Scale and Efficiency Fortify Tractor Supply's Narrow Moat

Brand Intangible Assets Support Narrow Moat Niche product offerings place Tractor Supply in a unique competitive position, insulated from peers that focus on one segment of the market. Tractor Supply's breadth--including livestock and pet (44% of sales); hardware, truck, towing, and tool products (22%); seasonal products (20%); work/recreational clothing and footwear (9%); and agriculture (5%)--provides a one-stop solution for those looking to fill multiple needs in a number of outdoor categories. While consumers are able to acquire similar merchandise at peers like Home Depot HD and Lowe's LOW, most are willing to pay premium prices at Tractor Supply in order to meet all of their outdoor lifestyle product needs at one location.

We believe that Tractor Supply's product offerings will allow the company to maintain its market leadership position in the $400 billion outdoor lifestyle market for two reasons. First, despite its leading position in certain categories, we think the firm can continue to benefit from scaling its operations as it builds out its store footprint (we expect it to add about 100 stores annually over our 10-year explicit forecast). We think another rural lifestyle competitor would need to get to more than 1,000 locations to begin to capture similar vendor pricing as Tractor Supply, particularly in some of the specialized categories like equine or livestock. If a competitor arose, we still think Tractor Supply could offer better pricing thanks to its established scale, possibly driving the new entrant out of business in key markets (or could even prevent entry). We have seen numerous small hardware and pet supply stores close their doors over the last few decades as larger competitors like Home Depot, Lowe's, and PetSmart have entered local markets.

We don't view Tractor Supply's competitive positioning as much different in the home improvement and pet supply sectors, which remain relatively insulated from e-commerce threats, as many of the more sizable items Tractor Supply stocks are costly to ship (generators, safes, animal feed). The company also captures vendor benefits from its sizable volume in certain categories that it can pass on in everyday low prices, which would put it on equal pricing footing versus an online retailer.

In addition, 30% of the company's goods sold are private label, up from 21% five years ago. Its evolving product mix has led to improving operating margins over the last five years (averaging 9% versus 7.4% over the last decade), which we think will persist. Private-label products generate gross margins that are 200-500 basis points higher than branded products. While management hasn't offered a target for its private label, we believe the company can get closer to 40% of total sales in private label over the next decade. In our opinion, this increase in private label could contribute up to 20% of our increase in gross margins, which are set to rise about 200 basis points over our explicit forecast, to 36%.

The Department of Agriculture notes that rapid growth was concentrated in recreational and scenic areas like the Rocky Mountains and Pacific Coast regions, which are geographies that Tractor Supply is just beginning to penetrate. As Tractor Supply opens locations on the periphery of suburban boundaries, it should be able to expand its reach and sales potential. In our opinion, these rural lifestyle consumers still have an increased willingness to pay for quality and value products that exceed expectations, leading to better full-price sell-through and ultimately higher operating margin results than some of the company's peers. We also believe these trends lend further support to the intangible asset underpinning our narrow economic moat.

With operating margins that are already in line with or better than most of its home improvement and pet supply peers, the profitability of the business indicates that Tractor Supply has already carved out a leadership position in retailing. However, as its retail and distribution footprint expands, we could see periods of inconsistent growth as the company spends to build out locations, improve inventory management, and create a leaner supply chain. Once the company increases its unit volume and grows closer to the 2,500 locations management has forecast, it could also develop a cost advantage through better bargaining power with suppliers (it currently has 800 vendors) and an improved distribution network. This could help Tractor Supply capture a wide economic moat, which should be evident through higher sales, operating margins, and ROICs.

"Outdoor lifestyle" is defined loosely, covering multiple merchandising categories across pet, livestock, home improvement, farm supply, and apparel products. These constitute nearly $400 billion in market potential. We think one of the key strengths of Tractor Supply's model is that no competitors have duplicated its product mix on the scale and size that the company already has--and there are few sizable competitors across individual categories in which Tractor Supply operates. That said, we do not think the business is bound by its current brick-and-mortar presence and still view both retail and e-commerce channels as avenues for positive growth over the next decade and beyond.

Brick-and-Mortar Expansion Potential Remains Strong With its fragmented product lineup, the company has the potential to increase its consumer penetration by expanding its footprint. Management currently estimates that Tractor Supply could reach 2,500 locations in the United States, which we believe it could almost achieve over the next decade (we forecast nearly 2,400 locations by 2024).

