Tractor Supply Co (NYSE: TSCO): The Billion Dollar Company You’ve Never “Herd” Of

Shehryar, you’ve been relatively quiet recently. What’s been going on?

I decided to take step back from actually analyzing companies for a while in order take some time to expand my breadth of knowledge when it comes to investing. Specifically, I had qualms about some of my recent analyses- for some reason, they didn’t fit well with my philosophy of value investing. As a result, I began to study Warren Buffet- and through snit-bits of interviews and quotes, I got a good idea about how he actually analyzes his companies. Then I had an epiphany: while my analyses are technically considered value investments, they do not bode well with value investing as it is practiced today.

The obvious indication of this was simply the frequency at which I posted ideas. Buffet uses the analogy of an at-bat: while you’ll be able to hit many pitches, you should only take the hit on the very best if you want a home run. I think many investors fall into the sunk cost fallacy- the concept that an idea ought to produce an investable upside since you already put weeks, sometimes months, of research into the company. In reality, you may just be setting yourself up for failure by adhering to such a philosophy.

Okay, great. So, what’s changed as a result of this exploration?

Well, I can identify four tangible things that have changed in my analyses:

1. In the past, I’ve looked exclusively for bargain stocks rather than companies with economic moats. Some examples include NROM, ANFI and BNED. This isn’t necessarily a bad thing, there are times when these companies make you unable to sleep at night, as was the case with BNED, which dropped 18% since I initiated a position in it. The value investing philosophy dictates, “if you have a clear conviction in an idea, then you should add to your position when the price drops.” The problem with this statement in the context of my strategy is that it is hard to have a clear conviction in a company like BNED- while it very well may prove to be a fabulous investment, it still keeps me up at night for the time-being. Therefore, I’ve altered my approach: I look for companies with economic moats trading at a bargain or fair value.
2. I do not look at the stock price before analyzing a company. I’ve noticed an inherent bias when I know the market capitalization of a security that cajoles me to subconsciously smudge the numbers to produce an upside. If you do not know the market capitalization, you’ll be more inclined to come up with the true intrinsic value.
3. I’ve changed my ROIC figure to “Return on Tangible Assets”. This is a figure that Buffet talks about a lot that is much more conservative than a traditional ROIC calculation- it removes to effect of excessive depreciation. It is defined as net income/(TOTAL PPE + Current Assets – cash).
4. A company can do two things with earnings: retain them or give them out in dividends. According to Buffet, unless a company can produce >$1 value for every $1 of retained earnings, it is better off giving the money out in dividends. To calculate this, you can either take the growth in earnings or the growth in market capitalization and divide it by the total retained earnings- the quotient should be greater than 1.

That sounds reasonable. I heard you invested in Tractor Supply Co (NYSE: TSCO). Can you tell me a little bit about that company?

Tractor Supply is a retailer of agricultural products. The company was founded back in the 1950’s and originally sold tractor parts. They then started expanding into the agricultural market, providing equipment, livestock feed and everything in between. Recently, they’ve been focused on growing their edible products- horse feed, bird feed, and the like- and livestock segment, which have generated over 40% of their revenue over the past decade. The company originally operated two segments: Tractor Supply Co, with 855 stores in 2008, and Del’s Farm and Feed, with 28 stores in 2008. TSCO has been aggressively growing its Tractor Supply segment and has adhered to an 8% increase in selling space YoY since 2008. The number of Tractor Supply stores has grown to almost 1,800, for a CAGR of 7.4%. Del’s Farm and Feed has not been growing and is now negligible. In 2016, TSCO purchased Petsense, as part of its ongoing effort to expand its edible product footprint, for a purchase price of ~$160m. Going forward, TSCO sees a domestic opportunity of 2,500 Tractor Supply stores and 1,000 Petsense stores.

Tractor Supply’s stock has fallen 25% since 2016 because of lower comparable store growth. According to the financial statements, warmer winter months and deflation were the primary causes of this decline. However, I think Tractor Supply is a stable company with an economic moat- and this short-term weather problem is transitory at worst. Even in this so-called “challenging year” the company still managed to deliver positive same-store sale growth and 9% growth in both revenue and net income. TSCO has a market capitalization of $7.3bn and 131 million shares outstanding.

