
Inventories79,72644,039
Operational working capital$111,06750,337
Annual percentage change20162015
Accounts receivable, net6.7%1.4%
Inventories8.7%5.1%
Operational working capital8.0%3.8%

In 2016, the annual growth in net accounts receivables outpaced the growth in sales. This was not the case through the third quarter, and was mostly a function of conditions in the fourth quarter of 2016. In the fourth quarter of 2015, we collected receivables from our seasonally stronger third quarter, but because demand fell off surprisingly sharply in November and December, our fourth quarter receivables were unseasonably low. In the fourth quarter of 2016, by contrast, we collected receivables from our seasonally stronger third quarter, but because demand was more closely in line with seasonal norms, our receivables in the period were similarly more normal. Over a longer period of time, investors should be aware that if we continue to see relatively strong growth in our international business and of our large customer accounts it could create difficulty in managing the growth of accounts receivables relative to the growth in net sales.

Our growth in inventory balances over time does not have as direct a relationship to our monthly sales patterns as does our growth in accounts receivable. This is impacted by other aspects of our business. For example, the dramatic economic slowdown in late 2008 and early 2009 caused our inventory to spike. This occurred because the lead time for inventory

procurement is typically longer than the visibility we have into future monthly sales patterns. Over the last decade, we increased our relative inventory levels due to the following: (1) new store openings, (2) expanded stocking breadth at distribution centers (for example, our master stocking hub in Indianapolis expanded its product breadth over six fold from 2005 to 2011), (3) expanded direct sourcing, (4) expanded Fastenal brands, (5) expanded industrial vending solutions, (6) national accounts and Onsite growth, (7) international growth, and (8) expanded stocking breadth at individual stores related to our CSP initiatives. All of these items impacted both 2016 and 2015. However, throughout 2016, the most significant contributors to the increase in inventories were the impact of infusing incremental inventory into our network beginning at the end of 2015 as part of our CSP 16 initiative, the relative growth of international sales, the growth of our Onsite business, and opportunist product purchases at year-end. Absent the opportunistic product purchases at year-end, growth in inventories would have moderated substantially from earlier in the year, reflecting the stabilizing of CSP 16 inventories.

The approximate percentage mix of inventory stocked at our selling locations versus our distribution center and manufacturing locations was as follows at year end:

201620152014
Selling locations64%61%56%
Distribution center and manufacturing locations36%39%44%
Total100%100%100%

New stores open with the standard store model (CSP 16), which consists of a core stocking level of approximately $60 thousand per location. This inventory level grows as the level of business in a store grows. In the fourth quarter of 2015, we began expanding the inventory offering at our existing store locations to the CSP 16 format. This inventory expansion continued throughout 2016.

As we indicated in earlier communications, our goal is to target a ratio of annual sales to accounts receivable and inventory (Annual Sales: AR&I) of approximately a 3.0:1 ratio. On December 31, 2016 and 2015, we had a ratio of 2.7:1 and 2.8:1, respectively.

Liquidity and Capital Resources:

Net cash provided by operating activities — Net cash provided by operating activities in dollars and as a percentage of net earnings were as follows:

201620152014
Net cash provided$513,999546,940499,392
% of net earnings102.9%105.9%101.1%

In 2016, the slight contraction in the net cash provided by operating activities was driven by our current initiative to add additional products into store inventory under our CSP 16 format, and an increase in net accounts receivable growth. This decrease was partially offset by a reduction in net cash paid for income taxes. In 2015, the increase in the net cash provided by operating activities was driven by growth in net earnings, and a decrease in the cash required to fund our net working capital, which includes accounts receivable and inventory changes. This was partially offset by an increase in cash paid for income taxes.

Net cash used in investing activities — Net cash used in investing activities in dollars and as a percentage of net earnings were as follows:

201620152014
Net cash used$188,093180,627188,781
% of net earnings37.7%35.0%38.2%

The changes in net cash used in investing activities were primarily related to changes in our net capital expenditures as discussed below and cash paid for acquisitions in 2015 and 2014.

Net capital expenditures (purchases of property and equipment, less proceeds from the sale of property and equipment) in dollars and as a percentage of net earnings were as follows:

201620152014
Net capital expenditures$182,946145,227183,655
% of net earnings36.6%28.1%37.2%

Note: A reconciliation of net capital expenditures is outlined in the table below.

