Analyst Note| by Jaime M. KatzUpdated Jan 27, 2022
We plan to raise our $141 valuation for narrow-moat Tractor Supply by 15%-20% after incorporating better-than-expected fourth-quarter results and a higher long-term outlook into our model. However, we still view the shares as rich, trading more than 30% above our updated intrinsic value and at 23 times the midpoint of the firm’s 2022 EPS outlook. Fourth-quarter comps of 12.7% (40% 2-year stack) were ahead of our 8% estimate, leading to 15% sales growth (to $3.3 billion). Both comp ticket and transaction growth were healthy, up 10.3% and 2.4%, respectively, although 850 basis points of lift in ticket stemmed from inflation. The operating margin of 8.8% was a mere 10 basis points ahead of our forecast, as expense leverage was largely offset by inflation and mix. Fourth-quarter performance, the time value of money, and a lower long-term tax rate outlook should account for around half of our fair value lift. For reference, we reduced our tax rate estimate to 23% from 27% as we now view a U.S. hike as unlikely.
The other half of our fair value hike stems from updated long-term metrics, as Tractor Supply lifted its long-term expectations for the business. The firm now calls for an operating margin of 10.1%-10.3%, up from its prior forecast of 9%-9.5%. Given the potential profit upside of both the side lot expansion and store remodeling efforts, we already had the last five years of our decade-long explicit forecast in this range. We now plan to lift the near-term profit metrics, which were in the high 9% range, even closer to the updated target, as 2022 is already set to achieve a 10%-plus operating margin. Additionally, we plan to nudge our long-term revenue forecast toward the 6%-7% range offered, which is in line with our 6% sales growth outlook for the next five years but modestly higher than the 5% we have called for in the latter portion of our outlook, as location growth helps boost a higher top line (with a target of 2,700 boxes, up from 2,500 prior).
Business Strategy and Outlook| by Jaime M. KatzUpdated Jan 27, 2022
Tractor Supply is the largest consumer farm specialty retailer in the United States, set to achieve more than $13 billion in annual sales in 2022. 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. At the end of 2021, the store base had grown about 26% over the prior five-year period, to more than 2,000 locations (around 2,200 including Petsense), driving sales and EPS compound annual growth rates over the past three years of 17% and 26%, respectively. We forecast that the firm will grow to around 2,900 stores by 2031 as it populates big-box centers in the western half of the U.S., with Petsense accounting for about 280 units.
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 evolving customer-led 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 the firm has reached critical mass in its consumer segment, and better efficiency gains ahead from category expansions like side lot and store updates under project fusion should help elevate the sales and profit growth opportunity set. Better customer attribution data, improved bargaining power with vendors, and more sophisticated logistics should also improve inventory levels and cash conversion. Additionally, stable gross margins thanks to strong private-label penetration and operating cost leverage from scale should help operating margins remain over 10% throughout our forecast. Despite the strides made, investments to improve the Tractor experience could limit near-term operating margin upside; capital expenditures will likely remain elevated over the medium term as the firm invests to support growth.
Economic Moat| by Jaime M. KatzUpdated Jan 27, 2022
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; maintenance products; and now extending into outdoor/garden) 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 $23 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 the outdoor lifestyle/farming alone constitute 20%-25% of sales, in our estimation. Additionally, with Tractor Supply's estimated 7% share of a $180 billion total addressable market (according to the company), we still see a robust opportunity for market share gains and adjacent category expansion (as noted earlier via the pursuit of garden/outdoor revenue).
In our opinion, Tractor Supply's generally resilient consumer base allows for more consistent revenue growth through both expanded footprint and category exposure, which are indicated by modestly improving gross margins over the long term. 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. This ultimately, will be returned to customers via way of everday low pricing, which should help shoppers stay sticky. 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.
If private label/exclusive brands become a more important part of sales (29% of 2021 revenue) and have 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 that 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 support stable gross margins as it increases its scale in multiple categories.
