Thesis Summary

·   TSCO has one of the largest beneficiaries of the COVID driven stay-at-home boom and the deurbanization trend.

o   While some of this sales gain is likely to prove sustainable, a regression to the mean seems likely as tailwinds from trip consolidation and the consumers staying at home likely ease in a post-COVID word.

o   Consumer benefits from stimulus are likely to fade in 2022 and consumer wallet share is likely to shift back to services in a post-COVID world.

·   An important point here is that unless sales trends reaccelerate, the upside case for TSCO (discussed below) is already priced in.

o   On Street numbers, TSCO is already trading at peak multiple on what are arguably peak earnings.

·       Store growth not far from saturation point: Management believes that TSCO has the opportunity for 2,500 TSCO stores nationally vs. 2,000 as of the end of 2021 – this suggests there is only 5-6 years of store growth remaining for the TSCO concept. Stagnating store-level productivity before COVID despite positive SSS suggests that TSCO was already seeing returns on new builds decline.

o   Our primary diligence confirms that TSCO likely only has a handful of years of store growth ahead of it.

·       Headwinds to core pet and livestock business from increasing e-commerce penetration in the pet category: Roughly 25% of TSCO’s sales relate to the pet category which is increasingly exposed to Chewy and other E-Commerce players.

Valuation, Returns, and Scenarios

NTM P/E: TSCO historically traded at 18-19x NTM Street EPS vs. Current 25x Multiple

And 11x Street NTM EBITDA vs. Current Multiple of 15x

Importantly, I believe that TSCO is already pricing in an upside scenario where the company sustains the current elevated sales per store seen in 2021 and simply grows off of that base. In this scenario, I also model EBIT margins sustaining at an elevated level.

Both my base case where there is modest regression to the mean in terms of sales/margins and my downside case both point to significant potential downside for TSCO. In my base case I assume a 19x EPS multiple (in-line with historical average) and in my downside case, I assume a 17x EPS multiple (slight discount to the historical average):

Note that while TSCO has received a second request from the FTC for the acquisition of Orscheln Farm, I am giving the company credit for the EPS accretion in my price target math for all 3 cases (worth about 6-7% to EPS assuming acquisition is financed with cash which it likely will be)

Putting it all together, the Risk/Reward for TSCO skews asymmetrically to the downside:

Company Overview

·       TSCO’s core consumer is the ‘recreational farmer’ who lives in a rural or suburban area, maintains a 5-10 acre plot, has pets, and may raise livestock (think having a chicken coop in your yard) or maintain a fruit/vegetable garden. TSCO is effectively a ‘rural lifestyle’ retailer. The company does also serve the professional farmer customer but more for their personal needs.

o   “Tractor in those areas is really looking for a customer base that's mom and dad both work, they have good-paying jobs, and they decided to get out of the city or the suburb and buy five, 10, 20 acres, build a home and a barn and have animals… Okay. They're in between a Walmart or a Home Depot Garden Center. They're not like the John Deeres or the Titan Tires or the real big guys in the ag space. Yeah. It's a hardware store for landowners, small farms, basically… If you own land and have animals, you can get about anything that you need to work on that land and work with those animals and maintain your home at a Tractor Supply” – Former Employee at TSCO

o   “Their target audience is the landowner of five, 10, 15 acres, it’s not the commercial farmers with 15,000- 20,000 acres, or the commercial ranchers. They do some business with that, but those ranches, those farmers do levels that TSC does not compete with” – Former Employee at TSCO

·       The company sells a mix of consumable (pet food, feed, etc.) and larger ticket items in addition to apparel, tools and light agricultural equipment, and seasonal and other general merchandise. Notably, the company’s significant exposure to the big ticket hardware, tools and truck category has made it an outsized beneficiary of government stimulus while the pet livestock and agriculture categories made TSCO an outsized beneficiary of the stay-at-home boom - both trends that we think are unsustainable. TSCO has also branched out into ancillary services for pets in order to better differentiate from E-Commerce.

o   Think of the company as a blend of Home Depot, Cabela’s, and a pet retailer that also happens to sell livestock feed (and even some livestock like baby chicks) and gardening equipment.

