Tractor Supply Company (TSCO) Earnings Call Transcript & Summary

Thank you for joining us today. This is Kate McShane from Goldman Sachs. If this is your first session with us, thank you for joining us at our 28th Annual Global Retailing Conference. We are very happy to be with the management team for Tractor Supply today. Tractor Supply is the largest rural lifestyle retailer in the U.S. and offers extensive mix of products for homeland, pets and animals with a focus on product localization and exclusive brands. As of June 2021, the company operated 1,955 stores in 49 states, and also operates Petsense with over 170 stores in 23 states. Today, we're very happy to have Hal Lawton, President and Chief Executive Officer of Tractor Supply. Hal has been in his current role since January 2020, and is a member of the company's Board of Directors. And we also have with us Kurt Barton, Chief Financial Officer. Kurt joined Tractor Supply in 1999 and has been in the current role for a couple of years now. So thank you so much for joining us, Kurt and Hal.

Thank you for having us, Kate.

So I wondered if we could start our chat about the state of the consumer. I think what has surprised us the most coming out of the second quarter is how most companies, most retailers, no matter if they cater to the higher-end consumer or a lower-end consumer, they still have a pretty robust outlook for the back half of the year, mostly driven by a robust consumer balance sheet. So our question is, has this surprised you as well given that we're moving further and further away from stimulus and as the economy reopens?

Yes. Hey, Kate, and again, thanks for hosting us this morning and this afternoon now. And on this question, we are -- we continue to be the view that it's a very robust macro environment. I think it will be mid- to high single-digit growth GDP this year, maybe in that 6% to 7% range and likely mid-single-digit GDP growth next year. So very robust economic growth. And to your point, driven by the consumer. And I think the big reason is the balance sheet, as you mentioned, the consumers have over $2 trillion of pent-up savings relative to what they normally would have in a normal environment and they're using that balance sheet to drive their spending. And I think you're seeing that across all of retail and also across all of segments the consumers spend into. The second thing I'd say is it relates to us. I think we've not only benefited from that macro trend but also almost all other trends that have either been created or exacerbated by COVID. And whether that's pet ownership and the humanization of pets, whether that's kind of just this -- the work from home and so consequently, the kind of the home is your oasis mentality. And also really the millennial population migrating out of urban environments, some into suburbia, but really what we're seeing in mobility data is even more into ex-urban and rural than normal just because of the -- to find affordable housing as they transition to that next phase of their lives. And so from a Tractor Supply perspective, very healthy overall, from an economic perspective in the country, but also, I think we are disproportionately even further benefiting from the trends and just kind of rural America where it is.

I guess the second question to ask on top of that is that you do have these macro trends behind you and -- or not behind you, but driving things, but I -- we also kind of touched on share of wallet. And you have seen an improvement or you've seen more share of wallet go towards leisure activities without necessarily coming away from any of the other categories. So again, it might be kind of the same question but asked a different way. How do you think about the sustainability of that for consumers to be participating in both?

