Tractor Supply's Secret Sauce Is To Go Where Other Retailers Don't

Summary

• Tractor Supply Company has carved out a unique niche in the world of retail. Its target customers are small farmers and ranchers and those who live a rural lifestyle.
• The company operates 1,800 stores nationwide and sees opportunities to open several hundred more.
• Same-store sales and number of customer transactions per store are strong.
• Tractor Supply Company's business model is by nature e-commerce resistant, but the company has also actively built out its own omnichannel platform.
• I give my best projection of 10-year yield on cost, as well as estimated annual total returns going forward.

Investment Thesis Summary

Tractor Supply Company (NASDAQ:TSCO) ("TSC") markets itself as a "rural lifestyle retailer," which is pretty much summed up in its signature slogan: "For Life Out Here." The company's stores are located in or near small towns and rural communities, and its products are geared toward small farmers and ranchers, outdoorsmen and outdoorswomen, sports enthusiasts, and pet owners.

Herein lies the very simple secret sauce of TSC's success. It focuses on being "the most dependable supplier of basic maintenance products to farm, ranch, and rural customers." This commitment is reflected in the fact that 47% of total revenue is derived from livestock and pet consumables, followed by 22% from hardware, tools, and various truck products.

Source: 2019 Investment Community Day Presentation

While the major commercial farming and ranching operations have their own supply lines established, small farmers and ranchers and those who enjoy the country lifestyle have traditionally been underserved by corporate retailers. That's where TSC has stepped in. Areas served only by mom-and-pop stores or small farm & ranch chains, if at all, have proven to be TSC's sweet spot, increasingly relying on it for their everyday needs.

This has proven to be an incredibly strong and recession-resistant business model, delivering consistent sales and profit growth over the last two decades (and through two economic downturns).

Data by YCharts

It has also fueled massive total return outperformance for the company's shareholders over the last ten years.

Data by YCharts

Indeed, TSC's concentration on an underserved customer base and intentional marketing toward them has served the company and its shareholders well. It doesn't try to appeal to everyone but rather to kindle a strong loyalty among those to whom it does appeal.

That is the company's secret sauce, its competitive advantage, and it is the reason why TSC stock is worthy of owning - at the right price - for all kinds of investors.

The Business

TSC has around 1,800 stores nationwide, and management sees the opportunity to expand to 2,500 stores total. Texas boasts the largest store count at 196 at the end of 2018, followed by Pennsylvania at 97, Ohio at 92, and Michigan at 87. This does not count the ~180 Petsense stores, which are expected to grow by about 10-15 per year over the next few years and could reach a total of 1,000 eventually.

Like Tractor Supply stores, Petsense locations tend to be away from the city center, on the edges of suburbs, so as to target the same demographic as TSC. This helps to diminish competition from the likes of PetSmart (CHWY), Petco, Target (TGT), Walmart (WMT), Costco (COST), and other sellers of pet supplies.

As mentioned previously, sales in the livestock and pet category account for a plurality of TSC's sales. The majority of sales come from product categories in which the company specializes.

Source: 2018 Annual Report

Even if a TSC store is located near a Walmart, Lowe's (LOW), or Home Depot (HD) (as some stores are), TSC sets itself apart by offering unique and hard-to-find brands, as well as a number of products not carried by its larger retail peers.

TSC tends to hire in-store employees who themselves have farming, ranching, or outdoor work experience and adhere to the "Out Here" lifestyle. They can be of more help to customers in need of advice or explanations about various products. After all, if one is about to make a big-ticket purchase, it's always nice to have expert validation, even if it is the job of that expert to sell products.

Same-store sales were phenomenal in 2018, coming in at 5.1%. This was the best annual growth in six years.

Source: 2018 Annual Report

The average number of transactions per store has also consistently increased year over year over the last five years, though it has slowed from 3.2% in 2014 to 2.6% in 2016 to 2.2% in both 2017 and 2018.

For TSC's landlords (of which there are many, since the company leases some 93% of stores), including Spirit Realty Capital (SRC) and Agree Realty (ADC), this is a very positive sign. New stores (the real estate of which is often acquired in sale-leaseback deals from TSC's hand-picked developers) tend to be added at a steady pace, though that pace has slowed somewhat recently. From 2014-2017, sales from new stores averaged 5.75% of net sales, but in 2018 that dropped to 3.8%.

For shareholders and landlords alike, the company's strong returns on investment and relatively high margins are also a positive sign. Return on invested capital has consistently improved over the decades, though with downward swings typically leading into recessions.

Data by YCharts

Likewise, TSC boasts the second-highest profit margin of its retail peers:

Data by YCharts

Of course, calling them "peers" is a bit misleading, as they are not direct peers. Home Depot and Lowe's focus on home improvement, construction, and maintenance. Target and Walmart are general stores with limited offerings in the farm & ranch category. TSC is the only one in the group that focuses on small farmers and ranchers and the "rural lifestyle" community.

As for gross margins (net sales minus cost of goods sold), the company's 33.9% falls right in line with that of Lowe's 34.3% and Home Depot's 34.4%. And TSC's operating margin (gross margin minus operating expenses) of 9.4% falls below that of HD's 12.1% but above LOW's 7.7% or WMT's 5.2%.

Net debt-to-EBITDA is quite low at 0.58x, while net debt-to-tangible book value sits at 0.41x (or 41% of tangible book value). As the company has taken on slightly more debt to fuel growth initiatives, interest coverage has dipped but still sits at a very comfortable 37x. Yes, that's right, EBIT covers the interest expenses thirty-seven times over.

Data by YCharts

Given fixed charges of around $370 million per year and trailing 12-month EBIT of around $733 million, TSC's fixed charge coverage is still comfortable right at 2x.

