Tractor Supply - Great Business, But Despite Sell-Off, No Great Investment Opportunity

| About: Tractor Supply (TSCO)


Tractor Supply disappoints investors again, issues a modest profit warning for the year.

The company's performance is a bit disappointing, but the track record, current growth and strategy remain solid.

The problem is the run-away momentum over the past few year's which creates little appeal despite this year's sell-off.

Investors in Tractor Supply (NASDAQ:TSCO) are witnessing a renewed disappointment after the company essentially gave a profit warning for the second quarter and full-year results.

While I appreciate the company's strong niche position, the solid strategy and focus on creating shareholder value, the momentum over the past few years has pushed the valuation up too far. I remain on the sidelines for now, not seeing a compelling short or long opportunity.

Preliminary Second Quarter Highlights

Tractor Supply reported preliminary second quarter sales of $1.58 billion, which is up 8.8% compared to the year before. Consensus estimates for sales stood at $1.60 billion so far.

Second quarter earnings are seen between $0.94 and $0.95 per diluted share. In comparison, Tractor Supply reported earnings of $0.87 per share in the second quarter of last year. Analysts expected the company to report earnings of $1.01 per share.

Looking Into The Disappointing Developments

The disappointing topline sales results are the result of the slowing comparable store sales results, which came in at just 1.9% versus 7.2% in the comparable period last year.

As one of the few retailers, Tractor Supply actually cited solid traffic growth while it saw strength in consumable, usable and edible products as well. This was offset by headwinds caused by sales of some seasonal products, softness in the safe category and deflation in some items.

The company stresses that sales trends improved throughout the quarter, as the weather became less of a factor. Gross margins are seen flat compared to the year before despite higher transportation costs and higher promotional activity. This was offset by deflation in some categories and initiatives taken by the company.

Tractor Supply notes that slower than anticipated comparable store sales results in an increase in selling, general & administrative expenses as a percentage of sales. This explains the larger shortfall in guided earnings versus expectations despite the slight sales miss.

Warning For The Full Year Outlook

As a result of the soft second quarter, Tractor Supply sees its full year results coming in at the low end of the previous full year guidance.

The company previously guided for sales of $5.62 billion to $5.70 billion based on comparable sales growth of 2.5% to 4%. Earnings per share were seen between $2.54 and $2.62 at the time, as the company will update the full year outlook when releasing its definitive second quarter results which are scheduled on the 23rd of July.

Recent Investor Presentation

For those not so familiar with Tractor Supply, I urge you to read the investor presentation held on the William Blair stock conference.

The company is a supplier of basic maintenance products to farm, ranch and rural customers. It operates 1,331 stores across 48 states supplying the needs of recreational farmers, small businesses and ranchers. This is a loyal and growing customer base looking for livestock & pet products, hardware, tools, gifts, clothing and other agricultural products.

The company has an excellent track record of growing comparable sales at mid-single digit rates over the past few years. It even managed to report comparable store sales growth in the difficult 2008. This was accompanied by solid and impressive operating margin expansion, which combined resulted in rapid EPS growth.

Key focus areas for the company includes the CRM program to learn more about its customers and leverage that information to drive sales going forward. Ongoing margin expansion is targeted through a combination of price management, a focus on exclusive brands, inventory management and strategic sourcing. Expenses are kept a tight lid on through its central value system, centralized purchasing, and central energy management.

All of this combined should allow the company to achieve its long-term targets of 8% square footage growth, 3%-5% same store sales growth and an annual operating margin expansion of 25 basis points.

Combined, this should result in earnings per share growth in the mid-teens. This target is a big challenge and is unlikely to be achieved this year.

Valuing Tractor Supply

Back in April, Tractor Supply released its first quarter results. The company ended the quarter with $47.8 million in cash and just $81.2 million in debt, resulting in a very modest net debt position.

On a trailing basis, the company posted sales of $5.26 billion on which it net earned $333 million. Trading around $57 per share, investors are valuing the niche player's equity at $8.0 billion. This is equivalent to a valuation of 1.5 times revenues and 24 times earnings.

The company's modest $0.16 per share quarterly dividend provides investors with a dividend yield of 1.1%.

Historical Performance And Future Outlook

Over the past decade, investors in Tractor Supply have seen great returns. Shares have steadily run up from levels around $10 in 2009 to highs of $80 around the turn of this year. Ever since, shares have fallen by about 30% to levels in the high fifties.

Of course, the huge returns have been driven by solid growth with revenues tripling in the period 2004-2013 to little over $5 billion. As a result of operating margin expansion from levels around 6% to 10% at the moment, earnings have five-folded. More impressive, the company has been able to reduce its outstanding shareholder base by about 10%-15% over this time period.

More repurchases are anticipated as sales growth is slowing down. Earlier this year, the board authorized the repurchase of up to $2 billion in its own shares going forward, sufficient to retire a quarter of the total outstanding share base. The not so impressive dividend comes on top of the sizable share repurchases. While the current yield is relatively low, the company has grown its dividend rapidly after initiating its first dividend back in 2010.

The long-term guidance is comforting to investors, even if the results fail to meet the long-term ambitious targets.

Final Takeaway

Tractor Supply has a great track record, a solid strategy and operates in a niche segment, resulting in good prospects for the firm. That being said, investors have pushed up the valuation way too much in recent years. Even after a 30% correction, shares still trade at 24 times projected earnings for this year, based on the premise of double-digit earnings per share growth going forwards.

Even after the correction, the risks for the short-to-medium term remain towards the downside, in my opinion, as the current risk-reward trade-off is not too attractive.

This picture changes dramatically of course when considering the very long term, as the solid strategy and continued growth make it an industry winner in a "shielded" and niche industry.

Let's peg a 20 times earnings multiple as an attractive multiple given the future plans and the track record, which would imply a small premium to the overall market. In my view, this is warranted and would translate into a potential entry point around $50 per share.

At those levels, I would be happy to start building a modest position in the shares. For those speculating on a further correction to the downside after 2014's downwards momentum, I would exercise caution, given the big run for the shorts already.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.