Tractor Supply Company (TSCO) Earnings Call Transcript & Summary

Well, good morning, everybody. Thank you for joining us here at our -- the 44th Annual Raymond James Investor Conference. I'm Bobby Griffin, the lead hardline analyst here at Raymond James. And this morning, we're pleased to host a fireside chat with Tractor Supply. With us from the company are CEO, Hal Lawton; CFO, Kurt Barton; and Senior VP of Investor Relations and Public Relations, Mary Winn Pilkington. First, Hal, Kurt and Mary Winn, thank you for the support. You guys have been long supportive of this conference. And we really appreciate you having here.

I guess to get us started, clearly, there are a lot of cross currents today in the economic environment, but Tractor seemed to be navigating those extremely well, capping off a really good 2022, on top of what I would say were 2 very tough prior year comparisons. So maybe to kick things off, can we talk about what you're seeing from your core customer? And really what do you think is driving the strong performance?

Yes. Good morning, everybody, and thanks for joining us today. It's great to have to see you and say hello. To Bobby's point, we've had -- the way to think about our business is a very stable, consistent business. It has a -- it's demand-driven and need-based. And we feel like we've got a bright outlook for 2023, and we've guided comps for the year between 3.5% and 5.5% with 2 to 3 points of incremental revenue growth due to new store builds and also our acquisition of Orscheln Farm and Home. So nice mid- to high single-digit growth rate again for us this year. If you look back over the company's history, that growth that we're talking about is very representative of what we've had historically. This is a business that's grown consecutively for 31 years. So we've had positive revenue growth through the 2000 downturn, the 2008 Great Recession and certainly, through COVID. It's a business that just has a track record of consistency, stability, resiliency, and that's because the underlying financials are demand-driven and need-based. We're the largest seller of bag animal feed in the United States, approximately a 25% market share. We're a top 5 player in pet food. Those are demand-driven grocery store like, and their activity drives footsteps in every single day. And in addition to that, all the other categories that we sell as a lifestyle retailer, whether it's a payroll, truck kind of types of power tools, agriculture equipment, gardening, all those are things our customers need on a daily basis. And then over the pandemic, our revenue growth has grew 70% over the last 3 years, with the bulk of that growth in 2020 and 2021. But last year, our revenue growth was 11-ish percent. So we grew right on top of 2 years of close to 30% growth for an absolute growth of around 70% over the last 3 years. And as we look ahead to this year and beyond, our long-term guidance is again for kind of this mid-single-digit comps. And our consumer remains resilient. Our consumer remains strong. We've not seen any elasticity to pricing, any trade down. We've noted some modest pullback in some discretionary bigger ticket categories. Those are less than 15% of our business. But kind of the other 85% of our business, which is very demand-driven, need-based, things our customers have to have on a daily, weekly basis to run their lives, that business continues to be very strong and solid. And we did see substantial inflation last year. But I'd also point to, our business remained resilient. Last year, our comp transactions were minus 0.6%, so basically flat for the year, which in retail, I think, is a standout relative to the rest of the market. So strong underlying customer fundamentals, and we're very positive on 2023.

And one of the other interesting things that's developed is this kind of been over the last couple of years, Tractor's growth with be younger millennial customer. Can you talk about what you're seeing from this customer and really what the maturity curve is like in their spending patterns?

Yes, one of the big underlying drivers of our business over the last 3 years has been kind of the embracement of what we call Life Out Here with the millennial generation. So to anchor that growth, 70% revenue growth, about half of that, call it 35%, was market growth. The other half of that was market share gains. On the half that was market growth, about half of that, so call it 15% to 20%, was driven by this millennial cohort that has embraced Life Out Here. So to kind of put that in a kind of bring that in a generalization to life, the average millennial now is 32, 33 years old. For the last kind of 8 to 10 years, after college, they moved to the cities. Historically, a generation, say, a Gen X or a Baby Boomer would have done that for 5 or 7 years and then moved out to suburbias and began their lives in a more stereotypical way. The millennials kind of put off those generational norms for an extra 3, 4, 5 years. COVID hits, and that generation then begin to kind of make-up time and move, say, 30, 45 minutes further outside of a city or perhaps to a whole another state, kind of the Sunbelt migrations been much written about. And that millennial generation has really embraced what we call Life Out Here. Life Out Here could be for them just getting a Carhartt Hoodie, which were the largest retailer of that brand in the United States. And maybe they've adopted a pet and -- or it could be that they are in embraced gardening and living that sustainable lifestyle they live as a millennial in the city and just bringing that out to kind of a country suburban lifestyle. Or it could be that they've adopted -- that they've -- they're raising chickens. 1 in 4 of our customers raise chickens. We are one of the only retailers that sell live birds annually. Right now it's Chick Days at Tractor Supply, and we'll sell 11 million live birds this year. And it's a big business for us and with all the feed and the hard lines that come along with it. But the millennial generation has really embraced all those sorts of hobbies and passions, and we see that as a very structural element and driver of our growth.

