Tractor Supply: A Portrait of a Compounder as a Young Company

Tractor Supply has been one of the best performing stocks of the past twenty years. It even beat the likes of Apple. The company is a niche “rural lifestyle retailer” whose customers are “recreational farmers, ranchers, and all those who enjoy living the rural lifestyle.” A rural retailer seems like an unlikely business to back one of the country’s best-performing stocks. Which begs the question, how’d they do it?

Source: YCharts via Twitter (@CharlieBillelo 6/28/2020)

History

Charles Schmitt founded Tractor Supply in Chicago in 1938. Schmitt lived on Chicago’s south side and had never set foot on a farm. He got the idea while working for an automotive parts company. He noticed that tractor maintenance was relatively recession proof because farmers would rely on replacement parts during lean times.

Selling replacement tractor parts wasn’t new. Schmitt’s twist was to operate as a mail-order only business, save on overhead, and pass the savings onto customers via lower prices. This was an early implementation of what Nick Sleep calls Scale Economics Shared. It’s one of the strongest business models because it creates a positive feedback loop of ever-lower prices that competitors with less scale are unable to match. GEICO, Amazon, and Costco have all used the model to great success.

Tractor Supply’s first retail store was built as a base for shipping products into Saskatchewan. The store did well as a stand-alone retail operation which convinced Schmitt to open more. Ever since then Tractor Supply has been in “replication mode.”

However, it wasn’t always smooth sailing. Between 1950 and 1960 the number of American farms decreased from 5.3 million to 3.7 million. Tractor Supply responded by broadening its retail mix away from its profitable farm and ranch niche. It even renamed itself “TSC Stores” to distance itself from the word “tractor.”

In 1969 Schmitt sold it to the conglomerate National Industries. National Industries neglected Tractor Supply and milked it for cash. After a few years it began losing money. Fuqua Industries, another conglomerate, bought it and sent Tom Hennesy in to fix it or sell it. Hennesy liked Tractor Supply so much he took it private in an LBO in 1983.

Hennesy steered the company back to its roots. He instituted everyday low prices, made great customer service a priority, and refocused the merchandise back to farms, ranches, and rural living. This reinvigorated the company. In 1994 Tractor Supply went public, beginning its modern history.

Since then the stock has had a staggeringly good run. Shares have compounded at 19.9% annually. So, how did they do it? How did a niche rural lifestyle retailer outperform nearly every other stock?

Stock Prices Follow Fundamentals

At the risk of stating the obvious, Tractor Supply’s stock did well because Tractor Supply, the company, did well. Over long periods of time changes in stock prices closely track changes in fundamentals. In this case, EPS increased at an 16.3% CAGR while the stock increased at a 18.5% CAGR. The difference, 2.2% per year, is due to multiple expansion (from 12.5x to 20x).

Reinvest At A High Incremental ROIC

If stock prices track EPS then what drives EPS? Incremental return on invested capital (“I-ROIC”) and reinvestment rate. Basically, how much growth can the company produce with each dollar it reinvests and how many dollars can it reinvest?

Tractor Supply’s growth is a function of same store sales growth and new store openings. Between 1994 and 2019 same store sales grew an average of 4.7% per year while the store count grew from 165 to 2,024, a 10.5% CAGR. These add up to a 15.2% growth rate which is close to earning’s 16.3% CAGR. Changes in interest rates, taxes, and share buybacks account for the difference.

The chart below shows a ten-year rolling estimate of Tractor Supply’s reinvestment rate and I-ROIC.

Reinvestment rate is the percent of net income the company reinvested in itself. In the early years, this was over 100%. There were lots of opportunities to build stores and net income was relatively small, so they used debt to supplement retained earnings and power growth.

More recently the opposite is true. Net income is high relative to the opportunities to build new stores. In 2010 they instituted a $0.035 dividend which has since risen tenfold to $0.35 per quarter. As reinvestment opportunities dwindle, Tractor Supply’s reinvestment rate should approach zero and dividends plus buybacks should approach 100% of net income.

I-ROIC measures how much net income increased relative to the increase in capital employed. It increased from 16% in 1994 to 37% in 2019. As new stores matured, same store sales increased which allowed the company to leverage its existing infrastructure and increase ROIC.

Most retail stores take a few years to mature, which means opening lots of new stores temporarily depress’s ROIC. Once the new stores mature and same store sales rise, ROIC increases. As Tractor Supply’s store growth slows, its ROIC should stabilize.

EPS growth is equal to reinvestment rate times incremental ROIC. Both reinvestment rate and I-ROIC are moving targets and difficult to pinpoint, but they can be estimated. Until 2014 Tractor Supply’s compounding rate was above 15%.

Dominate A Niche

Tractor Supply faces little competition. It dominates an attractive niche of hobbyist farmers and ranchers. These customers tend to have above-average incomes and an below-average cost of living. They live in rural areas where shipping costs are high, delivery is slow, and there are not many other retailers. Stores are a destination that offer one-stop shopping. The company focuses on “C.U.E.” products — consumable, usable, edible — that are low margin and hard-to-ship but regularly bought. These drive traffic which drives ancillary purchases. Tractor Supply hasn’t had to contend with Amazon because its products tend to be heavy and awkward. It hasn’t had to compete with Home Depot and Lowe’s because their geographic markets don’t overlap.