Wait a second! You think an agricultural retailer has a durable competitive advantage? Can you please explain how that is?

Let’s first look at it from a qualitative standpoint. TSCO has been able to grow its business at a tremendous rate for over a decade with no signs of slowing down. From 2008-2013, the company delivered YoY double digit revenue and EPS growth. Speaking of 2008/2009, the company showed no signs of slowing down during the recession; on the contrary, TSCO consistently surpassed expectations. Finally, TSCO has no established competitors and loyal customers. This demonstrates some degree of barriers of entry, and during the whole internet revolution/e-commerce revolution, people did not stop shopping at Tractor Supply stores.

Now let’s look at it from a quantitative standpoint. A company with a competitive advantage should have a high return on tangible assets. Because this calculation adds back accumulated depreciation, our threshold should be lower: any company with a ROTA greater than 10% is using its capital efficiently. While TSCO’s ROTA has been consistently above average, this is exacerbated by the fact that ROTA has been growing over the years. More than that, along with ROTA growth, the company’s margins have been increasing as well, indicating economies of scale.

The second test is the retained earnings test. An efficient company should theoretically be able to produce at least a dollar of value for every dollar of retained earnings. From an EPS standpoint, for the past decade, TSCO has produced $0.18 of earnings growth for every dollar of retained earnings (defined as net income less dividends). From a market capitalization perspective, since 2009, market capitalization increased by less than $1 for every dollar of retained earnings twice:

Read in conjunction with the earnings perspective, we can see that 2014 and 2016 were not caused by a decline in efficiency, but short-term market fluctuations/transitory effects. Overall, every dollar of retained earnings since 2009 caused $3.48 increase in the value of the company from a market capitalization perspective.

These are great numbers, but let’s look at this situation from a realist perspective. Don’t you think competition from Amazon is going to destroy TSCO?

 Since you’re being persistent, there are three major challenges that Tractor Supply faces:

1. Threat from Amazon or other online retailers: To start, the target market of Tractor Supply is farmers, not technology savvy millennials. This market is not 100% responsive to new technological changes, and that means there is some sort of barrier between it and the E-commerce revolution. Additionally, many of these farmers live in rural areas or have farms/ranches in rural areas- for the most part, they do not live in zip-codes with “same day shipping”. Tractor Supply stores themselves are located in these rural areas to cater to this specific need. Therefore, Amazon and other online retailers will find it hard to ship products efficiently to these areas. Speaking of products, there is also the issue of the type of product. Many of these products are, by nature, bulky, making them expensive to be shipped by an online retailer (think of bunches of hay). Second, these products are needed in a moment’s demand- farmers would not want to wait for two days to restock on their feed. These factors, coupled with the expertise and impressionability of Tractor Supply workers mitigate the effect of e-commerce on Tractor Supply’s target market.
2. Threat from other retailers: Again, there are no close counterparts to Tractor Supply’s business. The only potential threat are local retailers, but history has shown us this is not a problem. Tractor Supply existed in 25 states in 2008, and now exist in 49 states, so penetration in new markets does not present a challenge to TSCO. You may argue, “What about established retailers like Home Depot?” These large retailers do not carry the specialized selection of products you’ll find in a Tractor Supply store. You may be able to get a power drill in both places, but you cannot get a power drill along with horse bedding at Home Depot. Tractor Supply changes its product selection every 90 days to keep in line with the agricultural season- no other large retailer does that.
3. Petsense acquisition may destroy value: This is the only risk that I think can go either way. Petsense is not an established business, and may not be able to compete against PetSmart, PetCo, etc. Management plans to expand Petsense by 20% YoY and eventually reach 1,000 domestic stores. In the short term, however, Petsense is not a big player and even if you eliminate it from my valuation, you are still left with a substantial upside.

But how do you find value in this company? As you said, same-store sale growth has been slowing down- even if the company grew 8% YoY in the past, why should it grow in the future?

You bring up a valid point, and that is why we should not depend on future growth when it comes to this investment. So, let us go through this thought experiment: imagine if we can buy this company, and it stopped growing completely after we purchase it. That means same-store sales growth is 0% and no new stores are opened despite the domestic market opportunity of 2,500 stores.