o   Average ticket was disclosed at $55.50 as of 3Q21 compared to $46.90 for 2019

o   An expert discusses the breakdown of the livestock and pet category which is nearly half of TSCO’s sales: “Probably 40% is your dog, cat, that's related to typical pet store. You probably have 5%-10% that is bird-related: feeders, bird feed, etc. You probably have another 10%- 15% that is equine, horse-related products, whether it's grooming, feed supplies, saddlery kind of things.  Around 25% or so would be your farm animal, so cattle, chickens, goats, etc.” – Former Employee at TSCO

o   “We're focused on being a more complete resource for pet parents. In store, this includes relevant product assortment and brands, expansion of self-serve pet wash locations across 150 to 200 stores, and the build-out of 50 to 75 additional pet wellness centers. Currently, about 1,600 stores have vet services in-store through our mobile vet clinics. Starting this quarter, pet prescriptions can be fulfilled online at Tractor Supply, as I mentioned earlier.” – 4Q20 Earnings Call

·       Roughly 30% of TSCO’s goods are Private Brand and imports comprise a LDD% of sales. Expert call commentary suggests as much as half of pet food is likely private brand which also serves to provide insulation from E-Commerce Competition.

·       TSCO’s E-Commerce Penetration has ramped from 1% in 2016 to 3% in 2019 to 6% in 2020

o   Disclosures suggest roughly 80% of E-Commerce sales are from BOPUS as opposed to ship-to-home

·       TSCO competes in a fragmented industry – TSCO believes that their TAM for the Farm/ranch category is $110bn suggesting TSCO has roughly a 10% share

o   There is a steep drop-off in size between TSCO and its next largest competitor. Orscheln Farm and Home for example, TSCO’s largest competitor (who TSCO is in the process of acquiring) only has ~165 stores vs. TSCO’s 2,000.

·       Store base is concentrated on the East Coast/Southeast of the country and stores are in a combination of rural and suburban areas:

o   “With the road network, probably the hospitals, probably the Walmart is in that town, so on and so forth. Typically, that's where Tractor would look, the county seat of most rural agricultural counties… and if the county's got good ag numbers, meaning it has a lot of farms, a lot of small farms, a lot of horses, a lot of cattle, sheep, goats. Four-legged creatures equal strong sales dollars for Tractor Supply… If you take the more metropolitan areas of each state, typically, Tractor surrounds some of those more major metropolitan areas where suburbia meets countryside.” – Former Employee of TSCO

Source: 3Q20 Investor Deck

TSCO 2020 Sales by Category:

Source: Street Research

TSCO Quick Financial Overview:

·   At their 3Q20 ‘mini investor day’, TSCO suggested that sales would decline somewhat in a post-COVID period and then resume at the company’s new financial algorithm thereafter. This algorithm calls for 4-5% SSS growth and continued LSD% unit growth leading to 6-7% sales growth. The framework also calls for stable 9-9.5% EBIT margins (note – this is below current levels) and 8-10% EPS growth.

o   While initially management expressed a more cautious tone on the sustainability of the sales gains, in 2021 their tone has been much more optimistic suggesting that the improvements are a result of structural trends.    

·   Company was historically a 3% SSS grower which combined with 5.5% unit growth produced a HSD% Revenue Growth Algorithm. From 2015-2019, Company struggled to efficiently manage Opex which led to EBIT growth substantially below sales growth and EBIT margin compression from 10.4% to 8.9%.

Source: 3Q20 Investor Deck

New Store Growth Runway – Close to the End of the Line

Management believes that TSCO has the opportunity for 2,500 TSCO stores nationally vs. 2,000 as of the end of 2021 – this suggests there is only 5-6 years of store growth remaining for the TSCO concept. Stagnating AUVs before COVID despite positive SSS implied that new builds were opening up at significantly lower sales volumes and that TSCO was already seeing returns on new builds decline. Our own conversations with former employees confirms our skepticism of TSCO’s store growth runway.