Low Purchase Price

Warren Buffett alleges that it is better to buy a wonderful company for a fair price than a fair company for a wonderful price. I don’t think he’d argue that its even better to buy a wonderful company for a wonderful price.

Investors who bought (and held) Tractor Supply in its IPO did well. But investors who bought during the dot com bust did even better. In November 2000 Tractor Supply traded for just 4x 1999’s earnings despite reporting a profit every year since its IPO. To that point since its IPO it had reinvested 158% of its net income at a 9% rate, which suggested a 15% compounding rate.

Every few years the market crashes and wonderful companies trade at bargain prices. Investors who bought (and held) shares from 2000 onward substantially outperformed the business’s 20% annual EPS growth. A bargain price allows investors to outperform the business underlying a stock.

Even The Best Stocks Don’t Go Straight Up

Investors can occasionally buy wonderful businesses at wonderful prices because even good businesses see their stock prices crash every few years. A simple, predictable, and profitable business like Tractor Supply saw its price fall 40%+ on a number of occasions the past 26 years.

It’s one thing to look back and think you’d have bought Tractor Supply for 4x earnings in 2000. It’s another to think you’d have held it though all the subsequent 40%+ drawdowns it experienced on its way to becoming the second best performing stock of the past twenty years.

Wes Grey explored this in a paper titled “Even God Would Get Fired as an Active Investor.” He simulated a portfolio which deliberately looked ahead five years, saw which stocks had the highest forward returns, and bought them. By definition, the portfolio outperformed the market. What was shocking was the volatility. From 1927 through 2017 even the God portfolio experienced a 73% draw down and several drawdowns greater than 20%.

The antidote to market volatility is to focus on the fundamentals: reinvestment, I-ROIC, and EPS growth. The fundamentals drive the stock’s return over the decades and tend to be more stable than market prices. Beyond that, investors should remember that stock prices crash every few years and prepare to be buyers, not sellers, during those periods.

Culture Drives Long-term Returns

Investors tend to focus on what’s quantifiable. So far, I have: same store sales, store count, reinvestment rate, and I-ROIC. But just as not everything that can be counted counts, not everything that counts can be counted. Culture falls into the later category.

Tractor Supply’s 1996 10-K (the earliest available) has a section dedicated to customer service on page 1. This alone speaks volumes about how seriously they take it. All retailers say that they guarantee customer satisfaction, but Tractor Supply took it a step further. They actually empower every employee to do whatever it takes to satisfy customers. This relentless focus on customers is what has made many of today’s retail giants great: Amazon, Home Depot, and Costco come to mind. Under National Industries Tractor Supply forgot this and let itself slip. The company coasted on the goodwill it had built in prior years but eventually exhausted it and began to produce losses. It took a strong-willed character like Hennessy to reinstall Charles Schmitt’s original values.

Summary

Tractor Supply offers a good case study of what a compounder looks like in its early years. The key ingredients of its extraordinary 26-year run are:

A high reinvestment rate and decent, consistent I-ROIC;
A niche which insulates it from competition and the business cycle;
A low purchase price, relative to intrinsic value, which allows stock investors to outperform the business; and
A culture which is laser focused on pleasing customers and staying insider their circle of competence.

It’s easy to look back with hindsight and think we’d surly have bought Tractor Supply in 2000 and 4x earnings. It’s perhaps even more instructive to ask if we’d have had the willingness to remain invested through the ups and downs the stock took in the ensuing years. Even the best compounders don’t go straight up, which is all the more reason investors need to keep their eye on the fundamentals rather than the price.

The Future

The million dollar question is, what will the next twenty years look like at Tractor Supply? Unfortunately they’re unlikely to be as lucrative as the last twenty were.

Tractor Supply thinks they can build about 600 more stores. This should take about six years to accomplish at their current pace of 5% annual growth. If same store sales average 4% then the net income should grow about 9% annually. Last quarter the company reported a blow-out with 30% same store sales growth. If the pandemic causes a permanent shift from urban to rural living, Tractor Supply will gain an immense tailwind. However, I wouldn’t speculate on that.

Once Tractor Supply has saturated the country with stores, its growth will revert to about 4% or whatever same store sales average. The company will transition from a “reinvestment moat” to a “legacy moat.” Legacy moat businesses can still make good investments if the CEO makes intelligent capital allocation decisions. The simplest and most straightforward is to become a “cannibal” and spend all of its cash repurchasing its shares. AutoZone, NVR, and Verisign have used this strategy to great success. The worst thing Tractor Supply could do is make an acquisition outside of its circle of competence in an attempt to build an empire and reignite growth.

Today Tractor Supply trades for 25x trailing twelve month earnings. These earnings might be a bit above normal as the company benefitted from a rush to home improvement stores in Q2. A 25x multiple and 10% discount rate imply 5.8% perpetual growth. This looks rosy but not impossible. 2% perpetual growth would be an easier hurdle to clear. Same store sales and repurchases should generate at least that much. A 10% discount rate would value that at 13x. This about half of where the stock trades today but near where it traded a few months ago.

Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.

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