We can start with the 2016 EBIT of $694m. First, we add back depreciation and subtract maintenance capex- no growth means that some of the capex will not be used. The cost to open a new store is $1m/store and the company opened ~130 stores in 2016, so the maintenance capex is ~$100m ($226m total capex minus growth capex of $130m). Taking away tax, we have adjusted earnings of $479m. Historically, TSCO has had a P/E in the high 20’s, but this took into account growth prospects. In this steady-state situation, we can slash the P/E in half to get a steady-state value of $6.85bn.

Okay, so you’re coming up with a value of $6.85 billion, but the market cap is $7.3bn. Where does the upside you were talking about come from?

Well we went through some pretty serious assumptions to get to this value. First, we assumed that margins will stagnate. Keep in mind that the margins we see today are, in part, a result of the excessive growth of TSCO. In a zero-growth case, we can reasonably assume that the company can focus on efficiency and actually improve margins to an extent. Second, we took off about half of capital expenditures because of new store openings. The $1m per store is simply the cost of obtaining the store- it doesn’t take into account hiring personnel to run it, the logistics, etc. In fact, according to TSCO’s Q3 Investor Presentation, only 14% of total capex is reserved for existing stores. Third, we didn’t take into account share repurchases. TSCO recently announced an aggressive share repurchase program, with the goal of 2.5-3.5% annual net share reduction. Without growth, the company will have more capital to repurchase shares (at least ~$100m that was previously used for growth capex) and greater liquidity to take on debt. We can assume a net share reduction of 4.5% in a zero-growth case. Finally, keep in mind that we slashed the P/E in half to come up with our steady-state value. We used a P/E of 14, but the average P/E for Special Lines Retail is 23 and the average P/E for farming/agriculture is 20. After considering these factors, it is easy to see the upside in this investment; to illustrate this, if we take into account only 25% of capex as maintenance capex and an operating margin expansion of 2%, our initial yield will be 8%.

After taking into account the net share reduction, our annual ROI will be 12.5%, and this is assuming no growth. In reality, the company is growing at 8% YoY. In essence, in this investment we are getting growth for free.

Wow, this is shaping up to be a very nice investment! You said that we are essentially getting growth for free, but what exactly is the value of this growth?

What I like about this company is that you don’t need growth for it to be a great investment, contrary to what others think. A previous Seeking Apha article mentioned, “Upside here requires an acceleration in same-store sales,” but as I’ve shown, comp growth can be 0% and we still get a nice return on our investment. What are we really getting for our $7.3bn, though? We are getting a YoY increase in selling space by 8%, double digit EPS growth, high single digit revenue growth and 20% YoY growth in Petsense. To be fair, however, we will continue playing Devil’s Advocate even when delving into the growth value of Tractor Supply.

In 2008, Tractor Supply calculated a domestic market potential of 1,200 stores. In 2011, it increased that to 1,600 stores and again in 2014 to 2,100 stores. Most recently, it was 2,500 stores. For simplicity’s sake, let us assume that growth will taper off at 2,100 stores even though history has shown us that this probably won’t happen. Also, let’s continue with our 0% comp growth assumption. Right now, Tractor Supply has ~1,800 and they’re increasing their number of stores by ~130 every year. We can assume that in three years’ time, there will be at least 2,100 Tractor Supply stores in the United States. Each store makes $4m in revenue today, so 2,100 stores will bring in at least $8.4bn in revenues in 2021. The current net income margin is 6.5%, so let’s assume that same margin in 2021, even though it has been on an upwards trend. Applying a cost of capital of 10% and a terminal growth rate of 5%, the value for Tractor Supply is $10.92bn (alternatively, this translates to a P/E of 20 which is average for this industry).

We can do the same thing with Petsense. The company has ~160 stores right now and plans to open 30-40 stores per year. In three years, there will be about 300 Petsense stores and each store makes $1m in revenue annually. On management’s Q3 earnings call, management stated that Petsense margins were in line with Tractor Supply margins, so we use the same net income margin, cost of capital and growth rate (in reality, the growth rate of Petsense is expected to be 20-25% annually). This gives us a value of $1.56bn.

Together, the value of the company should be $12.48bn by 2021. The current market capitalization is $7.3bn, giving us a 71% upside. Since the value is realizable in three years, our annual return on investment is 19.6%. This calculation did not take into account the net share reduction of over 10% that is expected over the next three years, which will amplify our return on investment.