Tractor Supply as a Value Play

As a loyal customer, I have been a fan of Tractor Supply Co. (TSCO, Financial) for years, but have been reluctant to purchase the stock due to its high share price currently trading at nearly 20 times earnings. I am hoping this may change in the not-so-distant future.

What makes Tractor Supply special?

With a market capitalization of $21.68 billion, Tractor Supply has had a 15-year trailing 12-month compound annual growth rate of 21.87%, outpacing the S&P 500 by 11.65%. As of the date of this writing, the stock has a highly admirable PEG ratio of less than 1 and a hefty return on equity nearing 50% that GuruFocus ranks better than 95% of companies in the retail cyclical space. GuruFocus gives Tractor Supply a 10 out of 10 on the profitability rank.

TSCO Data by GuruFocus

Focused market

The company has adhered to an unwavering strategy characterized by a niche market, customer and employee loyalty and competitive pricing since 1978. Tractor Supply serves customers who embrace a “Life Out Here” rural lifestyle; mainly small, recreational farmers and ranchers and rural enthusiasts. Stores have convenient customer-centric layouts that offer one-stop shopping for the recreational farmer. Retail planograms are consistent from store to store with discretionary items located near the fronts of the stores and essential consumable, usable and edible items such as livestock, poultry and horse feed located toward the back.

A look through history is essential to understand Tractor Supply's laser-like niche focus. The company was started in 1938 by Charles E. Schmidt as a mail-order tractor parts supplier. The first store opened in Minot, North Dakota in the following year. Due to farm consolidation patterns after World War II resulting in a reduced customer base, the company moved closer to cities and was rebranded as TSC, which stood for “Town, Suburb and Country” and broadened its range of products. That move proved to be disastrous and Tractor Supply floundered both as a private and publicly owned company until the 1980s, when Tom Hennessey and a group of investors purchased the chain through a leveraged buyout. Under Hennessey's leadership, the company changed its name back to Tractor Supply, reduced its footprint and restored its focus to its original mission and niche market. In the words of Joe Scarlett as expressed in the book, “Work Hard, Have Fun, and Make Money: The Tractor Supply Story” and reiterated in the Investment Masters Class blog post entitled, “Learning from Tractor Supply Company”:

"Our people first, the customer second, vendors third, and our communities fourth. We don't focus on the investor because if we center our energy and attention on our team members, customers, vendors, and the communities where we do business, then we're going to have good results. Wall Street will take care of itself."

Tractor Supply stayed relatively small, honing its competitive advantage until the 2010s, when it embarked on a path toward rapid expansion.

Market dominance

Currently, the company has virtually no head-to-head, publicly traded competition. The company competes with national retailers like Home Depot (HD, Financial), Walmart (WMT, Financial) and Amazon (AMZN, Financial), but none of these companies offer the same focus and depth of product merchandise in brick-and-mortar stores. Tractor Supply's main competition consists of independently owned retail farm and ranch stores, privately held regional farm store chains and farm cooperatives.

Segment analysis provides a clearer picture of the competitive climate when looking at head-to-head comparisons. Fifty percent of Tractor Supply's business is comprised of equine, livestock, pet and small animal products. Included in this product mix are bulky items like pet and livestock feed and bedding, as well pet containment items that are hard to ship and have exorbitant freight costs. Efforts by publicly traded companies that serve Tractor Supply's market pale in comparison. Petco (WOOF, Financial) and PetSmart compete for the small animal market, but Petco shares have been on a downward trajectory since it went public in 2021 and PetSmart was bought by BC Partners in 2015 for $8.7 billion and was taken private. Chewy (CHWY, Financial) has begun to offer a deeper mix of animal products, including horses and livestock feed, but its $9.11 billion market capitalization is dwarfed by Tractor Supply's market cap.

The following is a breakdown of fundamentals with other traded companies in the cyclical retail space as of Nov. 3, 2023, unless otherwise noted:

*Based on my personal screening criteria. Please note that this does not constitute investment advice.

Branding

Personally, I have made use of the company's Neighborhood Club Loyalty program and branded credit card that offers kickbacks on purchases. Tractor Supply's loyalty program represented nearly 75% of sales, and the company achieved $1 billion in private label credit card sales in 2022. I also purchase its Dumor-branded horse feed that is manufactured by Purina.

Besides Dumor, Tractor Supply has several other private-label brands, including the TSC Tractor Supply Company brand, which is visible when driving down country roads on the back of truck toolboxes. Brand names also include 4health, American Farmworks, Bit & Bridle, C.E. Schmidt, Countryline and many others.

In addition to private brands, Tractor Supply carries prominent supplier brands like Purina, Nutrena, Producer's Pride, Wrangler, DeWalt, Makita and Rust-Oleum.

In 2021, Tractor Supply partnered with Carhartt to launch a co-branded “Support the Trades” T-shirts, in which part of the proceeds were donated to SkillsUSA. The company just partnered with Yeti (YETI, Financial) to add depth to Tractor Supply's line of outdoor gear.