Our net capital expenditures increased in 2016. This was primarily due to the purchase of industrial vending machines related to the leased locker program we signed in February 2016 and spending on automation in certain distribution centers. Our net capital expenditures decreased in 2015, which was largely related to the completion of distribution automation projects in process during 2014.

Property and equipment expenditures in 2016, 2015, and 2014 consisted of: (1) the purchase of software and hardware for our information processing systems, (2) the addition of certain pick-up trucks, (3) the purchase of signage, shelving, and other fixed assets related to store openings and our CSP initiative, (4) the addition of manufacturing and warehouse equipment, (5) the expansion or improvement of certain owned or leased store properties, (6) the expansion of our distribution/trucking fleet, (7) purchases related to industrial vending, which primarily consists of automated vending equipment and construction of a new centralized distribution facility (2014), and (8) costs related to enhancements to distribution centers with existing automation (2016, 2015, and 2014), and the expansion of our distribution centers in High Point, North Carolina (2016 and 2015), Modesto, California (2014), Scranton, Pennsylvania (2014), and Kitchener, Ontario, Canada (2014). Disposals of property and equipment consisted of the planned disposition of certain pick-up trucks, distribution vehicles and trailers in the normal course of business, and the disposition of real estate relating to several store locations (2016, 2015, and 2014) and a distribution center (2015).

Set forth below is an estimate of our 2017 net capital expenditures and a recap of our 2016, 2015, and 2014 net capital expenditures.

2017201620152014
(Estimate)(Actual)(Actual)(Actual)
Manufacturing, warehouse and packaging equipment, industrial vending equipment, and facilities$67,000131,793112,460144,649
Shelving and related supplies for store openings and for product expansion at existing stores13,00014,0798,9586,712
Data processing software and equipment21,00018,01519,65323,978
Real estate and improvements to store locations7,0005,4674,2474,091
Vehicles17,00020,0979,85010,044
Purchases of property and equipment125,000189,451155,168189,474
Proceeds from sale of property and equipment(6,000)(6,505)(9,941)(5,819)
Net Capital Expenditures$119,000182,946145,227183,655

We anticipate funding our capital expenditure needs with cash generated from operations, from available cash and cash equivalents, and from our borrowing capacity.

Net cash used in financing activities – Net cash used in financing activities in dollars and as a percentage of net earnings were as follows:

201620152014
Net cash used$340,872337,563249,732
% of net earnings68.2%65.4%50.5%

The fluctuations in net cash used in financing activities are due to changes in the level of our dividend payments and in the level of common stock purchases. These amounts were partially offset by the exercise of stock options and the related tax impact, and net borrowings under debt obligations. These items in dollars and as a percentage of earnings were as follows:

201620152014
Dividends paid$346,588327,101296,581
% of net earnings69.4%63.3%60.0%
Common stock purchases59,440292,95152,942
% of net earnings11.9%56.7%10.7%
Total returned to shareholders$406,028620,052349,523
% of net earnings81.3%120.1%70.7%
Proceeds from the exercise of stock options and the related excess tax benefits from stock-based compensation$(35,156)(22,489)(9,791)
% of net earnings-7.0%-4.4%-2.0%
Cash borrowings, net$(30,000)(260,000)(90,000)
% of net earnings-6.0%-50.4%-18.2%
Net cash used$340,872337,563249,732
% of net earnings68.2%65.4%50.5%

Unremitted Foreign Earnings – Approximately $70,995 of cash and cash equivalents are held by non-U.S. subsidiaries. These funds may create foreign currency translation gains or losses depending on the functional currency of the entity holding the cash. We intend to utilize these funds to support our expansion activities outside the U.S. The income tax impact of repatriating cash associated with certain undistributed earnings is discussed in Note 6 of the Notes to Consolidated Financial Statements.

Stock Purchases — During 2016, we purchased 1,600,000 shares of our common stock at an average price of approximately $37.15 per share. During 2015, we purchased 7,100,000 shares of our common stock at an average price of approximately $41.26 per share. During 2014, we purchased 1,200,000 shares of our common stock at an average price of approximately $44.12 per share.

Dividends — We declared a quarterly dividend of $0.32 per share on January 17, 2017. We paid aggregate annual dividends per share of $1.20, $1.12, and $1.00 in 2016, 2015, and 2014, respectively.

Debt — In order to fund the considerable cash needed to purchase industrial vending machines under our leased locker program, to expand our industrial vending business, to increase the use of automation in our distribution centers, and to purchase our common stock and pay dividends, we have borrowed increased amounts under our Credit Facility and our Master Note Agreement in recent periods.

