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Company Profile: Tractor Supply Offers a Compelling Growth Story

July 10, 2010 | About:
guruek

Ravi Nagarajan

51 followers
Despite much talk of an expected major retrenchment in consumer spending, the savings rate in America continues to hover in the low single digit range and consumer spending still accounts for over seventy percent of GDP. The fate of the overall economy may hinge on the degree to which Americans curb spending in the coming years in order to repair balance sheets that have been damaged by the housing crash and declines in the value of investment accounts. In such an environment, investing in retailers requires a careful consideration of the presence of a moat as well as secular trends that may provide the business with a tailwind.

Tractor Supply Company is a specialty retailer with a well defined niche market catering to the lifestyle needs of recreational farmers and ranchers. The company offers an array of products required in the daily life of those who live in rural communities. While discretionary durable goods are a significant portion of revenues, the company also offers non-discretionary consumable products that attract recurring business.

Background

Tractor Supply defines its customer base as those who enjoy the “Out Here” lifestyle. The company’s marketing message emphasizes a pioneering spirit coupled with the importance of rural communities and attempts to position itself as the supplier of choice within such communities. With 948 stores in 44 states averaging 15,500 to 18,500 square feet, Tractor Supply’s retail format is much smaller and more specialized than retailers such as Home Depot and Lowe’s which cater to a more suburban clientele. The company has been growing rapidly even in the midst of recession and operating with minimal financial leverage. As of Friday, July 9, Tractor Supply had a market capitalization of $2.39 billion at a share price of $65.74.

The following exhibit shows selected data for Tractor Supply over the past five years:

TSCODataSummary.png

The pace of store expansion slowed somewhat in 2009, but the company still had a net expansion of 75 locations which is a clear sign of confidence from management. Most stores are located on the periphery of major metropolitan areas or in rural communities as the map below shows:

TSStoreMap.jpg

The company is based near Nashville, has six distribution centers, and has a small presence in Western states. Management believes that there is a potential to nearly double the store count with Western states offering the largest opportunity:

TSLongTermStoreTarget.png

Diversified Product Mix Provides Some Stability

In recent years, Tractor Supply’s product mix has been shifting toward consumable products that drive recurring business. While the company reports results in a single segment, product category information is provided in the financial reports. The company reports six product categories which appear in the graph below. The Livestock and Pet category is the largest and has grown from 33 percent of sales in 2007 to 39 percent of sales in 2009. The company has also emphasized private label offerings in the pet food and livestock feed business.

TSCOProdCat.png

The company’s overall business is highly seasonal with the second and fourth quarter representing the stronger periods. To the extent that consumable products gain a larger share of sales, the seasonal variation in results may diminish to some extent. With an average transaction value of only $42 in 2009, a significant number of customers appear to be using Tractor Supply for lower ticket day to day supplies rather than big ticket items.

Solid Free Cash Flow Funds Expansion

Tractor Supply has been able to fund expansion without resorting to significant financial leverage due to the strong cash flow provided by the business. Management has improved cash flows from operations in recent years, in part driven by better management of working capital. Free cash flow has fully funded expansion capex as well as repurchases over the past three years. The company initiated a small quarterly dividend of 14 cents per share earlier this year. The following exhibit highlights free cash flow and the use of the cash over the past three years.

TSCOFCF.png

Management projects that total capital expenditures will be between $90 and $100 million for 2010 driven by approximately the same number of store openings in 2009 but supplemented by additional investment in the distribution centers required to support the store expansion.

What’s the Differentiator?

As noted previously, Tractor Supply faces competition from larger companies such as Home Depot and Lowe’s, so how does the company attempt to differentiate itself? It appears that there are a combination of factors at work and the business results over the past few years indicate that the differentiation strategy is working.

First, the company operates a smaller store format and is located in areas that are closer to its chosen niche market of recreational farmers and ranchers. By locating in smaller communities and operating a smaller and more targeted retail strategy, the company seems to be competing well against larger and more diversified home improvement retailers.