Capital allocation

The company purchased 81 stores from Orscheln Farm and Home in October of 2022, which are in the process of being rebranded as additional Tractor Supply stores. Tractor Supply funded the transaction primarily with cash through a sale-leaseback program to preserve cash flow and minimize the impact of debt levels and shareholder dilution. Management plans to expand its footprint to 3,000 stores nationwide, continuing this sale-leaseback program to fund future growth.

Both stores and distribution centers are strategically located. The company leases 95% of stores that are primarily located near outside major metropolitan areas and in rural communities. The chain owns eight distribution facilities that have been selected to minimize distribution costs and optimize distance to stores. Approximately 78% of merchandise to stores is supplied through this network, while other merchandise is dropped by vendors directly to store locations or to customers. This combination of store and distribution facility locations also allows the company to reap the benefits of lower square footage costs than its competitors that have stores in more heavily populated areas.

Heavy technology and infrastructure investments have allowed the company to develop management information and control systems, as well as an extensive omni-channel network to hone logistical efficiency and create enhanced customer experiences.

Tractor Supply also has a consistent history of growing dividends and share buybacks.

Pandemic explosion

Revenue surged during the pandemic for several reasons. CEO Hal Lawton, who has a background in both online and brick-and-mortar retail, was instrumental in building out the company's resource planning systems and omnichannel network. Tractor Supply was categorized as an essential business and had just begun a curbside pickup program prior to the pandemic. Furthermore, the pandemic spurred migration patterns of millennials from metropolitan to more rural areas, creating an expanded customer base.

Pet adoption grew and people began focusing on the care of their homes, land and animals. Demand grew for everyday merchandise, including consumable, usable and edible products and seasonal categories.

Customers began to raise chickens after egg prices increased 200% due to supply constraints. A more recent avian flu outbreak in 2022 has perpetuated this trend well into 2023.

Headwinds that may affect Tractor Supply's growth strategy

Tractor Supply's monumental growth is starting to revert to pre-pandemic levels. Most of the third-quarter 2023 sales increases were attributed to the company's expansion resulting from the Orscheln Farm and Home expansion. Comparative store sales and transactions were flat and comparable ticket sales declined by 0.3%.

Weather conditions drastically affect both vendor supply and customer demand. Production of ingredients used in consumable, usable and edible products is affected by shifts in crop planting dates due to temperature, draught, heavy rainfalls and the incidence of pests. Uncharacteristic weather fluctuations can affect the timing and volume of sales as customers switch to and from “Life Out Here” to indoor activities. Sales and profits are typically highest in the second and fourth fiscal quarters.

Lawton expressed concern over weather challenges affecting Tractor Supply's 2023 third-quarter performance, citing extreme heat in Texas and the Midwest. Texas comprises over 15% of sales.

Tractor Supply also faces challenges in maintaining its growth strategy in a softening economy.

Equine and recreational livestock markets are not as resilient as the small pet market during tough economic times. These pursuits are capital and time-consuming endeavors. For those reasons, horse and livestock owners are more likely to buy and sell animals, unlike small pet owners who consider their animals as members of the family and typically keep their animals for life. Animal lovers will continue purchasing feed and supplies through a recession, but are likely to reduce spending on discretionary items.

Additionally, 2022 gross margins were squeezed by a shift away from non-essential items and toward consumable, usable and edible products. That trend will likely continue with pressing inflation and higher interest rates. Although margins continue to grow steadily, they are average when compared to other cyclical retailers.

Finally, higher interest rates will increase Tractor Supply's cost of capital and may further suppress gross margins. Tractor Supply's debt-equity ratio is ranked by GuruFocus as 88.07% worse than its peers. Furthermore, cash on hand for 2022 represented a 76.94% decline from that in 2021. These characteristics present hurdles to the company's continued growth strategy and may make for a less loved stock price during 2024.

Debt, which increased by $742.6 million last year, may be a cause for concern. As of this writing, the company's debt-to-equity ratio exceeds 2.0 and its quick ratio is less than 0.4. Ideally, I would like to see a debt-to-equity ratio of 1 or less and a quick ratio of greater than 1. On the other hand, Tractor Supply's metrics for these ratios is higher than industry averages. Furthermore, the company does not have short-term debt, so should be able to meet its obligations to carry it through a market correction or a recession.

The company's recent share performance has shown signs of a weakening economy. Shares have fallen to less than $200 per share for the first time since October 2022.

Future value

Successful stewardship depends on Tractor Supply's ability to pivot in a turbulent environment if needed. Several directors serve on the audit committee and could redirect the growth strategy to a capital allocation strategy if needed. The company's current ratio and interest coverage are sufficient to keep the company healthy during a recession and its sale-leaseback buyback plans should help it control debt and cash flow levels in a softening economy.

This will be a great stock to add to a portfolio if the share price recedes without much deterioration in value in the future. As a hopeful value investor, I plan on picking up this stock if it falls within the $180 to $190 share price range.