Tractor Supply Company: Still Too Expensive
- There's much to like about the company's financial performance in 2021. The fact that management has increased the payout ratio to 40% is also intriguing.
- The problem is the stock. The shares are priced too richly in my view, so I must continue to avoid them.
- Thankfully the options market allows investors to generate very decent premia on deep out of the money puts.
Since I put out my cautious piece on Tractor Supply Company Inc. (NASDAQ:TSCO), the shares are up about 67% against a gain of about 40.5% for the S&P 500. Much has happened since, so I thought I'd check back in to see if it makes sense to buy or not. I'll make that determination by looking at the most recent financial history here and by looking at the stock as a thing distinct from the underlying business. I want to try to work out the sustainability of the dividend in particular. I’m also going to look at the stock as a thing distinct from the underlying business, because a great company can be a terrible investment if you overpay for it. Finally, I want to remind investors about the short Tractor Supply puts that just expired for a few reasons. First, it gives me an opportunity to brag, which is really what this enterprise is about. Second, it demonstrates, yet again, that it’s possible to earn decent returns at much lower risk.
Welcome, dear readers, to the "thesis statement" paragraph. It's here where I offer to you the highlights of the following article, so you can then decide whether you want to read the entire piece. I do this as a public service for those people who consider my writing to be “a bit much.” In my view, Tractor Supply is a great business, and I think the higher payout dividend is actually reasonably well covered. The problem is the valuation. It remains quite high in my estimation. Thankfully it’s possible to earn a decent return by selling deep out of the money puts here, which is what I’m doing, and recommending. If you’re comfortable with short puts, I would recommend mine or a similar trade. If you’re not, I would recommend avoiding this name until the price comes down to a more reasonable level. I did well selling options that just recently expired, and I think it’s possible to repeat that performance.
During 2021, the company increased its store count by about 3.6% (from 2,105 to 2,181), and it shows. Revenue for the year was about 20% greater than it was in 2020, and net income was up an eye popping 33%. In case you’re worried that comparisons to 2020 are invalid, I’d point out that 2021 looks even better when compared to 2019. In 2021, revenue was ~52% higher than it was in 2019, and net income was about 77% higher. Management was obviously in the mood to reward shareholders well, as evidenced by the enormous uptick in dividends per share from 2020 to 2021. I’d like to see debt drop further, but that’s the only financial criticism that can be leveled at this business in my view.
Financial History is interesting, to me at least, but investors care more about the future for obvious reasons. One of the things that affects the future of any stock is the sustainability (or not) of a given dividend. For that reason, I want to spend some time trying to explore the chance that the dividend will be raised again, kept level, or cut.
When I review the sustainability of a dividend, I remove my “accrual accounting” hat, and don my “cash is king” hat, because I think dividends are all about cash, and cash flow generating capacity. I like to compare the size and timing of future contractual obligations to current and likely future sources of cash. First, the obligations. I’ve taken the liberty of trying to make your lives even easier by replicating the following from page 69 of the latest 10-K. These are only the leases because the company has $650 million of debt due in 2030, and $150 million of debt due in 2029. Thus, the long term debt is not relevant as it doesn’t impose a near term call on cash.
We see from the above that the company has contractual obligations of about $423.6 million this year, and just over $411 million next year.
Against these obligations, the company currently has about $878 million in cash. Additionally, they’ve generated an average of approximately $1.11 billion in cash from operations over the past three years. At the same time, they spent an average of $378 million in CFI.
The company spent about $239 million on dividend payments in 2021, relative to the $997 million of net income they earned. That works out to about 24%. Note that the company will be raising its payout ratio dramatically to 40%, per the latest earnings call. That is a huge increase, as holding all else constant, that works out to an annual dividend commitment of $399 million, but even that figure is sustainable in my view.
All of the above suggests to me that the dividend is well covered, and there may actually be some room for an increase. I’d be very happy to buy back in at the right price.
Welcome to the “disqualify otherwise great businesses because their stocks are too expensive” portion of the article, dear readers. The fact is that a great company like Tractor Supply can be a terrible investment if you overpay for it. This is why I insist on buying cheap. Rather than try to prove my point abstractly, I’ll use shares of Tractor Supply itself to demonstrate my point. A person who bought these shares January 24 is down about 5.5%. The person who bought one month later is actually up about 7.3%. Not much happened at the company in that short time, so this 12.8% swing in returns is entirely dependent on price paid. The investor who bought this stock relatively cheaply did better. This is why I try to avoid overpaying for a stock and insist on buying cheap.