Yes. Our view is that the sales lifts that we've seen over the last 2 years to the tune of almost 50% sales growth in the second quarter year-over-year, and really, if you look at rolling 12 basis over the last 2 years is that the vast, vast, vast majority of that is structural in nature. There's 3 kind of core drivers of that lift that we've seen in our sales. The first is our core customer that either we are -- we've gained substantial market share with or that we've gained incremental core customers. And these are customers that we're shopping at other farm and ranch retailers or elsewhere. And due to, I think, the investments we made in technology and customer service, certainly on in-stocks, et cetera, we've significantly gained share there. And I'll point to what we, every quarter, disclose our CUE, consumable, usable and edible product growth. And the fact that it had sustained multiple quarters growth of over 20% really speaks to the strength of things like animal feed, poultry feed, equine feed. And if our equine feed is up, say, 25% in growth, there's not -- the horse count in the United States has been relatively flat. So that just speaks to the share gains that we're taking with our core customer. And I think a lot of that structurally sound as we move forward. The second is around Pet. We called out in our second order -- earnings call that Pet was up 25% year-over-year. And we did that very purposely just to ensure that we were signaling the market share gains that we're taking in Pet, right, by all accounts from our manufacturing partners, we're taking share, when you compare the growth rates we gave relative to other public companies that are reporting, we're taking share. And we see that the humanization of pet and pet adoptions driving those trends. And we think that's structural in nature as well. Those pets are going to be here as we look ahead over the next 5 and 10 years. And with a -- as we move into a hybrid work environment, where people are working from home, going forward, right? That is the world we're going to be living in. I think that humanization of pets is going to continue. And then lastly is this rural revitalization and a lot of that's been driven by millennials moving on into ex-urban and into the rural environment. And many -- and if you think about the behaviors that they demonstrated in an urban environment around sustainability and recycling and organic foods, that is the Out Here Lifestyle in rural and ex-urban America. And as we look at the significant increase that we're seeing in our millennial customers as a percentage of our sales, they're buying into garden, they're buying into poultry, they're buying into pet first. And then you can start to see them broadening their wings, so to speak, in the Out Here Lifestyle even more, into things like fencing and other categories. And so as we look at the trends that have really driven our business to the tune of a 50% increase in rolling 12 sales, we feel really good about the structural soundness of those. And as the consumer behavior continues to evolve, we're confident that our business will continue to maintain itself.

Great. And I guess within those 3 buckets that you just laid out, there's new customers layered in within that. I would imagine, especially that third bucket. So I wonder if you could talk to us a little bit about the customer retention that you've seen since, I guess, maybe the beginning or maybe more the height of the pandemic and what you're doing to keep those newer customers going forward?

Yes. So over the last 5 quarters, we've seen 16 million, 17 million new customers -- actually last 6 quarters, sorry, we've seen 16 million, 17 million new customers shop with us. Of that cohort, 60% have shopped with us a second time. So excellent retention of these new customer base. And 30% are joining our Neighbor's Club -- joined our Neighbor's Club program. And once we migrate a customer into the Neighbor's Club program, we -- that really solidifies our engagement and our relationship with them. And as we mentioned previously, our Neighbor's Club program, which we now have nearly 22 million members, is over 65% of our sales. And that club has an 80% -- members of that club has an 80% retention rate. And in fact, the top tier spenders in our Neighbor's Club program have a 95% retention rate. So it's a highly engaged group, one that continues to grow with new customers migrating in, one with great retention and excellent spend. As we remarked in our Q2 earnings call, our Neighbor's Club members are out-comping the total company significantly.

Okay. I wondered if I could move on from kind of the bigger picture macro questions to some of the things that you're working on and have brought to the table. And just as a reminder for anybody who's newer to the story, I mean, Hal really began his position right before the pandemic. So it's impressive that you've been able to move so offensively, I think, in the context of just very, very, very high demand and during a global pandemic. But 2 of those initiatives have been your side lot initiative and Project Fusion. So we're really excited about these 2 opportunities because we do think it will provide a longer-term comp lift over time. But I wondered of all the opportunities that you could have pursued why these 2 were chosen.

