Tractor Supply Company (TSCO) Earnings Call Transcript & Summary

I'm Peter Benedict, senior retail consumer products and services analyst at Baird. Welcome to the 2024 Baird Consumer Technology and Services Conference. Really thrilled that everyone took the time out to come today. Pleased to kick off at least our conference with the guys from Tractor Supply. Tractor Supply is leading rural lifestyle retailer in the U.S. They have more than 2,250 stores, plus another 200-or-so Petsense locations. Sales are expected to approach $15 billion this year, and the stock carries a market cap of around $30 billion. To my right is CEO, Hal Lawton, directly next to me is Kurt Barton, CFO. Mary Winn Pilkington, who is their SVP of Investor Relations and Public Relations is here in the audience somewhere along with Joseph Underwood and Tricia Widemor, who are part of her team. So no opening remarks here, we're just going to kick in. Good morning, guys.

Good morning.

Good morning.

Thanks for spending time with us.

So Hal, let's kick it off. Let's talk a little bit about consumer behavior. I mean you guys are in interesting business. You sell a lot of needs-based product, but you also have some discretionary stuff. So maybe give us a sense from your seat, how is the consumer doing?

Yes. I think at the highest level on the macro side, our view is that the consumer is still reasonably strong. You're going to have low single-digit GDP, still led by consumer spending, kind of first complication though is where they're spending those dollars for the last 12, 18 months now. It's been over-indexing on services. Year-to-date, I think services spend is a portion of PCE. Been running like 6%, 7% up year-over-year. We're back to 67.6% of total PCE spend on services. Goods by contrast, have only been growing 1% to 2% for the first 4 months of the year. PCE, it just came out last Friday. So you see this shift still from goods to services, still a bit of a recoil from the COVID years of '20 and '21. And then the second thing I'd say is you are starting to see some delineation at least in our business, on higher income versus lower income, and they got some well documented across retail over the last couple of earnings cycles. If not prior to that, where you're seeing, those who feel like whether it's stock market, just net wealth in general, feeling the ability to still spend, spend on discretionary, but those in the lower income feeling the impacts of inflation. To your point there, Peter, on our business, we're a demand-driven business. So a little over 20% of our business is animal feed and agriculture. Another 20% is companion animal dog food, cat food, those sorts of things. And so we have the people -- our customers are shopping us every single day, and they're shopping us for a lifestyle. And so our customer has continued to be very healthy, very engaged, net customer counts are up year-over-year, continue to be engagement strong, customer satisfaction is strong. Our business has a tendency to be one of the more resilient goods, if you will, oriented retailers. But net-net, I think the consumer is strong, just continue to be discerning.

So in the last quarter, I think you guys have a big category called C.U.E., consumable, usable, edible, I don't know whether that's half the business or something. It's a large percentage. It was kind of the first time in several quarters that it actually grew slower than the overall business. So I know, Kurt, maybe talk about that category, what you're seeing in terms of engagement there?

Yes. Peter, you framed it up well. So for those that don't know the product assortment really well, we do break up our business in categories, but across all of our categories, as Hal mentioned, a very needs-based, demand-driven business. We have roughly in between various quarters 40% to 45% of our revenue is in what we call consumable, usable or edible products. And that's feed, food, it could be lubricants, it could be pesticides. But really across most categories, there's some form of a consumable. And to your point, in Q1, it lagged the chain average. And it's really been a key part of our growth of our business. It's outpaced from a unit standpoint throughout the last 3, 4 years about any other category as you look at our business. But we went into the year expecting that the consumables would have some level of AUR pressure. We've seen inflation over the last few years in the feed, the food, not too much different than you've seen in grocery, right? And so we expected to see as we saw some of the grain prices decline. So AUR pressure is on the feed. And in the pet side of the business, I mean, the pricing is stable, but the industry itself is rather stable versus both inflation and growth in the last few years. And so our focus and our expectation for this year is some pressure on AUR, but growth in the units. And that's really the key thing for us, and it's exactly what we saw in Q1. The primary reason for Q1 and for what we expect for this year to have C.U.E. potentially below chain average is that this year, we'll cycle and still see some disinflationary environment in the consumable side of the business. And we're cycling some of the largest growth that we've had. And so for us, it's very manageable. It's an ebbs and flow that you can have in an area that can have inflation or disinflation. But the key for us is it's a traffic driver. And what we really gauge is units or pounds because that's what drives footsteps, and we continue to see growth in that area in almost every category of C.U.E. And that's what gives us confidence in our ability and that we're gaining market share and the ability to be able to hold the customer.