·       “I do think they're going to struggle with returns on the new stores not because of where they're going but how close they are to other Tractor Supply locations and the cannibalization impact that you get when you open up that new store…My worry would be that, because store growth is always been a big part of the Tractor Supply story, that there's organizational inertia that keeps going, that wants to build stores, that the store that you might have said no to five years ago and  you know you need to hit 80 stores and it was easier to hit 100 back then, you go, "Okay. Yeah, we'll do it.” – Former Employee at TSCO

·       “That number continues to come down on the new store count because where they're least penetrated is really the only part of the country that they have the most competition. In the Midwest, there are some some pretty good competitors that Tractor Supply's generally struggled with or at least not able to produce the same returns in Missouri and Illinois and Wisconsin that they were able to get in the Carolinas or Florida or Texas.” – Former Employee of TSCO

·       “Yeah. I'd say that it's fleet maturity in four or five years. The way I always thought it should work is, the 80 stores ought to go to 70 stores and then into 60 stories and then the 50 stores, and just not stick to a hard number or a percentage growth target.” – Former Employee at TSCO

·       “Obviously, they've been a high growth or a fairly high growth company over the last decade and a half with new store growth. And that is getting tougher. The low-hanging fruit per se is kind of gone or has been gone. The challenge these days is there are still markets out there that Tractor's not in but the cannibalization of surrounding Tractor Supply stores and the presence of competitors in or around that market” – Former Employee at TSCO

·       “For us, that was a little bit more just kind of a math game, where we've got 500 to 600 more stores to build. We know where the void spaces for those are. We also already know where some void spaces are that we've crossed out because there's already a competitor there, and we feel like there's not demand to allow for a second or third store, our store that maybe in that case.” – 11/2020 Bernstein Conference

·       “That's a great question. Right now, based on the current growth model, they have about 325-350 stores left to build, three years' worth” – Former Employee of Competitor Rural King

One former employee of competitor Rural King suggests the company is having an impact on TSCO in instances where the companies directly compete though this is difficult to quantify and likely not a near term concern given the company’s relatively small size (~120 stores vs. TSCO 2,000 and $2bn in 2019 sales (per expert vs. TSCO $8bn):

·   Former COO of Rural King:

o   “Tractor has a small 15,500-square foot sales floor. They're really a small-box type retailer but they look at adding several and have been to these tests all throughout the country, really… Rural King is an 80,000-90,000-square foot box. They will take over an old Lowe's or a Walmart, lots of Kmart buildings and they'll take the whole space. They operate at a different margin. They operate at lower margin, higher sales”

o   “When Rural King goes into a market where Tractor Supply stores are, they damage their sales pretty significantly… Remember the new stores we built were doing $20 million, $22 million.”

o   “Rural King is known for great prices whereas Tractor Supply is known for just okay prices. Rural King is known for great prices but again, they only make 28% margin whereas Tractor's at 35%-36% margin… A Tractor needs to make that because their SG&A is about 23% or 24% whereas the SG&A for Rural King, in large part due to real estate, is only about 18%-19%.”

o   “when we would open up a Rural King store in you name the market. Morgantown, North Carolina, Knoxville, Tennessee, we have about three or four, when they do $20 million, not only are they taking some business from Walmart, some from Lowe's. They're taking a lot from Tractor Supply not only their local store but many of the stores within 25-30, even as many as 40 miles away. When they know a Rural King's coming, they'll reduce their margin by 3% or 4% by selecting the items that are most visible, some of their top sellers to the rural customer that they're afraid that Rural King will get. They'll actually drop the prices significantly to match or slightly beat Rural King.”

o   “With all the opportunity they have, they still take half their business when they open up a store across the street from them. Literally, they will take 30%-40% of them. What other retailer in America can do that to an $8 billion publicly owned company? Rural King does it and they do it well.”

o   “as far as what they actually offer, it's about 13,000 versus a Rural King that has about 50,000 SKUs which some could argue Rural King has too much”

TSCO Sales per Store ($m) actually declined at a -0.7% CAGR from 2015 to 2019 and then proceeded to grow at a 19% CAGR from 2019-2021. Decline in sales per store despite the positive SSS growth suggests TSCO’s new store productivity and returns were likely deteriorating.