Yes. So I'd start with even with all the sales growth we've seen in the last 2 years, the thing that, as you mentioned, Kate, that I think unique about Tractor Supply is there's still significant opportunity for us to continue to grow comp sales. And it's really all about kind of what we call sweating our assets, right, really squeezing as much productivity out of those stores as we can. And so there's 2 main initiatives that we have underway to drive that productivity. The first one is our Fusion Remodel program, and that's inside of our store. And then the second is our side lot transformation, which is outside of our store. And I'll speak to each one of them independently now. The Fusion Remodel program is a wholesale remodel of the store. And there's 3 primary metrics that we're looking for. The first is an overall lift in kind of the consumer experience, which we measure through qualitative, our customer satisfaction surveys. We've got -- we're doing things like putting in new light boxes. We're opening up the sidelines of the store. We're bringing the customer service desk forward and integrating with our cashiers to create a better experience, right as you walk in the store and have all of our customer service kind of integrated into one. And we're seeing excellent improvement in customer satisfaction and comments on those changes after we implement fusion. The second is really around driving sales. Project Fusion actually is almost 100 individual resets where we're shifting space out of things like apparel into pet food, where we had a higher sales per square foot. We're introducing new vendors like Makita. We're grabbing space from our customer service desk and we integrate it with our cashier area and freeing up 300, 400 square feet back near feed where we can put pallet drops in. So I can go kind of on and on, but there's almost 100 little micro projects that ladder up to Project Fusion, all focused on driving sales productivity. And then the third piece of fusion is really like when we're a store base of 2000, that's -- we have to start investing in our stores and maintaining and repairing and remodeling them. And so we're also going in and doing that work, whether it's the floor, whether it's the bathroom, whether it's our break room, et cetera. But the great news is we're able to do that work and drive a sales lift at the same time and provide an improved customer experience. And we're on target to have over 300 of our stores this year complete with Project Fusion. We're well ahead of the guidance that we gave at the beginning of the year. And we think it's achievable in the kind of 5-ish year time frame from now to have every store in the company complete with Project Fusion, and we'll kind of fully updated the experience across all of our stores. On the Side Lot, we've got the same amount of space outside of our store as we have inside of our store. It's about 15,000 to 20,000 square feet. It's historically been kind of concrete slab with fencing around it, where we've kept our agriculture equipment, fencing, fence post, tillers, et cetera, stock tanks and that sort of stuff. And what we've done is consolidated that product, put it on racking, better merchandise it actually. But as we've done that, we've freed up space, a bit like organizing your closet. And what that's enabled us to do is to put about a 4,000 square foot garden center, really create a destination for live goods and garden product. In the vast majority of them, we're also putting a feed room in. We are the largest seller of bag feed in the United States. And our aspiration is to continue to gain share in that market, and we need feed rooms to facilitate that and ensure that we're the lowest cost to serve on bag feed in the country. And then we also put a drive-through in so that we can drive through buy online, pick up in store. And I was just at a store in Texas yesterday that had the Side Lot Transformation last November, and there were cars driving through the parking -- through the Side Lot repeatedly throughout the day doing their pickup. So it's great to see customers really take that -- really becoming part of customers' habits. But if we think -- if we step back, the big driver of the sales performance outside and the Side Lot is going to be the ad of that garden center. 4,000 square foot creates a real destination. For us, it really creates the third real destination inside of our store. About 40 years ago, we started with animal feed. And as I said, we're now the largest seller of bag animal feed in the United States. Prior to that, we were much more about tractor parts and supplies and agriculture equipment. About 20 years ago, we got really aggressive into pet food. And now we're one of the largest pet retailers in the United States. And this is now a third large destination kind of CUE category. And it's also the one that our customers told us that they most actively participated and that we least addressed their needs. So we're very excited about the potential there as well. We guided 150 to 200 Side Lot Transformation this year. We'll still be in that zone. And look for us to have, call it, half-ish of the chain complete over the next 5 or 6 years. We're really bullish on the opportunity and also on how its applicability across the majority of our store base.

I wondered if I could switch gears to the supply chain and inventory. I feel like there's been disruption within the supply chain since pretty much March 2020, but it does feel like it's reached a little bit more of a fever pitch as of late. So I wondered if you could remind us a little bit about the challenges that you're seeing in the supply chain and where some of the bigger bottlenecks are currently? And do things in your opinion, get tougher before maybe they get better from a disruption standpoint?

