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Tractor Supply's Long-Term Earnings Growth Tempered by Investments to Improve Market LeadershipTractor Supply's Long-Term Earnings Growth Tempered by Investments to Improve Market Leadership Jaime M. Katz Senior Equity Analyst Business Strategy and Outlook | by Jaime M. Katz Updated Oct 26, 2020 Tractor Supply is the largest consumer farm specialty retailer in the United States, set to capture more than $10 billion in annual sales in 2020. The firm has differentiated itself through its products and customer demographics, which provide underlying support to its brand intangible assets and a narrow economic moat. The store base has grown about 40% over the past five years, to about 1,900 locations (2,087 including Petsense), driving sales and EPS compound annual growth rates over the past three years of 7% and 13%, respectively. We forecast that the firm will grow to around 2,900 stores over the next decade as it populates big-box centers in the western half of the U.S., with Petsense accounting for about 430 locations. The firm competes with big-box retailers like PetSmart and Lowe's, which also have solid pricing power because of scale and distribution advantages across numerous categories. That said, we believe Tractor Supply derives its success from its customer-centric store layout, which makes it a destination store for many of its customers. In addition, since Tractor Supply focuses on an active do-it-yourself rural consumer, many of its products are higher-end than those found in retailers that focus on a casual consumer. We believe that Tractor Supply has reached critical mass in its consumer segment, which should facilitate consistent operating margin expansion helped by corporate development across arenas, including utilizing better customer attribution data, improved bargaining with vendors, and more sophisticated logistics. Such efforts can boost operating margins meaningfully, as seen in results at both Home Depot and Lowe’s in the past. Despite the strides made, investments to improve the Tractor experience (via side-lot expansion in garden and project fusion investments to increase productivity) could constrain near-term operating margin expansion. However, over time, improved gross margin results from strong private-label penetration and better merchandising could outpace operating expense growth, leading to operating margins that rise more than 10 basis points on average annually, from 9% in 2019. Economic Moat | by Jaime M. Katz Updated Oct 26, 2020 Tractor Supply’s brand and product mix have built a loyal following of recreational farmers, ranchers, and those participating in the rural lifestyle, supporting a narrow moat built on a solid brand intangible asset. The niche product offerings place Tractor Supply in a unique position, insulated from peers that focus on one segment of the market--Tractor Supply’s breadth across categories (equine, livestock, pet and small animal products; hardware, truck, towing and tool products; seasonal products; work/recreational clothing and footwear; and maintenance products) provides a one-stop solution (and destination) for those looking to fill multiple needs across outdoor categories. We believe the business’ ability to cater to a more recreational outdoor hobbyist lends the business to higher income demographics, and less revenue cyclicality. It has been estimated in the past that less than 10% of customers are classified as full-time farmers and ranchers, and the largest customer segment does not farm at all. And while hobby farmer consumers generate more than $17 billion annually in revenue for farm supply stores (IBISWorld), farm supply products represent only a portion of Tractor Supply’s merchandise selection, implying room for growth--seasonal and parts of other categories not directly tied to farming alone constitute at least 25% of sales in our estimation. Additionally, with a estimated 10% market share of Tractor Supply's $110 billion total addressable market (according to the company), we still see a robust opportunity for market share gains, and adjacent cateogry expansion (which it is currently pursuing in adding garden/outdoor to its offerings). In our opinion, Tractor's generally resilient consumer base allows for more consistent revenue growth through both expanded footprint and price increases, which are indicated by modestly improving gross margins ahead. We suspect gross margin improvement can come from multiple sources (better product offerings, more seasonal, more private label, price management initiatives), which should be sustainable or improved upon longer term. We believe Tractor Supply is somewhat insulated from competitive pricing pressure from Home Depot and Lowe’s in overlapping product categories, due to the company’s focus on rural presence, versus its competitors more urban/suburban focus. With private label/exclusive brands becoming a more important part of sales (31% of 2019 revenue), and having a disparate positive impact on gross margins by a few hundred basis points at least, the upward trend should be reasonable to achieve, particularly as consumers become more tied to these specific brands which are solely distributed at Tractor Supply. Private label is meaningful among the consumable, usable, and edible products the company sells and includes key products that customers use on a regular basis--making those end users become repeat customers--like pet food, seasonal products, livestock