Tractor Supply Company (TSCO) Earnings Call Transcript & Summary

Okay. Good morning, everyone. Welcome to our next session here at Baird's Global Consumer, Technologies & Services Conference. I'm Peter Benedict, senior retail and consumer products and services analyst here at Baird, and I'm very pleased to welcome Tractor Supply back to the conference. Tractor Supply is the largest rural market retailer in the U.S. through its network of roughly 2,000 stores and a growing omnichannel capability. Tractor Supply is really the go-to provider for everything these rural households need to take care of their animals, maintain their land and really just to live their lifestyle. Just before the onset of COVID, Tractor Supply welcomed their new CEO, Hal Lawton, and what a first 12 to 16 months it's been for Hal. And this morning, we're fortunate to have Hal with us, along with Kurt Barton, the CFO, and Mary Winn Pilkington, of course, who leads up their Investor Relations effort. I think the company has a few slides maybe to run through to kind of kick things off, some introductory comments, and then we'll jump into Q&A. So if you have any questions, please email. I'll put them into the portal. I'll do my best to weave them into the conversation. But with that, I'll just turn it over to Hal.

Yes. Thanks, Peter. In the spirit of time, I think we'll just have some opening comments in the slide, but we just want to say, first off, hello, good morning to everyone. Thanks for joining us today, and thanks, Peter, for hosting us. And yes, I think we'd just build off of your opening comments, Peter, and just really reflect a bit on the company, introduce it and then talk about our future. We're a company that was founded in 1938. We are a lifestyle retailer focused on the Out Here Lifestyle. That -- the business model and the focus on the Out Here Lifestyle has proven to be an incredibly resilient business model, one that's demand driven, one that's needs based, one that has a very loyal customer segment, has afforded us the ability to have positive sales growth the last 26 consecutive years. One of the better performing stocks in the S&P kind of top 10, top 15 over the last 40 years as well and one that just has an incredibly bright past. And first and foremost, that past has really been enabled by our purpose-built culture, very much grounded in mission and values that date all the way back to our founding in 1938 and then articulated over 40 years ago and still very much what drives and guides our organization on a day-to-day basis. We participate in a large, robust, attractive market. It's $110 billion-plus by our estimate. We have just over a 10% share of it on a rolling 12 basis. And we think we've got a very exciting Life Out Here strategy that we introduced last October externally. It really builds off of the previous strategies that the company has been executing, and we think it positions us for continued, sustained long-term growth and shareholder value creation. And excited to share more details on that and talk about the business here in this fireside chat.

Yes, great. No, it's a great setup. And I'm going to kick this off with a few questions that we're kind of asking everyone, but they're relevant to each company, of course. And the first is just really around consumer behavior. And as we're moving -- coming out of the pandemic now, mobility is starting to pick up, just curious from your standpoint, observations you have around how the consumer is behaving at the moment.

Yes, absolutely. I start out by saying I think the overall consumer in the country is very strong right now and stronger than perhaps we anticipated beginning of the year. And I'd say our consumer kind of in more ex urban/rural America is doing better than the average U.S. consumer. And there's a variety of reasons for that, but I think consistently over the last 15, 18 months, the rural consumer has been kind of lesser affected by all the challenges that COVID and other challenges we have been faced. I'd say a few more details on that. I'd say from a kind of tactical perspective, starting to see, as expected, basket size shrink a little bit back more towards historic trends as last year, consumers were stocking up and consolidating their tickets. And that also is being offset, though, by increasing transactions as people are kind of getting out more. So you've kind of got a little bit put and take there. The other thing I'd speak to that's kind of consumer behavior is on inflation. There's no doubt we're in an inflationary environment. We commented on that at the end of our Q1 call and said that the inflationary environment is exceeding what we expected at the beginning of the year. To date, we've seen little elasticity with customers' purchases, with consumers having incremental savings of over $2 trillion, many of them having saved the stimulus checks, the last couple, 3, and many of our consumers really having -- really not been affected by the unemployment that occurred last year and many of them actually working harder than they've ever worked with overtime, et cetera. Our consumer is in great shape, and so they're -- the inflation, we really aren't seeing it impact their purchase trends. The final thing I'll say that is specific to Tractor Supply is we saw 11 million new customers last year shop with us. And so a big question for -- as we entered the year is what sort of retention rates can we have on this 11 million new customers. We want to -- kind of you've got all the transaction basket size, kind of AUR kind of dynamics. But the big thing is, can you operate that at a higher level of customers? And we feel really good about our retention of those customers with the retention rates kind of staying at higher-than-normal rates on a higher-than-normal base, which we think sets us up well through the year and beyond, and it's a core part of our Life Out Here strategy.

