Tractor Supply Company (TSCO) Earnings Call Transcript & Summary

Okay. Good morning. Welcome to the Baird 2023 Consumer Technology & Services Conference. My name is Peter Benedict, senior retail analyst. Really pleased to have with us the management team of Tractor Supply. We've got the CEO, Hal Lawton. He joined in early 2020, interesting timing, joined from Macy's, but spent a lot of his career at Home Depot. And then at eBay. Kurt Barton, CFO, with the company for a long time; and Mary Winn Pilkington, who's back here who heads up the Investor Relations effort. I'm going to turn it over to Hal for just a quick overview of the business, and then I'm going to get into a Q&A. If you have any questions, [email protected], we'll weave it into the conversation if we can. If not, there is a breakout session in the Astro room A after this. So with that, I'll turn it over to Hal.

Great. Thanks, Peter. Good morning, everybody. I hope you're doing well. I thought I'd just start out with a quick overview of Tractor Supply to the extent you're not familiar with us as a business, and then we'll jump into Q&A. So Tractor Supply, we're celebrating our 85th anniversary this year. The company has been around since 1938. We have nearly 2,200 Tractor Supply stores and close to a couple of hundred Petsense stores across the United States. This year, revenues will be approximately $15 billion. And we serve Life Out Here. And that's dominantly what we call kind of country suburban, exurban rural America. I think the nearest store is about 1 hour 15 minutes through here. So you've got to go a little ways out to get to our stores. When we say we serve Life Out Here, the types of categories are really anything that is required to really live and work Life Out Here. So the core dominant categories are things like animal feed and pet food, things like agriculture equipment and then recreational vehicles, garden and supplies, truck tool and hardware, and then certainly apparel, but more in the workwear kind of mindset, brands like Carhartt, Wrangler jeans, work gloves, those sorts of things. But it's about all -- and all this is done in about 18,000 square feet. About 8% of our business is online, the other 92% in stores. That's just a quick overview. The business has had really strong performance really over the -- for the last 30, 35 years since we went public in the late '90s and really had some significant momentum in the last 4 years with our sales growth Q1 '19 to Q1 2023, up over 80%. Anyway, so a little bit about our business. Glad to be here today.

No, perfect. So let's start just with the addressable market because tractor does go after something. It's a little bit unique. A lot of times in retail, you have a specific vertical you're attacking. You guys kind of have a broad tent. So I think your current estimate is around $180 billion in terms of the total addressable market. You had increased that recently, your share is sub-10%. And maybe talk about how you build up to that $180 billion number and maybe what you think the growth drivers are for that going forward?

As Peter said, one of the things that sometimes when we're talking with investors and analysts, they always look for is like, who's your core competition, who's your direct competitor. And we're fortunate that we don't have a national direct competitor. So not it's difficult to size our market and to really get a good assessment of our business. We certainly compete against thousands of retailers whether it's regional local mom-and-pops that have a very similar format or against some of the national specialty chains and large mass and home improvement chains, but that's more on a category by category level, not in a kind of whole store kind of way. And as you said, Peter, our TAM, total addressable market for our business, we estimate to be about $180 billion. In 2019, we estimated that to be around $110 billion. 1.5 years ago, we updated the TAM and had 2 growth drivers going from $110 million to $180 billion. The first growth driver was just market growth over the last 3 years in the context of COVID, but certainly in just kind of the generational changes and lifestyle changes that are happening out there. And the TAM went from $110 billion to $140 billion just with that core market growth. The second thing is we're entering a number of new categories in our business, and we've been doing that over the last 3 years, namely pet services and also live goods and specifically, we've been adding garden centers as an attachment to our stores to the tune of about 3,000, 4,000 square feet, like what you might see -- a small version of what you might see at a home improvement store, what you'd see at say, an hardware or something like that. And we attribute those pieces, the extra vet services, the live goods and the additional garden categories that we'll be addressing, you made another $40 billion of TAM. So that walked us from $110 billion to $140 billion to $180 billion. And then as Peter said, this year, we'll do roughly $15 billion on $180 billion. So we're at 8-ish, 9-ish percent of our total market. So significant opportunity for us as we look ahead. Again, a track record of performance. excellent performance in the last handful of years, but a very bright future as well with significant share opportunity ahead of us, and we're investing in that opportunity.

