Why Tractor Supply Company Should Be a Stock on Your Radar

Recently on Industry Focus, we welcomed a team of Fool.com contributors to the studio to talk about some of their favorite companies as part of our Pitch a Stock theme week.

In this consumer and retail segment, Simon Erickson offers his take on Tractor Supply Company (TSCO 1.04%). The rural lifestyle retailer has carved out a successful niche for itself, proving that even brick-and-mortar chains can thrive with the right mix of customers, locations, and products.

As the company fends off pressure from big box competitors, even e-commerce competition has yet to fully crack its value proposition. Can the growth story last?

A full transcript follows the video.

This video was recorded on Oct. 17, 2017.

Simon Erickson: Hi, everyone. I'm Simon Erickson, the lead advisor of Motley Fool Explorer, covering some of the market's largest tech stocks. But today, I'm going to be talking about a consumer and retail play called Tractor Supply. Ticker is TSCO. This is the largest rural lifestyle retail store in America. They sell things like supplies for pets and horses and fencing and tools and equipment. Basically, anything you might need if you're living off of the beaten path or off of the paved road. There's 1,630 Tractor Supply locations across the U.S. They have 160 more that are Petsense locations for pets. But one of the big things I like about Tractor Supply is, it's shielded from larger retail competitors. I think this is important for any retail company out there. There's general bricks-and-mortar retailers like Wal-Mart, or do-it-yourself retailers like Lowe's or Home Depot that, really, it doesn't make sense for them to compete on the same turf that Tractor Supply is competing in. They're built in rural locations that are a little bit away from city centers, and it simply doesn't make economical sense for a Lowe's to put another location out there. They're already established, they have a brand with the local populace, and they've already established that power of habit with consumers. And I think that's very important for Tractor Supply, especially for those consumable recurring revenue purchases that they're always making there.

In terms of retail, we can't go on a retail show without talking about Amazon.com (AMZN -1.11%). I think that Tractor Supply is really a business that Amazon doesn't want to compete against when you're shipping 50-pound bags of deer corn and pig feed around, it just doesn't make sense for Amazon to be shipping that with the infrastructure they already have on an e-commerce business model. This is something that really works to Tractor Supply's advantage. They have those recurring consumable revenues that they're picking up from consumers that are out in rural locations that just don't make sense to be shipping around in e-commerce.

So in addition to being shielded from larger competitors, there's something else that I want to talk about that's very good for shareholders of Tractor Supply, and that's this company's capital allocation. Because they have this recurring revenue stream that comes in, they're converting about 6% of sales into free cash flow, which is something we love to see as investors because that can be used to our benefit. Two of the things they're actually doing with the free cash right now is paying an increasing dividend, and they're buying back shares of the company. Their dividend has more than doubled in the last five years, and it now yields 1.8%. The company has bought back more than 10% of its outstanding share count in the last five years, as well. So that gives us a bigger piece of the pie as existing shareholders for Tractor Supply.

Again, this is a company that has a recurring model, they're shielded from larger competitors in retail out there right now, and they have some really great capital allocation chops. I really want all of our listeners and viewers to consider Tractor Supply, TSCO, as an attractive retail purchase right now.

Shen: So Simon's made a pretty compelling pitch there, I think. It reminds me of a lot of different companies. One of the first things he talks about is how the location of the stores, and the target market, in terms of rural consumers in regions where it may not be as profitable for major competitors to open their own shops, offers a pretty solid moat. It reminds me a little bit of how dollar store retailers have been able to carve out a niche for themselves by often locating stores in underserved areas. I think this is an example of that. Tractor Supply's value proposition, it's a one-stop shop offering convenience and a wide enough product selection in these areas for their core customers. At the same time, these aren't huge stores. From what I can find, they're about 15,000 to 20,000 square feet. For some perspective, that's smaller than even a very modest modern grocery store. So customers, in terms of convenience, can also get in and get out with whatever they need.