Second, the company states that it seeks to differentiate itself through superior customer service by having employees who understand the rural lifestyle and the products required by customers. Home Depot in particular has suffered a hit to reputation in recent years for cutting experts from its stores in favor of less knowledgeable employees. Facing unique needs, the rural customer base seems to prefer dealing with people who understand their requirements.

Third, the company seems to celebrate the “rural lifestyle” and this message may simply resonate with the target market in a way that general advertising of the major retailers does not. Larger retailers like Home Depot or Lowe’s typically focus on the suburban consumer rather than the rural farmer. The advertising message of Tractor Supply is quite different from these larger players.

Demographic Tailwinds

There are a number of potential tailwinds at work that could help Tractor Supply grow profitably over the next decade. While the company targets a niche market, the size of that market could be growing.

Over the past decade, many Americans have decided that living in exurban or rural areas is appealing compared to the congestion and perceived risks of living near big cities. The September 11, 2001 terrorist attacks in New York and Washington accelerated this trend and while memories may fade over time, there is still a segment of the population that finds a rural lifestyle increasingly attractive.

The desire to live a rural lifestyle is not enough to establish a trend on its own because most people in urban and suburban areas do not work in agriculture and would not be able to replace their incomes by starting a small farm. Tractor Supply’s target market of recreational farmers and ranchers typically have other sources of income outside the agricultural sector. A major enabling factor has been the proliferation of broadband internet access throughout America. While the most rural areas still do not have adequate access, this is rapidly changing.

There are many Americans in professions where work can be done in any location that has high speed internet access and is reasonably close to a major airport. Professionals in a variety of fields can work in remote locations and still maintain access to urban areas when the need arises. Such consumers will have a high level of disposable income and live in areas with much lower housing costs.

Many Americans have no desire to live on a farm, but those who do may find it increasingly feasible to do so in the coming years. Given that this is exactly the market that Tractor Supply is targeting, the demographics could create a tailwind for the company in terms of expansion opportunities.

Summary

Tractor Supply is a niche retailer that has posted a strong record in recent years and seems to have ample opportunities for expansion over the next ten years. The company recently announced strong results for the second quarter of 2010 and this has not gone unnoticed by the market with shares approaching record high levels.

Based on management’s forecast of 2010 earnings, the shares trade at approximately 16.5 times forward earnings. While not inexpensive compared to the overall market on a P/E basis, the valuation is favorable when compared to Home Depot and Lowe’s given Tractor Supply’s superior growth prospects. Value investors may find the shares to be on the expensive side at the moment but the company is worth keeping on the radar in case negative consumer spending statistics in the coming months cause the entire retail sector to decline.

Resources:

Tractor Supply 2009 10-K and Annual Report (pdf)

Tractor Supply Q1 2010 10-Q

Pre-announcement of Second Quarter 2010 Results

Company Presentation – June 2010 (pdf)

Disclosure: No position in Tractor Supply

Ravi Nagarajan

http://www.rationalwalk.com



Rating: 3.2/5 (14 votes)

Comments

Hesperian
Hesperian - 4 years ago
In such an environment, investing in retailers requires a careful consideration of the presence of a moat as well as secular trends that may provide the business with a tailwind.

Indeed.

Tractor Supply Company is a specialty retailer with a well defined niche market catering to the lifestyle needs of recreational farmers and ranchers.

Sounds like this company, with its reliance on big ticket discretionary items, is just about the worst thing one could invest in when consumers are cutting back.

"Many Americans have no desire to live on a farm, For good reason, it's expensive and a lot of hard work. You should probably change that to "Most Americans..." Your assertion about internet access being the primary determiner is highly dubious.

but those who do may find it increasingly feasible to do so in the coming years. Given that this is exactly the market that Tractor Supply is targeting, the demographics could create a tailwind for the company in terms of expansion opportunities."

That seems like quite a stretch.

Based on management’s forecast of 2010 earnings, the shares trade at approximately 16.5 times forward earnings.

Jesus Christ!

While not inexpensive compared to the overall market on a P/E basis, the valuation is favorable when compared to Home Depot and Lowe’s given Tractor Supply’s superior growth prospects.

This is the kind of "reasoning" one often sees by analysts promoting some high-flying growth stock.

