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Executives

Erica Pettit - Financial Dynamics

James F. Wright - Chairman of the Board & Chief Executive Officer

Anthony F. Crudele - Chief Financial Officer, Executive Vice President & Treasurer

Gregory A. Sandfort – President & Chief Merchandising Officer

Stanley L. Ruta - Chief Operating Officer & Executive Vice President

Analysts

Peter Benedict – Robert W. Baird

John Lawrence – Morgan Keegan

Dan Wewer – Raymond James

Analyst for Alan Rifkin – Bank of America

Robert Higgenbotham – Goldman Sachs

Analyst for Mitch Kaiser – Piper Jaffray

David Magee – SunTrust Robinson Humphery

Jay McCanless – FTN Equity

Joan Storms – Wedbush Morgan

David Strasser – Janney Montgomery Scott

Andrew Wolf – BB&T Capital Markets

Jack Balos – Midwood Research

Tractor Supply Company (TSCO) Q2 2009 Earnings Call July 22, 2009 5:00 PM ET

Operator

Welcome to Tractor Supply Company’s conference call to discuss second quarter results. (Operator Instructions) I would now like to introduce your host for today’s conference, Miss Erica Pettit of FD.

Erica Pettit

Thank you. Good afternoon everyone and thank you for joining us. Before we begin we would like to take a moment to reference the Safe Harbor Provisions under the Private Securities Litigation Reform Act of 1995. This conference call may contain forward-looking statements that are subject to significant risks and uncertainties including the future operating and financial performance of the company.

Although the company believes that the expectations reflected in its forward-looking statements are reasonable it can give no assurance that such expectations or any of its forward-looking statements will prove to be correct. Important risk factors that could cause actual results to differ materially from those reflected in the forward-looking statements are included in the company’s filings with the Securities and Exchange Commission.

The information contained in this call is accurate only as of the date discussed. Investors should not assume that the statements will remain operative at a later time. Lastly Tractor Supply Company undertakes no obligation to update any information discussed in this call.

Now I am pleased to introduce Mr. Jim Wright, Chairman and CEO.

James Wright

Thank you. Good afternoon everyone. I am calling in from the road. Tony Crudele, our Chief Financial Officer; Greg Sandfort, our President and Chief Merchandising Officer and Stan Ruta, our Chief Operating Officer are together at our store support center.

During the second quarter, our largest in both sales and profits, we remained focused on our key priorities for the year which are to grow our business and to improve our business by continuing to differentiate our merchandise mix and execute our retail strategy. As a result of our collective efforts to win in the current environment and beyond we grew sales by 5% despite the challenging top line environment and improved gross margin by 150 basis points to 31.9% through a number of strategic initiatives that I will discuss in a moment.

We are pleased to deliver better than expected net income of $54.8 million or $1.50 per diluted share, a 30.4% increase. Let me briefly discuss some of the highlights that contributed to our performance. First, we continued to provide our customers with a compelling merchandise assortment that supports the basic and fundamental needs of the rural lifestyle. Our consumable, usable and edible or CUE category remained our strongest performers particularly animal and pet related products.

We have successfully increased our prominence in these less discretionary SKU’s in our advertising and in our new store presentations while ensuring we offer a compelling value in these categories to our customers. As we anticipated, demand for replacement parts has grown as consumers continued to place greater emphasis on repairing and maintaining their existing tools and equipment.

During the quarter we experienced particular strength in repair parts for outdoor power equipment, small farm tractors and farm implements. At the same time, we narrowed our assortment of certain big ticket items to reflect the anticipated weak trends in outdoor power equipment. We feel we are very well positioned to exit this season at very appropriate inventory levels in those categories.

We also expanded our lawn and garden offering by creating a destination department within the store. Throughout the first half our team studied and responded to the grow it yourself trend. Consistent with what we would anticipate from our self reliant customers, products related to planting gardens such as seeds, fertilizers and tillers had a very good sell through.

Additionally, our customers responded well to canning products. We look forward to applying our findings in the future as we enhance this category to fully capture initial opportunities.

Second, we effectively refocused our marketing program to align our spending and the offer with the current market conditions. In doing so this quarter we eliminated our television Ad spending and frankly have done so for the year. As you have heard us say before, we believe that while TV advertising has somewhat increased our [top] you might recall, we have never been able to correlate TV to sales or traffic. In a more normalized retail environment we will reevaluate televisions role in our marketing mix.

We also reinvested a portion of our TV ad budget into our direct marketing program that includes mailing and emailing circulars with partner offers to various customer groups which we have segmented by spending profiles. As we enhance our CRM capacities we are continuing to test and refine these offers through our promotions, drive traffic and profitable sales.

Third, we continue to deliver improved performance through our inventory management initiatives. We have had a lot of success this year with our 20/250 initiatives that focuses on the top twenty categories and the 250 most important SKU’s within those categories. We had very high in-stock level on these items while driving total per store inventory levels down on a year-over-year basis for the seventh consecutive quarter.

At the same time, we are investing in categories that are most timely and most important to our customers. Overall, we are delighted with our performance in the first half of the year and as you know we recently raised our earnings expectations for the full year. We are proud of other key metrics such as gross margin net of advertising and positive comp traffic.