Right. So it doesn't sound like anything concerning on a unit standpoint. Let's go to the big ticket stuff, which you guys define as anything items over $350, that's where units have not been very good. But in the first quarter, I think for the first time in maybe 2 years, that ticked positive. Maybe expand on that, what you're seeing there is just the start of something, or do you think it was more episodic?

Yes, we see it more of a sustained resurgence of big ticket. And the way we look at that and the reason why is we've had 6 quarters before 2024 of consistent declines in big ticket products. And really, the 2 drivers of that, as we saw it, was there was certainly a significant increase during the peak of COVID stimulus in big ticket in our business and across most of retail, and so we were cycling some of that throughout late 2022 and all of 2023. Also those 2 years did not really have ideal weather conditions for our big ticket items. So with severe heat, drought, a lot of the items we sell, riding lawnmowers, other products that we sell to help grow and cut, what does grow, really didn't have as much demand. And so we see -- we saw it for 2024, and we're seeing it as we expected is, you've got -- you're cycling some of the low. We really expected 2023. It looks like it was the trough on that with more normalized weather and new products innovation in areas like riding lawnmower zero-turns recreational vehicles, having new product innovation as well as normalized weather is really bringing back big ticket. And so we saw a nice growth in Q1, and we expect big ticket to outpace chain average in 2024.

Got it. Great. Hal, maybe back to you. On the first quarter call, you referenced outsized population growth in rural areas. And we've gotten this question over the last 10 or 15 years around people always trying to figure out why is Tractor Supply successful? Like, oh, [indiscernible], like, of course, there's so much of what you guys are doing, but this has now come back into the focus. We get people asking about world migration trends. And did they surge during COVID, and now they're going to go the other way, everyone is going to go back to the city and go back to office. Maybe talk about what you're seeing there, and what kind of -- what made you make that comment?

Yes. So rural America, step back, if you look at our store base of 2,250 stores, roughly 90% of our stores are in U.S. definition, either ex-urban or rural America, about 10% in suburban, 0% in urban America. And so to Peter's point, where people live and where people are moving really matter to us because we have a pretty big SKU as it relates to locations of our stores. And what we saw in 2020 and 2021, well documented, you saw kind of an exodus, a significant exodus, it's out of urban into really ex-urban and rural. And while the absolute number of migrations has continued in '23 and '24, the net number is still -- it still shifts significantly to rural America. And both in 2021 and '22 and '23 and now even into '24, that kind of movement, that mobility is really being led by the millennial generation. And our point of view is that this really wasn't as much a COVID thing as it is just a typical durational norm. The average millennial is now 31, 32, 33 years old. COVID helped stimulate that generation into the next phase of stereotypical generational norms, but they're doing everything used to do, maybe used to -- the previous generation might have done at 25, 27, 28. Now they're doing it at 31, 32, but household formation, getting a pet, buying a house. And as they think about where they're going to live and buy a house, really affordability becomes a major consideration, really where the millennial generation and to form a home is in rural America or ex-urban America. And then secondly, they want to live a lifestyle that's sustainable, that's environmentally friendly, organic type products and those sorts of things. And that's what Tractor Supply caters to very well with the Out Her Lifestyle that we cater to. And so this migration pattern, which started with robustness in 2020 and 2021, but it's continued into this year in the first few months, really has played to our benefit both from just a numbers perspective, but also the lifestyle that we market.

Got it. So A lot of times in retail, there are specific verticals like it's easy to understand what's the consumer electronics opportunity. What's the home improvement opportunity? What -- you guys are different, kind of a rural lifestyle retailer. So that gets down to the TAM. And I think Mary Winn deserves credit for digging into that a few years ago. Talk about the TAM. I think you guys have about an 8% market share right now. Where do you see the most opportunity? First, how you come up with a TAM, and then where do you see the most opportunity going forward?

