EUR 850.00 For Business Accounts Only

Morningstar | Tractor Supply Merchandising Continues to Drive Store Traffic, Boosting Sales; Shares Fairly Valued

Narrow-moat Tractor Supply remains an anomaly in retailing, keeping customer traffic driving to stores thanks to its differentiated product and category mix (31% in private label sales). While we suspect investors were disappointed that Tractor’s 2019 forecast called for same-store sales of 2%-4% after generating three quarters of above 5% performance, we believe this outlook is pragmatic and takes into account the type of growth that consumer companies encounter after a long period of economic expansion, which can remain positive but slower. Additionally, the forecast for flat operating margin performance, at 8.9% to 9%, which fell just short of the 9.1% our 2019 forecast incorporated, indicates further expense headwinds (logistics, inflation) could persist. Furthermore, the pruning of 10 PetSense locations leaves concern that further location closures could slow the brand’s growth, with boxes set to grow around 8% in 2019 versus the original outlook for 15% growth at acquisition.

That said, we still think Tractor Supply remains one of the best-positioned firms to weather both a cyclical downturn and the secular shift to e-commerce that continues to persist given its exposure to less elastic CUE products and customers' loyalty to private-label products. We don’t plan to alter our $90 fair value estimate materially and view shares as fairly valued, trading at 18 times the midpoint of 2019 EPS guidance ($4.60-$4.75). Our prior 2019 EPS outlook for $4.63 was supported by same-store sales of 3%, sales of $8.4 billion (in line with Tractor’s $8.31 billion-$8.46 billion guidance), and net income of $568 million (versus the $555 million-$575 million Tractor expects). This growth tunes into our longer-term outlook, which seeks 2.5%-3% comp growth, an average of 70 annual Tractor store openings, and modest operating margin expansion (to 9.5% in 2022 from 8.9% in 2018), as the firm continues to spend on IT initiatives and further build out its distribution network.

Strong fourth-quarter results followed suit with recent quarters, with sales that increased to 9%, to $2.1 billion, helped by same-store sales growth of 5.7% (ahead of our 3% forecast). Total comp was supported by average transaction value that rose 3% while transaction count hiked 2.6%. The gross margin contracted 60 basis points, to 33.6%, as Tractor was plagued by higher freight expenses (which should begin to lap in the second half), mix, PetSense clearance, and inventory rationalization. The SG&A ratio including depreciation ticked up 30 basis points to 25.1%, due to inflated incentive expenses and firm investments (infrastructure, labor, technology) weighed on the metric. All in, this led to an operating margin 8.5%, the lowest fourth quarter mark since the recession (fourth-quarter 2010).

Despite weak operating performance, the company is set to move into the second half of 2019 with the ability to leverage its expenses more easily. First, the new distribution center that began taking inventory in the fourth quarter will be fully operational, acting as less of a drag on expenses. Second, Tractor will begin to lap inflated logistics costs in the second half, on both carrier and fuel fronts. And finally, the benefit of initiatives including the further rollout of the Stockyard kiosks and mobile point of sales systems, as well as efforts to optimize the utilization of data being gathered by the 10 million member Neighbors Club, should help both merchandising and conversion. This should drive modest year-over-year operating margin improvement in the company’s second half, which should average about 8.5% in 2019 versus 8.3% in 2018.