And then coming up against the very strong performance the last couple of years, what's a couple of the key initiatives within the store or outside the store that you're excited about and the kind of team is working on? What do you think those long-term potentials are?

Yes. So if you haven't caught on, kind of Life Out Here is the word for Tractor Supply. It's our mission, it's the types of customers that we serve and it's also the name of our strategy. We call it our Life Out Here strategy. And there's a number of initiatives underpinning that strategy, a couple that I'll call out that are big areas of investment for us. One is our Fusion Remodel program. And the second is our Side Lot initiative. The Fusion Remodel program is a complete remodel of the inside of our stores. It takes about 3 to 4 weeks for it to be completed inside of a store. We do all the stores operating with very minimal disruption. It is, first and foremost, the space productivity play where we're going and optimizing every piece of square footage in the store to kind of mathematically drive an improved lift. So we're adding extra space to pet. We're adding extra space to power tools. We're doing some other things to shrink our service footprint and add more space for product. And then the second -- and when we do that, we see about a mid-single-digit lift in same-store sales when we complete the initiatives. So it's a very nutritive remodel program. In addition to getting that lift driven dominantly through space productivity, plus an enhancement for new customers, we're also upgrading the look and the feel of the store, making it a bit more contemporary from a retail perspective. And that's been -- created a more inviting atmosphere for the millennial generation. And then the third is our average store is a little over 10 years old. We have 2,150 Tractor Supply stores in the United States. And so it's bringing the age of those stores back to kind of a newness, if you will, the outside of our store. And we expect to have every one of our stores done by 2026 with the Fusion Remodel program. And we're over 600 stores in already. And then the Side Lot program is where we're adding a garden center. Think about what you might see at a normal -- at like a home improvement store or a hardware store or maybe a local garden in nursery. We're adding a 4,000-square-foot garden center. We added drive-thru buy online, pick up in Store lane. And we also add a feed room where you can drive through and pick up your pellets and feed that you might need for your animals or pets. And when we do both the inside of the store and the outside of the store in combination, we're seeing high single-digit sales lift in our stores in the first year. So both of them are big drivers of our fundamental growth. We think our -- the guidance we've given is that 2/3 of our store base is applicable to a garden center. And we have over 350 stores right now with the garden center. So we're, call it, 15-ish percent of the way, close to 20% of the way through our chain.

Maybe switching gears a little bit, Kurt, is as any of us have seen going to the grocery store, we're clearly not in a deflationary environment yet. But we do get a lot of questions about how Tractor Supply would operate in deflationary virus. So maybe can you talk quickly on what you're seeing from pricing today? Kind of what the expectations are for 2023? And then we can kind of build off of that.

Yes. Good morning, everybody. I would -- our position right now, what we see is we expect inflation to be sticky throughout 2023. From our business, from our perspective, inflation has peaked. It's beginning to moderate, but by no means are we seeing deflation in our business, whether it's the commodities, the consumables or even the non-commodity-based product. We expect this year to still see some level of moderate inflation. The aspects of inflation that is driven over the last couple of years, if you think about it, is so structural versus some of the historical areas where we've seen inflation where, in our business, it was either mostly fueled by changes in commodity price. But because it's commodity, because of its transportation, operating expenses, particularly labor costs, all those costs are fairly sticky and structural at this point in the primary areas of the consumable parts of our business. We are seeing from grains to petroleum-based product, the prices are relatively stable at this point. So we expect to be -- to see this year to continue to have some level of modest inflation. I think all of the recent economic data points that are out there continued to show 2023 is going to have -- while at a more modest level, is still having some level of inflation environment for us.

And then maybe switching over to supply chain inventory kind of where you are today on the supply chain efficiencies within the DC, and then Tractor has done a pretty impressive job of managing the inventory given all the supply chain challenges out there.