At the end of 2014, Tractor Supply had approximately 1,400 existing locations and saw room for new store growth in both new and existing locations. With 1,100 additional markets already identified for new stores, we see how the company could surpass the 2,500 mark, particularly if a handful of markets can bear more than one location, or if Tractor Supply expands outside the U.S.

Our base case assumes a 7.2% compound annual growth rate in locations over the next five years, which equates to 120 stores in 2017 and 2018, slowing to 115 or fewer each year beginning in 2019, as optimal real estate could become more difficult to capture and pricing could become less favorable. We forecast square footage rising at 7.3% over the same time horizon, as newer locations have included smaller-footprint stores. The economics of these facilities are similar, however, as they carry less inventory and lower occupancy costs with a standard product assortment. In the aggregate, our outlook assumes management will wait to build new locations in a disciplined fashion, at the right time and the right price.

Outside domestic brick-and-mortar growth, we believe there are three opportunities to expand the top and bottom lines faster than we currently expect. First, the company can expand into adjacent product categories through specialty-focused locations, like with the launch of HomeTown Pet. Second, Tractor Supply can reach beyond the U.S. market. Third, acquisitions in key markets could boost the footprint in certain regions faster than organic growth alone.

Pet Owners' Willingness to Spend on Pets Remains High The performance of the livestock and pet segment, which has doubled in revenue over the past five years, indicates that leaning into the pet trend could continue to prove lucrative for Tractor Supply, thanks to consumers' willingness to spend on their pets (and particularly on premium products). The pet market in the U.S. is sizable--the American Pet Products Association estimated the market at approximately $56 billion for 2013. For Tractor Supply, we believe the addressable market is $40 billion-$50 billion, adjusted for the $14 billion consumers spent on vet care in 2013. (Tractor Supply's Pet Vet Clinics offer immunizations but do not offer other veterinary services.)

Based on the 2013-14 APPA National Pet Owners Survey, approximately 68% of households in the U.S. own a pet, which represents more than 80 million homes. There are approximately 96 million cats and 83 million dogs owned as pets in the U.S. HomeTown Pet caters to the key categories of spending on pets, including pet food and treats, pet supplies and medicine, and live animal purchases.

HomeTown Pet was launched in 2014 and has two locations, which cater to the grooming and health-care needs of cats and dogs and facilitate the adoption of pets through the stores and shelters. HomeTown Pet should help build brand goodwill with Tractor Supply clients and offer adjacent services that are demanded but not offered at existing stores. We think finding alternate ways to distribute higher-margin private-label consumable, usable, and edible products at HomeTown Pet can help the business grow in ways that were previously untapped.

If the company decides to expand through adjacent businesses, like HomeTown Pet, location growth could rise faster than expected. While the square footage size and revenue per location would be lower, the margins of the business would probably be higher because of the service component of the business. We estimate operating margins of such a business could reach around 20%, versus Tractor Supply's 10% operating margins in 2014.

If Tractor Supply expands the HomeTown Pet footprint nationally, we believe it would be in a position to drive incremental cash flow, despite nearby Tractor Supply stores carrying overlapping pet products. However, the HomeTown Pet brand would need a sizable footprint for this to occur. The launch of these locations is up against peers like PetSmart, which offers vet care in around 60% of its nearly 1,400 locations and grooming services in all of its locations.

We don't see HomeTown Pet as driving meaningful earnings growth until it is represented on a national and widespread scale, well above 100 locations, which is at least few years away. Although we do see some benefit from a shared vendor and distribution network, the revenue and earnings potential in the service business doesn't make the expansion case compelling, unless these facilities can turn volume of product faster than we expect.

We do believe, however, that launching this concept was a strategic move, since there is an implicit benefit from new HomeTown Pet locations, mainly in the form of increased brand awareness, which should help support our narrow moat rating. The first-time acquisition of certain products at HomeTown Pet could drive new and existing customers back to Tractor Supply locations, where they can purchase products previously acquired at HomeTown Pet and possibly add incremental items to the total purchase basket. We believe pet supplies is a large enough adjacent category for this expansion to be compelling, but expansion into other adjacent categories like equine or livestock is less likely, given the smaller operating niche and limited scale that could be managed in such categories.

Potential Canadian Expansion Could Utilize Domestic Infrastructure We believe that once Tractor Supply penetrates the domestic market, ample opportunity lies outside the U.S., primarily in the Canadian market (some tertiary growth is possible in Mexico). However, such an endeavor is a ways off, given the still-robust opportunity in the U.S. Mostly, we view expansion in these countries as next steps because Tractor Supply can leverage existing infrastructure. Access to existing distribution centers, local suppliers, and friendly trade environments make Canada and Mexico logical options for future growth.