Yes. So I'll hit it in 3 ways. We'll talk about the global supply chain, I'll talk about us and how we're navigating it and then lastly talk about kind of the outlook. On the global supply chain, it's probably the most disrupted that any of us have seen from beginning to end. Whether it's the manufacturing of the product, say, in China or Vietnam or elsewhere, getting it to the port, getting it from the port onto a ship, finding a ship, finding a container, getting it across the ocean, getting it off the container and then getting it on a truck and getting it to a DC then having the labor to be able to process in the DC and then ultimately getting it to a store with another truck and help finding a driver for that. Every point in that supply chain are challenged. And certainly, the most disruptive I've seen in my career, and I think most folks would say that. As it relates to Tractor Supply, I'm very pleased with how we've been navigating it. First off, only about 15-ish percent of our products are affected by the kind of that end-to-end supply chain picture that I painted. The vast majority of our products are still manufactured in the United States. You think about pet food and animal feed, you think about pellets for wood stoves and such or even things like trailers that are a big business for us, all manufactured in the United States. But we still have kind of mid-teens percentage of our business that comes in through that end-to-end supply chain that I outlined. I think those who are faring the most best through at are ones with scale, and ones that have made investments over time. And that's certainly us. We've got 8 million square foot plus DCs in our network. Every 2 or 3 years, we've been adding a DC. We consistently invest in our systems like our warehouse management systems, our transportation management systems. We've got really great partners on really all facets of our supply chain. And because of that, we've been able to leverage our scale and our network to navigate these disruptions, I think, better than most. And we've said several times, we're pleased but not satisfied with our inventory in our stores. We finished Q2 at over -- just over 10% over last year on a comp store basis, and we continue to run in that level. And I was just in stores in Texas yesterday. And you'll see a category 2 as a bit of a pocket of out of stock or something like that. Some of it's storm-related, but for that, it's supply chain related. The recovery is pretty quick, a week or 2 weeks, and then we're right back in stock in that category. As far as the outlook, I think the supply chain is going to be kind of operating a bit in this -- kind of this heightened frenzy kind of, but in this -- at this level for really -- probably a good at least 9 more months. I think you've got an incredible amount of shipments that everyone's trying to bring in here in the fall and time for holiday season that's going to create a lot of continued constraints. And then as we -- then the L.A. ports all have a negotiation next year. Their contract is set to renew or it ends in May. And the history of that port is 5, 6 months ahead. Some of the disruption starts to happen there as those contract negotiations really start to amp up. And also, I don't think COVID is really going to be abating much over the next 6 to 9 months as well. So I think we'll be dealing with these constrained supply chain for the next -- better part of the next year. But again, really pleased with how we're navigating it. I think those with scale, those who made investments in supply chain have strong relationships so the ones they're going to fare the best, and that's certainly indicative of us.

And just to wrap up this piece of it. Can you tell us a little bit about what's happening on the cost side with regards to product costs or any cost inflation that's coming as a result of the supply chain and how you're managing prices in the store?

Kurt, do you want to take that one?

Yes, I'd be glad to. So Kate, we talked through both the first quarter, second quarter that we've seen inflation not only in product costs, but also in areas of supply chain that Hal was just referring to. And we exited Q2 and said that on the top line side of the business, we were seeing 300 to 400 basis points of our retail price increases from cost of inflation in both product and transportation costs. We said that we managed it well. We've been successful at this point, being able to pass through the inflation onto the consumer and the retail price. We guide and expect in the back half of the year to have higher levels of inflation. The first half of the year was principally commodity based. We've now seen, as most people have seen, things outside of commodity-based impacts on inflation as well as the back half of this year for the things that Hal just mentioned that the transportation cost for 2021 will likely hit as it flows through retailers' P&Ls, it really will hit probably more the pinnacle of the plateau in the third and fourth quarter. So as it stands for us, we will see higher cost in the second half of the year than we had the in first half of the year. But we are managing that well. For the things that Hal mentioned that we've got leverage of scale. We've got a great supply chain with vendors who have built their networks of commodity based near us. And so we believe that our guidance range, which assumes some modest pressure on gross margin to be able to -- really be able to overcome what has been some of the most significant level of 1-year cost increases that we've seen in the last 10 years across retail in general. So our plan is, is that we've managed and we'll continue to work with our vendors to keep our prices as low as we can for our customers but be able to have a really good balance on maintaining top line as well as a strong performance on the gross margin with these heavy cost increases.

And if I could just maybe pivot to just operating margins in general for the back half of the year, but also longer term. One question we do get a lot from investors is just your top line has been very robust, but there's been a little less flow through because you're investing in the business. So can you talk about how you're balancing the need for investment and margin expansion? And longer term, how do you envision this balance over time?

