Lead author: Frank Wang.
Source: agreerealty.com.Investment Thesis
The never-ending battle in the retail space has been disrupting so many parties - most notably, the department store. However, Tractor Supply Co. (TSCO), a relatively low-profile, mid-cap company, has not only survived but also thrived, having grown its earnings power and shareholder value year in and year out.
Source: Yahoo Finance; data as of 10/11/2019.
The stock, as you can see above, has outperformed the S&P Retail ETF (XRT) by a massive margin over the last decade.
What supports such an extraordinary performance in a fiercely competitive and rapidly moving environment? Is it sustainable? We need to find out.Business Overview
Tractor Supply Company is the largest rural lifestyle retailer in the United States. The company is focused on supplying the needs of recreational farmers and ranchers and all others who enjoy the rural lifestyle, as well as tradesmen and small businesses. The company operates retail stores under the names Tractor Supply Company, Del’s Feed & Farm Supply, and Petsense and operates websites under the names TractorSupply.com and Petsense.com. The stores are located primarily in towns outlying major metropolitan markets and in rural communities, and they offer the following comprehensive selection of merchandise:Equine, livestock, pet, and small animal products, including items necessary for their health, care, growth, and containment;Hardware, truck, towing, and tool products;Seasonal products, including heating, lawn and garden items, power equipment, gifts, and toys;Work/recreational clothing and footwear; andMaintenance products for agricultural and rural use.
Below is a graph representing how much each product category contributes to the total sales in the last three years. Nearly half of the revenue comes from livestock and pet products.
Source: Tractor Supply Company 10-K, 2018
On December 29, 2018, the company operated 1,940 retail stores in 49 states (1,765 Tractor Supply and Del’s retail stores and 175 Petsense retail stores).
Source: Tractor Supply Company 10-K, 2018Economic Moat
In our view, the niche-market strategy constructs the economic moat around Tractor Supply's high-ROIC business, which, in turn, leads to a few other competitive advantages. Per the chart below, the company generated high returns on tangible assets - above 10% except for the 08/09 financial crisis - over more than a dozen years.
Source: GuruFocus; data as of 10/11/2019.
Tractor Supply Company focuses on a specialized market niche: supplying the lifestyle needs of recreational farmers and ranchers and others who enjoy the rural lifestyle, as well as tradesmen and small businesses. By locating retail stores in rural areas, the company is shielded from other large competitors such as Walmart (WMT), Lowe's (LOW) or Home Depot (HD). Also, Petsense, which was acquired by Tractor Supply in 2016, operates away from the city center and avoids the competition from urban-focused pet big retail companies such as Petco. Below are two regional maps representing the locations of Tractor Supply (in yellow), Walmart (in blue), and Petsense (in green). As you can see, Tractor Supply tends to be located in less dense and populated areas, which may not make economic sense for Walmart or other large players to cover. Also, you can find Petsense stores in the suburban and rural regions.
Source: Google Map
Source: Google Map
As e-commerce keeps thriving, many retail businesses have been disrupted by companies like Amazon (AMZN). However, the business of Tractor Supply may not be attractive for Amazon, which has invested hugely in building logistic infrastructures to ensure that its Prime members can get anything they want within two days. It is just not cost-effective for Amazon to deliver many of Tractor Supply's products, which are big, bulky, and lower-valued (e.g., 50-pounds horse feed) in the rural area. Meanwhile, according to the company, greater than 70% of tractor supply’s e-commerce orders are being fulfilled at stores. This illustrates a great customer preference for indoor shopping and the attractiveness of Tractor Supply retail stores.
The niche focus rewards the company with a great deal of customer loyalty.
The target customers of Tractor Supply Company are home, land, pet, and livestock owners who generally have above-average income and a below-average cost of living. The company has established for 80 years and has more than 10 million members in the Neighbor’s Club, its reward program launched a couple of years ago.
According to the management, the 1-year retention rate of this program is consistently running at nearly 90%, with customer feedback continuing to be very positive. The sales per customer are increasing, and the Club members shop three times more than the company's average customers. With the rich customer data, Tractor Supply can further drive customer-centric engagement, the average ticket per customer, and the traffic in stores.
Below is a table showing the average gross margin and operating margin of Tractor Supply, Walmart, Lowe's, and Home Depot from 2010 to 2018. Through comparison, we could see that Tractor Supply has remained a healthy gross margin and operating margin, representing a good cost structure. The stabilized low-cost structure generally attributes to sound management of sourcing, distribution, and overall operation. More importantly, Tractor Supply stores typically range in size from 15,000 to 20,000 square feet of inside selling space, along with additional outside selling space. At the same time, the average size of a grocery store is measured at over 45,000 square feet. This implies a lower store maintenance cost, thanks again to the niche-market play.
