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The Nuts And Bolts Of A Rebound

While much of the U.S. and global economy face chronic challenges, domestic agriculture remains a bright spot. Net farm income is forecast to climb 28% for 2011, according to the Department of Agriculture, topping the $100 billion mark for the first time.

That puts farm and ranch store retail chain Tractor Supply Co. (NASDAQ:TSCO - News) in a sweet spot. The building, farm and garden products chain has grown steadily the past few years. This year, CEO Jim Wright sees more of the same.

"Our expectation is 2012 will be yet another good year for Tractor Supply," Wright told IBD.

Tractor Supply is a top performer in the Retail-Wholesale Building Products group, which ranked No. 1 among IBD's 197 industry group Friday. The largest names in the group, Home Depot (NYSE:HD - News) and Lowe's (NYSE:LOW - News), operate more stores and pull in many times the revenue of Tractor Supply.

But Tractor Supply's sales, up by double digits the past seven quarters, easily outpaced the bigger chains. Profits soared by at least that rate the past 10 quarters. And if analysts' forecasts are on target, it will show a double-digit earnings gain in Q4 2011 — and the full year, when it reports the the quarter's results on Feb. 1 .

The company keeps a tight focus on its customers: recreational farmers and ranchers as well as tradesmen and small businesses, says Wright. It hires team members who relate because they have lived or understand the lifestyle.

It's benefited from the relatively good shape its customers are in.

"We do business on the edge of suburbia, in small-town rural America," said Wright. "As a result, we've been somewhat isolated from a lot of things going on in the housing boom and bust.

Overall, building materials, garden and supplies retailers are also benefiting from gradual improvements in the ravaged housing market. Strengthening housing starts and permits data have boosted a broad range of construction-related stocks, including building products wholesalers. The leaders in that category are maintenance and industrial supplies distributor W.W. Grainger (NYSE:GWW - News) and Fastenal (NASDAQ:FAST - News), which focuses on nuts, bolts and screws, but also sells a broad array of construction and industrial equipment and supplies.

1. Business Tractor Supply, Grainger and Fastenal serve different markets, but managed to grow in a tough economy.

Wright says Tractor Supply's customer-centric focus has been central to that success. The company takes a personable approach to knowing its customers, he says, to understanding their needs and what they're looking for in products. That translates to high customer loyalty scores. The company has also spent years cultivating a culture based on "shared values." That means it nurtures a climate of trust, encourages its team members to take risks and to work hard and through collaboration.

Tractor Supply is small next to Home Depot and Lowe's. But it is a comparative heavyweight next to its smaller regional competitors. Wright puts his chain, with more than 1,000 stores, at more than three times the size of the next six competitors.

"We bring the power of a $4 billion company," said Wright.

Grainger is primarily a wholesaler. Its customers are mainly commercial maintenance operations that manage businesses, facilities and campuses. The largest distributor of facilities maintenance supplies in North America, its fat catalog is a standard fixture in most maintenance departments and includes everything from light fixtures and electrical switches to motors and floor cleaners.

It also serves customers through multiple distribution channels, including sales reps and direct marketing materials.

"We have a multichannel model designed to deliver a high level of availability and high level of service," CEO Jim Ryan told IBD.

Facilities managers typically don't stock items they're not sure they'll use. But when they do need a product — often for emergencies like an air conditioning breakdown or a power outage — they need it right away.

"Our business is designed to solve that problem," said Ryan, noting it carries more than 400,000 products in the U.S.

Its products are available the same day in its branches or for next-day shipping. Ryan says many customers have been consolidating their suppliers to cut costs.

"The broader your product line and the better your service, the more likely customers are to consider you as they're consolidating suppliers," Ryan said. "That's been a big part of our growth.

Fastenal is also a wholesaler, distributing industrial and construction supplies through a network of company-owned stores. Most of its customers are manufacturers and nonresidential builders, and the company has also made customer service a core competency, says Robert W. Baird analyst David Manthey.