Yes. Sure, Kate. On the operating margin side, I hit it from 3 points. One, just historical reminder; two, talk about our investments in the Life Out Here strategy; and then I'll quickly give a little bit of puts and takes as we see it over the next few quarters and even our -- how we look at it compared to our long-range targets. So first, the first 12 months of the pandemic, and as we're starting to cycle that now, just as a reminder, the business performed extremely well. In the last 3 quarters of 2021, we averaged of around 150 basis points of operating margin improvement. For the year, it was a little over 100 basis points operating margin improvement. And we're cycling some strong operating margin performance. And we believe with all of the strategic investments we've made in our plans, we've got not only significant increase on the top line, as you mentioned, but an opportunity when comparing back to pre-COVID, be able to maintain a meaningful improvement in the operating margin, it's compared to pre-COVID. The second point on our investments. For a lot of the things that Hal just mentioned, we are very focused on and very committed to investing right now from a position of strength for this Life Out Here strategy. The things we are doing and the opportunities we have to invest to maintain and sustain the 17 million new customers, the significant growth in the Neighbor's Club and to get more of those 17 million customers in the Neighbor's Club is a key to that is the investments in Life Out Here strategy. What does it mean for the operating margin? Most of the operating margin gain that we achieved during the last 12 months has been from the gross margin side. Principally, like in most of retail, very little promotion, very little clearance. And our inventory is an extremely healthy position. And we anticipated and have said that if there's some give back in the operating margin, it's through normalization of some of that promotion and some of that clearance. We expect to maintain great everyday low pricing, less promotions, but anticipate some give back. We haven't seen that yet. But over time, as I indicated in our enhanced earnings call, there may be some normalization over time. We expect that there could be some normalization in gross margin. And then with the additional top line revenue, it's given us an opportunity to invest -- make investments in the business and keep that SG&A at least flattish with maybe even some potential for upside in it. And so for us, it's a great opportunity from this position of strength, be able to do these investments and keep at a strong operating margin. We like that scenario. And so we're going to continue to manage through that. And we feel really confident in our long-term targets on operating margin.

Okay. Before we open it up to the audience for questions, just as a reminder to the audience, you can just type your questions in, and I will be able to read them to the management team. We've been asking 4 questions to all the management teams that have been presenting. We've already touched on most of them. It's more just for posterity to kind of like a punchy Q&A, and it's multiple choice. So for the first question, we talked about consumer demand, but how do you expect consumer demand to look in the second half of 2021 versus the first half? Do you expect to see sales accelerate, decelerate or stay the same?

Hal, you could take that?

Yes, I think our guidance has kind of stayed the same as a run rate.

Okay. The second question is about digital penetration. How do you think about digital penetration in 2022 relative to what we saw in 2021?

Increasing.

Okay. The third question -- no, sorry. The third question is -- and Kurt, you just mentioned this a little bit, but how should we think about promotions in 2022? Will it be higher, lower, the same versus 2021? And I'll even throw in higher or lower the same versus 2019.

I'd say that our guidance has been there, we anticipate that over time to have some additional promotions over the 2021. And so same to some moderating into promotions.

Okay. And then the last question is actually 2 parts. The first is what do you think your biggest lever is when mitigating some of these supply challenges? And second, do you expect inventories to grow faster or slower than sales in the second half?

Yes. So our biggest lever to mitigating the supply chain is really leveraging our scale, leveraging our strategic partners, being innovative in the way we source product, where we source it. And again, only around 15% of our products are impacted by the full global supply chain challenges that are being seen out there. I'd say in terms of inventory growing at a faster or slower than sales, I think it will grow at about the same in the second half of this year. And we've been fortunate. We've been able to keep our inventories above last year, even in spite of the strong sales growth we've seen. In the second quarter, we had 10% comps on top of 30% comps from the prior year and still we're able to maintain our inventory 10% above last year on a comp store basis. And our expectations is that we'll continue to be able to navigate inventory and sales similarly throughout the balance of this year and into next year.

Great. That's helpful. I'm just going to ask one more time if anyone has any questions. And we have a couple more minutes. So while we wait for maybe 1 or 2 questions to come in here, I thought we should talk about capital allocation and your priorities going forward, you have the investments that we just walked through with the Side Lot and Project Fusion, but you also had the acquisition earlier this year. So can you talk again about the balance between investments and acquisitions and anything else with regards to capital allocation.