TSCO looks like a great short candidate.

_
The market seems to agree, with the short interest this stock has.

Disclosure: No position in Tractor Supply

No surprise!

So what was the point?

I know you say you wrote this so it can be on our radar if the market drops, but with such tenuous, unsubstantiated reasoning for this company's growth prospects, a new analysis would be required anyway to see if the flimsy prognostication here is still valid after consumer wallets tighten up.
halis
Halis - 4 years ago
I think that you need a high margin of safety to buy this stock. That way if the growth prospects don't continue to pan out, you won't get hurt too bad, hopefully. Right now you would definitely be well overpaying for the stock above fair value. So you are essentially placing a bet on the company growing much larger in size and only getting a mediocre return on investment as a result.

If you bought it at fair value, then you're basically buying the idea that they can succeed at their current level in the future. But if you buy it on sale, then you'll make money if they grow larger, you'll make money if they stay flat and you hopefully don't lose too much if they trend the other direction.

Without a large margin of safety, which right now the margin of safety is well in the negative territory, you have nothing. So even if it got killed and was selling at fair value, I would wait for it to get killed again before buying. If that happened, whatever caused them to get killed might make you reconsider the whole thing altogether.

I'm not sure where this analysis really leaves us with anything to consider as an investment.
rnagarajan
Rnagarajan - 4 years ago
The process of investing involves reading about as many companies as possible, not all of which qualify as immediate buying opportunities. If you restrict yourself to looking at companies that might qualify as a buy today, you will be entirely unprepared to opportunistically act when market meltdowns serve up opportunities in the future.

I think that I quite clearly state that Tractor Supply is not cheap *today*. Anyone who has been around financial markets for any length of time understands that what holds true *today* may not hold true *tomorrow* or in a week or a month. The purpose of the article was to highlight a company that I think has an impressive track record and prospects for future growth of the *business*. Whether the *stock* represents an attractive commitment depends on the relationship between the intrinsic value of the business and the stock price.

It is a bit strange to think that the only time it makes sense to look at a company is when it is quantitatively "cheap" based on some screen, unless you want to be reactive in your investment process rather than forward looking. Personally I like to keep lists of companies that might be too expensive now but are "on deck" in case Mr. Market has a nervous breakdown, but to each his own.
augustabound
Augustabound - 4 years ago
Ravi's articles are obviously well thought out and well written and I agree that you need to research many companies, not only to find something suitable for investment, but also to stay sharp and learn.

Compare Ravi's articles to those of the Street Authority bunch............Night and day.

Notice Ravi was here to reply to your comments. I have yet to see anyone from Street Authority reply.
Hesperian
Hesperian - 4 years ago


The purpose of the article was to highlight a company that I think has an impressive track record and prospects for future growth of the *business*.

Since you agree that the company is overvalued and not a good buy at the moment, the actionable value of this article hinges on 1) you providing what you think is a good price to buy in the event of a market downturn, and 2) a good case for this outstanding future growth potential you speak of.

You do not do 1), and for 2), you seem to imply that increased access to the internet in rural communities will make significant numbers of mobile professional urbanites want to suddenly start farms on the side, which is an unsupported, highly doubtful claim.

rnagarajan
Rnagarajan - 4 years ago
@Hesperian

What I presented, within the limits of a short format article on my blog, shows a fairly clear track record of very strong *business* performance in recent years. There are reasons behind this success, even in recessionary conditions. Access to rural areas for professionals is but one such catalyst, not the totality of the story (never suggested internet access was the sole cause behind the performance).

Obviously anyone who reads the 10-K can see that management has been able to delivery very strong *business results* for many years. What *price* to pay is a different story and one an investor must determine on his own after conducting his or her own due diligence.
Hesperian
Hesperian - 4 years ago
Access to rural areas for professionals is but one such catalyst, not the totality of the story (never suggested internet access was the sole cause behind the performance).

You seem to think that it is the strongest, most likely catalyst, since it is the only one you mention, although you hint at the possibility of others.

What *price* to pay is a different story and one an investor must determine on his own after conducting his or her own due diligence.