Yes, I think it's a great point. So as a point of reference, and then I'll talk about what we've done, to Hal's point, the company has grown 70% in the last 3 years. And during that time, we pivoted quickly to grow our supply chain, but you could imagine what we had to do and have done during these 3 years, where we didn't open up a new distribution center while we're in the process of building it. So we pivoted to pop-up DCs, third parties, but the team have done a phenomenal job making sure that we leverage our size. I mean, we are clearly, in farming ranch, the largest provider. And so we leverage that size. But in the last 3 years, it's been relatively less efficient than the previous years. We just opened up our ninth distribution center early this year. We'll be opening up soon, within 12 months, the tenth distribution center. So we've been investing during this period of time to continue to even build even more robust supply chain. And the inventory for the first couple of years lagged by far, the growth of the business, and we're now really getting to the point now where our inventory per store, when we look at the level of inventory versus sales growth, that it's getting brought back up to where we really feel like we've got the inventory that completely meets the needs of the business versus 2021, would be a great example where it was more hand and mouth on the inventory.

Yes. And I think the growth is a great point, too. So one of the questions we get a lot is when you see a retailer add, that type of sales growth in that short of a period of time, is there a catch-up from either capital spending or the SG&A side? And what's kind of the capital needs of the business over, call it, the next 3 to 5 years given this new revenue base?

Yes, as you recall, we said that 2022 and 2023 are our peak investment cycles. But really, over the last 3 years, we've accelerated with the Life Out Here strategy that Hal as referring to. We've significantly accelerated our capital. So the important thing is what we've done during these 3 years of phenomenal growth is take that, we call it our COVID dividend and investing it back in the business, whether that's investing in our labor and our team members. So that we've seen significant growth in that investment or in the capital side of the business. So Hal talked about what we've been doing in technology, our plans for the next 3, 4 years on the Fusion Remodels and then as I mentioned, our distribution center growth. So we've moved from roughly $300 million in capital to $600 million to $700 million in capital. It's peaking right now. We're able to take all the leverage of this growth and be able to grow our operating margin because we can absorb in the impact of additional investments. The next 3 years will be those investment cycle, all of that is to be able to fund the Life Out Here strategy. The great thing is, is we're able to grow the business, invest that additional cash back into it and be able to sustain and even grow our operating margins during that time. So we have been investing, and it's part of the next few years operating and financial targets.

And you guys do have a couple of multiyear targets out there from an operating margin expansion point. As you mentioned, where do you see more opportunities within the gross margin line or the SG&A line over the next few years?

Over the next few years, it will be a balanced opportunity between both gross margin and SG&A. It can differ perhaps by any particular year. We're seeing significant leverage in the core SG&A expenses. As I mentioned, it then gives us the opportunity to balance out the pressure from the investments on SG&A. Next year to 2 years, there's more likely to see SG&A performing flattish as a percentage of sales or slight improvement. We see with all the investments we've made historically in the supply chain that we have the opportunity between the efficiencies that are now just starting to see that benefit of the distributions that are driving efficiency in supply chain, transportation costs coming down, where some of the transportation inflation we absorbed over the last couple of years. As we're able to claw back and benefit from some of the moderation in transportation cost and efficiency or supply chain, I'd say the next year or 2 is more on the gross margin opportunity. But over the long term, we have opportunities in both to drive that operating margin north.

Very good. And then, Hal, maybe let's switch gears, talk about one of the more recent events, your acquisition of Orscheln Farm? And for those that don't exactly know where it is, maybe a quick recap, but then what are you kind of seeing on the early integration and from there?

Yes. So as I mentioned a couple of times now, we have 2,150 Tractor Supply stores. That includes 80 stores that we acquired from Orscheln Farm and Home. We've given our long-term store target of -- we've given a long-term store target of 2,800. So call it, 650 stores remaining to build. Our preferred method of growth is new store builds. But certainly, we'll do opportunistic acquisitions, as Bobby mentioned, from time to time. We typically build around 70 new stores a year -- 70 to 80 new stores a year. So we've got the better part of the decade left to go on new store growth. And we think that's an attractive component of our business model, so you're going to get nice mid-single-digit comp growth and you're going to get an extra 2 or 3 points from new store growth to get to that mid- to high single-digit revenue growth on an annual basis. As Bobby mentioned, we did acquire Orscheln Farm and Home, and we closed on that acquisition at the kind of beginning of our fourth quarter last year. And it's a very exciting business. It's very complementary to our business. The size of the store, the products that they carry, the culture of their teams that they have in the stores, they're all very similar to Tractor Supply. Because we've been spending the last 2 to 2.5 years doing our Fusion Remodel program, we're able to really just execute a slightly more intense Fusion Remodel program in these original stores and convert them over to Tractor Supply's. And that will be our main focus for this year is executing that conversion. And we're a handful of stores already underway in that effort. And it will contribute nicely to our revenue growth this year and earnings growth, and there's a good bit of synergy upside as well on same-store sales productivity as well as operating margin rate. Our stores operate at much higher levels than their stores do. But it's a very -- it's an opportunistic acquisition, and it fits -- in addition to the synergies and the kind of similarity to this model, it fit nicely in our store portfolio. They were the first to market in a number of states like Missouri, Kansas, Iowa and many of the count were kind of one-store towns, and we were unable to go in there to financially kind of in a viable way, build a competitive store. So acquiring them and bringing them into our portfolio worked very well. And we're excited about it this year. It's going to be a material impact to our sales and revenue growth and our -- the value creation that we create.