We used Tractor Supply's peers in these markets to approximate the company's potential opportunity. In the $40 billion Canadian home improvement industry, Lowe's forecasts reaching 100 locations (currently at 37 and reaching 60 within the next three years). Home Depot already operates around 180 locations in Canada (we expect very moderate growth in locations going forward, in the low single digits at most). On the pet side, PetSmart operates 86 locations in Canada. Research group Packaged Facts has estimated that Canadians own 26 million pets and spent just under $7 billion on goods and services for their pets in 2013. We view the spending relevant to Tractor Supply at almost $4.5 billion, if we include pet food, pet supplies, and nonmedical pet services (grooming), where we believe the firm will focus its offerings.

Geographically, the top six cities in Canada have upwards of a million residents each, and we believe the regions surrounding these metropolitan areas could prove fruitful for the expansion of Tractor Supply locations. If the firm were to build 10 locations in the surrounding areas of each of Canada's top 10 cities, we believe avid outdoor lifestyle participants would be willing to adopt the brand, leading to roughly 100 new possible locations. Even if Tractor Supply captures slightly lower productivity and operating margins, the addition of these locations could add just under 5% growth to our 2020 estimated operating income and significantly more if the company expands in line with the high end of its peer group.

Rona is the main home improvement threat in the Canadian market, with more than 500 locations nationally. However, as in the U.S., there are few meaningful competitors that carry the mix and value of products that Tractor Supply sells, indicating that the business can continue to dominate its niche in Canada and maintain its narrow moat rating if it builds out its brand as carefully as in the U.S.

The opportunity in Mexico is more difficult to quantify. Home Depot (111 locations) and Lowe's (fewer than 10 locations at the end of 2014) already are operating in Mexico's $25 billion (according to Lowe's) home improvement market. For pet products, Euromonitor predicted sales of MXN 100 million over the last year. We see Tractor Supply being able to capture part of these pet market sales if it chooses to enter the region. Petco entered the market in 2013 and plans to open 50 stores over its first five years of operation. With a smaller market potential likely than Canada--so much of Mexico's area is geographically further from the distribution network--we think Tractor Supply would focus on locations closer to the U.S. border before expanding further south. Overall, expansion to such a market has virtually no impact to our fair value estimate over our explicit 10-year forecast, but we think that such an opportunity could be sought out longer term.

Evolution of Family Businesses Could Provide Acquisition Opportunities With a clean balance sheet and no leverage, Tractor Supply could draw on its operating cash flow and access the debt markets to facilitate the acquisition of a compelling competitor to increase its presence more rapidly in the domestic market. At the end of 2014, the company was only 54% of the way to its footprint goal in the Midwest, which has many storied family businesses operating in the farm supply and outdoor lifestyle space. Most of these companies remain private and closely held, but as family leadership changes over the next decade, there could be opportunities to consolidate some smaller operators into Tractor Supply. Acquisitions could put footprint growth on a faster trajectory than we currently estimate in our base case.

We think a combination with a sizable business like Menards would be unlikely, given the number of locations that would need to be converted or consolidated, which could also lead to an unaffordable valuation on the transaction versus some of Tractor Supply's smaller peers. But we think the acquisition of a competitor operating 30-40 stores would add about $0.08 in earnings per share and $1 to our fair value estimate if such a deal were to occur in 2016.

High Near-Term Capex Leads to Long-Term Payoff in Free Cash Flow Tractor Supply will not be the first big-box retailer to facilitate its expansion on a grand scale, and the successes and failures of some of its peers provide insight into how to the business might proceed strategically. Operating 2,500 locations instead of 1,400 suggests that significant capital will be required for rents, buildings, and infrastructure improvements to continue to expand the brand's presence and improve operating margins. Lowe's expanded from nearly 1,400 locations to about 1,840 locations over the past nine years, with $19 billion in capital expenditures over the period. Tractor Supply is expected to grow from about 1,400 to around 1,850 over just four years, and we think it is likely to incur meaningful capital expenditures as well to support this growth.

Tractor Supply has eight distribution centers across 1,382 locations, with another distribution center that will be fully operational in the next 12 months. Each warehouse caters to 150-200 stores. If Tractor Supply grows to the 2,500 units it is forecast to reach, about 1,100 new stores will have to be incorporated into the distribution network. At about 150 big-box stores per distribution center, this would imply the construction or rental of about seven new locations.