In the 10-K, management summarizes the way they approach this selection and convenience. They just say, "We cater to the rural lifestyle, and often serve a market by being a trip consolidator for many basic needs for farm, ranch and rural customers." What are your thoughts?

Douglass: When I first heard Tractor Supply Company, my immediate thought was, oh god, this is a company that invests in agriculture. Frankly, agriculture as a whole is not a great business to be in. You have a commodity, and you're so beholden to other prices, and you're usually a price taker as opposed to a price maker. Farming is tough. Anyone who farms will, I think, agree that it's a tough thing. Warren Buffett and Charlie Munger got a question at Berkshire Hathaway a couple of years ago about cattle ranching and what they thought of it as a business, and Munger's response was, and I'm paraphrasing, "I can't imagine a worse business for us to be in." And Buffett softened it and said, "Well, it's not quite that bad, but most of the successful cattle ranchers owned a few banks on the side," or something like that. It's a tough business to be in. What's interesting about Tractor Supply is, first off, they're diversified -- 46% of sales are in livestock and pet, 22% hardware, they have gifts and toys, clothing and footwear, agricultural products making up the balance for their 2016.

Shen: A very small balance for that agriculture, too.

Douglass: Right, yeah, I think it's 5% for 2016 sales. And what's been crazy to me is the margins they've been able to maintain. They're at 9.9% operating margins so far in 2017, and over the last year, their gross margins have been about 34%. I do not know how they have pricing power, but it appears that they have some kind of pricing power, and that is, frankly, very attractive.

Shen: To put that into perspective, a Wal-Mart, for example, will claim a gross margin level of about 25%. So, this is 10 percentage points ahead of that. And management doesn't try and do a high-low pricing strategy, getting you in on staple items and charging a premium on others. They just want to offer their customers consistent, solid values across the board, feel like they're getting a good, fair deal when they make their visit to Tractor Supply stores. I think an important part of that is keeping the customer coming back. Simon spoke to this, it's the recurring revenues from the consumables that Tractor Supply customers tend to purchase, and how that offers some stability. The company refers to these products as consumable, usable, and edible, and they are key to driving traffic to stores. There are other growth initiatives in the store that you'll see on the shop floor, that are focused on, for example, introducing new products. To keep the shopping experience exciting, they're starting to offer more localized products, as that trend really grows across the retail industry. We've talked about that on the show previously. They're also offering some exclusive brands that can help foster some customer loyalty. Some of the big box stores are venturing into that, hoping that exclusive brands will give them a little bit of loyalty, too. And those brands at Tractor Supply make up 30% of revenue already.

I know this company comes up all the time, especially in my segment, just by the fact of how much they've influenced --

Douglass: Everything. [laughs]

Shen: -- the competition, which is Amazon. Simon brings them up specifically, basically speaking to how the company's insulated a little bit from Amazon and also e-commerce competition in general, due to the nature of their business and the products that they sell. What do you think? Do you think that's something that's sustainable? Do you think that's something as true as he pitches it as?

Douglass: I have to say, I think a lot of the benefit that Tractor Supply has right now appears to be the fact that they have the store in this underserved location, something like that. In a lot of ways, it's a supply chain issue that I think Amazon might struggle to overcome. Does that mean Amazon can never overcome it? I'm not sure. I would actually even say, I would think probably not, I think they ultimately could if they really put in the time and the effort. The question is, is this a market they're going to go after? I don't think it's going to be one they'll go after for a while, because there's so many other markets that Amazon is trying to disrupt right now. I think Tractor Supply has time to get its ducks in a row. And perhaps, over that time, it can build that moat to really protect itself. I mean, one of the things that really jumped out to me is, they have about 1,620 stores, something like that. They're planning to expand to 2,500. So when you look at the western region, think Colorado and points west, they have 172 out of the 424 stores that they have planned. So that speaks to me about how much opportunity they have in a lot of these states where there's a lot of ranching, there's a lot of rural agriculture, to really build more of these in these relatively underserved areas, really build up that brand and that customer loyalty, and perhaps build something that's fairly impenetrable for Amazon.

