Tractor Supply Company (TSCO) Earnings Call Transcript & Summary

Thank you. Good day, everyone. I'm Simeon Gutman, Morgan Stanley's hardline, broadline and food retail analyst. It's my pleasure to be hosting this fireside chat with Tractor Supply Company. Quick 15-second intro of this company. It's the largest chain, about -- of 1,900 rural lifestyle stores in the U.S., on pace to generate over $10 billion in sales in 2020. I'm joined by Kurt Barton, EVP, CFO and Treasurer, who's been with Tractor Supply for over 20 years; Hal Lawton, President and CEO, who's approaching his 1-year anniversary with the company; and we have Mary Winn Pilkington from Investor Relations. Quick fun fact. Hal is among the top 10 youngest CEOs of the Fortune 500 companies. Sorry to embarrass you, Hal. Fun fact #2, in 2012, we actually hosted a symposium on e-commerce and digitalization. Hal was sent. He was the speaker from Home Depot. At this time, e-commerce was pretty nascent. It was more about pure e-tailers at this conference. And I don't think a lot of people came to listen about Home Depot's strategy, but Hal got up, he blew the crowd away with his e-com expertise, which is a platform he helped build at Home Depot. Real quick disclosure. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales rep.

With that out of the way, I'm going to start this. And this is my little prop here, my Tractor Supply hat.

I like that.

First question for both of you, or for Hal, why was now the right time to launch a new financial plan rather than waiting until after COVID?

Hi, Simeon, and good morning, everyone, and thanks for your interest in Tractor Supply and for joining us today. Yes, as it relates to that, I'd start with -- we were already starting to operationalize internally against our updated strategy or Life Out Here Strategy, and we're starting to commit resources to it. We were starting to put -- starting to execute against it, starting to build our plans around it. And we just felt like it was appropriate to both begin getting the strategy internally -- externally at the same time that we were communicating it internally. More broadly, as we just step back, we got a lot of momentum in the business right now. We really are committed to emerging from the pandemic, a much stronger company than we were when we went into it, although it was already quite a strong company. And we feel like we're investing from a position of strength, and there's significant amount of opportunity ahead of us. And we want to take advantage of that opportunity and kind of seize the day. We talked recently about -- in our -- we had an enhanced earnings call a few weeks ago and talked about a $100 billion market, a 10% share -- a $110 billion market with about a 10% share of it ourselves. And that's a significant amount of opportunity to go after. And so the timing was right, both because we were already operationalizing it, but the timing was right also because we were investing from a position of strength.

I think part of this plan is that CapEx is going to double. Curious why you think or what gives you confidence it's going to pay off? And is it new customer acquisition? Is it share gain? What's going to enable this growth to accelerate?

Yes. So as I just mentioned, the total addressable market that we participate in is quite large, and we're uniquely positioned to capture that market share and it's a highly -- beyond our kind of share of approximately 10%, it's a highly fragmented segment where our nearest competitor has only maybe 150 to 200 stores compared to our nearly 2,000 Tractor Supply stores, plus a couple of hundred almost Petsense stores. And we've got this ability to leverage our scale and our supply chain and technology, and we're really excited about unlocking that opportunity. As you mentioned, Simeon, we've got a strong core customer base that repeat shops with us on a monthly and annual basis at incredibly high rates. And we're attracting new and reengaged customers at all-time highs. We've got a strong balance sheet right now. And we've got a track record of executing on our initiatives. We've got some very exciting initiatives ahead of us right now with Side Lot and Fusion. We've done all the business planning around those. We're very confident and bullish on the returns that they can generate. We are committed to very disciplined capital spending and to generating robust returns. This has been a very resilient business model over the last 80-plus years. Incredibly bright past, but we're also [Audio Gap]. And again, as I said, we're well positioned to capture that market share. And there's a lot of new customers and reacquired some customers in our business right now, and we think now is the right time to really double down on the business, invest in it and go and capture that incremental share.