What price did you determine is a good price to pay after conducting your own due diligence?
rnagarajan
Rnagarajan - 4 years ago
If you believe management's estimate of potential market size at roughly 1800 locations, there is the potential to roughly double the store footprint. At a pace of 75 stores per year, the build out to that level might take a bit over a decade. It is proper to view management projections of this kind with skepticism if not backed up by a strong track record. In the case of TSCO, the track record provides some reassurance that management knows what it is doing given that growth has been conservatively funded and margins have not been compressed in the process. This indicates that prior expansion has been intelligent.

The fact that the company has a small presence in Western states is reassuring when looking at expansion possibilities. Expansion possibilities in the South and Midwest could be more subject to cannibalization and margin pressure if not done well.

If you don't like the theory behind more professionals moving to rural areas, that's fine. There can be other theories behind the company's growth record in the past - but there is no doubt that the growth existed and is real - facts are facts. Will it continue into the future? That's for each investor to determine.

Taking a simple back of the envelope projection, if you assume that future stores will, on average, have roughly the same sales volume and margins once fully mature, it is not unreasonable to think that the company could more than double in size over ten years considering expansion and organic growth within existing stores. If the company can earn $8 to $10 per share by 2019, you could reasonably assume the shares might trade between $110 and $130. Then it's a matter of deciding what level of return you require when making a purchase today. Since I normally look for 12 to 15% anticipated returns, I would probably look for an entry of around $40, perhaps up to $45. The shares traded below that level for long periods last year but I had not read up on the company at that time.

Again, there is value in keeping a list of businesses that you like and setting target prices to be well positioned to take advantage when the market melts down. The specific target price will vary from investor to investor but the point is the same: If you exclude companies from analysis unless they pass a quantitative "cheapness" test, you won't be able to quickly pounce on opportunities when they arise. Looking back at the last bear market, I did not know enough about many companies that today I wish I had purchased. I don't intend to make that mistake again.
halis
Halis - 4 years ago
I also think that the company is worth about $45 per share (roughly). This is based on a simple discounted cash flow calculation, with conservative assumptions. Considering the dubious growth prospects, I probably wouldn't touch it until it traded around $25 (maybe even $22.50).

At that point, you would have such a large margin of safety that permanent loss of capital would seem highly unlikely. Unless something changes of course.

TSCO has grown a lot, they've quadrupled their revenue in 10 years! But it's a niche market and it could prove played out. Also, they have tons of competition, even in the rural market: Wal-Mart, Ace Hardware, Lowe's does build stores in semi-rural locations, I don't know if Home Depot does or not, they have freestanding Sears stores in small towns, Target is starting to go into smaller communities as well to compete head-to-head with Wal-Mart.

Don't get me wrong, they could very well continue on like this, but it's far from certain. If it got down to $30 per share right now, some people would be tempted to buy it, I wouldn't.
rnagarajan
Rnagarajan - 4 years ago
I'm not sure why the growth prospects are dubious - in fact, I've concluded the opposite. It certainly appears that the company's track record proves out the formula, particularly given the performance through the recession.

Anyway, differing opinions are what makes a market and keeps things interesting.
halis
Halis - 4 years ago
The growth prospects are dubious, to me at least, because barriers to entry are low and there is lots of entrenched competition. I actually like the story, they just built one in my town, which has only 10,000 people in it and is fairly rural.

But operating margins and net margins both have declined since 2006, which was before the recession started. I'm not saying they peaked in 2005, but there's enough doubt for me, that the concept might be worn out, that I wouldn't touch it without a margin of safety.

Believe me, you want people on here disagreeing with you or taking the opposite tack. It will prove much more useful to you than universal acceptance of your ideas.
rnagarajan
Rnagarajan - 4 years ago
From my experience in the past living in a rural area where my only choices were Home Depot or small mom & pop retailers, I would have jumped all over the Tractor Supply concept. I was initially skeptical about the niche strategy, but my investigation convinced me that they are on to something, and I think the results indicate that it works.