Yes. So as you said, Peter, $180 billion TAM, really cut that 2 ways. The first is by the categories that we sell, so a pretty normal kind of bottoms-up build. But then we also narrow it to just the markets that we're in. So it doesn't include, say, demand for dog food in urban America because we don't sell into that segment. On our customer base, and how it kind of makes up that $180 billion TAM, where do we see the opportunities? There's kind of 2 entry-level customer segments that shop us. One that pursues this kind of country lifestyle living and one that's a pet enthusiast. So they come in, and they'll either buy garden products, or they'll buy maybe some Carhartt hoodie, or they'll start doing raise bed gardening, or they buy dog food. But then where we really start to win major market share footsteps and get big share of wallet is when they become kind of this big backyard enthusiast, whether it's a 1-acre plot of land or whether it's a 5-acre plot of land, when they start to engage with multi-species, so chickens, goats, rabbits, those sorts of things. That's when they really start to jump into the Tractor Supply lifestyle. As an example, 1 in 5 of our customers, actually we had over 30 -- around 35 million customers shop us, 1 in 5 of our customers raises chickens as an example. And so when they start to shop multi-category multi-species with us, that's really when we lock them in and start to get substantial share of wallet. And then, of course, our core farm and ranch customer is where we have substantial share, probably 20%, 25% of that market share. But this new backyard enthusiast is over indexes millennial, over indexes female. It's where our highest growth rates are, and it's a very exciting segment of our customer base that's growing rapidly and a huge opportunity for us to look out.

Kurt, maybe pivot over to you here. So a little over 2,200 stores. Last year, you guys took the store target to 3,000 domestically. I remember back when you guys took that to 1,800, it was like crazy. So to talk about the next 800, where they reside? Is it new markets? Is it existing markets? And then maybe talk about your approach to development because I think last year, you pivoted a little bit to do some more sale leasebacks. You start to use your balance sheet a little bit, so talk about that.

Sure. I think a key on our journey of our real estate and our opportunity for markets has always been about 2 things, principally around the customer though. The more we've done and learned about the customer that lives this lifestyle. And the more that we're able to gather the level of data and refine that has always been the points where we've seen that we've accelerated, increased the target. And now that we have 34 million Neighbor's Club members and the data we have on them and as a comparison roughly 14 million in 2019. So the amount of data we have today on our customer is so much greater. And the level of systems and capabilities we have at the Square Mile level on customer cohort is really driving a lot of what we know and believe we can do for new stores for Tractor Supply. So it's the culmination of all of those that continue to tell us we can do more. We can get to 3,000 specific locations in the United States. In regards to the locations, and where it's still pretty diverse, we've got markets that we now know that we can add a second Tractor Supply store or even a third Tractor Supply store in a town or a market, but then there's white space where we don't have a tractor supply today that we're still growing some of those more out west where we're growing our stores with our distribution network. So we look at it as new stores in white space, add in stores that are dropped in, all vary just -- just similar in regards to its level of return or productivity. We still got the 800 rough stores that will run very similar in regards to its performance. And then in regards to the sale leaseback that we announced last year, the real benefit to the new stores is that we have -- we're doing sale-leaseback of new stores because we are now switching to nearly 50% of our stores being owned or fixed fee developed. And that gives us more control. We're able to drive down occupancy cost and really take out some of that risk and cost of a developer that was part of 100% of our new store model. And so that's giving us a better return, but also in some cases, it allows us to get into a market that may not have penciled because we really are able to drive down the cost of construction, the cost as you flip that into a sale leaseback. And so it's all been part of a better performance and return on new stores as well as the ability to get to 3,000 stores. And in the long term, it will be part of it, and it is part of our target to grow our operating margins.

Yes. So most companies in your position mean a big dominant player kind of in the space, always has a #2 or #3 that they're going against. I mean, yes, there's Costco, there's also Sam's Club. There's Target, there's -- you can go through the list. One of the unique things about your business is there really isn't a #2 with any real scale. Now that the Orscheln transaction is over, we can talk about it and the FTC can't, same thing. I mean, like at the end of the day, that was 100-some-odd stores, but that was your largest next competitor. I mean just talk maybe briefly about the competitive set who you go against. And then with the Orscheln acquisition, are there others out there that you think other chains that you think would make some sense to kind of find different places you can go.

