Tractor Supply ?>

Tractor Supply

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Summary

TSCO is the leader company in its niche. Their shares have been hit during the last months, losing a ~36% since June 2016.

The company has some moats that are protecting it from competitors and still has room to expand the business abroad the US and internationally, and its acquisition of Petsense is going to diversify the business and help to improve revenue.

Financially the company is strong, delivering great returns and margins, maybe helped by the industry tailwinds that have helped to reduce costs.

Despite all that, I believe that the company is quite expensive if we consider the fact that we’re in an asset bubble, so I would no recommend opening a position higher than a 25% of the total position right now, and I would wait until share price hits the $40 range to enter with more than that. Below $40, if all the conditions discussed in this report remains intact, my recommendation would be ‘buy’ with a 100% of the position wanted.

For long term investors, this can be a great entry point to a company that has potential in the long run.

 

Business Description

Tractor supply is the largest retail store chain selling rural lifestyle products in the USA. The company has more than 1700 stores in 49 states. The company was founded in 1938 and its HQ are based in Tennessee.

Their stores are located in towns outlying metropolitan markets and in rural communities. They also have an e-commerce branch. A 94% of their stores are leased.

The company bought ‘Petsense’ in 2016, a retail store chain specialized in pet care products. They have more than 140 Petsense stores (included in the 1700 mentioned before). The company was bought in September 2016 and operates in 26 states. Their stores are focused on small and mid sized communities.

Their products include:

  • Equine, livestock, pet and small animal products, including items necessary for their health, care, growth and containment.
  • Hardware, truck, towing and tool products.
  • Seasonal products, including heating, lawn and garden items, power equipment, gift and toys.
  • Work/recreational clothing, outerwear and footwear.
  • Maintenance products for agricultural and rural use.

The company has been able to increase their stores a 136% during the last 10 years, and plan to keep opening new stores in the US. Being based just in the USA makes me think that they have a lot of potential if the try to reach some more agricultural/farming countries, such as South American countries or even Poland to say some of them. As I wrote in a previous entry of the blog, the world population is growing fast, but it’s growing faster in not developed countries such as India, and that kind of population will need cheap food sources such as grains, and Tractor Supply can be benefited from this growing trend.

Their size makes them strong to negotiate with suppliers and help create scale economies, what can provoke an improvement to their economic moat.

As reported in their 2016 annual report, the board wants to improve their CRM capabilities and also their supply chain, what in my opinion, will help to improve margins and efficiency. They are also committed to develop new products by listening clients needs.

One of their priorities are making their clients loyal, and to reach that they give every worker enough power to do ‘whatever it takes’ to support customers. That’s in my opinion something that will help them, jointly with other things that I’ll discuss in the risks part, combat other companies such as Amazon. They are also hiring people with farming backgrounds, what in my opinion is a key thing as they have that expertise that some customers are looking for and will help to sell their products (as a sales professional, I now that you can’t sell anything properly if you don’t have a deep knowledge about what are you selling. That background also helps to know what clients might want.

The company also has a recycling corporate responsibility program. I don’t now if they collect all the things they recycle for free (from the clients) neither if they earn some money from the process and, if so, what the make with that money.

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Source: TSCO 2016 Anual Report.

Despite Livestock and Pet are nearly a half of their sales, any of their products represented more than a 10% of total sales in 2016.

 The company buys its products from more than 850 suppliers and none of their suppliers represents more than a 10% of their total purchases, what helps to maintain that negotiating strength against their suppliers.

They don’t just sell well known brands but also sell their own brands, that represented a 32% of their total sales in 2016. All those brands are registered and Tractor Supply owns their rights. Those products are produced by other companies.

In order to reduce their logistics costs, they use a mix distribution policy. They use their own logistics to distribute a 75% of their merchandise and the other 25% is delivered directly to the stores by their suppliers. That, according to the board, helps to improve delivery times for their e-ecommerce branch and reduce costs.