I measure the cheapness (or not) of a stock in a few ways, ranging from the simple to the more complex. On the simple side, I look at the ratio of price to some measure of economic value like sales, earnings, free cash flow, and the like. Ideally, I want to see a stock trading at a discount to both its own history and the overall market. In my previous missive, I droned on about the fact that the shares were trading at a PE north of 26 and the price to free cash flow was a whopping 21.5. Things still look quite expensive in my view, per the chart below. The price to free cash flow measure in particular is very near an all time high.
In addition to simple ratios, I want to try to understand what the market is currently "assuming" about the future of this company. In order to do this, I turn to the work of Professor Stephen Penman and his great book that I can't recommend highly enough "Accounting for Value." In this book, Penman walks investors through how they can apply the magic of high school algebra to a standard finance formula in order to work out what the market is "thinking" about a given company's future growth. This involves isolating the "g" (growth) variable in a fairly standard finance formula. Applying this approach to Tractor Supply at the moment suggests the market is assuming that this company will grow at about 5.6% over the long term. This is a fairly optimistic forecast in my view. Taking all of the above into account, I'm not willing to buy back in at current prices.
Options As An Alternative
In my previous missive on this name, I recommended selling the January 2022 puts with a strike of $75 for $3.90 each. So, although I didn’t participate in the upside from the stock, I earned a very decent, low risk return, and the whiskey acquisition fund expanded by $3,900 as a result.
Before getting into the specifics, I should remind the good readers why I consider short puts to be "win-win" trades. If the share price remains above the strike price, I'll simply pocket the premium, which is a great result. If the shares fall, I may be obliged to buy, but will do so at a very attractive price, one that is superior to the current market price. This is also a "win" in my view. Hence, "win-win."
In terms of specifics, my preferred short put here is the January 2023 $120s. These are currently bid at $2.30, which I consider to be a reasonable return for tying up capital for eleven months. If the share price remains above $120 over the next half year, I'll simply add these premia to the pile. If the shares fall 41.5% from here, the shares may be put to me. Holding all else constant, the net price at which the shares would be put to be would be $117.30. At that price, the dividend rises to over 3%, which I consider to be reasonable.
I hope you're downright electrified by the prospect of finding a "win-win" trade, because we now come to the part of the article where I get to spoil the mood by writing about risk. The reality is that every investment comes with risk, and short puts are no exception. Short puts can be risky, if you write them on shares you don’t want to own, or write them at strike prices that are too high. Thus, what I describe as “win-win” short puts are only a select subset of all short put options. These are “win-win” only when they are written on stocks you want to own, at strike prices where you’d be happy to buy.
In my view, investors who write “win-win” short puts take on risk, but they take on less risk (sometimes significantly less risk) than stock buyers in a critical way. Short put writers generate income simply for taking on the obligation to buy a business that they like at a price that they find attractive. This circumstance is objectively better than simply taking the prevailing market price. This is why I consider the risks of selling puts on a given day to be far lower than the risks associated with simply buying the stock on that day.
I'll conclude this rather drawn out and ponderous discussion of risks by looking again at the specifics of the trade I'm recommending. If Tractor Supply shares remain above $120 over the next eleven months, I'll simply pocket the premium and move on. If the shares fall fairly massively in price, I'll be obliged to buy, but will do so at a net price more than 40% lower than the current market price. Both outcomes are very acceptable in my view, so I consider this trade to be the definition of "risk reducing." You may think me strange to conclude a discussion of risk by writing about the risk reducing potential of put options. Yep. It’s true. I can be strange sometimes. Try to contain your shock.
There’s much to like here, obviously. For one thing, the company is growing very nicely in the “age of Amazon.” At the same time, even the expanded dividend is reasonably well covered in my estimation. The problem is the fact that the shares are quite expensive in my view. The returns an investor enjoys is largely a function of price paid, and the price on offer is too dear at the moment in my view. Thankfully, the options market presents yet another opportunity for us to earn a decent return while obliging ourselves to buy this wonderful business at an even more wonderful price. If you’re comfortable with short put options, I would recommend this or a similar trade. If you’re not, I’d remind you of the importance of preserving capital and, would suggest that you hold off here until the price falls to more closely line up with value.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of TSCO either through stock ownership, options, or other derivatives. 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.
I just sold 10 of the puts described in this article for $2.30 each.
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