Yes. So as we mentioned earlier, $180 billion TAM, there's tens of thousands of retail locations in the context of that TAM that we compete against. We think about it in 2 buckets. About 1/3 of that TAM call it, $60-ish billion outside of our revenues is in what we would call the core farm and ranch channel, the kind of legacy farm and ranch channel. That's dominated really by 2 sets of competitors, about 8,000 of these co-ops and mom-and-pops that are across the country and then another 1,000 or 2,000 that are regional chains, chains like Atwood and Murdochs, Rural King, Family Farm and Home, they typically between 50 and 100 stores or 30 to 100 stores, and they're regional in nature. And that's about 1/3 of our market. It's very fragmented, no one at the same scale that we have again is we have 2,250 stores. Our online revenues are larger than any of our direct head-to-head competitions total revenues with the exception of one competitor. And then the other, call it, $105 billion of our market is really just a fragmented list of category-specific competitors. So on the pet side, we compete against grocery. We compete against mass. We compete against pet specialty, on tools and hardware and trailers and those sorts of things, we compete against home improvement and some of the other more hardlines players against garden, again, home improvement and mass. So kind of as you go around our store, we're going to compete against a variety of different competitors. But in total, it's 2 main segments of competitors, but very fragment in the context of that and tens of thousands of locations, and to your point, not really a head-to-head competitor at a national level, which I think gives us a lot of advantages from a competitive and a defensibility perspective.

Kurt had mentioned data earlier, how much more you have in terms of understanding where to put your stores and your customer. Loyalty has been a big story at Tractor over the last several years. I think your Neighbor's Club membership is north of 34 million at this point, which is a crazy number, up 14% year-over-year. I think it's doubled since the beginning of pandemic. Talk about kind of success you've had with loyalty, but also kind of what lies ahead because these loyalty programs kind of have a life of their own and just help us understand the opportunity there.

Yes, the Neighbor's Club program is a key foundational component of our our business model. As Peter said, 34 million members, a very active group, nearly 80% active on an annual basis. So very engaged, healthy customer file. They represent close to 78-ish -- 78% of our total sales on a quarter-to-quarter basis. So active, large, robust and the majority of our sales. We shifted to a tier-based system in the spring of 2021. That was coming on the heels of nearly 20 million new customers on a 12-month basis. And so we really use the Neighbor's Club program to lock that customer base in and drive engagement and drive loyalty. This year, kind of 3 years on the anniversary almost of updating it to a tier-based point system. We changed some of the tiers, changed some of the rewards. We have great success with our top end customer base, almost virtually, never trip that customer base, our top end on an annual basis. The medium -- the middle bucket is very, very strong, active, continues to grow in frequency, number and also in spend per transaction. It's the -- like most loyalty programs at entry level that you really want to try to stimulate where the largest number is, but less engaged, and we made some adjustments this year for that. We've got a hometown heroes program, launching this summer that acknowledges our military and first responders, fire, police and EMS, while rural America is 20% of the U.S. population, it's 50% of our military force. So a big opportunity for us to be able to engage that group. We're excited about that. It will be launched a couple of weeks prior to July 4th. And so there's a lot of customer-facing benefits and engagement in tiers. But on the back end, it's almost as equally as important for us because all this data is up in the Azure cloud. We've got all the various sophisticated software applications on top of it. These applications will offer deep data mining, but also applications allow for deep personalization. We can do that digitally and digital ad banner ads and social ads, or we can do it via e-mail or on our website or in the consumer mobile app. So a high degree of personalization. As an example, 10% of our customers own horses. We know exactly who that customer base is, and we can spend real time with that customer base. And the other 90% that don't own horses, we don't need to spend time talking about horses. Another is like 75% of our customers own dog. So let's talk to that 75% that own dogs, but the other 25%, let's find other ways to market to them. And those are just very modest, very straightforward examples. But we break our business on a weekly basis in the marketing segment of over 50 different customer types to be able to get that tailored versioning.

Got it. Kurt, let's do some financials quickly. So the long-term algo 6% to 7% revenue growth, EBIT margin is 10.1% to 10.6, 8% to 11% EPS growth. We're not there yet. But maybe talk about some of the structural changes in gross margin that have occurred. Is there anything on the tariff front that we need to be aware of because let's assume that comes into the conversation here over the next several months? And then what are the conditions you think are required to kind of get you to the high end of that margin range share over time.