Right now their growth strategy is focused on opening new stores in the USA and, if possible, acquire new businesses at good prices. I think that this is a great strategy until the reach stagnation in their own country, but I also think that the company should try diversify their geographical income.

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Source: TSCO 2016 Anual Report.

We can see that their stores are quite concentrate in the south of the the USA, so that leaves room to expand the business to the north-west of the country.

 

Industry overview

During the last two years oil prices have been quite low, helping to reduce costs such as transport, that’s a huge cost for the companies in this industry. In my opinion, despite being higher, oil is going to remain lower than it used to be when its price was around $100 as above the $50s range fracking companies are going to boost production.

The US economy keeps going at a modest pace, and, jointly with a close full employment, is helping to improve wages, what’s going to translate in higher spending. On the other hand, inflation is growing that will hurt some retailers if they are not able to transfer the increase in raw materials cost to consumers.

As TSCO sells animal food, we must take into account grains prices, and, if we look at them, we can see that during the last 2 years, corn and wheat price have been close to the prices we saw in 2009-2010 so that decrease in grain prices is going to help the company to reduce costs.

Another major trend of the industry is the giant Amazon, that has been able to set itself the number one in online retailing, eroding revenue from almost every company of the retail sector. The company is a threat to almost every company in the sector, but as I’m going to discuss later in the risks section, TSCO has a competitive advantage against them that’s going to protect revenue for a great part of its revenue.

On the other hand, markets are living on borrowed time due to the ultra expansive monetary policies conducted by several central banks, that have provoked a lack of alternatives other than stocks as bonds have quite low yields.

We also have the fact that, as I have discussed before in this blog, the farming and grain industry is going to book due to demographic trends, and if the company is able to take profit from it by positioning itself in those countries, growth is going to be massive.

Analysis

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Source: TSCO Anual Report.

Taking a look to its P&L from the 2016 annual report, we can see that sales have grown an 8.9% YoY. If we take into account revenue growth from the last 3 years, we obtain a 9.5% 3 years average growth, what is a bit below industry average (13.3%).

On the other hand, gross profit has increased an 8.5% during the last year, close to revenue growth. But looking at net profit growth, that at the end of the day is what we must care about, has grown a 6.5%, what is quite below the 3 years average and 2014-2015 growth (10% and 10.51% respectively). That’s due the increase in depreciation and amortization and, in a lower measure, the increase in interest payments, that despite being quite a small number compared to revenue, has doubled its value YoY due to the increase in debt hold by the company. Looking at other expenses, all look reasonable taking into account the increase in net sales.

Looking to the last 10 years, we can see how the company has been able to increase its net margin from a 2.72% low and 5.6% average, what can be due to the economies of scale creation and the focus that management is conducting on improving its logistics and general costs.

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Looking at the chart above, we can see how the balance sheet is distributed. At the time of 2016 annual report publication, assets (green) represented a half of the balance sheet, while liabilities (red) represented less than a 25% of the balance sheet. One of my concerns is the fact that cash has been reduced during 2016 and being just $53.9 million the company would just be able to pay back a 6.94% of its current liabilities with cash. But, if we use current assets, we can see that the company would be able to pay back 1.9 times its current liabilities, what’s a fair amount if we consider that a 90% of its current assets are inventories and in the case of ‘crisis’ in which the company would need to use inventories to pay back debt inventories would not be sold at that value but at a significant lower one. So, 1.9 times is, in my opinion, a safe ratio considering because if we simulate a fair 50% decrease of inventories value (in case the company need to sell it to pay back debt in an extreme situation) the company would still be able to pay back 1.07 times its current liabilities.

Taking a deep look to assets, we can see that the land, plant and equipment is increasing according to the company expansion. Intangible assets have been increased  approximately x12 (from $10.3M to $125.7M), but that doesn’t worry me because the potential that Petsense has due to the expansion path that it has across the USA is compensates that ratio.