Our borrowings under the Credit Facility peaked during each quarter of 2016 and 2015 as follows:

Peak borrowings20162015
First quarter$440,000185,000
Second quarter485,000400,000
Third quarter460,000395,000
Fourth quarter405,000390,000

As of December 31, 2016, we had loans outstanding under the Credit Facility of $305,000 and contingent obligations from letters of credit outstanding under the Credit Facility in an aggregate face amount of $36,267. As of December 31, 2016, we also had loans outstanding under the Master Note Agreement of $75,000. Descriptions of our Credit Facility and Master Note Agreement are contained in Note 9 of the Notes to Consolidated Financial Statements.

Effects of Inflation — During the first half of 2016, we experienced some deflation in our fastener products, which was largely offset by some inflation in the latter half of the year, and minimal price movements in our non-fastener products. In 2015 and

2014, we experienced some deflation in our fastener products and minimal price movements in our non-fastener products, with the net impact being a slight drag on growth.

Critical Accounting Policies – Our accounting policies related to certain assets and liabilities are an integral part of our consolidated financial statements. These policies are considered critical because they require application of assumptions and judgments based on historical trends and the composition of account balances. Although we believe our reserves are adequate, the results could be materially different if our assumptions and historical trends do not reflect actual results.

Allowance for doubtful accounts – This reserve is for accounts receivable balances that are potentially uncollectible. The reserve is based on an analysis of customer accounts and our historical experience with accounts receivable write-offs. Our methodology for estimating this reserve includes ongoing reviews of the aging of accounts receivable, the financial condition of a customer or industry, and general economic conditions. If business or economic conditions change, our estimates and assumptions may be adjusted as deemed appropriate. For fiscal years 2016, 2015, and 2014, actual results did not vary materially from estimated amounts.

Inventory reserves – The reserves are for potentially obsolete or excess inventory and shrinkage. The reserves are based on an analysis of inventory trends. The analysis includes reviews of inventory levels, sales information, physical inventory counts, cycle count adjustments, and the on-hand quantities relative to the sales history for the product. Our methodology for estimating these reserves is continually evaluated for factors that could require changes to the reserves including significant changes in product demand, market conditions, condition of the inventory, or liquidation value. If business or economic conditions change, our estimates and assumptions may be adjusted as deemed appropriate. For fiscal years 2016, 2015, and 2014, actual results did not vary materially from estimated amounts.

Insurance reserves – These reserves are for general claims related to workers' compensation, property and casualty losses, health claims, and other self-insured losses. The reserves are based on an analysis of external data related to our historical claim trends. We perform ongoing reviews of our insured and uninsured risks and use this information to establish appropriate reserve levels. We analyze historical trends, claims experience, and loss development patterns to ensure the appropriate loss development factors are applied to the incurred costs associated with the claims made. For fiscal years 2016, 2015, and 2014, actual results did not vary materially from estimated amounts.

New Accounting Pronouncements

A description of new accounting pronouncements is contained in Note 12 of the Notes to Consolidated Financial Statements.

Geographic Information

Information regarding our revenues and long-lived assets by geographic area is contained in Note 7 of the Notes to Consolidated Financial Statements. Risks related to our foreign operations are described earlier in this Form 10-K under the heading 'Forward-Looking Statements' and 'Item 1A. Risk Factors'.

Certain Contractual Obligations

As of December 31, 2016, we had outstanding long-term debt and facilities, equipment, and vehicles leased under operating leases. Our future obligations to pay principal of and interest on such long-term debt and to make minimum lease payments under such operating leases are as follows:

Total20172018 and 20192020 and 2021After 2021
Principal of long-term debt$390,00010,482304,51840,00035,000
Interest on long-term debt(1)15,7457,6764,3113,115643
Operating leases321,382129,445148,78541,7661,386
Total$727,127147,603457,61484,88137,029

(1) Interest on the long-term debt outstanding under our Credit Facility was calculated using the interest rates and balances at December 31, 2016.

Purchase orders and contracts for the purchase of inventory and other goods and services are not included in the table above. Our purchase orders are based on current distribution needs and are fulfilled by our vendors within short time horizons. We do not have significant agreements for the purchase of inventory or other goods or services specifying minimum order quantities.

Liabilities for uncertain tax positions have been excluded from the table above due to the uncertainty surrounding the ultimate settlement and timing of these liabilities. A discussion of income taxes is contained in Note 6 of the Notes to Consolidated Financial Statements.

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