Source: Morningstar; data as of 10/11/2019.Long-term Prospect
With at least a narrow moat to protect the profitability and shareholder value, we believe that the good days are by no means over at Tractor Supply for the next few years. Some primary growth opportunities are listed as follows.
Over the past five years, Tractor Supply Company has experienced considerable growth in stores, growing from 1,276 stores at the end of FY2013 to 1,940 stores (1,765 Tractor Supply and Del’s retail stores and 175 Petsense retail stores) at the end of FY2018. The management believes that given the size of the communities that they target, there is ample opportunity for new store growth in existing and new markets. They have developed a proven method for selecting store sites and have identified approximately 700 additional opportunities for new Tractor Supply stores. They also believe that there is an opportunity for up to 1,000 Petsense stores. With the expansion of stores, Tractor Supply can reach more potential customers and drive the overall sales.
Thriving pet industry
The pet industry has been experiencing explosive growth. According to the American Pet Products Association, 67% of U.S. households own a pet, which equates to 84.9 million homes.
In 2018, $72.56 billion was spent on our pets in the U.S. Over the last 30 years, pet ownership has gone from 56% to 67% of all households. Besides, research shows that as millennials and Generation Z have come into adulthood, they are more likely to raise pets than their elders. While baby boomers own 32% of pets, nearly 62% are owned by households headed by younger cohorts. It is also found that pet care is a recession-proof industry. During the past 20 years, spending on pets has increased by 7% annually. Meanwhile, pet-caring expenditure increased by 24% in the 2001 recession and by 5% during the financial crisis between 2008 and 2009.
Source: American Pet Products Association
With the acquisition of Petsense, Tractor Supply expands its pet products offering, reaches more geographic regions, and leverages Petsense’s experience in the pet industry to enhance the business's operations and efficiencies. With the tailwind of the booming pet industry, Tractor Supply is likely to maintain a decent growth of sales in the space.
Expansion through digital and Omni-channels
Tractor Supply Company has kept invested in digital and connected with customers in various ways, including e-commerce websites and social media. Online sales have shown strong double-digit growth during the past few years. At the same time, as mentioned above, more than 70% of online businesses are picked up in stores. According to management, when customers come to the store to pick up the products, they will add another 15% or so to their tickets. Also, online orders are typically twice as big as the average ticket in terms of ticket sizes at Tractor Supply.Investment risk
Compared with many other retailers, we think that the competitive risk facing Tractor Supply is being reduced thanks to the narrow economic moat described above.
However, the business is still prone to a sales slowdown during an economic downturn, even though it remarkably maintained its growth momentum throughout the last recession (see the revenue growth below).
Source: GuruFocus; data as of 10/11/2019.
In the longer term, the digital side of Petsense could face continuous competitive pressure from established and newly-entered e-commerce sites. Additionally, there is no guarantee that large retailers would refrain from paying more attention to the lucrative rural lifestyle space, especially with the advancement of technology.
Internally, a significant portion of Tractor Supply’s growth strategy is to build more Tractor Supply and Petsense retail stores. With the increasing penetration in the market, new stores might adversely affect the sales of existing stores in the same markets or nearby. Below is a graph showing the comparable store sales in the past five years. If the comparable store sales show consistently low single-digit or even negative growth in the future, there could be an indication of sales cannibalization.
Source: Tractor Supply Company 10-K, 2018Valuation
The current valuation of TSCO appears fair to us. All major price multiples (e.g., P/E, P/B, P/S, P/CF) are being traded below their respective 5-year averages, according to Morningstar below.
Source: Morningstar; data as of 10/11/2019.
As shown below, the P/S ratio (one of the critical valuation indicators for retailers) steadily rose after the last recession to the top during 2014/2015 and then trended down a bit after that.
Source: GuruFocus; data as of 10/11/2019.
The current free cash flow yield (our favorite valuation indicator) of TSCO is almost 5%. With a presumed low-teens CAGR in EPS and FCFPS, the stock is reasonably priced.
Source: GuruFocus; data as of 10/11/2019.Summary
Overall, Tractor Supply is a rare species in today's competitive retail space. We think that at least for the medium term, the business is both Amazon-proof and Walmart-proof, thanks to its niche-market play. The stock seems reasonably priced in light of the growth prospect and investment risks. Long-term buy-and-hold investors could establish a small position in TSCO at this level and accumulate more shares over time.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Mentioning of any stock in the article does not constitute investment recommendations. Investors should always conduct careful analysis themselves and/or consult with their investment advisors before acting in the stock market.