So with respect to competition, there's no scale player that does everything you do. There are players that from time to time, will try to do part of what you do. I think currently, Lowe's has been doing some things around some of the rural categories. Petco is doing some rural market stores. So talk about maybe your nontraditional competitors what they're doing? And is that something that investors need to be concerned about?

Yes. I'd start out by just saying our main focus has always just been on our customer. And I think that's been a hallmark of our company over the last 85 years, is focusing on our customer, taking care of our team members. And if we do those, -- we think everything else takes care of itself. We're certainly always watching what's happening in the competitive landscape, not just for those players, but across the country. And we might find some things that we tweak because of that. But I'd just go back to -- we have a large competitive moat as it relates to our business. We've got 2,200 stores across the United States that are purposely built to address our customer and the lifestyle that we serve. We've got a 30 million membership Neighbor's Club program, a top 5 loyalty membership program in the United States. We've got 9 million square foot distribution centers, 15 cross-dock mixing centers that are purposely built to move over 8 billion pounds of food and feed during the year. We're just -- we're built for our customer, and we're committed to continuing to improve our business to continue to serve our customers even better and better. I feel very confident about our future and the growth we have ahead of us.

Now it's a good segue to the next question, which is on loyalty, the 30 million Neighbor's Club members. I think it's maybe 3/4 of your sales. You kind of rebooted that program in 2021, added some tiers. I mean, loyalty programs -- every people in this room are familiar with loyalty programs across a number of businesses. You're going to -- you set out, you've built the base, I mean 30 million is an amazing number. Talk about maybe what Loyalty 2.0 looks like right here, where you can take it? What are the opportunities from a wallet share standpoint because that's something that's always fascinated me. If someone is in your store, and they're shopping one category like they should be shopping multiple categories because all the categories are relevant. So I would think it's a very fertile ground for a loyalty program.

Yes. Absolutely, Peter. I'll break it up into 3 parts, kind of historical what we're doing now and then where we're headed. Historically, so 7, 8 years ago, maybe almost 10 now, we launched our Neighbor's Club program. It was really more of a -- almost a keep up kind of swipe thing. And once a quarter, we would send you a coupon code and you get some things on your birthday. But it was a bit more like a standard kind of loyalty program early first version. When the pandemic hit and we saw this surge of new customers, we said, hey, we've got to really reinvent our loyalty program to lock in the additional share, the additional customer base that our business had expanded to. And so we spent all of 2020 reconfiguring the back end of our loyalty program and launching a new loyalty program in the spring in 2021 to have a tier-based points loyalty reward system. It's been incredibly successful. Our top tier, which is our Preferred Plus almost has no attrition. It's like 98% retention on a year-over-year basis for those customers. The total retention base for our 31million, 30 million members of our program is over 80%. It represents 75% of our sales. And to your point, when a customer uses our private label credit card, they're in our top tier, they get 5% back in points. We see significant usage of the private label credit card on bigger ticket items like riding lawn mowers and such. And then they use those points to then redeem them on their food and feed, which is their weekly daily consumables that they need for their animals and pets. Over -- nearly 90% of our customers have animal and pets. Most have more than 2 pets. And the vast majority also have animals as well, whether it's a small livestock or things like equine and cattle. Where we're going in the future is really now that we've got this base, we've got an incredibly sophisticated technology platform up in the Azure cloud with all kinds of applications on top of that, that allow for sophisticated analytics and CRM is really starting to harness the power of that and start to really target our customers in a very personalized way. Right now, we know about 10% of our customers have horses. We know about 200,000 of our customers that have cattle. We know that 75% of our customers that have pets, but we can do a lot more to tailor our messaging and tailor our personalization because our customers have very specific shopping trips, but then they can expand across additional categories, as Peter was saying, and that's what we're working on right now. Say we're in the fourth or fifth inning of the CRM personalization, certainly the eighth or ninth inning on building the technology platform and the points-based system.

That's fantastic. Kurt will get you involved here. So inflation in the macro, big topics. I think inflation was 11% tailwind, maybe last year, high single in the first quarter. You guys are obviously expecting that to moderate. Talk about how the customer is responding to inflation and just kind of how you're viewing kind of your pricing position and what you're doing from that standpoint?

