2023-12-12 18:28:47 ET
Summary
- Tractor Supply is a formidable business with robust competitive advantages and a rich history.
- The company benefits from secular trends and follows a straightforward business strategy.
- I like the high ROC figures, management incentives, the niche moat, and the business culture.
- This is a great business at a reasonable price, with relatively low risk.
My Thesis
Today, we will delve into Tractor Supply Company ( TSCO ). I believe it to be a formidable business, boasting robust competitive advantages and a rich history. The company benefits from secular trends providing tailwinds, follows a straightforward business strategy, and consistently delivers high returns on capital, coupled with commendable growth figures.
While we may not witness the explosive growth seen during the COVID era, I refrain from basing my valuation models solely on such exceptional periods. In my assessment, TSCO appears to be trading around its fair value. Drawing inspiration from stalwarts like Charlie Munger and Terry Smith, I embrace the notion that acquiring a quality business at a fair price can be a bargain.
Furthermore, I posit that Tractor Supply is the type of business capable of yielding market-beating results with lower risk. This aligns with the philosophy of esteemed investors like Howard Marks, who views consistent returns with lower risk as potentially more impressive than higher returns accompanied by higher risks.
Why I like The Business
I'm drawn to Tractor Supply because it embodies the traits I value in a business. A noteworthy aspect is that 50% of its product offerings revolve around pet and livestock items, creating a steady stream of revenue and offering recession-resistant products. I recently covered Zoetis in an article, concluding that people prioritize spending on their pets even during economic downturns. This 50% recurring revenue aligns with the growing trend of pet adoption, further boosting the demand for pet care.
The business's niche focus is another aspect that appeals to me. Instead of trying to compete with giants like Lowe's Companies, Inc. ( LOW ) and The Home Depot, Inc. ( HD ), Tractor Supply has carved out its niche market and managed it like a masterpiece. Each store, boasting a 20-30% return on invested capital, suggests a niche moat with robust brand power.
A key driver of this success is its loyal customer base, currently standing at 28 million members out of the 46 million Americans residing in rural communities. The company attributes much of its customer retention to the exceptional service provided by its employees. This management philosophy reminds me of another retailer Munger admired -Costco Wholesale Corporation ( COST ).
Tractor Supply shares similarities with Costco in its use of private-label brands, constituting 30% of its revenue. These brands, naturally carrying higher margins, contribute to an upward trajectory in overall margins over time.
Growth Trends
Well, there are a couple of growth trends that will boost same-store sales for TSCO. First up, there's the increasing spending by younger generations on their pets, coupled with a rising adoption rate. Take a look at this quote from Forbes :
Gen Z pet owners are also the most likely to spend money on behavioral training (41%), doggy daycare (35%), specialized pet food (44%) and dog walking services (31%).
Another growth avenue stems from the trend of people moving away from cities, seeking a more rural lifestyle with larger, more affordable homes. Recently, it's been the millennials leading this shift into rural areas. As the CEO of TSCO discussed with CNBC, he addresses the new wave of millennials and their evolving shopping preferences. Here are the top 10 areas Americans are moving to:
1. Sarasota, FL2. Dallas-Fort Worth, TX3. Nashville, TN4. Tampa Bay, FL5. Ocala, FL6. Myrtle Beach, SC/Wilmington, NC7. Knoxville, TN8. Atlanta, GA9. Orlando, FL10. Phoenix, AZ
Additionally, consider this noteworthy quote :
Approximately 56% of those surveyed expect that they will own 1-5 acres when they move, 32% expect a large backyard or prop under an acre, and 12% plan to own more than 5 acres. Meanwhile, equipment needs are rising, and people say they expect to purchase more equipment if they move to a rural area.
So, in my view, those are the two main drivers for same-store sales growth. Apart from that, there's also the expansion in store count, which we'll discuss later.
Management
Hal Lawton has been the CEO since 2020, and with the company being 85 years old, there's no significant insider ownership. Lawton brings extensive retail experience from his tenure at Home Depot and as the president of Macy's, Inc. (M), demonstrating commendable operational results during his almost four years as the chief.
The compensation structure is solid, though not the best I've come across. However, it predominantly aligns with shareholders' interests, with nearly 70% of TSCO being equity-related. Performance metrics include customary measures like EPS and revenue, though I'd prefer to see a return on capital as a metric.
Overall, it's a good compensation plan, and Lawton has delivered positive results thus far. Other executives (CFO, CTO, etc.) have similar compensation plans.
Directors' compensation is also noteworthy, with over 50% of it in the form of stock awards.