Margin of safety is critical in any investment. Generally it starts with a clean balance sheet and a solid operating track record. Then one must ensure that trends and forces leading to past success have not materially changed in a way that could shift industry dynamics in future years. I think that if anything the dynamics behind TSCO's growth over the past ten years will accelerate in the years to come. The price is too high for me now but this can change rapidly.
batbeer2
Batbeer2 premium member - 4 years ago
FWIW, I think there is some evidence that this is a well managed company with opportunities for growth. The fact that they stick to their niche and have an ink-stain growth strategy is good.

However, much of the price implies a continued succesfull execution of that strategy. At 3x book and say 15% ROE, these are not cheap assets.

There are many things that could (temporarily) break the trajectory. Take Walmart... they tried to transfer a great growth strategy from one US coast to another. If memory serves, it did not work out exactly as planned. Long term investors probably did well in the end..... but a few were probably disappointed along the way.

Hesperian
Hesperian - 4 years ago
If you believe management's estimate of potential market size at roughly 1800 locations, there is the potential to roughly double the store footprint. At a pace of 75 stores per year, the build out to that level might take a bit over a decade. It is proper to view management projections of this kind with skepticism if not backed up by a strong track record. In the case of TSCO, the track record provides some reassurance that management knows what it is doing given that growth has been conservatively funded and margins have not been compressed in the process. This indicates that prior expansion has been intelligent.

...Taking a simple back of the envelope projection, if you assume that future stores will, on average, have roughly the same sales volume and margins once fully mature, it is not unreasonable to think that the company could more than double in size over ten years considering expansion and organic growth within existing stores. If the company can earn $8 to $10 per share by 2019, you could reasonably assume the shares might trade between $110 and $130. Then it's a matter of deciding what level of return you require when making a purchase today. Since I normally look for 12 to 15% anticipated returns, I would probably look for an entry of around $40, perhaps up to $45. The shares traded below that level for long periods last year but I had not read up on the company at that time.


Thanks, that would have been a great addition to your initial post. I'm glad that since our discussion you emphasized that you think this company is in fact overvalued and probably not a good buy right now.

I'm surprised you didn't mention the role that tax subsidies and loopholes for "small farms" (often with a nudge and a wink) may have played in this company's growth, however. Perhaps that doesn't fit into the growth potential angle you've been aiming for, so you left it out.
rnagarajan
Rnagarajan - 4 years ago
"I'm glad that since our discussion you emphasized that you think this company is in fact overvalued and probably not a good buy right now."

I have no idea how anyone could have come to a different conclusion regarding my views after actually reading the article.

Sivaram
Sivaram - 4 years ago


Interesting stock. Couple of questions...

Any idea how the market share of Tractor Supply compares with others? I know it's hard to compare retailers but how about in the main products Tractor Supply sells?

On another note, is there a similar company in the West? If Tractor Supply is doing quite well in the Eastern US, who is providing similar products in the West? Is it the big box stores (Wal-mart, Home Depot, etc) or are there other chains like this in the west.

The way I look at it, the big risk here is the expansion strategy. We have seen many retailers trip, including powerhouses like Starbucks, when their expansion went out of control. But on the other hand, if the expansion strategy works, this stock will never get "cheap." It'll like Wal-mart in the 90's (obviously with smaller potential market.)
rnagarajan
Rnagarajan - 4 years ago
"On another note, is there a similar company in the West? If Tractor Supply is doing quite well in the Eastern US, who is providing similar products in the West? Is it the big box stores (Wal-mart, Home Depot, etc) or are there other chains like this in the west."

I don't know of anything like TSCO that has a dominant share of this concept in the West.

I happen to be from California where I owned a small piece of acreage before I moved East. It was more of a hobby farm than a business - essentially, I was TSCO's target market. This was ten years ago so maybe there is a concept like TSCO now but back in the early '00s, Home Depot, Sears (for garden tractor/supplies), and local small retailers were my main suppliers.

As I said in a previous comment, I probably would have been a regular TSCO customer but if there were any nearby locations at the time, I did not know about it, nor did I know about the TSCO concept.

This is all anecdotal and a decade old, but my two cents on the market out west.

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