Got it. No, that makes a lot of sense. I'm going to follow up on the new customer question in a moment. Before I do that, though, I just want to stick with inflation very quickly and just pivot over to kind of the cost side of things and input costs, whether it be on products, whether it be labor, freight. All are factors that all companies are dealing with. And so just kind of curious, maybe your updated thoughts on how those dynamics are playing in your business.

Yes. This is Kurt. I'll take that. And let me start by leading into it with a comment that Hal made, which is, there's little doubt right now, and I'm sure you're hearing that through the conference, that we're in an inflationary environment. For -- in summary for Tractor Supply, we believe, as we saw the indicators of these inflationary-type items and we indicated that even in our last call, that our long-term financial targets and algorithm, we can maintain those during this environment. Certainly, Tractor Supply has shown over the years it's an area that we've had to build the muscle, and we've -- we manage through inflationary and deflationary environments. But let me hit those -- that question by first talking about, one, the inflationary pressures and then, secondly, our approach towards that. We are seeing it across the board. That is a bit of an unprecedented time. So we've been through times where you see cost pressures on the input costs or you see specifically freight. But as most retailers are, we're seeing product cost inflation. For us -- the strongest piece of the input costs for us are in corn and grains and steel. Those are the 2 things that we indicated going into the year and even said we're starting to see higher amounts. So from a product standpoint, we're seeing it on the grains and steel. We're also seeing the disruption of supply chain, certainly driving double-digit increases in both domestic and import carrier costs. And the labor market is certainly an area where we're seeing more competitive pressures today. And so those are the 3 things that we really are working towards, monitoring it really well. We've got some great plans in our approach. As I indicated earlier, we believe we can manage our current year guidance and our long term. The organization manages through these environments frequently. We're going to leverage our scale and our partnerships with our vendors. For instance, on the product side, Tractor Supply being a high-q, commodity-based, consistent, needs-based business, we and our vendors know we have a consistent volume that we purchase through them that gives us the ability to partner, predict and leverage our scale and our strong supply chain. We're taking pricing actions. Hal mentioned right now, we currently see and anticipate that this year, there'll be less elasticity in the consumer. And so we're leveraging our pricing tools that -- it's been a year or 2 since we've talked about that, but those are the investments we made a few years ago. And so our price intelligence and how we manage that to maintain market share, we believe today's environment with the consumer, more ability to pass on those costs. We will continue, though, to be an EDLP retailer, right now less promotional. It allows us to stay low on that. And so the mix of all of that, while normally inflation does put pressure on the gross margin, that in this environment, even in high levels of inflation, we believe we can maintain our guidance on our gross margin and bottom line in it. So a lot of things that we're managing very nimble, and the team is able to manage through it right now very well. And all these factors give us continued confidence in Q2 as well as the back half as for our guidance.

That's great. No, that's super helpful, yes. Just a lot there, so I appreciate you unpacking that a little bit. Hal, back to the new customer situation. You mentioned 11 million last year. I think the first quarter was another 2.5 million, something in that neighborhood. And you've got around 20 million, I think, neighborhood loyalty members. So maybe talk about how you're using Neighbor's Club to kind of drive engagement. I know we're at kind of Neighbor's Club 2.0 here right now. I know loyalty programs have a life cycle of their own. So maybe expand on that a little bit.

