The valuation pendulum swings back to the bulls
Tractor Supply (NASDAQ:TSCO) is a stock that I’ve been bullish and bearish on at different times in the past. The valuation tends to move wildly from one end to the other, creating opportunities on both the long and short sides. However, the company’s steady earnings growth in recent years, combined with a share price that is right where it was four years ago, has created a chance to buy. Recent results are outstanding from a revenue growth perspective, and it looks to me like it is time to give Tractor Supply another chance from the long side.
Revenue growth is the key
Year-to-date results have been very strong for Tractor Supply, after previous years had shown some slowing of growth. This year, which is three quarters old, has been an entirely different story. Total revenue is up 8.9%, thanks to 63 new Tractor Supply stores and 13 net new Petsense stores, in addition to a 4.9% comparable sales gain. That stacks on last year’s 2.2% comparable sales gain for the first nine months of the year as the company continues to create sales momentum.
Comparable sales have always been the key to the Tractor Supply story, which is why the valuation has moved so rapidly one way or the other in the past. Today, the stock isn’t pricing in the growth the company is producing on the top line. With comparable sales momentum accelerating from already-strong levels and new stores opening, I expect top line growth to average in the mid-to-high single digits for the foreseeable future.
Growing is one thing, but growing profitably is another. Tractor Supply, in the past, has struggled somewhat with creating revenue growth while preserving, let alone improving, profitability. That is still somewhat the case, but the company isn’t blindly chasing revenue growth at the expense of margins, which was the case in past years. Gross margin so far this year is flat at 34.4%, so it isn’t like profitability is suffering, but I’ll make the same point I have on Tractor Supply before. Typically, when a retailer is growing comparable sales by sizable amounts, as is the case here, it achieves some sort of leverage on expenses that boosts gross margins, even without the benefit of better pricing. For instance, rising revenue can create supply chain efficiencies, buying efficiencies, etc. However, that just never seems to happen for Tractor Supply, so expecting margin gains to drive earnings growth in the future is unreasonable. This is why I said in the open that the story really is about comparable sales; margins aren’t a growth driver, but we must keep an eye on them to ensure they don’t unwind over time.
The same story is true for SG&A costs, which also never seem to be leveraged down despite very strong top line performances. Indeed, SG&A costs are up 50bps this year as a percentage of revenue, despite the fact that revenue has grown 8.9%. That means SG&A spending continues to ramp higher, but this is what we are used to with Tractor Supply. The most recent reasons given for higher SG&A are technology and other infrastructure spending, along with higher incentive compensation. Those were partially offset by occupancy leverage, which is the product of higher comparable sales. However, there is always something driving SG&A spending, so again, margin growth is not a valid earnings growth driver for the years to come, as Tractor Supply is still very much focused on growth, not profitability. There will likely come a day when the company will have reached maturity and will focus on cutting some of its spending, but that day isn't going to occur anytime soon.
Reasons to own it
Does that mean one cannot own the stock? Surely, it does not. Indeed, Tractor Supply is doing just fine for itself, relying upon revenue growth as its primary growth driver. However, there are other reasons to potentially own the stock outside of the favorable revenue outlook.
First, the company buys back a meaningful amount of stock, reducing the float and driving EPS higher. So far this year, Tractor Supply has repurchased almost $300 million in stock, good for nearly 3% of the float, or roughly 4% annualized. That’s certainly not the largest buyback program out there, but it is a significant EPS growth driver, and in my view, takes the place of absent margin expansion. The company has made capital returns a priority, so I suspect we’ll continue to see this level of repurchases in the years to come.
Second, Tractor Supply is becoming quite the dividend growth story. The current yield is just 1.5%, so it isn’t enticing from an income perspective, but the growth in the payout has been huge. The company has raised its dividend for eight years, and its five-year annual payout growth is ~20%. Not only has growth in the payout been huge, but the current dividend represents just one-quarter of earnings, so there is an enormous amount of room for future growth. When you throw in the fact that Tractor Supply is growing earnings in the mid-teens annually, the dividend could be raised by 20-30% annually for a very long time without undue stress on the financials. Tractor Supply, then, is one of the best dividend growth stories in retail, and that is something investors should keep in mind when evaluating the stock.
Shares are trading for just 18 times next year’s earnings estimate of $4.70, which is very cheap by Tractor Supply’s own historical standards. Indeed, the valuation has crested 30 at times in the past and generally trades in the mid-20s, so 18 times earnings is quite favorable and attractive from a value perspective. I see mid-teens growth in earnings accruing from a combination of sales growth and the buyback, primarily, with margins being the big wildcard. Thus, 18 times earnings is not only attractive based on Tractor Supply’s own history but on an absolute basis as well.
Given all of this, combined with the strong dividend growth story, I think Tractor Supply is worth a look on the long side. The company serves a niche of retail that is underserved by Big Box retailers, and the formula obviously works. Store growth, comparable sales growth and the buyback should fuel double-digit EPS gains for a while to come, so Tractor Supply looks like a buy.
