Does Tractor Supply have a Competitive Advantage?

By Simon Erickson - July 6, 2012 | Tickers: BUD, KO, TSCO | 0 Comments

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QUICK -- think of a growth stock that has crushed the market over the past decade.

Chances are that you rattled off a household name like "Apple," "Amazon," or perhaps even "Netflix."  But I'd be fairly surprised to hear anyone claim to have named Tractor Supply Company (NASDAQ: TSCO), even though an investment in this stock is now tenfold (up 916%) what it was a decade ago.

As a bit of background, Tractor Supply is the largest operator of retail farm and ranch stores in the United States.  They have 1,100 stores in 44 states, and they believe that they can open another 2,100 locations domestically.  Their motto is "enjoy the 'out here' lifestyle."  We can consider them a specialty retailer that has a niche customer base.

I've been scratching my head trying to figure out how a farm equipment retailer has completely obliterated the market like this, so I've chosen Tractor Supply to be the next victim of my almost-famous Competitive Analysis.  In this, I analyze four distinct categories, with particular things that I look for in each:

1 - Intangibles:  Brand recognition, Patents, Leadership and Vision, Culture

2 - Stickiness:  Recurring/Habit Forming, High Switching Costs, Distribution Network

3 - Customer Experience:  Network Effect, Word-of-Mouth Advertising, NPS Positive

4 - Cost Advantage:  Resource Location, Process/Scale

I then give out points for advantages in any of the sub-components, for a total possible score of 12 points.  I generally consider a company that scores at least 3 points to have a competitive advantage, and at least 5 points to have a strong competitive advantage.

So hold on to your boots, partner...we're going to see how well Tractor Supply saddles up.

Every retailer strives to build brand recognition, and Tractor Supply has worked to build a name for itself to keep its customers coming back.  However, much of this repeat business might not have anything to do with brand at all.  Their retail outlets are placed in small-town locations where they are often the only store for customers to choose from.  While this is certainly a locational advantage that could keep competitors out of their backyard, I'm dubious as to the importance and relevance of the Tractor Supply brand.  If it were seen that consumers would pay more at Tractor Supply stores than in other stores, I might re-consider that there is a brand recognition advantage.

The Leadership and Vision of TSCO is very strong.  The company continually refers in their annual report to a goal of Momentum, which they further detail in a five-point business strategy.  Their ultimate goal is to achieve loyalty from their customers, employees, and investors.  They like to promote from within, and familiarize employees with the ground-level of the business before reaching management-level positions.  Overall, the company does a great job of promoting tenured employees into management positions.  I am convinced that the board has the right vision of how to lead the company into the future.

TSCO scores 1 out of 4 possible points for Intangibles -- one for Leadership and Vision.

Tractor Supply has been continually monitoring its customers purchasing behavior, and they noticed a few years ago that consumers were becoming more interested in "repairing and replacing" equipment rather than making new discretionary purchases.  TSCO adapted to this change in consumer behavior in 2008 by adding more 'CUE' products -- "Consumable, Usable, and Edible."  The move paid off.  Annual revenues are up nearly 50% since 2008 and operating profits have tripled.  And if you've paid attention to the stock price, you've seen that the market has clearly applauded this decision as well. 

Tractor Supply has also laid the groundwork of a potentially solid distribution network.  70% of their merchandise goes through at least one of 7 distribution centers connected through a central network.  The company uses ERP (Enterprise Resource Planning) to plan for demand and reduce inventory buildup.  Though this is a step in the right direction, it simply isn't at the same world-class scale as a Coca-Cola (NYSE: KO) or an Anheuser-Busch InBev (NYSE: BUD).  Coca-Cola and Budweiser have been selling to the same customers for decades, running the same routes week after week through a highly-optimized logistics network.  In other words, Tractor Supply doesn't yet have a universal distribution system that can block out competitors from reaching customers.

TSCO scores a 1 out of 3 possible points for Stickiness -- one for Recurring/Habit Forming.

I am cautiously optimistic about the experience received by Tractor's Supply's customers.  The company does seem to have effective word-of-mouth advertising, as is evidenced by the fact that they spent even less on advertising in 2011 than they did in 2006.  They also have an internal CRM program to anticipate customers needs and preferences in advance of their purchases, which helps them boost seasonal demand and carry lower inventories.

But other than this, I think that the stores and locations are too isolated to truly benefit from a network effect.  The nature of farming requires a fairly sedentary lifestyle, which minimalizes the benefit of having an enthusiastic customer base that wants to tell everyone they know what a great business you have.

I'm not charitable enough to give any points here.  TSCO scores a 0 out of 3 possible points for Customer Experience.

TSCO strategically chooses locations for its stores in small towns that can support one farm supply store, but likely not two.  This is a great strategy to create a barrier to entry and keep competitors from reaching your customers, as competitors simply can't financially justify building in the same locations.

Lastly, we are all familiar with the toll that online retailers have taken on big-box retailers such as Best Buy or Borders.  Although TSCO might not have an absolute cost advantage against lower-margin competitors, their niche market make them more difficult to directly compete with.  After all, how often do people search for "tractor" on Amazon?

TSCO scores 1 out of a possible 2 points for Cost Advantage - one for Resource Location.

Pencils down!  Let's see how TSCO stacks up in their Competitive Advantage: 

With a score of 3, Tractor Supply shows some moderate signs of Competitive Advantage.  Their leadership's experience and vision has the company in good hands for the future.  Their recurring and loyal customer base coupled with strategic store placement can keep out potential competitors.  They also have some up-and-coming initiatives in their distribution system and CRM program, though these are not mature enough yet to qualify as competitive advantages.

Just like any investment, Tractor Supply has its risks (the largest being exposure to adverse weather conditions and seasonal sales fluctuations).  But after plowing through the Competitive Analysis, we can better understand what it is that makes Tractor Supply's motor run.

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