And what about from a market structure, is there any other opportunities like that? Or is it getting tougher and tougher to find those little tuck-in ones that work very well for you?

Yes, it's a little work to get this one through the FTC. And so I don't know that we'll follow that exact same pattern again. Again, we're not a serial acquirer. I think of us more as an opportunistic kind of reactive acquirer, but certainly always have our pulse on the market. And I think there's other opportunities that we might explore over time, but not something you would expect us to do in a large scale way, anything that would -- we're not a proactive acquirer.

Okay. And clearly, with 2,800 store target, a lot of runway left in the store growth. What is kind of -- that target got moved up. Kind of we're seeing tractor supply show up in a little bit newer areas of towns and stuff like that. So maybe unpack kind of what drove that. You've seen them a little bit closer into the city centers, kind of what you're seeing from customers to give you permission to win there? And then on a very long-term basis, do you see an opportunity for this business to be outside the U.S. in any one area?

Yes. So in the, let's see, October of 2020, we communicated that we estimated our TAM to be -- total addressable market to be $110 billion. We updated that at the beginning of last year to $180 billion. So a $70 billion growth -- $70 billion in growth on our TAM. There was 2 main drivers of that growth. We went from $110 billion to $140 billion in growth. So $30 billion of that was just core market growth. And so that goes back to earlier, what I was saying about half of our growth rate that we've seen over the last 3 years has been market driven. The other $40 billion was because we -- as we are building up these garden centers, we're entering the live goods space. And so we added that to our TAM as well. So anyway, going from $110 billion to $180 billion in TAM growth, then unlock the opportunity for us to build more stores. And so we went from a 2,100-, 2,200-store target to a 2,800-store target over the last kind of 5 to 10 years. And we're excited about the opportunities we have to build out more stores in the United States. Again, as I said, we do about 70 a year. And we do -- I'd say, as it relates to other geographies outside of the United States, certainly, the type of lifestyle that we serve exist beyond the United States. I mean Canada, Mexico, Europe, even in like New Zealand and Australia, people have animals. They have pets. They have farms. They have ranches. They have lifestyles around out here. It's something we evaluate, we look at, we best practice and share with the various retailers in those markets. And I think there's opportunity outside of the United States over time, but nothing that we're focused on in the here and now.

Okay. And then maybe switching gears again, talking about leveraging CRM data in the Neighborhood's Club program. It's really been an area of growth here for Tractor Supply over the last couple of years, especially with the surge of demand. So where do you think you are in that journey? And what further opportunities are probably out there to unlock from now this big data set that you guys are developing?

Yes. So if you're not familiar with that, we have a loyalty program, call it our Neighbor's Club program. We've put it up there with any of the best-in-class loyalty programs out there in the United States. Certainly, I think it's a top 5 loyalty program. The way it operates is it's a tier-based program. So the more you spend, the more points you get back on a per dollar basis. So in essence, there's a silver gold and a platinum level. And then when you use our private label credit card, then you get incremental points above and beyond that. In addition to the points that you earn, you also -- we also, on a quarterly basis, provide free services like same-day delivery as well as free trailer rental as well because a lot of our customers have trailer needs when they're moving, say riding llama or fencing or something like that, either on their property or they're buying it from us to take home. The Neighbor's Club program has over 28 million members. So it's a very large program. It represents 75% of our total sales. So it's a big part of our sales. And our retention rates in the program are 80-ish percent. So it's a highly retentive program, very active customer base. And as you can imagine, when you have that sort of program, it creates a significant competitive advantage. None of our core competitors have anything close to it. And in addition to driving customer behavior through the points program and such and the recognition that comes along with that, the underlying data fundamentals allow us to then go in and target our customers and deliver content and offerings and promotions and -- that are tailored to their interests. So 1 in 10 of our customers, 10% own horses. The average customer owns 5 to 7 horses. So how are we talking to that customer group about all their equines? 1 in 4 of our customers raises chickens. How are we talking to those customers about their poultries? 75% of our customers have a pet. How are we talking to them about their pets? So we have all that data. We know their underlying purchase behaviors. We're able to then win a target and deliver very relevant content to them. And then also, we're able to follow them on their journey. So a typical millennial customer that, say, moved from Hoboken out to like Monroe Township in New Jersey, as an example, when they move out in year 1, call it 2020, 2021, they adopted a dog. They bought a Carhartt Hoodie and they were living Life Out Here. The next year, they started to do chickens and they buy a coop, and now they're expanding in the gardening and doing a raise bag garden, we can follow their journey. And as we see their purchase behaviors adjust both in a manual way through just segmentation and content creation, but also in using machine learning and AI, we can then deliver the right content for those customers at the right time. And it's an incredibly powerful part of our business model, and I think one that's a standout in all of retail and certainly compared to our core competition, which don't really have anything of that level of sophistication.