Yes, Kate, our first priority on capital allocation is investment in the business. That would be organic growth, new stores continue to maintain a consistent 80 new Tractor Supply stores a year. And then we've talked a lot about the investments in the business. Side Lot and Fusion would be great examples of several of the investments we're making. And we've said that our investments in the business are growing from $200 million to $300 million capital in the past few years to $400 million, $500 million and even our latest guidance for this year of $550 million to $600 million in capital this year. So we'll invest in the business in the next 5 years that will be our #1 priority. Second, we are committed to a consistent strong dividend growing with this business. And then third, where there's opportunity for M&A. And Orscheln is an example of an opportunistic tuck-in type acquisition. And then rounding out capital allocation, certainly, with the strength of the cash flow from this business, it allows us to continue, always be active in a consistent share repurchase program as well. And that's how I'd frame up our capital allocation approach.

Okay. Great. Just waiting if there are any questions. It doesn't look like we are getting too many questions from the audience. So I'll just -- I'll ask one final one in our last 3 minutes here, if you don't mind. This is a little bit off the cuff -- off the beaten path of usual questions that you get. But I just wondered what opportunities you're seeing for product innovation right now? Are there any product categories where you're seeing the opportunity to better serve that millennial customer or any areas that you can lean into from a product innovation standpoint?

Yes, absolutely. It's a great question, Kate. And I think if you're in our stores right now, you'd see a lot of innovative products, a lot of new product. And I'd say if you think about the Tractor Supply kind of loyal core customer, they're very much a do-it-yourself or self-reliant and have accordingly bought product like that from us. As we're seeing a large uptick in the millennial customers shopping with us, moving from an urban lifestyle to a rural and ex-urban lifestyle, they've got a little less DIY orientation, at least starting out. And so as an example, log splitters. So we sell incredible amount of log splitters and chain saws. And our core loyal customer that's what they use to create fire with for their homes and for fire pits and that sort of thing. But our new millennial customer buys cords wrapped firewood. And it seems like such a small thing. But I was in a store recently with our -- with Joe Scarlett, kind of the modern day founder of Tractor Supply, and he was pointing out firewood and he said, oh, no one will buy a bundle of firewood from Tractor Supply. And I share with them the units that we're doing of that, and he was shocked because we really now have both sets of customers in there. The same thing goes in poultry. We have -- this past year, we introduced a poultry beginners kit, a starter kit that has really everything you need when you're starting a flock, everything from the heating lamp, to the heating bulb, to your extension cord, to your first thing of shavings and food and your watering and food containers and we couldn't keep that kit in stock. And historically, that would not have been an item that really played well to our core customer base. And you can kind of go on and on throughout the store. We're starting to -- in apparel, starting to increase our female-oriented assortment and bringing in car heart women's jeans and pants and starting to broaden our apparel sections there and piloting with companies like Duluth Trading. And -- so we've got that really throughout the store, same thing with the power tools in this home improvement growth that we're seeing and kind of the home is your oasis and people kind of keep updating their home or we just introduced Makita into our stores, and we're seeing great performance there. And historically, as another example, we've always been a gas-powered type products on engines, whether it was push mowers, whether it was handheld, that sort of thing, power -- even on a power tools more electric pneumatic. We're now bringing in with partners like Dewalt and Porter Cable and Makita bringing in a cordless product and seeing that perform very well. So I'd say the biggest thing we're seeing is innovation related to emerge the newer customer base that's coming in our stores and making sure that we're evolving rapidly our assortments to meet their needs. And as I said, I gave a few examples there, but I can go throughout the store and share more. But really, really pleased with what our merchants are doing to really challenge themselves even in this heightened supply chain environment to find great new solutions for our customers.

Okay. Great. Well, with that, we are at 2:20. So I really appreciate all the time, Hal and Kurt for today, and thank you for joining us, everyone.

Thanks, Kate. Enjoyed the discussion.