So there are 2 things you mentioned that I want to hone in on. The first is the projects. You mentioned Side Lot, and you mentioned Fusion. The other side of it was customers. But let's start with Side Lot and Fusion. Can you talk about the nature, describe them in more detail what they entail? What are the initiatives? And how do you envision the returns on those initiatives paying off?

Yes. So if we kind of reference back to the Life Out Here Strategy, that I mentioned a few minutes ago, that was the strategy that we rolled out at our enhanced earnings day 4 weeks ago. And one of the 3 pillars was really around operating The Tractor Way. And Tractor Supply has a track record of kind of operational excellence, whether it's in merchandising in our stores and/or in our distribution centers. And The Tractor Way -- operating The Tractor Way really has a few different pillars in it. One of them is around space productivity. And this will be a little bit of a newer focus for us or a heightened focus for us on going after every single -- making every single square foot in the store count, driving our dollars per square foot up and really kind of sweating our existing assets as much as possible. And with that in mind, there's 2 big programs that we're focused on executing right now. One is our Side Lot initiative, which is the concrete pad, that's about 15,000 to 18,000 square feet, typically adjacent to our store. And then the second is our Fusion project, which is inside the store and focused on inside the 4 walls and really optimizing that square foot. So with that as background, Simeon, I'll address real quickly the Side Lot project. And so to your -- to a point earlier, it's about 15,000 to 18,000 square feet, typically adjacent to our store, fenced in and historically, it has been used dominantly just to hold agricultural equipment kind of for our customers and kind of inventory storage. What we've been able to do is to compress the space that, that inventory requires, organize it, put it in racking. And then that's freed up, call it, 10,000, 12,000 square feet for us to then convert that space into a much more robust selling environment that can drive significant sales for us. And there's a few different things we're doing with the Side Lot project. The first is building a garden center that on average is 3,000 to 5,000 square feet. The second is building a feed -- a drive-through feed area where customers can load up their food or their feed and go. A big convenience play for us and a big opportunity to continue to gain share in our core farm and ranch category. The third is Buy Online Pickup in Store drive-through. We've had incredible success with curbside pickup in the last 6 months, and we see this as just the natural evolution of our business and the preference that our customers will have. And then the last thing is just continued selling of that agriculture equipment that I mentioned earlier, just in a more organized way and actually a heightened selling environment. We're very bullish on the opportunity, as it relates to the garden center, which will be one of the core sales drivers of the initiative. Our customers tell us that garden is the category that they most participate in that we least address their needs. And we pride ourselves on being a lifestyle retailer. We think garden is a natural add to the lifestyle that we're already addressing through our other categories. And we're very excited about the rollout of Side Lot. We'll have kind of -- this second half of the year, we're really focused on getting the initiative going, building out our operating rhythms around it, learning how to work with local municipalities on zoning and permitting, getting the kind of construction crews lined up to help us with this. Starting to order all the materials necessary to execute. And we'll have kind of 30 or 40 stores done by the end of this year. And then next year, we're looking to do around a couple of hundred and start to ramp up our effort, and we think it will be a material driver to space productivity improvement of our business.

So this side space has been out there for quite some time. What's been the holdback to utilizing the space before? And is it the complexity of doing garden business supply chain, what were the holdbacks and what are some of the risks as you approach this?