Yes. As you mentioned, we have a -- I'd start off by saying we have a very loyal customer base. And several years ago, we rolled out our Neighbor's Club loyalty program and saw excellent embracement of the program by our customers. And over the past few years, we've built that base up to over 20 million Neighbor's Club customers. They represent approximately 60% of our sales, and the retention rate for those in that loyalty program is extremely high. When you dig into the Neighbor's Club membership, what you see is you kind of break it into 3 value tiers, kind of a low-, a medium- and a high-value tier. As you would expect, you see higher retention rates as you step up the value tier. And so what we did this past year was we rolled out an update to our Neighbor's Club program, and we created 3 customer-facing tiers that reflect those same spend levels. You can be a Neighbor, a Preferred Neighbor, or Preferred Plus Neighbor, basically a silver, gold, kind of platinum sort of approach. And based on your spend level, if you're a Neighbor, you earn 1 point per -- 1% off basically per dollar spent; if you're in the preferred, it's 1.5%; and if you're in the preferred plus, it's 2%. If you use our private label credit card, you earn 5%. And so it's just kind of a step-up, providing a bit more value for our customers, driving -- kind of reinforcing those tier spend levels, all focused on migrating people up the tier levels. And we're seeing excellent early responses from our customers on it. We're seeing increased sign-ups. Some of that's because last year in COVID, it was a little bit more difficult. But we're seeing nice sign-ups. We're seeing excellent adoption of the private label credit card. We talked about that end of Q1. We're seeing usage of some of the benefits that come along with it. If you're a preferred plus, you get free everyday shipping online, you get 1 free trailer rental a quarter or you get 1 free same-day delivery a quarter, and we're seeing nice use of that. And again, we're seeing excellent behavior. What this affords us behind the scenes to do is to take all that data. And over the last few years, we've made substantial data investments. We migrated that data to the Microsoft Azure platform. We're able to use all the cloud-based tooling that's out there to drive kind of analytics around our customers and ultimately deliver a better customer experience through personalization of things like their website visits, their mobile app visits, emails that we send them, all those sorts of ways that you can personalize and create a better experience for the customer. Last year, as you mentioned, we were -- we benefited to the tune of having 11 million new customers and approximately 2.5 million in Q1 with the momentum continuing into this year. Many of those customers have moved into the Neighbor's Club program. And as mentioned, 20% of those new customers shop with us again within 30 days and over 50% shop with us again within a year. So excellent retention rates of those new customers. And we're seeing them really embrace that Out Here Lifestyle. And so when you're -- I was in our stores in upstate New York yesterday, and you can see when you're walking our stores that loyal kind of Neighbor's Club, historical kind of farm and ranch customer that's kind of been living the Out Here Lifestyle for several -- for decades. And then you can see that newer, a bit more millennial customer shopping our stores that's kind of being welcomed into the Out Here Lifestyle. And in fact, we're launching a new marketing campaign this quarter. It's rolling out right now. That's incremental to our national advertising campaign we've been doing for over a year that's specifically focused at the millennial and doing it in a much more digital way through Pandora and Spotify and YouTube, kind of pivoting our creative messaging to say, welcome to the Life Out Here, versus with our core. We've been reinforcing how they just enjoy life out here and appealing to something that they're already doing. So very exciting dynamics occurring in our customer base, all with very positive trends.

Yes. No, that's great. I mean, look, we've been covering Tractor Supply for around 20 years, and there's always things going on, and it's been great to see the evolution of the business and where it's come from. But when we're trying to talk to folks about it right now, we kind of feel like -- I'm not sure there's ever been a time where there's more change or transformational initiatives underway at the same time that we kind of dubbed the Tractor 2.0. And loyalty is one, what you're talking about there, the new customer acquisition. Another thing I want to touch on are 2 of the things going on kind of at the store level, the first being Project Fusion, and the second being Side Lot. Let's start with Fusion, which is basically a space optimization effort. Maybe talk about Fusion, strategy behind that, how many you think you have done, and then we can pivot over to Side Lot.

Yes, absolutely. So on Project Fusion, to start with, we have -- we're nearing 2,000 stores, and many of those stores are in need of reinvestment, as any kind of maturing retailer has to do. And so on Project Fusion, the great thing about it is, is we're able to drive significant space productivity improvements, significant customer experience improvements and go in and do the maintenance and updating things that you need to do once the store has been open 10 or 15 years. And so I'll kind of speak to each one of those. On the space productivity piece, we've taken all of the line reviews and all the pilots and tests that we've done over the last couple of years, augmented that with the investments we've made and assortment optimization and planogram tooling and localization and gone in and built about 50 to 80 business cases inside of Project Fusion, and that's what we're rolling out. And so it includes things like removing an entire aisle out of payroll and shifting that over to pet, where we have a much higher dollar per square foot. So you're mix adjusting your productivity. Another example is we're taking the customer service desk, which is about 300 or 400 feet in the back, and bringing that forward, combining that with our cashier wrap, and that's freeing up space for us to do pallet drops for feed and food, which were the dominant market share leader. It's also allowing us to bring in new brands, such as Makita, and kind of really upsize our tool corral area and make it more formidable against some of the home improvement competition. So there are, as I said, 50, 70 little mini business cases just like that, all of which are focused on really driving our space productivity in a kind of science-based way. The second is the customer experience. So when you walk in, it feels like a more modern retail but still kind of has that feel of a Tractor Supply. There are light boxes on each one of our end caps that we can change out seasonally to represent what's going on. And we do a number of other things through with new signage, new way finding, all the things that are -- create a more modern customer experience. And then lastly, we go in and we do things like the lighting, the floorings, the bathrooms. And all that comes together for a remodel that takes kind of 6-ish weeks to execute inside of our store. This year, our goal is to do about 150 to 200 as we ramp up this muscle. And then over time, we see at least 1,500 of our existing 2,000-store base receiving the remodel. And all new stores that we're building are receiving the Fusion prototype treatment.

