07/16/2018

Tractor Supply Company NASDAQ: TSCO – An Attractively Priced Investment Idea

Below is an investment idea that was released to our clients on April 6th, 2018 from our Quarterly Focus Buy List. This list is designed to highlight 5-7 new buy ideas every quarter that are attractively priced and have a clearly identifiable short-term catalyst. Our analyst team delivers a short report on each name as well as a custom model to help our clients with fresh buy ideas that have been researched and vetted.

Overview: Tractor Supply is the largest operator of rural lifestyle retail stores in the US., focused on supplying the needs of recreational farmers and ranchers and others who enjoy the rural lifestyle, as well as tradesmen and small businesses. At December 30, 2017, TSCO operated 1,853 retail stores in 49 states (1,685 Tractor Supply and Del’s retail stores and 168 Petsense retail stores). Tractor Supply’s target customers are home, land, pet and livestock owners who generally have above average income and below average cost of living. We like Tractor Supply for the following reasons:

Unique strength in serving a differentiated customer base: TSCO’s customers choose to live in the rural area, are largely needs based, and do-it-yourself people. More than 60% of them own a full size truck, nearly 50% of them have livestock, and more than 75% own a pet. The customers are exceptionally loyal, value seasoned advice, and visit TSCO stores on average 6-12 times a year.

To best serve this unique customer base, TSCO offers unmatched products catering to the rural life style, and hires employees from customers who are knowledgeable, understand and appreciate the life style. TSCO truly incorporates itself to the local environment and its stores are usually the gathering place for the communities.

With 1700 locations in 49 states, TSCO stores are within 15 minutes drive for most of its customers and serve as a one stop shop for their needs. Despite its national footprint, TSCO offers product localization and price products on a regional basis, so it stays close to the community and compete favorably with locals. In addition, nearly 30% of its revenues are generated from exclusive products, which further help with loyalty and differentiation.

Overall, TSCO has limited competition from physical stores due to high industry fragmentation in the rural area. The nature of the products it sells, bulky items with long shipping distances, also makes TSCO better protected from Amazon and other internet only retailers. Moreover, TSCO is focused on driving omni-channel experience and operates a thriving e-commerce. By 17Q4, TSCO has achieved 22 consecutive quarters of double-digit sales growth in its online business, and Buy Online Pick Up In Store now drives 45% of its online business.

Strong track record and healthy long term prospect: In the past decade, TSCO grew sales at ~10.5% CAGR, with comparable store sales growth averaging 3.7% a year. In the same period, EBITDA margin grew from 7.8% to 11.7%. Operating 1700 Tractor Supply stores today, management targets long term store count of 2500. Based on the 80-100 annual opening rate, TSCO has a long run way ahead in terms of generating mid-high single digit sales growth from new stores. Combining that with comparable store sales growth of 3%, management believes the company can grow top line at 7-9% a year in the foreseeable future. In the mean time, operating margin should improve 20 to 60 bps from 2018 to 2021.

Catalyst: TSCO lost nearly 20% of its market value since providing FY18 outlook in late January. TSCO reported better than expected comps growth and EPS for 17Q4, but surprised market with its FY18 margin outlook. FY18 operating margin will decline by ~ 60 bps to 8.8%, due to wage investments, higher freight rates, and expenses related to the ramp up of a new distribution center in New York. In addition, the company is accelerating investments in key growth area such as e-commerce and technology, to utilize some tax savings. We believe investors over reacted to TSCO’s near term margin pressure. Assuming only 4% top line annual growth in the long term and a 50 bps improvement in operating margin in the next 4 years, TSCO shares are worth $87, representing ~40% upside. We believe management has lowered the bar enough that the company could exceed expectations relatively easily. The company could in particular surprise on the upside in Q1, because: 1) comparison is easier in 1H with comps growth in Q1 likely above the full year’s 2-3% guidance; 2) operating margin compression will be benign in 1H due to better comps leverage; 3) Easter weekend falling into Q1 could help drive more sales; 4) Inflation could become a tailwind as it has been picking up and energy prices have remained significantly above the year ago level. In 17Q4, for the first time in 17 quarters, deflation was neutral and not a drag on comps for TSCO.


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