Yes, from the holdbacks, obviously, this is my [Audio Gap] all the depth historically would that have occurred in just a moment to do so. But I would just say it's been really a natural evolution of where we are as a company. We had only a couple of hundred stores, and we're now approaching 2,000 with a 2,500 store target. So we're starting to kind of reach more of a maturity point. The second thing is about 10 years ago, we got really focused on -- maybe 11 or 12 now, got really focused on the C.U.E. business and started to real -- and so that was kind of a big evolution for our company. 3 or 4 years ago, we doubled down on our ONETractor strategy and -- with a big investment in digital. And I think this is just [Audio Gap] everything is kind of very natural order. So it's not that it wasn't a priority before or wasn't in -- thought as an opportunity, it's just more about timing and prioritization. And then I think the risks are more so about getting -- more so about our execution. And I think we're convinced on the opportunity -- we're -- from our customer perspective. We've -- I've got experience from my Home Depot days on the garden center and know how successful they can be, how productive they can be. We've got connections to the growers that we know are going to be necessary to ensure that we've got adequate supply and the right product for our customers. We'll have to grow into it and learn the right assortments that meet our customers. They will certainly be tractorized compared to what you might see in other garden centers with focus more on fruits and vegetables and things that people put in their gardens. We'll certainly still have the shrubs and the annuals and perennials, but I think they'll just be a lower percentage than what you might see in a normal kind of more urban to suburban location. And then we've got to go execute. We've got to get these couple of hundred stores that we're planning on doing in next year, build up that kind of muscle for us. And then we're excited about executing this at a large portion of our stores over the next handful of years.

Great. And then can we touch on Fusion and talk about some of the enhancements that you're planning to make? And you have a merchandising background, and it seems like some of these things are to increase the productivity of the current store. So if you can touch on Fusion, please.

Yes, absolutely. So Fusion is really a -- it's our inside the 4 walls productivity program. It's really the best of what we've done in the past with ONETractor in combination with all the other tests and pilots that we've done over the last couple of years. And then layering on top of that, all the latest analytical tooling investments that we've made, which include things like store clustering, store-specific planogram capabilities, CAD technologies for our stores. And really what that allows us to do is to come to build a store-specific planogram that optimizes the dollars per square foot for that store based on all what I just mentioned. And I'll give you a few examples of the types of things that we're doing in there. The first thing we're doing is just modernizing our layout. Historically, we've had a customer service desk in the back with our cashier stand upfront. We're now integrating those 2 and making 1 customer service cashier area. Frees up about 300 square feet in our store, which allows us to merchandise the [Audio Gap] agricultural products and the [Audio Gap] in this case, to kind of stack out more product and really ensure our in-stocks and our kind of -- and allows us to have the quantities that we need of those products for our customers. The second thing is really around allocation of space between categories. And so part of this reduces the lineal feet that we devote to apparel by 8 square feet. And then the pet food picks up. Pet picks up that extra square footage. While apparel has nice dollars per square foot productivity, pet is much, much higher. And so you're really kind of doing a mix shift on 8 lineal feet to a much higher productivity category and allows us to go after things like cat and pet -- and other areas in pet in a more robust way than we have in the past. The last thing I'll bring up is it also allows us to bring in new vendors and expand programs that in the past have been more of a convenience play. And so an example of that's in power tools, where we've been dominantly focused on and provided Dewalt product to our customers. And we're adding Makita into our power tools area. And so we'll have both of those brands going forward and a much more improved shopping experience for each with demo stations, product readily accessible below the stations. And again, a much more contemporary way to sell power tools with a -- the addition of an outstanding brand as well. So those are just kind of 3 examples of some changes we're making inside the store, but literally every single square foot of the store is being assessed and analyzed and evaluated for optimization opportunities. We're really pleased with the early results of the pilot stores we've done with both Fusion and with Side Lot. With Fusion, we plan on having between 50 and 75 stores done by the end of the year. All of our new stores will start to change over to Fusion next year in Q1, and again, we're targeting around a couple of hundred stores next year for Fusion. And we feel like we've got -- we've assessed all of our stores, and we think a large portion of our stores are applicable for Fusion over the next handful of years.

Thanks for that, Hal. This one maybe more for Kurt. I'll let you choose. So the Street took down -- took your latest financial targets as a sign that, "Hey, we're investing more in the business at a lower incremental margin." That's compared to where the business currently sits during this COVID period. But in fact, it looks like your financial plan shows faster growth and higher margins versus where you were in 2019. So my question is, do you see the plan as a step down in profitability? Is there any way to sustain the sort of COVID margins in a normalized environment? Or is the plan, "Hey, we're planning to improve sales and margins going forward?"

