Undervalued Dividend Growth Stock of the Week: Tractor Supply (TSCO)

The average person might think that it takes a long time to get rich.

Indeed, it can be a long and tough journey to go from being broke to becoming a millionaire.

This kind of stuff doesn’t happen overnight.

But what exactly does it mean to be “rich”?

Is it being a millionaire? A multimillionaire? A billionaire?

Wealth is relative and subjective.

But what I can tell you is that one doesn’t need to be a millionaire to be rich, nor does one need to be rich to be financially independent and live life on their terms.

Indeed, I quit my day job at the tender age of 32 years old.

And I became financially independent at 33 years old, whereby the five-figure passive dividend income my real-life and real-money dividend growth stock portfolio generates on my behalf covers my basic expenses in life.

You can see that I’m not walking around with a million dollars.

But because I’m able to live on very little money and still be very fantastically happy in life, I can do more or less whatever I want every single day.

If that’s not true wealth, I don’t know what is.

For me, wealth is freedom. Wealth is owning one’s time.

That’s because time is worth far more than money. Time is life itself. And so there’s nothing I’d rather own than my own time.

The good news is that this kind of wealth is accessible to almost anyone reading this article.

In fact, it’s far more accessible than the simplistic and, perhaps, misguided idea of being rich, where one just aims to become a millionaire.

One just needs to build a lifestyle that prioritizes value over price and time over money, living below their means in the process.

And then they invest their excess capital into high-quality dividend growth stocks like those you can find on David Fish’s Dividend Champions, Contenders, and Challengers list – a compilation of more than 800 US-listed stocks that have paid increasing dividends for at least the last five consecutive years.

Of course, one doesn’t just pick random stocks – even dividend growth stocks – at random times and random prices.

One needs to make sure they’re focusing on high-quality dividend growth stocks when they’re undervalued.

A dividend growth stock is undervalued when its price is less than its intrinsic value.

Price simply represents what something costs. But value represents what something is actually worth.

And when a high-quality dividend growth stocks features a former well below the latter, major benefits can be conferred to the long-term investor.

An undervalued high-quality dividend growth stock can offer a higher yield, greater long-term total return potential, and less risk.

This is relative to what the same stock would otherwise offer if it were fairly valued or overvalued.

Price and yield are inversely correlated; all else equal, a lower price will result in a higher yield.

That higher yield positively impacts total return right off the bat, as total return is comprised of income (dividends/distributions) and capital gain.

The former (income) is given a boost right away via that higher yield.

In addition, the latter (capital gain) is given a possible boost, too, via the “upside” that exists between the lower price paid and higher intrinsic value of the stock.

If you pay much less than a stock is worth, taking advantage of a temporary “mismatch” between price and value by the market, you put yourself in an advantageous position, as there’s a good chance that the temporary mismatch corrects itself over time, bringing price and value closer to alignment over the long run.

This position is also advantageous in terms of reducing risk.

That’s because you introduce a margin of safety when you pay less than a stock is estimated to be worth, bringing about a “buffer” that protects the investor.

Because our estimate of intrinsic value cannot possibly be precise, and because anything in business can happen, we need a margin of safety.

A margin of safety offers our investment protection against turning upside down on us (i.e., a stock being worth less than we paid) if an unpredictable event reduces the value of our investment.

As just mentioned, it’s not possible to precisely value any dividend growth stock.

But we can estimate the intrinsic value of just about any dividend growth stock with some degree of accuracy.

One resource designed to help a dividend growth investor accomplish this task is fellow contributor Dave Van Knapp’s guide to dividend growth stock valuation, which is part of a larger series of articles that educate investors on the dividend growth investing strategy.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be reasonably undervalued right now…

Tractor Supply Company (TSCO) is a specialty rural lifestyle retailer that supplies the needs of farmers and ranchers through just over 1,600 stores across 49 states and an e-commerce website.

