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Tractor Supply Co. (TSCO - Analyst Report) reported yet another encouraging quarter with earnings surging nearly 19% to 69 cents per share in the third quarter of 2012, beating the Zacks Consensus Estimate of 67 cents. The company’s results benefited mainly from strong top-line performance and improved operating margin.

Quarter in Detail

Tractor Supply has been witnessing increasing trends in same-store sales. The reported quarter was no exception as robust performance in core consumable, usable and edible products − mainly for pet food and animal feed − acted as a catalyst for a 2.9% increase in same-store sales on top of an 11.5% rise in the previous-year quarter.

During the recession, Tractor Supply had suffered setbacks since the buyers avoided big-ticket purchases, such as mowers, but recent quarters have seen a reversal of these trends. The company’s impressive merchandising improvement strategy resulted in high single-digit top-line growth.

Net sales in the quarter improved 9% to $1.066 billion from $0.978 billion in the comparable prior-year quarter. However, total revenue missed the Zacks Consensus Estimate of $1.069 billion.

Gross profit during the quarter increased 9% to $0.357 billion compared with $0.328 billion in the prior-year quarter. However, gross margin remains flat year over year at 33.5%, as the benefit from improved sales of big ticket seasonal items and positive impact from lower sales of low-margin products were fully offset by increased transportation costs and adverse impact from the shift in sales mix to freight-intensive C.U.E products.

Better cost containment related to store personnel and lower incentive compensation expenses resulted in a 30-basis point (bp) improvement in selling, general and administrative expenses, as a percentage of sales, which came in at 26.2% versus 26.5% in the prior-year quarter. Consequently, operating margin during the quarter improved 30 bps to 7.3% versus 7.0% in the prior-year quarter.

Financial Position

Tractor Supply ended the quarter with cash and cash equivalents, including restricted cash of $0.078 billion compared with $0.118 billion at the end of the year-ago quarter. Stockholders’ equity came in at $1.054 billion compared with $0.937 billion at the end of the third quarter of 2011.

Long-term debt as of September 29, 2012 stood at $0.040 billion versus $0.035 billion. At the end of third quarter, the company’s long-term-debt-to-capitalization ratio remains flat year over year at just 3.7%.

Store Update

In the quarter under review, Tractor Supply opened 17 new stores and closed one, compared with 12 new store openings and 1 closure in the year-ago quarter. As of September 29, 2012, the company operated as many as 1,151 stores in 45 states.

Management Guidance

Looking into 2012, the company expects its profits to grow continually, given the right mix of products and marketing plans to maintain customer footfall. Encouraged by strong third-quarter operating performance, the company raised and narrowed its 2012 earnings guidance range to $3.61−$3.65 per share compared with its earlier forecast of $3.58−$3.66 per share.

Moreover, looking at the favorable weather conditions, the company anticipates better fourth quarter winter sales. Tractor Supply has also raised and narrowed its net sales and comps guidance range for full-year 2012.

The company now expects net sales to be in between $4.61 billion and $4.65 billion compared with $4.58−$4.65 billion forecasted earlier. Similarly, comps are expected to grow in the range of 4%−5% instead of the previously forecasted range of 3.5%−5.0%.

Our Take

We believe that Tractor Supply has successfully tweaked merchandise assortment across its stores, which is in line with the prolonged economic downturn. The company has increased the proportion of less discretionary items, such as animal and pet-related products, while reducing shelf space for certain big-ticket merchandise, such as outdoor power equipment.

Moreover, in an effort to boost margins, Tractor Supply is expanding its portfolio of private label brands and is focusing on direct sourcing. The company has set a long-term target of generating 25% of sales from private label brands and 13% from strategic direct sourcing. This provides a strong upside potential to the company.

However, sluggish economic recovery along with the risk of unfavorable weather conditions affecting farmers’ business operations are matters for concern. Moreover, due to intense competition from larger retailers such as The Home Depot Inc. (HD - Analyst Report) and Lowe’s Companies Inc. (LOW - Analyst Report), Tractor Supply may find it difficult to execute and implement new business strategies, which in turn, may impact its operations adversely.

Currently, the company has a Zacks #2 Rank implying a short-term Buy rating. However, we remain slightly cautious on the stock and uphold our long-term Neutral recommendation, waiting for further catalysts before becoming more positive on the stock.

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