We have continued to add to our position in Tractor Supply (NASDAQ:TSCO), which was one of our top contributors in the third quarter. Over time, we have noticed that whenever we see unseasonable weather cause weakness in retail, the cries of “Amazon, Amazon, Amazon!” get louder for a period of time. As we have stated before, Amazon’s retail business has been wildly successful in building revenues (if not profits or returns on capital) over the past 20 years, and this has led them to a low-single-digit share of U.S. retail. However, the U.S. retail market is a monstrous, and growing, multi-trillion-dollar opportunity, which leaves trillions of dollars (and growing) of addressable market for everyone who is not Amazon.
As this relates to Tractor Supply, specifically, we believe that the Company has spent most of its history differentiating itself from imposing competition. Their strategy to remain relevant to their customers in the face of Amazon is a natural evolution for a company that established its value proposition around the sides of Home Depot, Lowe’s, and Wal-Mart – which, incidentally, has roughly 5-6X the domestic sales of Amazon, and which is a far more relevant competitive threat due to its size and physical proximity to Tractor. Reiterating our prior stance, we believe Tractor Supply brings stores, service, and on-the-ground inventory to an underserved, rural customer base. Weather will impact quarterly results, as it always has, and we are willing to accept these short-term disruptions. Finally, we have argued repeatedly that the stock was selling at or near recessionary valuations, and we would note that the stock bounced off of our estimate of its trough valuation on its most recent quarterly results, despite a reduction to full-year earnings guidance.
After unhelpful weather had hindered Q1, we saw a nice rebound in Q2 results, which coincided with a return to normal weather across most of the country. Revenues came in ahead of expectations, as did gross margins – in fact, gross margins turned in their best performance in six quarters – so we fail to see any sign that Amazon is encroaching on their business in terms of crippling sales or pricing pressure. Furthermore, just as we see every quarter, the Company’s “CUE” (consumable, usable, edible) category – which should be the area most susceptible to online incursion – once again turned in the Company’s strongest performance. Management did lower full-year guidance by 7% to account for the Q1 weakness, and, we believe, to build some cushion into second half expectations. We were expecting a modest guidance cut, ourselves, although we were a little disappointed with the magnitude of the cut; however, the market clearly was expecting much worse, with the stock having corrected -35% at that point from its highs in anticipation of what ended up being a 7% reduction to guidance. We believe the significant bounce in the stock since the Q2 report validates our belief that the market has been overly negative on financial expectations and valuation. We still believe that Tractor Supply can continue to grow its store base over time while generating healthy, flat to improving returns, leading to mid-to-high-single-digit revenue growth and double-digit EPS growth.
From David Rolfe (Trades, Portfolio)'s Wedgewood Partners 3rd quarter shareholder letter.