There’s a paradigm shift occurring within retail right now.

Traditional retailers with exposure to a heavy B&M footprint are part of a business model that’s starting to become outdated as more and more shoppers look to engage and buy online.

That said, business doesn’t exist in a vacuum. Not every retail business is the same.

Enter Tractor Supply Company.

While this is a traditional B&M retailer, it’s a smaller, niche player (the company’s market cap is just $8 billion) that relies on a product assortment that lends itself to supporting (and perhaps even requiring) a physical footprint.

That footprint is spread out across over 1,600 stores that are mostly located in more rural areas, as these stores serve rural customers that farm and ranch in recreational terms.

Many products in these stores are what Tractor Supply Company calls C.U.E. products: consumable, usable, edible.

These are products that are purchased for immediate use, or use in the very near future.

In addition, Tractor Supply Company specializes in many large and very heavy products.

As such, shipping can often be impractical for this business model, which should serve to protect the business as these changing retail dynamics continue to play out.

However, the company also has an online presence (it would be foolish not to) through its e-commerce website, which reinforces the business and allows it to engage with customers when the appropriate products are being purchased.

All of this bodes well for Tractor Supply Company’s ability to earn a profit and grow that profit.

Of course, we wouldn’t be talking about this business and its stock if it didn’t share that growing profit with its shareholders.

Indeed, Tractor Supply Company has paid an increasing dividend for eight consecutive years.

As one will often find with newer/shorter dividend growth streaks, Tractor Supply Company has increased its dividend at a monstrous rate recently, with a five-year dividend growth rate of 33.7%.

Even with that big dividend growth, though, the payout ratio is only a lowly 32.0%.

The one major drawback with this dividend growth stock’s dividend metrics and attractiveness might be the yield.

At 1.67%, that’s not only low in absolute terms, but it’s also one of the lower-yielding retail dividend growth stocks out there.

However, that yield is almost twice the stock’s five-year average yield, with the current yield almost 80 basis points higher than its five-year average.

This is simply a stock that rewards you more with dividend growth than current yield, so it really depends on what kind of investor you are and what your income/growth needs are.

In order to really determine whether this investment makes sense here, though, we need to look at the overall quality of the business through the lens of its fundamentals.

Of course, we also need to reasonably estimate the value of the business, which will tell us a lot about how good this investment might be at the current time.

Fortunately, looking at the fundamentals helps us considerably when it comes time to value the business and its stock.

We’ll now see what Tractor Supply Company has done in terms of top-line and bottom-line growth over the last decade, and we’ll then compare that ten-year track record to a near-term forward-looking forecast for profit growth.

Considering both the past and potential future like this in tandem with one another should give us a pretty good idea as to what kind of growth Tractor Supply Company is capable of.

The company’s revenue has increased from $2.703 billion to $6.780 billion between fiscal years 2007 and 2016. That’s a compound annual growth rate of 10.76%.

Very strong top-line growth here. I usually look for mid-single-digit growth from fairly mature companies, and I’d say Tractor Supply Company is somewhat mature for its respective niche/industry. So this is pretty impressive, in my view.

Meanwhile, the bottom line saw earnings per share expand from $0.60 to $3.27 over this same time period, which is a CAGR of 20.73%.

Again, very impressive.

The excess bottom-line growth has been fueled by a combination of share buybacks and margin expansion.

The outstanding share count has been reduced by approximately 16% over the last decade. Furthermore, the company has authorized a share repurchase program that allows up to $3 billion in buybacks through 2020. That’s more than 1/3 of the company’s current market cap, for perspective.

And the margin expansion story is really rather incredible, especially considering that the whole paradigm shit noted earlier has been playing out in earnest over the last 10 years.

That said, the last three fiscal years have shown a flattening out in margin expansion, with even a reversal in that story in recent quarters. And recent quarters have also shown concern in regard to comps.

Looking out over the next three years, CFRA is calling for Tractor Supply Company to compound its EPS at an annual rate of 11%.