feed, and pest control. The increased emphasis on immediate-need, or CUE, products (which we estimate to represent 40%-50% of sales) could tick gross margins higher on a sustainable basis, indicating the company’s pricing power and the strength of its brand. While some CUE products generate lower merchandise margins, the increased frequency of consumer visits drives adjacent product sales with higher margins. Additionally, Tractor Supply should be able to raise gross margins as it increases its scale in multiple categories. More important, the management team is developing the business to continue to succeed. Solid focus on culture (specifically, the continuous improvement that was previously highlighted in the Tractor Value System program) and the business holistically (Team, Sales, Customer and Execution) gives the company good footing to resonate with its consumers going forward. TVS was launched in 2006 in order to reduce waste, cost, and improve efficiencies throughout the organization. Ultimately, this process identifies areas that need improvement, which eventually leads to innovation and shorter lead times as new processes are implemented. This expedites newer product in the channel with better technological features, allowing for consistent price increases. The launch of TSC&E was all about cultivating a lean environment without sacrificing quality of merchandise or customer service. Building a team from the customer base, and rewarding employees based on success helps develop the right leader to take the business forward. Efforts like the OneTractor initiative, increasing customer engagement through digital technology (including stockyard kiosks), better CRM, GURA (greet, understand, recommend, ask), growth of the Neighbor's Club loyalty program, and expanded supply chain capabilities in order to better serve customers, caters to the evolving consumer landscape, helping to ensure the company's brand intangible asset remains intact. A recently enhanced focus on accessibilty, including curbside pickup, same- and next-day delivery, and a easy to use app have created further opportunities to connect with the customer base during the social distancing period of COVID-19. Overall, all of these points have helped Tractor Supply deliver average adjusted returns on invested capital excluding goodwill of 17% during the past five years. We believe this metric should rise to 19% in fiscal 2029, as current investments slow and begin to pay off (versus our cost of capital assumption of 9%.) We still think the familiarity of the brand and improving knowledge levels of the employee base keeps the business in the forefront of consumers' minds as the premier choice for outdoor hobby and pet needs. We are confident that the brand intangible asset will continue to be relevant and will benefit Tractor Supply for at least another 10 years, as we find it difficult to believe any new entrant would be able to enter the market with scale across the numerous categories the company has operated in retailing. While we think new competitors could enter through the e-commerce channel, in our opinion they would be limited to operating in few and particular categories because of the prohibitive shipping costs numerous products entail. Additionally, shipping in general is more expensive in rural areas, where households are farther apart and delivery routes are longer. Fair Value and Profit Drivers | by Jaime M. Katz Updated Oct 26, 2020 We are maintaining our $109 fair value estimate after incorporating third-quarter results that delivered revenue growth of 31% and same-store sales of 37%, as the firm benefited from its focus on the socially distant outdoor lifestyle, as well as the boom in pet adoptions. These gains were largely offset by more tepid long-term guidance that included sales growth of 6%-7% (versus 7%-9% prior), comps of 4%-5% (above 3% prior), an operating margin of 9%-9.5%, and long-term EPS growth of 8%-10% (down from low double digits). Our fair value estimate implies a 2021 price/earnings ratio of 16 times and an enterprise value/EBITDA multiple of 11 times. This is versus a five-year historical P/E based on fair value of 23 times and an EV/EBITDA multiple of 13 times and a forecast for low-double-digit earnings growth on average over our outlook. Despite that some of the categories that Tractor Supply operates in are relatively mature, we view the breadth of its offerings and potential for growth of its current consumer base as well as increased penetration of new consumers as positive factors that could drive top-line growth. We project that total sales can grow at an average of 9% over the next five years (driven by 25% expected growth in 2020) supported by mid-single-digit comparable-store sales (5%, resulting from 22% estimated comps in 2020) and low-single-digit square footage growth. We forecast gross margins to rise moderately over the next decade (by roughly 130 basis points, to 35.7%), constrained by our belief that e-commerce retailers can compete in about 30% of the sales areas Tractor Supply operates within. We forecast the selling, general, and administrative expense ratio to leverage 20 basis points to 22.9% from 2019 results as the business continues to invest to maintain its leadership position in the outdoor enthusiast segment. The company's updated three- to five-year goals imply that only modest expansion is ahead from the 8.9% it delivered in 2019 (our forecasts are for nearly 9.6% in 2021 and 2022). Our