A few weeks ago, I made the case that Tractor Supply (NASDAQ: TSCO) was a hidden gem in the retail industry. Amazon.com's (NASDAQ: AMZN) onslaught may have put several bricks-and-mortar retailers out of business in recent years, but Tractor Supply's rural customer demographic, with its recurring-purchase behavior, significantly insulates it from the e-commerce juggernaut.
The company reported third-quarter earnings a few weeks back, and my colleague Demitrios Kalogeropoulos provided a fine recap of the results, noting the company's 6.6% increase in same-store sales and its 35 new store locations. Wall Street nodded in approval of the report, and the stock is up a modest 5% since then.
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But as Foolish investors, we're less interested in a single quarter and more interested in the longer term -- which requires us to do some deeper digging. I used this quarter as a chance to check in on the business value Tractor Supply is creating for us as shareholders. If the company is using its resources to generate returns that exceed its costs, it's creating equity value. For retailers like this, it's important for us to compare the company's return on invested capital with its weighted average cost of capital.
To simplify that point, say a retail company borrows $1 million to build out a new store. To borrow the money, it needs to pay the bank 5% interest per year. But after the store gets up and running, it starts generating $120,000 each year of profit -- even after paying all of its expenses and associated taxes. The 12% return on invested capital ($120,000 return divided by $1 million investment) exceeds the 5% cost of that capital, so the business is creating shareholder value.
Crunching the numbers
In the same light, let's see if Tractor Supply is creating value for us as well.
I first look at the company's sources of capital. It uses a combination of debt and shareholder equity to fund its business.
There's a cost associated with raising money either through debt (estimated at 4.5%, according to the latest annual report) or through stock (estimated at 10.5%, going by long-term average equity returns for a company of this size). Since the end of last year, Tractor Supply has taken quite a bit more long-term debt, likely to take advantage of the still-attractive low-interest rates. It's deployed the cash it raised into building new stores and also share repurchases, signaling that management believes the share price is undervalued.
As long as the debt load is manageable, which it appears to be, the company has done well for shareholders by decreasing the average cost of capital from 9.3% to 8.5%. If a company can raise capital at lower rates to generate the same returns, you're keeping a larger slice of the pie for your shareholders.
In terms of those returns, I next took a look at the company's revenue and net operating profit. Net operating profit deducts all of the company's operating expenses and associated taxes -- so it essentially represents how much profit the business is generating.
The company's revenue is growing at a nice pace, even though it's capturing a slightly lower operating profit than last year. Some of that is due to non-cash expenses, the depreciation of previously built stores or share-based compensation. But all other things equal, we'd still rather see the return on invested capital increasing rather than decreasing.
Finally, we can compare the weighted average cost of capital to return on invested capital to see if Tractor Supply is creating value for us as shareholders.
The company's 23.5% return on invested capital is significantly greater than its 8.5% weighted average cost of capital. The conclusion is that Tractor Supply is making smart managerial decisions, deploying our capital in ways that are indeed creating business value on our behalf.
The Foolish bottom line
Some headlines might lead you to believe that the entire retail industry is headed to an early grave. But by digging deeper into individual company results, we can find that certain opportunities still exist. Tractor Supply is growing its top line and opening new stores, but also creating business value for shareholders. It appears to be an attractive opportunity in the retail space.
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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Simon Erickson owns shares of Amazon and Tractor Supply. The Motley Fool owns shares of and recommends Amazon. The Motley Fool recommends Tractor Supply. The Motley Fool has a disclosure policy.