TSCO is Overearning likely on a Combination of Stimulus Benefits and Consumer Wallet Share Shifts from Services to Goods as a result of the pandemic. TSCO is also exposed to ‘stay-at-home’ categories. We think there will be at least some mean reversion in 2022 which will lead to declining Same-Store Sales and margins due to operating deleverage. 

All Goods PCE:

Growth in Goods PCE – outsized increase in 2020-2021 driven by stay-at-home boom. This wallet share shift has already begun to unwind as the US economy reopens and consumers resume consumption of services such as travel.

Total Goods PCE – USD M

All Goods Share of total Consumer Wallet – COVID completely unwound 10 years of consumer wallet share shift to services from goods with 2021 goods share of wallet returning to 2006 levels. This phenomenon will likely prove to be unsustainable.

Retail Sales in TSCO’s Key Categories are up 30%+ in 2021 vs. 2019 levels suggesting TSCO is mostly riding the tailwinds of being exposed to categories that have benefited from COVID. We suspect these gains will at least partly unwind as consumers resume services spending.

Source: Census Bureau Retail Sales data

The Macro backdrop is likely to be less supportive in 2022 as consumer wallet share shifts from durable goods consumption to services and the benefits of stimulus fade:

Rising food and gas prices are likely to prove a headwind to TSCO and big ticket retailers in general as more consumer expenditures are forcibly diverted to food and energy. Inflationary headwinds to disposable incomes combined with a natural wallet share shift back to services should both prove to be headwinds to TSCO’s sales.

Source: Census Bureau

TSCO’s 2019-2021 increase in SSS has been Driven in Roughly Equal parts by Traffic and Ticket. Even assuming the increase in Transactions represents 100% new customers, 20%+ compounded gains in ticket should prove to be unsustainable.

·   Management Commentary Suggests that while meaningful, new customer acquisition only accounts for ¼ of the gains in average sales per store: “And for the first quarter, when looking at the strength of our business, the new customers, both new customers that entered transacting with Tractor Supply in 2020 as well as new in first quarter, really represent a key for us in the first -- our quarter results in the high single-digit range of our mix of the 38.6% comp.” – 1Q21 EC

·   Ticket gains relating to inflation should admittedly prove more sustainable: “That's grown to -- as we stated in our last call in Q3, about 700 basis points of inflation benefit in the ticket in Q3, and we said that we expect Q4 would be somewhat similar to the Q3 rate.” – 9/2021 GS Retail Conference

·   “At some point, I really feel like they're going to have to comp the sales they're getting this year, 30% comps to 35% comps as a result of being an essential retailer for the COVID-19. I think to comp those numbers not just next year. I doubt they will comp those positive next year.” – Former Employee of Competitor Rural King

E-Commerce channel rapidly gaining Share in TSCO’s Core Pet Food Category which leaves questions about TSCO’s ability to continue to growing pet care sales  

Pet Care Category Sales ($bn) – Grew at a 5.3% CAGR from 2015-2019 and a 12.4% CAGR from 2019-2021E  

TSCO Livestock and Pet Category Sales ($bn) – Grew at a 9.4% CAGR from 2015-2019 and a 25.1% CAGR from 2019-2021E

On a per store basis, this is less impressive – corresponding to 0.9% CAGR in Livestock and Pet sales per Avg. Store from 2015-2019 and 20% CAGR from 2019-2021

Livestock and Pet Sales per Avg. TSCO Store

 CHWY Sales ($bn) – Grew at an 84% CAGR from 2015-2019 and a 35% CAGR from 2019-2021

E-Commerce Penetration of Pet Care Category

Pet Care Sales Share by Channel: Pet Specialty, Grocery, and Mass Have Been Share Donors to E-Commerce

Source: Hedgeye/Euromonitor

 TSCO Livestock and Pet Sales – Share of Pet Care Category has been slightly increasing over time although the pace of share gains had begun to slow in the years leading up to the pandemic as E-Commerce players became more formidable competitors.