model assumes margin expansion of more than 10 basis points annually over the next decade, helped by more consistent improvements later in our forecast. After the post-COVID-19 period normalizes (2022), we project a rising high-teens return on invested capital rate versus our 9% cost of capital assumption, providing support for our narrow economic moat view. Risk and Uncertainty | by Jaime M. Katz Updated Oct 26, 2020 We've assigned Tractor Supply a medium uncertainty rating despite operating in a cyclical retail environment in which consumers' spending habits in large part drive sales. Tractor Supply’s target demographic is fairly affluent, which helps insulate the firm somewhat during a recession (generating same-store sales of 1% in 2008, negative 1% in 2009, and set for 22% in 2020). While we believe some segments of the business could be swayed by weather (lawn and garden, heating) or the performance of the housing market (clothing, tools), we think sales from the CUE product categories, including pet food, livestock, and equine categories, will offer stability in the revenue cycle and continue to bolster 2020 sales despite COVID-19. In markets and product categories that Tractor Supply overlaps with other big-box retailers (Home Depot, Lowe’s, PetSmart, Walmart), we think the company could be forced to be a price taker, which could weigh on local profits. Additionally, there are no barriers to entry to prevent new competitors from operating in any of the firm’s markets, although with numerous sizable operators (Home Depot, Walmart) already in many markets, we’d find it difficult to see how a smaller, less nimble business would be able to offer similar product prices, as it probably would not have vendor relationships of the same strength. With our forecast for nearly 2,500 Tractor Supply and around 430 Petsense stores over the next decade, the firm risks oversaturation and cannibalization of sales in established locations, however, we expect some localized merchandise selection could prevent this. We still believe risk lies in competition from the e-commerce channel, particularly in categories that have been commodified. The biggest risk, in our opinion, is a slowdown in domestic economic growth, which could lead to declines in home sales pricing, higher unemployment, or slowing income growth levels. We continue to track COVID-19's impact on these metrics. Stewardship | by Jaime M. Katz Updated Oct 26, 2020 Tractor Supply’s management has proved to be an Exemplary steward of shareholder capital, in our view. In January 2020, former president of Macy’s, Hal Lawton, became CEO of Tractor Supply. We surmise Lawton was chosen for the role due to his wide expertise across retailing, most recently directing merchandising, marketing, stores, operations, and more at Macy’s. More importantly, his extensive e-commerce experience, with both narrow-moat eBay and wide-moat Home Depot, could help Tractor Supply better monetize its omnichannel presence. Prior CEO Greg Sandfort will temporarily stay on as a strategic advisor to ensure a smooth management transition. In 2019, prior CEO Greg Sandfort was given about $8.7 million in total compensation, with a significant portion (more than 65%) in stock and option awards as well as in healthcare and retirement plan payments. Lawton's base salary of $1.125 million isn't materially different than the $1.25 million Sandfort received in 2019. We believe executive compensation is reasonable, given the company's positioning and history of operating results and returns. Furthermore, the mix of base salary, annual or short-term incentives, and long-term incentives that reward company and individual performance generally ties in well to the long-term creation of shareholder value. Although executive officers and directors in aggregate own less than 2% of Tractor Supply's common stock as of the most recent proxy, we believe the absolute dollars invested are enough to align their interests with shareholders'. Board members are also expected to hold shares of the company with a market value equal or greater than 5 times the director’s annual cash retainer within five years, aligning the board’s interest with shareholders as well. The board of directors is sufficiently independent, with eight of the nine members up for election in 2020 from outside the organization, and we like that the members are up for re-election annually. The top two shareholders controlled 19% of shares according to the most recent proxy, which could sway the outcome of issues to be voted upon. The solid ROICs that the management team has delivered (17% average annually over the past five years) indicate to us that the team is investing in value-added initiatives, which we expect to persist. We like that the company is forward-looking and made changes to its capital structure in anticipation of improved performance ahead--for example, an increase in common stock availability (from 200 million units to 400 million units in 2014) offers Tractor Supply flexibility in its capital structure to issue shares for future stock dividends and splits, acquisitions, capital-raising transactions consisting of equity or convertible debt, equity-based incentive plans, and for other general corporate purposes. The capital-allocation strategy remains well rounded, split between investing for growth and returning cash to shareholders through dividends (payout target of 30%) and share repurchases. |
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