Note: The company recently hired a new CEO to take over the top spot from the longstanding Greg Sandfort, who is retiring. Hal Lawton, the former President of Brand Operations for Macy's with experience also at Home Depot, eBay, and McKinsey & Co., will be the new CEO. According to Lawton's LinkedIn profile, he is married with three kids, and they are "[a]ctive participants in sports, church, community activities and charitable causes." This description strikes me as a good fit for the culture of TSC.

Beyond that, I cannot speak to the qualifications or merits of the incoming CEO.

E-Commerce Resistance

TSC's target customer niche is by nature e-commerce resistant.

Consider the logistical requirements of getting packages around the country in a short period of time (a handful of business days). The package will likely pass through a chain of warehouses and distribution facilities, from the massive storage centers to last-mile distribution sites. It will need to be delivered by a truck that probably averages around 6-9 miles per gallon.

Obviously, the most cost-effective direct-to-consumer online commerce business would focus on population centers, not rural areas. The cost of maintaining last-mile facilities to service a small, dispersed population would be prohibitive. Thus, Amazon (AMZN) and other online commerce players are unlikely to step in and compete directly with TSC, which already has its logistical network built out.

Source: 2019 Investment Community Day Presentation

What's more, if you simply take a walk through any Tractor Supply store, you'll notice that the inventory tends to be quite large. I mean physically large - and often heavy. From truck bed tool boxes to deer stands to riding lawn mowers to 50-pound bags of feed, TSC's products veer away from those that an online-only competitor would be likely to poach. The cost of shipping these straight to one's doorstep is far too high to be worth it in most cases.

Even so, TSC operates a growing omnichannel (i.e., "buy online, pick up in store") business of its own, with 70% or more of website orders fulfilled in-store (rather than delivered directly to consumers) and around 20% of in-store pickups involving additional purchases. Online sales grew 20% per year from 2016 through 2018, demonstrating that at least some of TSC's customers are tech-savvy and comfortable with e-commerce. In fact, management boasts that the company has enjoyed 27 straight quarters of double-digit online sales growth.

Source: 2019 Investment Community Day Presentation

TSC is also focusing on various methods of driving in-store traffic. Consumables such as pet and livestock food bags are a fundamental driver of traffic, but TSC has other methods, such as trailer rental, pet wash stations, PetVet clinics in 80% of its stores, and a robust rewards program (including a credit card offering 5% cash back on all TS purchases).

The rewards program ("Neighbor's Club") already boasts 12 million+ members and accounts for over 50% of sales. Club members spend 3-4x more than non-members, purchase ~25% more per transaction, and end up making ~3x more purchases. This rewards program is focused on engendering customer loyalty based on TSC's "Life Out Here" rural lifestyle theme. Plus, it allows for the use of data analytics to suggest targeted products to club members, thus generating more sales.

Retention in this program runs very high, around 90%, which speaks to its popularity among regular customers.

It appears, also, that capital spending on TSC's tech build-out is nearing (or has reached) its zenith.

Source: 2019 Investment Community Day Presentation

This means that the cost per dollar of online sales should decrease going forward, and margins should improve.

Valuation and Dividend

Using a variety of valuation metrics, it appears that TSC stock is around fair value or slightly undervalued.

The current price-to-sales (top panel below) of 1.37x is about 10% higher than the median 1.25x since the beginning of 2007. The current price-to-earnings (middle panel) of 20.5x, however, is about 10% lower than the median 22.5x over the same time period.

Data by YCharts

How about operating cash flow, or cash flow from operations (bottom panel)? The current 15.1x operating cash flow is 19% lower than the median 18x.

Putting the three together, it's difficult not to see TSC as at least slightly undervalued. A company with a proven business model and good growth prospects probably deserves higher multiples. If we assume a fair value P/E of 22.5x and give the stock five years to return to fair value, then that would add 2% per year to the total return. Add to that the 10.9% annual earnings growth expected by analysts and the 1.5% dividend yield, and we arrive at an estimated annual return of 13.4% over the next five years.

And what about that dividend? Is it safe? Is it likely to continue growing at a rapid pace?

To answer the safety question, see this chart showing annual free cash flow on top and the growing dividend on bottom. FCF has always covered the dividend comfortably, and now the payout ratio based on FCF sits at a low 39.2%.

Data by YCharts

What about 10-year target yield on cost (YoC)? As a dividend growth investor with a long time horizon until I will need to tap into my investment income stream, it matters less to me what a stock pays today than what it will pay many years from now. The 10-year YoC projection is my attempt to quantify, to the best of my ability, the amount of income that will be thrown off from an investment ten years from now.

With a five-year dividend CAGR of 20%, three-year CAGR of 16.5%, and one-year growth of 13.3%, it is clear that the dividend growth rate is slowing down. Over the medium to long term, it will likely settle around the 10.9% projected annual earnings growth rate. Let's round up and assume that dividend growth will average 11% per year over the next ten years. Given the starting yield of 1.5% based on the current share price, that dividend growth rate would result in a 10-year YoC of 4.26%.

The minimum projected 10-year YoC that I will accept is 7%, and that is for high-conviction, blue-chip core holdings. For secondary and tertiary holdings, I look for at least an 8-9% projected 10-year YoC to compensate for what I perceive as greater risk and to establish a greater margin of error / uncertainty.

As a dividend growth investment, TSC does not interest me. However, it is clearly a solid company with a proven business model, a loyal customer base, a strong balance sheet, and many growth opportunities. As a total return investment, 13%+ per year based on a fairly valued or slightly undervalued stock is quite attractive in today's richly valued market.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.