How Tractor Supply Is Defying the Train Wreck of Retail

I know you've read the headlines. "Bricks and Mortar is Dying." "Malls are Doomed." "Retail is Falling Apart."

Every day, it seems we read about another retailer kicking the bucket. My colleague Dan Kline recently wrote that nine major retailers went bankrupt in the first three months of 2017. That was more than the entire number that went bankrupt the year before.

We of course know the reasons for this. The unstoppable e-commerce trend continues, with Amazon (NASDAQ: AMZN) expanding into organic groceries and potentially even pharmacies. As a percentage of total retail sales, e-commerce overall has risen from 6% in 2013 to 9% today, and it's expected to hit more than 12% by 2020.

The most common investor response to this trend has been to 1) buy Amazon and then 2) run, screaming, away from every other retailer in sight. If you want a terrifying Halloween costume for your kid, have them dress up as a JCPenney store.

The gloomy headlines and numerous bankruptcies have significantly driven down valuation multiples. Retail stocks are now officially sitting in the bargain bin. But Warren Buffett's "be greedy when others are fearful" advice begs us to ask a Foolish question: Aren't there any Amazon-resistant retailers who are selling for a huge, unwarranted discount right now?

I believe the answer is yes, in a humble retailer called Tractor Supply (NASDAQ: TSCO). And unless you're living out in the country, you may have never been to -- or even heard of -- this diamond-in-the-rough investment opportunity.

The "Out Here" lifestyle

Tractor Supply is America's largest rural lifestyle retailer. They sell the necessities of the "out here" lifestyle, including wire fencing, farm tools, and pet feed and supplies. Now with 1,630 Tractor Supply stores, they serve customers who may need to "turn off the paved road" to find and shop at their rural locations.

Perhaps unexpectedly, a competitive advantage accompanies Tractor Supply in being the first mover to set up shop in these rural locations. In many ways, it has shielded them from larger competitors.

General retailers like Walmart (NYSE: WMT) and do-it-yourself warehouses like Lowe's (NYSE: LOW) or Home Depot (NYSE: HD) have made fortunes appealing to suburban America. But it's harder for them to justify the significant capital expenditures that would be required to open new stores in less densely populated areas. Bound by corporate metrics such as return on investment, rural stores wouldn't generate enough profits to make for a rational financial decision.

And that doesn't even include the marketing expenses. As someone born in rural Iowa, I can attest that scheduled trips to the grocery or hardware store are an enjoyable part of the weekly routine. These stores serve as common places for people to see and chat with their neighbors. Walmart and Lowe's would also need to invest heavily in advertising to try to win over a brand-loyal customer base.

It's just not worth it. Tractor Supply has a first-mover advantage in locations that can't rationally support a second player. This results in diminished competition, which gives them pricing power and a captive customer base.

Amazon isn't interested

But let's get back to e-commerce. Even tiny, humble Tractor Supply has an advantage over e-commerce powerhouses like Amazon. Rural locations might be one of the few remaining places where David still beats Goliath.

Amazon has willingly invested in a strong logistics infrastructure so it can ship pretty much anything within two days to its loyal Prime members. They're also continuing to step on the accelerator, vowing to soon use commercial drones to deliver packages even more cost-effectively.

Even so, there is some retail business Amazon just isn't interested in. Many of Tractor Supply's products are commodities, which are generally higher-weight and lower-value. Drones may be great for delivering DVDs or light packages, but they're not so great at flying around 80 pound bags of deer corn. Trucking could be an option, but that would require delivering to rural routes that are far away from Amazon's warehouses.

Amazon, too, has its limits, and it isn't looking to always serve everyone, everywhere.

The Foolish bottom line

Tractor Supply's regional monopolies are providing it with a competitive advantage. The isolated nature of its stores, coupled with the recurring nature of its products and its customer base, are generating a solid profit stream that it is using to reward investors.

Next week, I'll write a follow up to this article by taking a closer look at the actual value that Tractor Supply is creating for shareholders. We'll compare the company's return on invested capital to its weighted average cost of capital to demonstrate just how well it's using investors' money to generate excess returns.

I'm impressed with the performance of this little-known and lesser-followed retailer. It might be one of the few bright spots in the ever-worsening landscape of brick-and-mortar retail.

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*Stock Advisor returns as of October 9, 2017The author(s) may have a position in any stocks mentioned.

Simon Erickson owns shares of Amazon, Lowe's, and Tractor Supply. The Motley Fool owns shares of and recommends Amazon. The Motley Fool recommends Home Depot, Lowe's, and Tractor Supply. The Motley Fool has a disclosure policy.