Yes. Simeon, thanks. I'll take that, and good morning, everyone. The -- I'll address that in 2 ways. Let me first just talk about how we view that. And I think you set the stage well with it. How do we view the financial targets and what the comparison is? And then let me just share some of the financial targets on that. And to your point, I mean, 2020 from all facets is an unusual year, unprecedented and this has been a tremendously resilient business that is thrived in it. 2020 and all its level of unusualness really causes us to encourage investors to view our strategy and our long-term targets really in comparison to pre COVID versus a normalized post COVID. And when you look at that, we see a great opportunity this year that we've taken, and we are investing to make sure that we sustain this level of growth. And so we believe we've got a great opportunity to sustain this stepped-up level of growth, the new customers, the reengaged customers. And so in regards to comparing the financial targets, how we view it is taking the previous financial targets, the 2019 performance, and really, how does that compare to a normalized post-COVID environment, where our top line revenue growth on a much higher level of revenue that we've stepped up, and we're investing to sustain. We see an opportunity to achieve 6% to 7% revenue growth, fueled mostly by comp store sales growth, a 4% to 5% comp store sales target. Our new stores, we're continuing to -- we plan to continue to open at a consistent level. But with the stepped-up level of growth, the new store contribution at the level of revenue now is really about a 2% contribution versus that 3% to 4%. So the 6% to 7% is fueled principally by a stepped-up level of comp sales growth. We believe this -- our financial targets includes a higher level of operating margin improvement over the long term. All of that contributing to an 8% to 10% earnings per share growth on a higher level base of revenue. And when you take on a commitment of a 30% dividend payout ratio, it gives a really compelling, strong, sustainable total shareholder return over the long term in the low double digits. And we believe, while making the level of investments we're making during this period of time to be able to achieve those operating margin levels and grow earnings per share 8% to 10% is a great compelling investment opportunity, which gives us a great opportunity to gain market share. And for us, it's a long-term strategy.

And as part of some of the out-year plans, you've permanently increased wages and improved benefits. We're now seeing other retailers follow suit. So it seems like this is going to become the norm. Can you talk about in what ways you think you've seen the payoff or in what ways you will see the payoff? And it feels like this is just pulling forward something inevitable for retail, if that's a fair comment. But can you just talk about the idea and the reason for moving up wages and benefits and some of the payoffs you're seeing?

Yes. So I'd start with just if we look back over the last handful of years in retail, and certainly, it's been the case for Tractor Supply, wage rates have been going up and Tractor Supply has demonstrated the ability to find offsets and efficiencies to adequately manage the P&L even in the context of that pressure. And to your point, Simeon, I think that's -- it's going to be a continued pressure that all companies face is just increasing wage rates, whether it's state and local municipality, laws and rules or whether it's just competition for team members and just supply demand. And then the second thing I'd say is, as it relates to current -- in the moment, I think we've always viewed at Tractor Supply, our team members as a strategic asset. And we pride ourselves on delivering legendary customer service to our customers. We have some of the best customer service marks in retail. And we have some of the lowest turnover rates in retail, particularly at the store manager level. And so we thought, just given the nature of the pandemic, the essential work that our team members are doing, the courage and commitment that they're demonstrating we thought it was only appropriate to invest in our team members in an outsized way. And to your point, we announced that back in June. Several of the retailers have followed suit since then. But I think we were one of the first. And our -- the big 3 things that we announced were, one, that all team members in the company, hourly team members would be receiving a dollar wage rate or more increase. The second thing were that -- the second thing was that all part-time team members would have access to the same benefits as the rest of the -- our team members in the company. They had not previously had access to benefits. And then the third thing was that our DC managers and our store managers going forward will be receiving restricted stock grants, and we did an off-cycle grant for all those team members in the July time frame to kind of start the process, and they'll all receive their second grant in the normal annual cycle. As we look forward, we certainly know that, that investment needs to have a return. And we're already seeing that investment in our results and have every expectation that, that will continue. We're seeing it in our customer satisfaction scores. We're seeing it in our retention or lack of attrition. We're seeing it in our internal ESAT surveys, but we're also seeing it in just our customer voting with their feet. So we've had over 10 million new and reacquired customers shop with us in the last 6 -- in the Q2 and Q3. And we've seen the repeat shop rates of those new and reacquired customers run at higher levels than we've seen in the past. And those customer satisfaction surveys that those customers fill out, explicitly call out the customer service in our stores as one of the main reasons why they're shopping with us, in addition to things like safety and cleanliness of the store, which has been a big focus for us over the last 6 months, 8 months. And we expect those sorts of benefits to continue as we move forward. And again, our team members are a big part of our -- a strategic advantage for us, a strategic asset, and we're committed to continuing and invest in them to deliver that -- the customer service that we're known for.