"They provide the platform and the tools and the information to each of their over 2,500 store managers to allow that to be the No. 1 distributor of construction and industrial supplies in that area," he said.

Through training, it offers store managers the tools to make their location the best in their area. So when you visit a store, managers understand their buys, margins, revenue and other metrics and how they fit into the overall corporate numbers, Manthey says.

Home Depot, the No. 1 home improvement retailer, has done an "excellent job" turning around its business over the last four or five years, says Piper Jaffray analyst Peter Keith. He says a key driver has been improving its customer service through efforts like allocating more labor in its stores and offering bonuses to employees based on store performance. Overall, it's created a better working atmosphere, he adds. That's helped improve the shopping experience.

It's among the changes that have helped the company "turn around its business in recent years and retake market share" in the home improvement industry, he adds.

Name of the Game: "The key to success in our business is providing a highly reliable service across a very broad offering of products," said Ryan.

Developing team member loyalty and "empowering them to develop customer loyalty" has helped drive success at Tractor Supply, says Wright.

Offering a "compelling" product assortment at a competitive price is important in home improvement retailing, adds Keith.

2. Market Keith says the home improvement retail industry is more consolidated than other industries he follows, but still somewhat fragmented. The big dogs — No. 1 Home Depot and No. 2 Lowe's — both cater mainly to do-it-yourself customers who fix up their own homes. Next in line are the do-it-for-me customers, who buy materials and hire contractors to do the work, says Standard & Poor's analyst Michael Souers.

Keith says companies have done a good job driving purchases of smaller-ticket items, like paint or garden tools, when economy-stressed customers aren't taking on large remodeling projects.

3. Climate Sales for home improvement retailers like Tractor Supply, Home Depot and Lowe's started to improve in 2010, says Michael Niemira, chief economist at the International Council of Shopping Centers. After two years of industry declines, 2010 sales rose 5.5% vs. the prior year, he says, citing the Commerce Dept. That trend continued last year with a 6% rise.

Niemira forecasts another 4% rise in sales in 2012 and a 3% gain in 2013, moving toward full recovery over the next few years.

Key to that outlook is a housing market in the early stages of what may be a rebound.

"We're moving from a position where the housing market has been a head wind for these retailers to where it becomes neutral or maybe a slight tail wind," Keith said.

He says in October, the S&P/Case-Shiller Home Price Index was down 3.4% vs. the prior year.

"That doesn't sound great, but the two prior two months were down roughly 5.5% year over year," he said. "It seems like we have reached an inflection point where home-price declines have started to abate. I think we're in a position where over the next couple of months, we should see home prices stabilize on a year-over-year basis.

Souers says the environment for home improvement and building supplies retailers is gradually improving. But they still face challenges. Nagging unemployment and weak wage growth mean there's not a lot of additional spending power, he adds. At the same time, it's tough to get home equity loans — a major source of remodeling funding — amid tough credit and underwriting standards.

4. Technology Grainger has built an e-commerce system open to access and navigation regardless of a customer's system, said spokesman Robb Kristopher via email. Small customers use grainger.com, and Grainger links directly to the inventory systems of its larger commercial customers.

Tractor Supply is rolling out a warehouse management system. It's also in the early stages of redesigning its own, multichannel effort.

That includes developing "the most robust content" with product information and other features to help customers enjoy their lifestyles.

"We want to become expert at converting buyers to shoppers online," Wright said.

5. Outlook Given the uncertain housing market and an only slowly improving economy, the outlook for building materials retailers and wholesalers is a mixed bag.

Upside: Keith expects both Home Depot and Lowe's to have a better 2012 than 2011. Housing is becoming neutral, rather than a negative for the business, he said. "That's an important change.

Souers says he's "neutral" on the home improvement retail industry. He expects growth to be "lackluster" over the next couple of years.

"All in all, there's going to be a slight improvement, but the home improvement retailers will slog through the next couple of years," he said.

But he sees some favorable drivers. They include record-low mortgage rates and good housing affordability.

Downside: On the negative side, Souers cites a lack of bank financing, ongoing weakness in the macro environment and soft home prices.