Petsense Acquisition Makes Sense for Narrow-Moat Tractor Supply

Narrow-moat-rated

Petsense's 136 stores will join Tractor Supply’s 1,542 locations. While on a store basis, Petsense's 136 locations represent 9% of total stores, they represent only about 3% of selling square footage by our calculation, so much of the growth over the next few years will continue to stem from Tractor Supply-branded location. Petsense locations have about 5,500 selling square feet whereas Tractor Supply checks in around 16,000 inside selling square feet.

From our best estimate, Petsense is achieving roughly $100 million-$125 million in annual sales, consistent with management’s comments some stores made more or less than $1 million in sales per store annually. Furthermore, management noted it expected no material impact to the gross or operating margins over the next few years, which supports our thought that the medium term won’t benefit significantly from Petsense (one time transaction costs of about a penny will occur in the fourth quarter). Tractor Supply indicated EBITDA margins were positive, but we assume were at a portion of Tractor Supply’s 12% EBITDA margin as the business doesn't have similar scale.

However, we could see the logic in the Petsense acquisition for a number of reasons. First, Tractor Supply had taken on its own foray into the pet care market in recent years with the opening of two HomeTown Pet locations in Tennessee. Petsense offers Tractor Supply rapid expansion into pet categories it wasn’t operating widely in across its core locations, including grooming, training and vaccinations. It also provides faster footprint growth into pets, with plans to increase the Petsense store base 15%-20% per year (this equates to 20-25 boxes in 2017). As a percent of the total growth in 2017, this could mean that just under 20% of new boxes and 6% of square footage growth represent Petsense locations.

Second, Petsense adds another channel for Tractor Supply to drive private label sales, which already comprise more than 30% of total sales. At this time, Petsense is completely branded, and while Tractor Supply doesn’t plan to enter necessarily with its own private label brands, it does plan to enter with potential new private label brands that cater to the Petsense customer. Private label can generate a few hundred basis points of incremental gross margin versus branded products, leaving longer-term margin expansion on the table.

Finally, the Petsense acquisition bolsters the company’s ability to reach the 2,500 locations it has forecast over the long term more easily, as it expands into adjacent markets that cater to many of its already existing categories, including pet, and highlighting its differentiated CUE (consumable, usable, edible) category goods. This adds 20-25 stores incrementally to the 8% square footage growth Tractor Supply has at its core boxes, at least over the near term, helping boost growth (and Tractor Supply believes there could possibly be 1,000 box potential for Petsense).

We like that Petsense has similar regional exposure to Tractor Supply, away from urban and suburban locations and closer to a rural footprint, preventing them from competing directly with Petsmart and Petco in many markets. That said, while Petsense appears to be in traditional Tractor Supply markets, it tends to cater to a different pet owner, one which doesn’t have significant property and is looking for a bit of different product mix for their pets. We expect because of the differentiated mix, expanding Petsense closer to Tractor Supply markets will not cannibalize sales, but rather continue to attract customers outside of Tractor Supply’s traditional end user. We plan to maintain our capital allocation forecast, which calls for no further leverage on the balance sheet, continued dividend payout ratio of about 25%-30% and tactical share repurchases.

Tractor Supply Is Set to Reach Critical Mass Tractor Supply is the largest consumer farm specialty retailer in the U.S., with more than $6 billion in annual sales. The firm has differentiated itself through its products and customer demographics, which provide underlying support to Tractor Supply's brand intangible assets and a narrow economic moat. The store base has grown by 50% over the past five years, to more than 1,500 locations, driving sales and earnings per share CAGR of 11% and 22%, respectively. We forecast that the firm will grow to nearly 2,400 stores over the next decade as it populates big-box centers in the western half of the U.S.

The firm competes with big-box retailers like Petsmart and

We believe Tractor Supply is positioned to reach critical mass in its consumer segment over the next decade, but that consistent operating margin expansion depends on corporate development across arenas, including better customer attribution data (through a loyalty program, which is currently being implemented), better bargaining positions with suppliers (improved payables and credit terms), and more sophisticated logistics (as store footprint and distribution centers grow). These types of projects can increase operating margins meaningfully—and these are projects that both Home Depot and

Weakness in Oil-Producing Regions Problematic, but Won't Stunt Potential Growth Our fair value is $84 per share, accounting for persistent weakness in oil-producing regions, with little in the way of rebound in demand over the next two years. We think mismatched merchandising for the cold season ahead piques our concern that merchandising isn't as dynamic as we would prefer to bolster comps during periods of cyclical uncertainty. Our fair value estimate implies a 2017 price/earnings ratio of 23 times and an enterprise value/EBITDA multiple of 14 times. This is versus a five-year historical P/E based on fair value of 28 times and an EV/EBITDA multiple of 15 times and a forecast for midteens earnings growth longer term.

While some of the categories that Tractor Supply operates in are relatively mature, we view the breadth of its offerings and potential for growth of its current consumer base as well as increased penetration of new consumers as positive factors that could drive top-line growth. We project that total sales can grow at a high-single-digit pace over the near term (after rising 6% in 2016, down from 9% previously) supported by mid-single-digit comparable-store sales (1.1% in 2016, from 3% prior) and high-single-digit square footage growth. We have forecast gross margins to expand moderately over the next decade (by roughly 150 basis points, to 36%) while the selling, general, and administrative ratio leverages 220 basis points (to below 20%) from our 2016 outlook as the business continues to improve its relationships with vendors and strengthen its supply chain as its footprint scales. Over the next five years, we project a rising double-digit return on invested capital rate versus our 9.0% cost of capital assumption, providing support for our narrow economic moat view.