No, that's great. Certainly, the first kind of system-wide or chain-wide remodel effort that we've ever seen at Tractor. We all know that -- how those can pay off for the company and for investors. So that's really great to hear. Side Lot is the other kind of, I think, super exciting thing going on in the stores. Maybe talk about that transformation. What attracted you to the $20 billion lawn and garden category? Maybe a little bit of your history there. And just your thoughts on space utilization out on the Side Lot even beyond the kind of peak seasonal periods.

Yes, absolutely. So Peter, as you mentioned, you've been kind of following Tractor Supply for a while. But for those who haven't, we've really had 3 transformative product category moments in our history. In the late '70s, we really started to lean into animal feed in a much bigger way. Prior to that, we've been more of a parts and -- tractor parts and agriculture equipment-type retailer, really just focusing really on that farm and ranch customer. And Joe Scarlett and a few other folks had the idea of really starting to sell equine feed, livestock feed, goat/sheep feed, those sorts of things, in a much bigger way. Now we're the market share leader in the country on bagged feed. And then in the early 2000s, kind of 2005 time frame, we'd always had a convenience play for pet food, but we started to really lean into that more and started to really devote space to it, create private-label brands and become a large player in pet food. And those 2 kind of category additions really drove significant momentum over a multiyear, decade-long period for us. We view garden as a very similar transformation of the company and really kind of a third wave of momentum. And that -- the Side Lot Transformation that you're mentioning really allows us to go after the garden business in a way we hadn't before. Our customer insights tell us that garden is the category that our customers most participate in that we least address from a destination perspective. And so to your point, well, we have typically a 10,000 to 15,000 square foot concrete pad with a fence around it at the side of our stores that we call the side lot. Historically, it's held agriculture equipment, fencing, corrals, T-post, those sorts of things, and they've really been kind of just laid on the concrete. And customers who are kind of -- really kind of the fishing, auto, farm and ranchers go out there and buy their products and load up their trucks. But other than that, it's not really a merchandised space that we see lots of customer traffic through. So the Side Lot Transformation is really around bringing that space to life, making it much more productive. We take all that agriculture equipment, fencing. We put it on new -- on racking, get it up off the floor, get it positioned well with much less space, same assortment. And then that allows us to create a 4,000 square foot garden center that we can then -- in a very robust way, it'll become a destination for things like fruits, vegetables, certainly color annuals, perennials and shrubs. And it is a market-leading best practice live goods experience. It also allows us to get into things like soils and mulches that go along with that in a much, much bigger way. We've historically played very strongly in feed and fertilizer. But as you start to get into gardening, that's where we've played more convenience oriented. And the last thing I'll say is with our market share lead in bagged feed and the fact that we're gaining significant share there and that business is growing in an outsized way, many of these stores were also adding a feed room in and creating a drive-thru lane where you can do buy online, pickup in store drive-thru as well as feed drive-thru. That feed drive-thru, really besides creating capacity for us, really removes kind of the one final advantage that many of the co-ops have, which is ability for someone to just drive their truck up and us to drop a pallet of feed in the back of their vehicle or on their trailer. So we're very excited about the initiative. Again, our target this year is around 150 to 200 of these. We think long term, out of our existing, call it, 2,000-store base, we can do 1,500. And kind of middle, towards the kind of third quarter this year, our new stores will start incorporating the Side Lot Transformation in the build, where appropriate.

