Description

Tractor Supply Company is a niche retailer with a proven business and with growth opportunities, selling at a big discount. TSCO is a specialty retailer that primarily serves the daily farming and maintenance needs of hobby farmers and ranchers and others who pursue a rural lifestyle. The stock is at about $14 1/8, which is about 6.2X the $2.25-$2.30 in EPS that the company is projecting that they will do in 2001 -- which is too cheap for a fundamentally good business expected to grow earnings at a 10%-15% pace over the next 5 years. A fair valuation for TSCO might be 12-15X earnings in today’s market -- making a fair value for the stock $27-$34. The stock is cheap because after several years of solid growth, earnings were down about 8% in 2000 -- from $2.03 in 1999 to $1.87 in 2000, as a result of TSCO having flat same store sales in 2000, primarily due to very strong sales in 1999 that were related to Y2K spending (they sold a lot of generators and related products in 1999), that were difficult to surpass in 2000. However the business is fundamentally solid, and the company is expecting to do $2.25-$2.30 EPS in 2001 with a modest 4% increase is same store sales. In addition to the fact that the stock is very cheap, and results are improving, there are a few other important catalysts. The company has a new aggressive President (been with the company about 3-4 months) who is fired up about reinvigorating same store sales increases, which is the company’s number one priority, and there is a huge opportunity to improve inventory turns to free up a substantial amount of cash, which is the company’s second priority.

TSCO currently has about 308 stores, and they have been adding stores at about a 12% pace over the last 5 years or so. The company believes that there is the potential for 700 to 800 stores East of the Rockies, which is where all stores are located today, and potentially more in the West if they ever decide to grow in that direction -- so there is plenty of growth potential. Stores are generally located in smaller towns or the distant suburbs of larger cities. They plan to continue to increase their store base at 10% or so per year, although in 2001 they will only increase the store base by about 8%, so that they can focus on operating improvements this year. About 8% of their revenue is from commercial farmers, the balance is from hobby farmers and others who enjoy a rural lifestyle, so this is really a consumer business, not a supplier to the cyclical production agriculture industry. Main product lines are lawn and garden products including riding mowers and replacement parts, animal and pet products including feed and equine products, light truck and towing equipment, farm maintenance products such as air compressors and welding equipment, general maintenance products such as chain and cable, and work-wear including heavy-duty denim and work boots. This product line is selected to meet the needs of their customer target, and their goal is provide customer service and expertise as well as the special products that are difficult to find elsewhere. TSCO’s direct competition consists of traditional farm supply stores, which are generally smaller chains of privately held businesses, and larger groups of stores controlled by the farm co-ops. However they do indirectly compete with big box retailers such as Home Depot and Lowe’s in hardware and tools and the pet supply stores in animal supplies. TSCO works very hard to not compete directly with the big boxes, by providing products that are focused on their customer niche that the big boxes don’t want to devote the space to, and by having personnel with expertise in agriculture and animal care (especially equine) which the big boxes cannot do. Approximately 30% of their SKU’s are carried by the home centers, but generally their goal is to “stay out of the headlights of the big boxes.” The company generates about a 13% after tax return on equity, which should be more than sufficient to fund their expansion program, so they are not dependent on the capital markets for growth capital.

They have about 8.8 mm shares outstanding so the equity market cap is about $124 mm given the current $14.125 stock price. Their primary debt is a revolver that is primarily used to finance seasonal working capital needs – they ended 2000 with $50 mm on their revolver, plus $13 mm in other debt, for a total of $63 mm in debt. So their enterprise value is about $187 mm. In 2000 they did EBITDA of $44 mm and in 2001 they should do $50 mm in EBITDA. Therefore the company is trading at 4.3 times last year’s EBITDA and 3.7 times this year’s EBITDA – so the company is trading substantially below private market value. At a conservative private market value of 6 times 2001 EBITDA of $50 mm – the stock would be at $27, basically double today’s price. In 2001 they will do about $17 mm of capex, of which about 50% is related to new store development and 50% related to the existing business, so this is not a business that consumes much of its cash from operations in maintenance capital.

The senior management team consists of Joe Scarlett CEO, Jim Wright COO and President, and Cal Massman CFO. Joe Scarlett has been with TSCO for almost 30 years, and has been leading the company for 15+ years, taking the company private in a successful LBO from Fuqua Industries and then taking the company public 5-6 years ago. Jim Wright recently joined the company about 4 months ago as President after being CEO of a 150-unit private-equity controlled automotive service company -- Tire Kingdom -- which he sold to a public company called TBC Corp. Prior to Tire Kingdom he was with Western Auto and K-Mart. Call Massman has been with TSCO for about a year -- in the past he was CFO of Builder’s Square when it was controlled by K-Mart, and had been in numerous financial and senior management positions with W.R. Grace. My assessment is that Cal Massman is a competent CFO, Joe Scarlett knows this business and the target customer very well, and Jim Wright is the “new blood” that is ready to shake things up and make some operational improvements that could be a positive catalyst. Jim Wright comes from the highly competitive automotive service retailing industry, and seems to bring a level of intensity to TSCO that may have been lacking in the recent past. As a new COO Jim Wright would like to make his mark on TSCO, and he is pursuing multiple improvement opportunities -- including improving store-level management, doing full line reviews of all TSCO categories looking for ways to improve merchandise selection, and working on to improving inventory turns. Jim Wright’s efforts have the potential to result in incremental improvements to sales, profitability, and returns.