Yes, certainly. I'll just start with saying that as we ended 2022, and it's played out very much as we expected, we believe Q4 in our business was really the peak of any level of inflation. And to your point, we saw overall retail price inflation about 11% benefit last year. And a lot of the cost structure is in the pricing as of the end of 2022. So we've seen this play out. We expect it to play out this year that high single digit in Q1 and then really moderating down to low single digit because most of the inflation has already been baked into the retail pricing. It's a bit of wrapping of last year's cost in there. So the consumer to an extent, absorbed and saw the change in the pricing in 2022. And at this point, there's a bit of a plateau. Most of the cost structure is pretty consistent. There are some levels of inflation in certain categories, and we have some level of deflation for the most part, though, really consistent pricing. Our consumer is a needs-based consumer to house point, it's a lifestyle that they live, the land, the animal, those are needs to them. And certainly, they're very cost conscious. Our customer comes to us and looks for us for everyday value. Tractor Supply at house point has been built to be a big, bulky, large bag moving type retailer. So our supply chain, our vendors, our distribution centers are built to build to ship and get 40- and 50-pound bags to our customer. And so we're a bit of that large -- like almost a warehousing-type large bag type value play for our customer. And so they view us as an everyday low price value. So in this particular environment, while we're not seeing any real shift in our core customers' shopping patterns at this point, a benefit for Tractor Supply is that we are viewed as an everyday low price. Maybe last thing just to point out, as we look at the data, we estimate up 15% of our products that we sell. Our customer looks at it as discretionary. But around 85% of it is really needs based for them that they've got to come through. And we continue to pass on and give them the lowest price in what we offer. When you look at products that we sell, the items like under $100, a vast majority of our product, we're seeing really no difference in the consumer spend. So we're fighting every day, we're clawing cost that we can to give the best price, and we believe we're the lowest cost to serve. I think that produces an environment where our customer sees it that same way. And so we're seeing really no meaningful shift right now from the consumer on the products that they're shopping at Tractor Supply.

Yes. And I think with respect to big ticket, I think maybe you can provide some perspective on that. I think there's been pressure on big ticket, that's been going on for a while. It's been going on for probably over a year now. Just maybe give us a perspective there because I think there's a lot of fear that consumers really taking a big incremental step down here. And I just -- I don't know what you can share with us on that in terms of behavior around big tickets?

Sure. I mean, I think the best place to start is in the first 2 years of the pandemic, 2020, 2021. You saw really high solid double-digit growth in big ticket categories. I mean outpacing even the comps that the chain was performing. And so in 2022, we saw negative mid-, high single-digit decline in big ticket. And we're seeing a little bit of the expected softness in some of those discretionary items this year. And the important thing is that the new customers we've acquired, the needs-based part of our business, even in big ticket continues to be strong. And so in big-ticket category, we're very pleased in the trends in the business that a vast majority continues to have solid performance, and the performance in the sales volume has still well exceeded and continues that trajectory and that plateau just step up above pre-pandemic levels. It's not a category. It's not an overall category that was a complete give back after stimulus of 2020 and 2021.

Yes. Yes. Well, there are a lot of benefits for having been attracted for a long time. One of them, is you were around the last time we went through a recession. So maybe provide us a little perspective on what Tractor's playbook is in a recession. Obviously, a lot fear about that occurring on the horizon here.

That's a great point. I've had certainly in the 24 years, I have the opportunity to go through a few of the recessionary times. Hal mentioned it earlier. We've had -- the last 30 years, 29 out of 30 years have been comped positive sales, 1 year that there wasn't, was in 2009, and it was less than negative 1%. And it just -- I share that to validate the needs-based part of our business, the resiliency, but even the growth in the overall market and just the continued growth in rural America. And so in a recessionary environment, what we have seen and what we continue to use, as you said, our playbook, I label it being nimble. And that is the market will shift in where they spend and where the customer spends. And it just shifts into a needs-based, which is a benefit to Tractor Supply. You might see, as we're seeing in this year, you may see less in some of the discretionary and less of big ticket, but it pushes more towards repairs. The needs-based value-driven large bag, feed and food. And so we've consistently been able to weather those recessionary storms. And we encourage our investors to be aware of how it shifts on the top line. You may have inflation that puts a little bit of pressure on transactions that we saw last year. But in this year, we're seeing growth in transactions. And there's a little bit of pressure from discretionary on the ticket. And so it's a mix play. And as we said on the last earnings call, we're very confident in our ability. There's a number of scenarios that we manage towards and the year could play out in various scenarios. We feel very confident in those scenarios on how we can manage the operating margin and how we can manage the bottom line in various scenarios.