More important, the management team continuously develops the business for success. 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, which has now graduated to Project Fusion) 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. Furthermore, Project Fusion, a space productivity program, was initiated to enhance the customer experience across the store base, encouraging customers to make repeat visits. Previous 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 accessibility, 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 including goodwill of 16.3% during the past five years. We believe this metric should be 17% in fiscal 2031, 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. KatzUpdated Jan 27, 2022
We are raising our fair value estimate per share to $168 from $141 after incorporating better than expected fourth quarter results and a higher long-term outlook into our model. Fourth quarter comps of 12.7% (40% 2-year stack) were ahead of our 8% estimate, leading to 15% sales growth (to $3.3 billion). The operating margin of 8.8% was 10 basis points ahead of our forecast, as expense leverage was largely offset by inflation and mix. Fourth quarter performance, time value of money, and a lower long-term tax rate outlook accounts for around half of our fair value lift. For reference, we reduced our tax rate to 23% from 27% as we now view a U.S. hike as unlikely.
The other half of our fair value hike stems from updated long-term metrics, we think Tractor Supply should benefit from a longer-lived opportunity set . The firm now calls for an operating margin of 10.1%-10.3%, up from its prior forecast of 9%-9.5%. Our model calls for average sales growth of 6%, comps of 4%, and operating margin of 10.6% over the next decade. Our fair value estimate implies a 2022 price/earnings ratio of 18 times and an enterprise value/EBITDA multiple of 11 times.
We view the expanding breadth of its offerings (side lot repositioning to include lawn and garden), potential for growth of its current consumer base, and increased penetration of new consumers as positive factors that could drive top-line growth. Over the medium term (next five years) we project that total sales can grow at an average of 7%, supported by 4% comparable-store sales and about 3% average square footage growth. We forecast gross margins to rise moderately over the next decade (by 30 basis points, to 35.5%), constrained by our belief that e-commerce retailers can compete in about 30% of the sales areas Tractor Supply operates within and the everyday-low-price strategy. We forecast the selling, general, and administrative expense ratio remain flattish at the end of our forecast (22.5%) as the business continues to invest to maintain its leadership position in the outdoor enthusiast segment. Our model assumes stable operating margins over the next decade, as consistent improvements in the supply chain and merchandising are offset by elevated investment to remain a best in class retailer. Over the long term, we project a mid-teen average rate of return on invested capital rate versus our 9% cost of capital assumption, providing quantitative support for our narrow economic moat view.
Risk and Uncertainty| by Jaime M. KatzUpdated Jan 27, 2022
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 23% in 2020). While 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, should offer stability in the revenue cycle.
In markets and product categories that Tractor Supply overlaps with other big-box retailers (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 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 more than 2,600 Tractor Supply and 280 Petsense stores by 2031, the firm risks oversaturation and cannibalization of sales in established locations, however, we expect some localized merchandise selection could prevent this.
Some 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 believe risk stemming from environmental, social, and governance concerns is manageable, as the factors with most materiality (higher cost of wages and turnover, as well as higher energy costs) still provide low risk to economic profits.
Capital Allocation| by Jaime M. KatzUpdated Jan 27, 2022
Our capital allocation rating for Tractor Supply is Exemplary. Forecast adjusted returns on invested capital, including goodwill (14% on average over the next five years) are set to handily outpace our weighted cost of capital estimate (at 9%) over our entire outlook, and the balance sheet remains sound, given the company's medium revenue cyclicality and operating leverage. With little debt, the balance sheet remains sound. Net debt/EBITDA should average below 1 times over the next decade, and near-term capital demands remain minimal.
Former Macy’s president Hal Lawton became CEO of Tractor Supply in January 2020. We think 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 (digital sales accounted for 7% of total sales in 2021, up from around 2%-3% at the end of 2019).
We hold a positive view of Tractor Supply's investment strategy, as we see the company is spending strategically to maintain its competitive advantages and respond rapidly to evolving demand. Despite the recent hiccup when re-evaluating Petsense's long-term opportunity set (which resulted in an impairment), active spending on potentially lucrative expansion categories (garden and outdoor, for example) should more than offset such missteps. Quantitatively, we believe this is supported by robust ROIC (including goodwill) and improving operating margin performance (averaging 10.6% over our forecast).
We deem cash distributions as appropriate, with the management team returning capital to shareholders when optimal. As such, it suspended share repurchases early in the COVID-19 cycle but has resumed opportunistic purchases given the strong demand that has persisted over the last year (providing such flexibility). Additionally, Tractor Supply has consistently raised its dividend in recent years, most recently lifting the payout by 77% to $0.92 per quarter, in an effort to return excess capital to shareholders.