Yes. No, that's great. And I visited Nashville a few weeks ago and was able to see kind of the side lot and the drive-thru kind of working as -- I guess, as intended, also integrating the Theatro communications system. There's an audio communications system where all the store associates have an earpiece, and they can communicate to each other just by pressing a button in their apron. It was -- I mean, it was seamless. It was really impressive and certainly another way that Tractor is kind of separating yourselves from the competition in the market. So it was great to see. Sticking with the stores, you're on track, as you said, for this year to end with around 2,000 stores. You guys -- I think if the Orscheln deal closes, that would put you north of 2,100, certainly. How are you thinking about the 2,500-store target at this point? Where could that go to? And then as we think longer term even, when is the right time for Tractor Supply to consider maybe pushing out beyond the borders of the U.S.?

Yes. Kind of respond in 4 ways there. The first is we feel very good about our 2,500-store target. It's a very detailed model, built zip code level up. Second thing I'd say about that -- the second thing I'd say is on that model, it's based dominantly on 2019 data. We've obviously seen the market grow substantially ever since then and our performance grow. As Kurt has mentioned on our Q1 earnings call, our new stores are significantly outperforming their pro formas. And so we routinely update our model to reflect the demand at the zip code level as well as to reflect kind of what we think our performance will be as we put a store into that void space. So as we get further into the remaining kind of 500, 600 stores we have left to build, we'll evaluate are there void spaces in the past that we thought weren't value creating that now could be. And then as we update that model, we'll share more details, but certainly could imagine that, that could be the case. The third thing I'll say is that on the Orscheln acquisition, we're very excited about welcoming them into the family. And there are many -- there was tens of -- almost hundreds of stores that Orscheln has that were in void spaces that we would have liked to have had a store, but they were there first and the economics would not justify us building a store because they were already there. So the acquisition of Orscheln, many, many of their stores will be incremental to our 2,500-store count, and they have really strong positions in Missouri and other Midwestern states right there. The last thing I'll say is that California and the West Coast is probably the largest area for us in terms of void spaces as we look at our remaining store count. And we've talked openly about 3 new distribution centers being built over the next few years, and we've announced publicly one of them in Navarre, Ohio. One of the remaining 2 will be on the West Coast. We're in the process right now of looking for the right location, and then we will accelerate our efforts there. As that DC opens up, it will make some of those void spaces on the West Coast even more attractive because the cost to serve those stores would be less. And then, we'll probably have more to share on anything outside of the U.S. once we can actually travel outside of the U.S. and start to look at extending into maybe other adjacent markets. But for right now, we're laser focused on really executing our strategy here in our -- in the United States.

No, that's good to hear, appropriately so. Obviously, you've got a lot going here. I guess we'll wrap up in another 2 minutes here. Kurt, maybe give us a sense, the capital spend required to kind of support all these great initiatives that you have going on. Is -- the $450 million to $550 million benchmark that I think is laid out for this year, is that a good bogey for the next several years as you build out this distribution, fund these remodels, et cetera? Just kind of -- maybe you can take us some of that?

Yes. The way to look at it is that as we said on our enhanced earnings event late 2020, that our investments in the business for the next few years will outpace the last few years. We stated that the next 5 years, we estimate about $2.5 billion of investments into the business. So that would say that on average, it probably will run similar to that range, Peter. It's going to have some ebbs and flows based on the timing of distribution centers that Hal just mentioned, will be consistent with our new store organic growth but also can time on the cadence of our rollout of the Fusion and Side Lot stores. In year one, we're developing that, as Hal mentioned, and we'll have a better framework as to the timing. So that level of investment will average about similar over the next 5 years. We feel really good about the strength of the operating cash flow of this business. We've said in our long-term targets we expect $6 billion of operating cash flow. And with that, we've got a great capital structure. All that affords us the ability to invest organically in the business. And then the remainder would be -- consists with our capital allocation to shareholder returns through dividends and share repurchases. So it's a great package of overall investments for return for our shareholders.

Yes. No, absolutely. Well, listen, perfect. That -- our time is up. But listen, Hal, Kurt, Mary Winn, thank you so much for your time today. Thanks, everybody, for listening. If you have any questions or follow-ups, please don't hesitate to reach out to me, and we'll be sure to respond. But thank you to Tractor Supply for participating. Hope everybody enjoys the rest of the conference.

Thanks, Peter.

Thank you.