No, that's great. And so I'm going to pivot quickly. We have 3 questions. We're going to be asking all of the companies that we have here at the conference. The first is just on a health of your consumer, your view on where that will stand in the second half of this year relative to where they stand today? Better, worse, the same? Is there a strong view there?

Yes. I think customers are shopping needs not once, and that bodes well for us. We are a demand-driven needs-based retailer. We're investing in areas that are of needs, things like pet and live goods, as I mentioned earlier. On Pet, as an example, our business for the last year has outgrown the market by 3x on poundage and by 2x on dollar growth rate. We're taking substantial share in that category. But over the next 6 months, we expect our consumer to basically run at about the same pace it's been running now with no substantial change in behavior.

Okay. Inflation was the next one, but you've already answered that, you expect it to be moderating as we move through. Last one is on inventory. A year ago at this conference, I remember all sorts of alarms were being sounded around inventory. You guys were not one of them, as I recall, your inventory was in very good shape. But maybe how do you think about where your inventory would land at the end of this year relative to where it started the year, high or lower saying?

Yes. So we've -- I think over the last 4 years, as I said, Q1 '19 to Q1 2023, we've had over 80% revenue growth. But our inventory has grown maybe in the pace of about 70% during that time. So we've grown sales faster than inventory on a 4-year basis. And in 2023, what you can expect is for inventory growth to basically equate to about comp growth. So we think we've been through a period of robust growth over the last 3 years. We've scaled on our inventory a bit, and we think they'll start to grow in accordance with each other through the balance of this year.

Fair enough.

Very much in control.

Yes. Let's go back to space productivity. You kind of alluded to it a little earlier. You have 2 initiatives underway. Project Fusion, the remodel program and then the Side Lot Garden Center program. I think Fusion's in around 30% of your stores right now, Side Lot maybe in 15% or so. Maybe talk about the time and cost to complete these projects, how that's been trending? And what do you think the cadence of the rollout is going to be for each?

Yes. So we have a program called Fusion remodel program that's focused on addressing the inside of our store. Our plan is to do all stores through 2026, 2027. So we've got kind of a handful of years left to go. We're doing 200 to 300 stores a year, plus all new stores are being opened with our Fusion format. And all the Orscheln stores, which we acquired are being remodeled to the Fusion format. Really what the Fusion format is, is an update of the layout inside of our store to get more space in the higher productivity categories and drive kind of the math up on sales in our stores doing that and taking the space away from the lesser productivity category. So as an example, we're taking one entire aisle away from apparel and adding an entire aisle of pet. That's really allowing us to drive that growth that we're seeing in pet and apparel is running above market even as we do that. We added an entire aisle for power tools, brought in brands like Makita, Bosch, Dremel also exclusive with PORTER-CABLE our outside the store remodel program is the addition of a garden center. If you're familiar with the Tractor Supply we're about 18,000 square feet inside, and we're about 15,000 square feet outside with a concrete pad that historically would have had ag equipment, fencing, those sorts of things. What we're able to do is through better merchandising get those up and racking create 4,000 square feet of space and build a garden center, which allows us to get more substantially -- and play as a destination in the live goods business. So we've got 2 very significant remodel programs. If we do just the inside of the store when we complete the program, in the first 12 months, we're seeing about a mid-single-digit lift in performance in the store. And when we do the inside and the outside of the store at the same time, we're seeing a high single-digit lift in the store. So substantially, very nutritive remodel program. In addition, our average store is about 10 years old. So when we complete these programs, it really re-ages the store to kind of brand new. So you're kind of -- you're getting that benefit of a store re-aging even in the context of the remodel program.

And then sort of just at the cost of what -- I mean when you launched this program, it happened kind of during COVID so of course, the cost [ were all ] -- maybe talk about that and the impact it's having on your CapEx plans.