While this would be a much lower growth rate than what Tractor Supply has put in over the last decade, one simply cannot expect this business (or any other business, for that matter) to grow at 20% indefinitely.

New store openings (which Tractor Supply Company is committed to, as per its business model) mitigate some issues with margin compression and comps, driving absolute growth in the face of relative growth challenges. That, combined with the buybacks, could very well support a 11%+ CAGR for EPS over the near term.

Plus, the company is extremely flexible, as its incredible balance sheet allows the company options in terms of M&A, its footprint management, growth, and even its dividend.

The long-term debt/equity ratio is only 0.18, while the interest coverage ratio is over 100.

These are incredible numbers for any industry, but I think they’re especially robust for the retail industry.

And the profitability story, as foreshadowed earlier, is nothing short of noteworthy.

Over the last five years, the company has averaged net margin of 6.36% and return on equity of 29.31%.

Both averages are considerably higher – close to double – than what they were a decade ago.

So even though there’s been some flattening recently, the company is still much higher quality now than it was a decade ago.

Yet the stock is down almost 15% over the course of 2017, while the broader market is up well into the double digits YTD.

Sure, there are some concerns over the retail industry. There’s saturation, competition, and the massive paradigm shift toward online shopping.

Not every retailer will survive what might eventually be “the great retail purge”.

But not every business is the same. Buying a small lamp isn’t the same as buying farming equipment.

Tractor Supply Company’s fundamentals indicate (strongly indicate) that its business is quite healthy in the face of these concerns.

And with the market’s pessimism over retail potentially creating a mismatch between price and value, we might just have an opportunity on our hands…

The stock is trading hands for a P/E ratio of 19.14 right now, which is quite low for a company that’s been compound its earnings at 20%+ annually over the last decade. That’s a backward-looking PEG ratio of less than 1. And it’s a P/E ratio that’s lower than the broader market and industry average. Also consider the five-year average P/E ratio for this stock is 28.7.

Investors are paying much less for this company’s sales and cash flow compared to their respective recent historical averages.

And the yield, as shown earlier, is significantly higher than its five-year average.

So the stock does look relatively cheap here, but how cheap? What might its intrinsic value be?

I valued shares using a two-stage dividend discount model analysis to account for the low yield and high growth rate.

I factored in a 10% discount rate, a 12% dividend growth rate for the first 10 years, and a long-term dividend growth rate of 7.5%.

This DGR is actually conservative, in my opinion. That near-term DGR is well below the stock’s demonstrated dividend growth rate over the recent past, while the long-term DGR is well below anything near the company’s current overall output.

Consider, too, the most recent dividend increase was 12.5%, which is very close to what I’m forecasting for the company’s dividend growth potential looking out over the next decade.

The DDM analysis gives me a fair value of $67.55.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

My valuation shows us a stock that’s potentially modestly undervalued.

As I expressed, my valuation model was arguably quite conservative. However, I like to add perspective and depth to the article by comparing my valuation to what professional stock analysts come up with.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates TSCO as a 4-star stock, with a fair value estimate of $81.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates TSCO as a 3-star “HOLD”, with a fair value calculation of $69.83.

Averaging the three numbers out gives us a final valuation of $72.79, which would indicate the stock is possibly 13% undervalued right now. It’s not as cheap as it was when I first presented the idea back in the summer, but there’s still a lot to like here.

Bottom line: Tractor Supply Company (TSCO) is a high-quality niche retailer that has a business almost perfectly suited to a more traditional B&M retailing model. Incredible fundamentals and the possibility of 13% upside adds up to a fairly compelling idea here for long-term dividend growth investors looking for exposure to the retail space.

— Jason Fieber

Note from DTA: How safe is TSCO’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 94. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, TSCO’s dividend appears very safe and extremely unlikely to be cut. Learn more about Dividend Safety Scores here.

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