Shen: Yeah. I look at this in terms of the Amazon threat on two sides. I completely agree that if there's any company out there that's going to innovate away some of the logistical issues of shipping the kind of things that they do, I think Simon mentioned the 50 pound bag of livestock feed, for example. But at the same time, the nature of Tractor Supply's customers and where they're located adds a little even more of an insular effect in, last mile fulfillment and logistics is often by far the most expensive part of that journey. Your package might travel thousands of miles, hundreds or thousands of miles, but those last few miles are often the most expensive part of the process. So here, you have customers in very rural areas that adds to that complexity there.

Then, I also think there's something unique in terms of the way that customers shop at Tractor Supply. Their average transaction value is just around $45, with almost half of the revenue of this company coming from that livestock and pet category. I think that also adds a complication where, that's not a very large ticket size. You're trying to ship some water container or something like that, that might not be very expensive to justify the free shipping and offers that Amazon is known for that really attracts those customers. So there's another added complexity. At the same time, I think, on the other side of that, this isn't a company that's not thinking about their omnichannel strategy, either. They've launched buy online pickup in-store recently.

Douglass: Which is huge.

Shen: Yeah. Management was very excited about that. And that makes up 55% of their online business, which is pretty incredible. And it's boosting traffic where, conveniently enough, management says that customers buy online, pickup in-store, and while they're at the store, they'll add another 15% or so to their ticket. So it's pretty powerful. The buy online pickup in-store orders and their other online orders enjoy ticket sizes that are twice as big as their average ticket. I think this is a case where customers, in a lot of these cases, in these areas, they're traveling pretty far even to get to Tractor Supply. This is an instance where, they might think to themselves, you know what? I might order extra to have just in case since I'm already going to the store and I know it's going to be there waiting for me. And there's convenience in that that I think their target market really appreciates.

Douglass: Yeah, and let's face it, when we look at Amazon's penetration, a lot of the opportunity there is particularly in urban areas, where you have such dense compact groups of people that it's relatively easy to get delivery. Out in rural Montana, that gets a lot tougher. And somebody like a Tractor Supply can provide a lot more to those folks a lot sooner for a lot longer. I think Amazon is in a place to disrupt a lot of things. Obviously, it's already disrupted a lot of things. But it still commands a relatively small percentage of the market. And it seems to me like it's going to be a very long time, if ever, before they will be able to actually properly go after this particular segment of the market, unless Jeff Bezos just decides, meh, we're going to go after it because I feel like it, which really hasn't been his modus. Usually, he goes after things based on size and potential opportunity. So think of it as low effort, high value opportunities. Trying to disrupt Tractor Supply does not seem to be one of those.

Shen: So closing out here on our discussion for this very unique retailer, in terms of big picture, we talked a little bit about what they see as their runway for store development, approximately 1,600 to 2,500 stores, they recently acquired pet-focused Petsense chain as well, and they see a lot of potential there. What do you think, is there anything that does worry you in what otherwise seems to be a really strong business model?

Douglass: Truly, when I look at it, there's not much. There's going to be some seasonality. That's just part of the deal. That's fine. They had a miss last year, because of some issues around that. But that's really ... welcome to retail, that's just part of the deal.

Shen: Absolutely.

Douglass: When I look at it, I think across the board, the only real concern I have is that someone big comes in and disrupts things. But again, I don't see a compelling value prop for somebody else to try and do that. These folks are driving a great gross margin, good operating margins, it's very clear that they have their ducks in a row, they have aggressive expansion planned, and it looks like they're really trying to protect themselves against potential e-commerce disruption by going ahead and building off some of those buy online and pick-up in store capabilities. Just across the board, this is a stock that I'm going to be digging deeper into, personally.