About liabilities, we can see how long term debt has been substantially increased due to the acquisition of Petsense. All the other liabilities have been increased according to the expansion of the company.

Now, taking a look to some metrics, we can see that the company is able to generate a large amount of value as it’s able to generate a 25.58% ROIC while WACC represents a 8.65%, creating a difference between both metrics of a 16.93%. We can also see that ROE and ROE are quite attractive, being able to generate a 30.04% and 16% respectively.

One of my major concerns is that days inventory and sales outstanding have been increased, but if we look the ‘good side’ we have that days sales outstanding are much better than industry average ( Industry avg: 14.54 vs TSCO: 0.39) and days payable, despite being a bit below the industry average, has been improved from 37.97 to 50.96 days. So the company has quite a good margin of days to pay for its inventory, what allow them to run the business without borrowing any money in order to finance their main activity.

In order to set a fair price, we need to take a look to their FCF:

fcf

 

As we can see in the chart above, FCF has been quite volatile during the last 10 years (blue line) but it has had a growing trend (yellow line).

The average FCF during the last 10y have been $174.7M, but as the company has experienced quite a great growth, I think that it’s more realistic to focus in the last 5 years average, that are $239M, in order to set a starting FCF for my DCF model.

On the other hand, I’m going to use the 10y average FCF growth, as it’s lower than the 5y average (40% vs 63%). I’m going to be very conservative as I usually do with my DCF model, as I want to avoid a crash as discussed in the industry overview section.

nicome

About net income, we can see how it has had a descendant trend since its peak in 2009, after droping a -15% in 2008 due to the crisis. As net income growth has been falling a -24% since 2009, I should use that %, but as we have previously seen, the company can be beneficiated by economies of scale, the Petsense acquisition and margins improvements policies conducted by the board, so I’m going to use 1/2  of that growth fall (12%).

The inflation long term objective is a 2%, but as It’s quite difficult to maintain a 2% rate, I’m going to set a 1.5% perpetual growth rate. I also don’t want to set a 2% growth rate in order to hedge a scenario in which the company doesn’t expand business internationally and hits stagnation in the US.

As the company is well managed, it still has room to expand the business, it has a 8.65% (but, we’re in an asset bubble due to ultra expansive monetary policies and interest rates are close to 0, so we need to cover a scenario in which share are not as high as now and/or interest rates are higher) and it has a fairly great moat against online retailers, so I’m going to set a 10% discount rate.

All those metrics derive in a $38.23 fair price. So right now the company is trading a 19.6% more expensive than my fair price.

ratios

Source: Gurufocus.com

 

If we look at some ratios, we can see that the company is in a good position relative to its own history, but it still has some high ratios due to its ability to grow its business in a every time more urban world and its growth potential. Relative to its industry, we can see that the company is quite fairly valued.

 

Risks

  • The main risk is a deceleration in revenue growth due to maturity, that would hurt share prices as we have seen during the last months.
  • Amazon is not going to be a major risk for the company as TSCO has many moats such as being located near the customer and selling products that the customer needs at the moment, so that it can’t wait for it. TSCO also has the moat that it sells heavy products, that would be quite expensive to deliver as Amazon does.
  • Increasing raw materials prices is a heavy risk for TSCO, as it would hurt margins.
  • As the company works in an industry that’s quite dependent on weather, any extreme weather conditions would hurt revenue.
  • An increase in oil prices is going to be a negative factor for the company, as shipping costs between stores and warehouses is going to increase, hurting again margins.
  • A future risk, if the company decides to expand the business internationally, would be foreign exchange rates, but at the moment that’s not a concern for the company. Otherwise, that sets a major risk, and it’s that the company is totally dependent on the US economy.
  • Competition such as Home Depot is a risk for the company, as it sells some similar/Equal goods. The only thing that saves TSCO from that, is the fact that the consumer is willing to pay a premium in order to buy all the products in the same place.

As we can see, the company is playing well its cards in order to minimize risks.

 

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