So we have about 3 or 4 minutes left. There haven't been any questions that came in from the audience. So maybe I'll ask one for you, Hal, and one for Kurt as a 2-parter to bring us home. First, for you, Hal, I wanted to ask about the pet food business. It's been a hot topic, a key debate point for Tractor Supply story. It seems like your business there has been on fire, and there's more pet families. And more importantly, you're retaining that business. Is it just going to some other players in e-tail. So that's the first question on pet. The second question, maybe for Kurt, at the enhanced earnings event, there was a mention of tuck-in acquisition, as -- there's a capacity to do that. I didn't know if that was just, "Hey, just in case, we look at things," but can you talk about maybe Petsense, which was the last acquisition, I think Tractor did, any -- are there any certain capabilities that you may look to buy rather than build in the future?

Yes. So I'll hit the pet food question quickly here. I'd start off by just saying it's incredibly strong and strategically important category for us at Tractor Supply. It's a category with a very large TAM. It's also a category with a lot of momentum with pet adoptions and ownership being at all-time highs, plus the humanization of pets as well. We have a very differentiated offering where we combined strong exclusive brands like 4health, complemented with services like our pet clinics and pet washes. And then also complemented with our really strong omnichannel capabilities that allow for same-day, next-day delivery to a customer's home as well as curbside pickup and, of course, obviously, just BOPUS in general. The category is driving significant new customers for us due to the convenience and selection that we have. We talked in our Q3 earnings call that our C.U.E. business, which stands for Consumable, Usable and Edible, but it's a proxy for things like pet food and animal feed, was in the mid-20% growth rates. And so we feel like we're gaining share in the business. And we're leveraging all of our core differentiating factors to do so. And we believe we can continue to win in this very important category as we move forward, and we're making the investments necessary to do so.

Yes, and Simeon, in regards to the question on acquisitions, at the enhanced earnings event, we very specifically pointed out our priorities on capital allocation. And one of those was acquisition. But let me quickly just reiterate our #1 priority, which is where we focused a lot on the event was investing in the business, investing in new stores. And as we just talked about in the last 30 minutes, the investment in our existing stores. And then in addition to that, we previewed a lot of the work we'd have been doing to really shore up a great capital structure. We've got a very strong balance sheet, a great capital structure, capacity to have a 2.5x leverage ratio, and with that, it allows us to then be very active and give compelling strong return to shareholders, and it still gives us a good capacity to be able to be open to any tuck-in acquisitions. And that's really the emphasis that we've got the ability to invest in the business, return to shareholders, still have the capacity in our industry where it's very fragmented in farm and ranch. Tractor Supply can be a great exit strategy. And there's areas where we don't have plans or don't have stores in markets that others may. And so we feel like from a core farm and ranch standpoint or if there's a capability that buy versus build, those would be the level of tuck-in. And the important point is we're capable of moving and acting upon that. And the Petsense acquisition allowed us to build an infrastructure to be able to systemically tuck in acquisitions much better and easier than we had in the past. So we're prepared and able to do that from a financial and systemic side of that scenario.

Great. Well, Hal and Kurt, thank you very much for sharing at least a sliver of Tractor Supply story and the investments going forward. Congratulations on a stellar 2020. Wish you success in Q4 and in 2021, and thank you.

Thanks, Simeon. Appreciate it.

Thanks, Simeon.

Thanks, guys.