CHWY Rapidly Gaining Share of Pet Care Category

Risks to Short

·       Remodel and Fusion Programs could provide upside to SSS growth and therefore profitability as well: “It's right in line with our expectations that (inaudible) Fusion transformation. They've outpaced the control group showing us that we expect within 1 year, they generally contribute up mid-single digit incremental comp growth. If you have both Fusion and Side Lot, that's high single digit right in line with our expectations.” – 9/2021 GS Retailing Conference

o   Mitigant: These programs should be reflected in guidance and buy-side expectations considering the company took the LT SSS growth guidance up to 4-5% vs. 3% historically

·       Company has cited evidence of significant new customer acquisition during the pandemic:

o   “For the full year, over 11 million new identified customers and more than 6 million reactivated customers shopped with us at Tractor Supply. We're seeing strong retention with these customers, and we have plans in place to engage them with new capabilities, marketing and product offerings.” – 4Q20 EC

o   “approximately 20% of our new customers reshop with us again within 28 days, so a second time. And this reshop rate has been at the 28th day mark has been consistent, kind of right around 20% since the start of the pandemic. So we haven't seen kind of a half-life, a diminishing return on that retention rate as the year progressed, which is, for us, gives us some optimism around the retention of these new customers.” – BAML 3/2021 Conference

o   “notably are also seeing strong customer retention. As an example, for our new customers from the first quarter of 2020 last year, more than 50% have returned to shop with Tractor Supply. This is about 300 basis points higher than the cohort from the first quarter of 2019.” – 1Q21 EC

o   “The share gain has been aided by the increase in our unaided brand awareness, which has improved by 21 percentage points since November of 2019. This improvement, combined with positive trends in our overall customer satisfaction, are a significant contributor to the share gains we are experiencing.” – 3Q21 EC

·       TSCO is also the beneficiary of structural trends including migration outside of urban areas, increased pet ownership (and raising of chickens etc.), and adoption of hobbies such as gardening.

o   “I think on the last call, we talked about poultry and chickens and flocks and how they're a bit of an annuity stream given that they have a 7-, 8-year lifespan. Obviously, pet is very much the same way. With pet adoption up at an all-time high, those pets, as they grow, are only going to -- they're going to move from puppy food to adult food. We're seeing that, by the way, in our trends. Typically with dogs, as they get a little older, they eat a little more as they get bigger. So we're actually seeing that -- the benefit from that a little bit on the tonnage side.” – 4Q20 EC

o   “As we all know, pet ownership is at all-time highs. The great thing about that is that, that is not a COVID-related kind of category in terms of meeting kind of as COVID abates, knock on wood, that I don't think there's not going to be a change in consumer spend. Those pets are still going to be there. They're still going to have their needs. And different than a grocery store, they're not going to go to restaurants as the economy opens back up, right?” - BAML 3/2021 Conference

o   “Another structural customer trend that is working to our advantage is the significant increase in pet-owning households and number of pets adopted. Compared to the overall U.S. household pet ownership of approximately 2/3, our customers over-index in pet ownership by about 10 points. And our current survey work with our customers indicate 25% have recently acquired and adopted a new pet. New companion animal ownership acts as an annuity for our business as these puppies and kittens grow up and have growing life cycle needs. These customer trends are an indication that we continue to benefit from the numerous tailwinds such as pet ownership, the millennial urban exodus, backyard poultry, homesteading and home as an oasis” – 1Q21 EC

o   “But we do -- about 2/3 of it, we feel is very much structural in nature. And a few of the key drivers that I'll call out would be pet adoption and ownership and a humanization of pets to -- almost 73% of our customers have a pet. 25% of them said that they all got a second pet in the -- during -- over the last year. The pets are like annuity streams for us, right?” – 6/2021 RBC Conference

o   “These structural trends that continue to work in our favor include things like rural revitalization, trip consolidation, omnichannel adoption, and a self-reliant lifestyle movement, including DIY trends and investments in hobbies like gardening, backyard poultry and, of course, pet ownership.” – 3Q21 EC

§  Mitigant: even if the new higher level of sales proves to be sustainable, this scenario is already being priced into the stock