Yes, I'll hit that. You started out right, Peter, in regards to -- we launched the program in -- other than the pilots, really 2021. And so Phase 1, some of the early costs, construction costs were high, et cetera. The team is doing an excellent job of reengineering and even clawing back the cost to do each of those. Right now, the typical Fusion will run anywhere from $600,000 to $800,000 in cost. It very much differs based on the type of store that it is. And a combination of both a Fusion and a garden center can run anywhere from $1 million to $1.5 million of investment and Hal talked about the returns that we get on those. And right out of the first year, you're either a mid-single-digit on Fusion, a high single digit on a combo. But as we're -- as we expected to go in with the investment and we're seeing now, that also has a typical maturity cycle. So it's mid-single digits in 12 months, but then it continues to grow and outpace in the next 3 years. And so the return on invested capital of the Fusion and Side Lot combo stores have been at or above our -- really right at our current return on invested capital and better than the initial investments in the first years of a new store. So we're very pleased with the ability of the team has done to claw back some of those costs, but also the long-term 10-year return on invested capital that these give us.

Yes. No, I mean, we think it's one of the most exciting remodel efforts in all of retail and kind of been waiting for it for years. We've always thought that Side Lot had a lot more opportunity. So pleased to see you guys doing that. Let's go to the -- there's a narrative in the market that Tractor Supply's over earning. I mean, I almost hear that of every company I cover. I find a little curious because while you guys had a big lift in sales per foot like everybody else we cover, you do not let the margin explode like some of the other companies had, you reinvested aggressively. But with that in mind, people still think you're over-earning here. And so maybe in the context of your EBIT margin guidance for this year and the longer term, just maybe talk about why that's an off-base scenario. Look, in the event that the top line comes in lighter, how do you feel like you can be nimble from a margin standpoint?

Yes. I'd first start with the last 3 years, we have been unapologetically, purposely investing in the business for the long term. I would take the complete opposite view of over-earning. I think it's -- if you look at the numbers and the comparison, we've been very purposeful to not over-earn in areas like our retail pricing and our cost of goods sold and gross margin. In the peak of transportation and supply chain, we absorbed a good portion of those inflationary costs. And you saw some impact in the gross margin on that because we view that as one of the very few transitory inflationary cost items. And we're seeing a benefit in 2023 on that. We made meaningful investments in technology and our team members. Our labor costs. We made investments in 2021 and 2022, over 20% investment in overall compensation benefits for our team members. And in this year, that's like a low mid-single-digit growth. And so we've made the right investments, and that's in the run rate. And so we really see the next few years, as we've made those investments, it gives us the ability to invest in Fusion, in garden centers and be able to maintain the SG&A as a percentage of sales while we're making new additional investments in the business and grow operating margin. The team's clawing back a lot of the costs that we saw during inflationary times. So we see the path that we laid the last 3 years gives us the confidence to hit the long-term targets of 10.1% to 10.6% and believe we've got the cost visibility and the opportunity, particularly in the gross margin scale and the scale that we have now today to be able to have good methodical growth in our operating margin.

That's great to hear. Last question, we had one come in from the field. It was around CapEx. Your $700 million, $750 million, I think, in that range maybe for this year or $700 million, $775 million. Is that a peak level here? I mean you've got all these remodels. You've got a lot -- you've already spent money on, but should investors expect that to be kind of the cadence over the next few years? Does it start to come down a little? How should we think about CapEx?

We said that in 2022 and 2023 would be a bit of a peak mainly because the $600 million, $700 million that we would average over the 5 years of Life Out Here strategy that launched in 2021 would have 2 peak years where new distribution centers were launched in these 2 years. But really going forward, you're still at $600 million, $700 million in capital just to support the investments in digital Fusion garden center. And a great point of reference is pre-pandemic, we were running CapEx 3%, 3.5% of sales. At the size of the business, we were at under $9 billion at that point and you have $300 million in capital, and you're running over 3%. We're running at the peak, roughly 5%. And in the next few years, we may be averaging as a percentage of sales, 4%, a little over 4%. And I think even at the size of the business has changed. And so 4% or 3.5%, 4%, may be a good balance for a good growth company like Tractor Supply in CapEx spend.

I think makes a lot of sense. Well, listen, we're out of time. I want to thank you guys for spending the time with us this morning. Again, there will be a breakout session in the Astro A room. So join me in thanking the folks of Tractor Supply.

Thanks, Peter.