Yes, I'll start with the structural piece of gross margin, and it's been -- it's a great story over the last 4 years. I'll continue to reference 2019 as a great point of view of the growth that Tractor Supply has seen. But we've seen 150 basis points growth in our gross margin, and that pretty much makes up all over most of our operating margin improvement. But it's been very strategic and very purposeful, and it demonstrates the structural nature of it that in the gross margin, roughly 2/3 or a little over 2/3 of that is is from investments we've made in SG&A. So if most -- if all or most of the operating margin came from gross margin, SG&A is not growing, but we've grown the company significantly during that time. We've reinvested in areas like introduction of our field activity support team and our distribution network, which we had to grow. So the investment and pressure on SG&A for those resources have benefited gross margin. So over 100 basis points has come from the benefit out of our field activity support team, which is funded by our vendors. Over 50 basis points is coming from just efficiency and reduced miles in our distribution network. We literally cut out over 20% of the average miles since 2019 by having new distribution centers in our network, which we needed to grow because the total revenue has grown roughly 80% since 2019. And so there's the structural nature of it. The remaining piece of gross margin has been the leveraging of our scale and negotiating great pricing from having great distribution center points, but a larger power of our buying. And what we're seeing now is the additional aspects of gross margin that we're able to have other efficiencies. All of that on the gross margin side has been in the headwinds of a pressure from mix. As I mentioned earlier, C.U.E. has grown, over the last 4 years, significantly as well as inflation over the few years. We're still at higher levels in inflation by nature has put pressure on gross margin. So we've made purposeful investments in SG&A to continue to fuel and fund the business and gain market share. And so it's been very strategic that our growth in gross margin is what's really driving it, but it's all very structural as well. And then in regards to some of the other parts of the question, what really gets us to the high end of our operating margin range. We believe what we've done in the last 3 years, 4 years to invest in the business, continues to put -- as we've seen the peak of investments in SG&A, so we see right now, we're really positioned well to be able to leverage the fixed cost, leverage that we put into the business and have less pressure on SG&A. So we expect we can grow gross margin continually, but less pressure on SG&A. Basically, if we hit our expectation targets on for the long term in regards to our comp sales, and we just need normal conditions for our comp sales. In this year, we're seeing disinflation and deflation, you're seeing shift from goods to services. Those pressures are existed this year, and that's why we've set the targets that we've had for this year, knowing that there's some transitory pressure on the business. But for the long term, if we hit our long-term targets of 4 to 5 comp sales, we're able to really leverage the SG&A, and that's what puts us at the high end of our target range. And I think, Peter, that hit all or most of your questions unless you...

Tariffs, you really have now...

Tariffs, on that, we've seen tariffs before, and we've managed it well. To some extent, we're a bit less vulnerable to that with only about 12% of our products being direct import. Some product is also sold to us domestically. But Tractor Supply is a bit less vulnerable than, I'd say, most of retail on that. It's -- you handle it fairly well. You handle it as you do on another level of inflation. And if we have that situation, it's going to apply to all of retail, and I think we can manage that as well as we did in the past.

Yes. Final 2 minutes. You said 2024 is the year of the Garden Center. I mean the side lot transformation, I think, is one of the great remodel programs in retail today. Now almost less than 2 minutes, a quick update on what you see from the Garden Centers, what you see is the opportunity, given your background with that category?

Yes. One of our very exciting strategic initiatives we have is an ongoing store remodel program. With 2,250 stores, I think you've got to have a remodel program once you've reached scale and in retail. And one of our inside the store remodel program is called Fusion. We have -- at the end of this year, we'll have nearly 50% of our stores in the Fusion prototype. Secondarily, we're also building Garden Centers where we have the space and the financial model makes sense. And this year, as Peter said, we kind of coined it as the year of the Garden Center. We just opened our 500th Garden Center this past Saturday. This used to be a kind of open sidelot space, as Peter was saying, Think about this as a concrete pad, 12,000, 15,000 square feet. We'd have our agriculture product out there, stock tank fencing, those sorts of things, 3-point equipment, all just kind of laying on pallets out on this concrete slab. We went out, use that space differently, merchandise that equipment, that product a little differently got it up on racking, got it organized better. And that freed up 5,000 square feet that's just kind of found space for us to go build Garden Centers. Our customers told us in 2019, we were doing research that the #1 category they participate in that we least address was live goods, particularly fruits and vegetables, trees and shrubs, things you need for rural Americans. So we went out and built a solution for that. We've been very pleased with the results. When we do both Fusion and Garden Center, we get a high single-digit comp lift on a 12-month basis in our stores. And we've got the rest -- the other half of the chain to go remodel and well over another 500 Garden Centers to go build in the future.

Awesome. Right. Well, listen, that's all the time we have, but they will be available for a breakout in room A. So please join us.