Numbers
TSCO exhibits linear growth, a key factor in my view, suggesting resilience across various economic conditions while maintaining growth. Additionally, the company demonstrates operating leverage.
As we delve into future growth, we'll discuss it in the valuation section. Notably, high and stable margins held by TSCO signify pricing power. The significance lies in providing management with a margin of safety. In the event of a one-time decline in margins, the company won't necessarily need to make immediate cuts to dividends, buybacks, or future store investments.
Those high margins play a crucial role in the noteworthy Return on Capital figures, which I consider as important as revenue growth over the long term. The consistently high ROC figures, over an extended period, point to an efficient business structure and stability. Recent research by Morgan Stanley supports this notion, revealing that a high and growing spread between ROIC and WACC is a common characteristic among companies that compound value over time.
Another crucial factor in the long-term thesis is the company's share buyback program, with a consistent reduction in shares by about 2% annually. This plays a significant role in the growth of Free Cash Flow per share. When the company repurchases stocks at a reasonable price, it creates value-following the footsteps of other successful retailers like AutoZone, Inc. ( AZO ) and Lowe's over the past two decades. Additionally, TSCO offers a solid dividend yield of 1.9%.
Speaking of solvency, the management maintains a conservative approach, avoiding excessive debt due to the business's strong cash flow. TSCO can cover its net debt within two years of free cash flow, boasts a current ratio of 1.5, an Altman Z score above 5, and a debt-to-equity ratio of 0.8. Furthermore, approximately $650 million of the total debt carries a low 1.75% interest rate, making it a positive debt component.
Valuation
Now, let's dive into growth rate projections. My calculations include approximately 3-4% long-term comparable growth, aligning with analyst estimates . Additionally, I'll factor in around 3% store count growth, consistent with the pace of the last 5 years and in line with TSCO's goal of reaching 3000 stores. This sums up to a 6-7% long-term growth in the top line. To further boost per-share earnings growth, I'll assume around a 2% share count reduction, in line with recent trends. This results in per-share earnings growth of approximately 8-9%, without assuming margin expansion.
A business with high single-digit growth and robust returns on capital is indicative of a quality business. Paying 21 times earnings for such a business is reasonably justified. This multiple is slightly higher than the market average, considering that this business belongs to the top tier. Moreover, it is trading below its long-term averages.
Turning to the Discounted Cash Flow analysis, I'm assuming a 2% terminal growth rate, a 7.4% WACC, and an average Free Cash Flow margin of about 5% over the last 10 years. In the first scenario, I'm considering a 9% FCF growth, based on the earlier calculations. This positions the stock around fair value, with an intrinsic value of $208.
For a more bullish outlook, taking the last 10 years' revenue growth of 11% CAGR suggests the stock is undervalued by 11%.
In a more conservative scenario, envisioning a slowdown in same-store sales to 2%, and an overall FCF per share growth of 6%, the stock appears overvalued by 34%.
In my perspective, the first case with a 9% FCF growth has the highest probability. While it might not present a 40% undervalued bargain, acquiring a great business at a reasonable price seems like a prudent move.
Risks
Despite being a great business, there are notable risks to consider:
1. Halt of Buyback Programs: If the buyback programs were to cease, it would impact FCF per share growth, thereby influencing valuation models.
2. Competition from Big Retailers: If a major retailer decides to enter Tractor Supply's niche market, it could potentially harm TSCO's margins.
3. Product Sensitivity to Economic Conditions: Not all products sold by TSCO are recession-proof, as evidenced by flat same-store sales in the last quarter. Economic downturns can affect consumer spending on non-essential items.
4. Dependency on Rural Migration Trend: The company's growth rates are closely tied to the trend of people moving to rural areas. Any significant shift in this trend could affect its valuation.
5. Expansion to Suburban Areas: TSCO's attempt to expand into suburban areas is not without risk. If this strategy doesn't perform well, it could potentially impact margins.
Acknowledging and monitoring these risks is essential for a comprehensive evaluation of Tractor Supply's investment potential.
Conclusions
In simple terms, it's a quality business trading at a reasonable price.
I appreciate the moats it possesses, and Morningstar's endorsement with a wide moat rating adds to its appeal. I'm drawn to its simplicity and the enduring strength of its brand. Management appears effective, with strong incentives, and, crucially, the price isn't sky-high compared to similar companies.
I rate the company as a BUY, and I would even consider upgrading it to a STRONG BUY if it hovers around the $180 mark.
What are your thoughts on this business?
For further details see:
Tractor Supply: Great Business At A Fair Price