Additionally, we believe the company will open more mixing center locations to facilitate the quick turnover of high-bulk, high-velocity (but lower-value) products. These rapid distribution centers are 50,000-80,000 square feet and cost about $8 million per location. Two will be operating in the Texas region in 2015, and these cross-dock facilities could be helpful in each of the company's regions to more efficiently facilitate the movement of certain bulk products at a lower cost. Once Tractor Supply is able to glean further lessons from these two mixing centers, we expect at least another 20 to be constructed nationally over the next decade. This, in turn, should allow operating margins to rise thanks to improved selling, general, and administrative expense leverage.

Management's medium-term capital expenditure plans call for $250 million-$280 million annually for 2015-18, or 4% of our 2015 sales estimate. In our opinion, this level of spending will persist through our explicit forecast as the company builds out both its footprint and continues to make IT and merchandising improvements that evolve with consumer demands. Cumulatively, over the next decade, we have modeled capital expenditures of $2.7 billion to support footprint growth and improved efficiency. This is moderate spending when we consider the $8.9 billion in cash from operations we forecast the company to earn over the same period.

At this time, Tractor Supply generally views the opening of new distribution centers as a net neutral to operating margins, as better gross margins in transportation are offset by higher SG&A required to open a facility. However, once the supporting infrastructure is completed to deliver product to the 2,500-store base, the company can optimize operating margins to reach better levels through localized vendor relationships; higher stock-keeping unit demand across stores, generating better bargaining power; and improved SG&A metrics, as the company leverages its expenses on higher sales.

We estimate improvements to the operating margin (which reaches above 12% in our model in 2019) could lead to free cash flow that doubles over just the next five years (from $249 million in 2014 to $515 million in 2019), as gross margins improve 100 basis points and SG&A leverages 90 basis points. With free cash flow rising faster than capital expenditures, we view the 20%-30% dividend payout ratio and the repurchase of shares on the order of 50%-60% of operating cash flow ($280 million-$400 million) annually as supported and sustainable, particularly since the company has yet to tap the debt markets, which could be another source of future liquidity if needed.

We believe Tractor Supply is doing a good job of allocating capital and returning excess cash to shareholders. Over the past five years, the firm has returned $255 million in dividends and $927 million in share repurchases to shareholders cumulatively. While we don't think the company will raise its targeted payout ratio materially, we forecast it rising to 30% of net income in outer years from 23% in 2014, and with rising revenue and income growth, absolute dollar growth in dividend payouts should be promising and enticing to dividend-seeking shareholders.

Business Model Attractive, but We'd Wait for a Wider Margin of Safety Overall, we believe Tractor Supply is one of the best-positioned retailers to benefit from brick-and-mortar growth over the next decade--very few retailers are building out a national footprint at this time on this scale. Additionally, in light of recent foreign exchange headwinds, owning shares in Tractor Supply is relatively defensive; the firm has almost no foreign exchange exposure since all locations are in the U.S. Other ongoing market trends have been largely neutral, with issues like falling gas prices helping consumers with high gas expenses and hindering those who work in the industry. In our opinion, Tractor Supply has positioned itself to be less affected by externalities than its peers, and we would view a moderate pullback in the shares as a good opportunity to invest in a business with long-term earnings growth and healthy cash flow generation potential.

We can see wide variability for Tractor Supply's free cash flow potential longer term, which largely depends on what growth choices management makes. While we believe the business will focus on its domestic expansion and the appropriate supply chain initiatives over the next 5-10 years, we also see longer-term periods as compelling. Tractor Supply will have better ability to improve operating margins materially as it capitalizes on the breadth of its business, including a broader information base that can capture more nuanced client demand trends through improved point-of-sale data and loyalty programs that are still being put into place.

We also see support from the continued improvement in the housing market and support of the wealth effect from stock market valuations. Tractor Supply has frequently stated that its clientele generally have above-average income and a below-average cost of living (the cost of living in rural versus urban areas), and we think consumers like this are generally disproportionately affected by the aforementioned factors. A stronger housing market and higher portfolio values increase customers' confidence and willingness to spend incremental dollars on both their homes and their pets, key categories in which Tractor Supply operates.

In our opinion, the domestic housing cycle is only partway through a full recovery. According to the most recently available metrics, we expect a decent runway for growth in the housing market, particularly since lending standards remain relatively tight. Once banks become less restrictive in lending, this could facilitate increased demand for home ownership and spending on housing improvement (repair and remodel), as millennials are more easily able to acquire the necessary leverage to purchase property, driving profits of firms operating in the home improvement space--including Tractor Supply--even higher.