Probably the biggest improvement opportunity and a big catalyst for the stock is in inventory. TSCO currently turns inventory only about 2.1 times per year. This is a pretty low level of inventory turns, and results in them carrying quite a bit of inventory – they ended 2000 with $222 mm in inventory, and their seasonal peak inventory during 2000 was $267 mm at the end of Q3. They carry a high level of inventory generally as part of the way they compete -- one of the ways they meet the needs of their target customer is by making sure they have in-stock the unique products that a customer may need to repair a small tractor for example. As a destination retailer, they need to be certain that they have the product in-stock that a customer made a special trip to TSCO to pick-up. As a result, they are never going to be a high-turn retailer, but there is significant opportunity for improvement. Its worth noting that the currently low level of inventory turns doesn’t represent a negative change or a recent build-up in inventory that can signal a problem for a retailer – its just the way they have been operating the business in the past. For example, in 2000, their sales / average inventory ratio was 3.5, down slightly from 3.6 in 1999, but better than 3.2 in 1998, 3.3 in 1997, and 3.2 in 1996.

The company believes that they can get to 3 turns in a few years and have identified this as a priority. If they can move from 2 turn to 3 turns, that would reduce inventory about 33%, freeing up about $70 mm in cash based on their 2000 ending inventory. $70 mm represents about $8 per share in cash that could be taken out of working capital and used to finance growth, permanently pay-down debt, and/or be returned to shareholders through a stock buy-back. Permanently reducing capital tied up in inventory will also improve their returns on assets and equity. This $70 mm or $8 per share reduction in inventory is a significant opportunity for value creation for a company whose stock is at $14.50 and whose enterprise value is $191 mm. The company has already begun working on inventory turns by pushing more vendor shipments through their distribution centers rather than direct to stores, which reduces freight costs and allows smaller shipments of individual SKU’s to be shipped to stores. During 2000 they reduced inventory about 4% per store -- from $760,000 to $730,000 per store. Inventory reduction is their second priority for 2001 -- after driving same store sales which is management’s biggest priority.

A potential risk we see is that in the long term the big box retailers such as Home Depot and Lowe’s could pick up key product categories that TSCO is successful in and go after them aggressively. This does seem to be a longer term risk, maybe 3-5 years out, because today TSCO has a strong business and customer niche, and they spend a lot of time thinking about how to differentiate themselves from the big box retailers. They are continually refining their product selection to provide products that their customer set needs but aren’t available at big box retailers. Historically and today TSCO seems to have done a good job managing this risk, but who knows if they can continue to deal with this in the long term. For this reason, we may consider selling TSCO after 1-2 years as the stock gets more fairly valued at $27-$34, rather than holding the stock for 5 years while they grow and create more value, but this is something that we will evaluate over time.

To meet their 2001 projections of $2.25-$2.30 in EPS, the company is planning on generating 4% same store sales growth plus the addition of 25 new stores. However they are projecting comps of –1-2% in Q1 2001, due to a later spring selling season compared to 2000’s Q1. In 2000 spring came early due to weather patterns, so they had strong sales in late March, which they don’t expect to happen until April this year. (Q2 is their strongest quarter seasonally due to spring, followed by Q4 due to cold weather which drives sales of heating and apparel plus gift purchases.) They typically have a small loss in Q1 since it is their seasonal low period, and this year’s Q1 loss is expected to be bigger than last year’s. Although they expect to have slightly lower comps in Q1 2001, this is really driven by weather as opposed to operational or marketing problems, and they expect to pick up any lost sales in Q2 when spring starts (making their Q2 comps easier to achieve this year). So these really aren’t lost sales for TSCO in Q1, just a shift to Q2. They expect to have stronger comps in the last 3 quarters of the year, driven by operational and marketing improvements, as well as the fact that 2000 was generally flat so the company believes that those comps shouldn’t be that difficult to beat. Over the last 5 years, their comps have averaged 4%, so they are not planning on doing anything heroic to achieve the $2.25-$2.30 in 2001 – these results seem reasonable and achievable. For example in the last quarter, in Q4 2000, they were able to achieve comps close to 5%.

Overall we think TSCO has a compelling risk/reward profile at these prices. Risk seems pretty low due to low valuation versus current earnings and private market value, while there is the potential for very good upside with pretty conservative valuation assumptions. Operationally, this is not a teen fashion apparel retailer that continually has adapt – TSCO should be a reasonably steady performer due to the relatively slow rate of change in their customer base and the needs of their customers. Catalysts include improved operational performance in 2001 versus difficult 2000 and opportunity for significant inventory reduction.

Catalyst