And then what about on the vendor side if we're starting to do the work where you can get a greater share of promotional dollars, maybe even a little bit of like an advertising business or something where the vendors value that type of insight to into the customer?

Yes. If I were to step back, we are an everyday low price retailer. And if you -- Kurt mentioned earlier our operating margin growth that we've seen over the last 3 years moving from an 8.9% operating margin growth rate in 2019 to a low 10% operating margin over the last 3 years, anywhere between a 10.15% and a 10.3%, the vast majority, in fact, all of that operating margin growth rate has been in gross margin. And our gross margin rate, a big driver of that increase has been due to reduced promotion activity. And we -- different than some other retailers who saw their promotional clearance activity increased last year, we actually had lesser promotional activity last year than we did in 2021 and lesser promotional activity in 2021 than we did '20. And the reason to that was we've eliminated print ads. Print ads are a fundamental driver of promotion activity. We used to do about 30 a year. Now we're doing 1 a year for Black Friday. And so because we have less promotional activity, it allows us to then have a partnership with our vendors. It's all about driving growth through innovation, through tailored marketing, through new products and assortment. And we spend a lot less time on promotions. And so to your point, the Neighbor's Club data is gold for our vendors, working with them to get tailored relevant offerings to stimulate the right behavior at a customer-specific level, has been a big win-win for us and our vendors.

Very good. I think we got about 2 minutes left. So 2 rapid fire questions here. One, I can't let Kurt go without a capital allocation question, so I'll let you hit on those key points and then how ESG is becoming a bigger focus. You guys have been doing a lot of work on that. So maybe 1 of the 2 or 3 quick high-level focus points over the next few years from an ESG perspective.

Yes. I'll start on capital allocation. We've got a great capital allocation story. For us, this business produces a tremendous amount of cash flow. So our operating cash flow, roughly $1.5 billion of operating cash flow, we've said we're in peak investments. So with $600 million or $700 million in capital, that then still leaves just $800 million, $900 million of free cash flow. We then take that free cash flow, invest in share buybacks. So we'll drive -- roughly, we target net, about 2% shares reduction through our buybacks, and then a dividend program that we target about a 40% payout. And so between buybacks and the dividends, it's roughly at or about $1 billion. And so with our strong capital structure and balance sheet, ultimately, with the growth of the business, that a few hundred million dollars that we lever up to be able to do that continues to keep our balance sheet at around or below a 2x leverage ratio. And with the growth of the business, as we've increased even recently some debt, again, it continues to keep a very low debt leverage ratio and be able to do all of those things, the investment and the return to shareholders.

Very good. And then maybe a quick one on ESG?

Yes, A quick couple of minutes on ESG. We talk a lot about preserving Life Out here. That's really our True North. We believe that what's good for our customers and good for our communities over the long term is good for us. And so that comes in many ways. It comes in our giving program. We've given $50 million back to our communities over the last 5 years. It comes through efforts in sustainability environment. We have a 25% reduction goal in our carbon emissions by 2025 and then beyond, up to a zero carbon emissions goal by 2040. It comes through reduced water usage. And then it also comes through our diversity efforts, which are very dominantly focused on representation, particularly people have called our representation in our stores to reflect our communities. But it's a key piece. We've been focusing on stewardship and preservation of Life Out Here for over 15 years. We have robust reporting and metrics around it, and it's just a core part of who we are.

Well, thank you. Hal, Kurt and Mary Winn, thank you for your time, and thank you for joining us.

Thanks, everybody.

Thank you.