I would like to take a moment to thank all of our associates. The collaboration of our store and store support teams has really been excellent and we continue to demonstrate our ability to navigate in a challenging environment. Our teams have been very proactive as we transitioned from last year’s high inflationary environment. We are successfully managing cost changes and testing the stickiness of retails on a daily basis. In doing so we are mitigating the risk of steep deflation.

Further, we have managed through the seasonal period where big ticket items have in the past had a more pronounced impact on our business. Now I would like to turn the call over to Tony to review the financial performance and discuss our outlook for the remainder of the year. Tony?

Anthony Crudele

Thanks Jim. Good afternoon everyone. Q2 is our largest sales volume quarter and we are extremely pleased with the overall results. On a year-over-year basis we grew sales by 5.4% for the quarter and reduced our per store inventory levels for the seventh consecutive quarter. We believe these achievements continue to demonstrate the strength of our business model as we navigate through these tough economic times.

For the second quarter ended June 27, 2009, net sales were $946.5 million and net income was $54.8 million or $1.50 per diluted share. Total comp store sales in the period decreased 2.7% and non-comp sales were approximately $72.8 million or 7.7% of sales. Comp sales were negatively impacted by 100 basis points due to one less selling day in the quarter because of the shift of the Easter holiday.

We estimate inflation benefited comps in the 3% range which was significantly lower than recent quarters. We have been successful in our efforts to actively manage pricing in an inflationary period by maintaining our gross margin rate and per unit profit.

While our customers are making more frequent trips to the stores they are primarily shopping for essentials that support their rural lifestyle. The comp transaction count increased 4.6% and we are very pleased that we continued to drive footsteps into the store especially in light of the decreased marketing spend. The average comp ticket decreased 7% resulting principally from softness in the sale of large ticket items.

Our core consumable, usable and edible categories including livestock feed as well as pet food and supplies continue to be key merchandise drivers of our sales. Spring was delayed by a cold April and had a pronounced negative impact on comp sales in the quarter. May was slightly warmer and wetter than last year, particularly in the Southeast.

As a result, May was the strongest performing month on a comp sales basis. June was minimally cooler than the prior year and was wetter in the Northeast. However, as a result of lower demand for big ticket items we did not recapture the sales lost during the cold April. Sales were the strongest in the south where the colder April had less of an impact. We were happy to see sales in the Southeast perform well as we cycled against dry conditions and as the performance of our Florida stores seems to have stabilized.

Comp sales in our Del’s stores were approximately at chain average. Since feed and hay make up a significant portion of Del’s product mix, we do not expect strong comp sales as Del’s cycles last year’s high inflation in these categories. Overall, we were pleased with Del’s gross margin improvement and their ability to exceed plan under less than favorable economic conditions.

Turning now to gross margins. Compared to the prior year quarter we increased gross margin by approximately 148 basis points to 31.9% of sales. The favorable LIFO provision relative to last year’s abnormally large provision accounted for 61 basis points. The LIFO provision was approximately $0.06 per share in the second quarter of 2009 compared to $0.14 in the second quarter of 2008.

Four other components contributed to gross margin improvement. First, lower freight expense compared to the prior year was a strong driver of this improvement resulting from fuel price decreases relative to last year and some preliminary gains from our transportation cost savings initiatives.

Second, higher direct profit margins because of better purchasing as well as continued vendor support of our merchandise initiatives and promotions. Third, lower mark down impact. As we have kept inventories fresh we minimized exposure to margin erosion from mark downs. Lastly, our loss prevention initiatives have resulted in a reduction in year-over-year shrink.

For the quarter, SG&A including depreciation and amortization was 22.6% of sales which was less than a ten basis point increase over the prior year quarter. While we did not leverage this expense due to our negative comp sales, we are pleased with the SG&A expense control. Importantly, our advertising expense offset a large portion of the de-leveraging and improved by approximately 110 basis points. As we noted in our business update press release earlier this month, we eliminated our TV spend and our direct marketing program is proving to be very efficient. As Jim mentioned, our focus on driving gross margin dollars net of marketing expense has been effective as evidenced by our comp transaction increase.

Although we are pleased with SG&A cost reductions, some of the savings were offset by additional incentive compensation related to the better than planned operating results. The pre-opening expenses for new stores were approximately $1.5 million compared to $2.6 million in the prior year quarter. In the second quarter we opened 13 stores compared to 23 stores last year. Pre-opening expense per store was consistent on a year-over-year basis.

Turning to the balance sheet, we continued to improve our inventory productivity. At quarter end inventory levels per store were down approximately 7% on top of a 12.2% decrease at the end of Q2 last year. Our calculations are based on average cost of inventory and excludes in transit inventory and inventory held in unopened stores.

Annualized inventory turns for the quarter were 3.32, nearly a six basis points improvement over last year’s second quarter. We had a slight decrease in inventory financing to 53.4%, down 209 basis points as we have been more aggressive in working with our vendors in capturing discounts.

Capital expenditures for the quarter were approximately $15.3 million related principally to our new store opening program. This is a decrease compared to last year’s second quarter spend of $27 million because we opened fewer stores this year and spent approximately $5.3 million last year on our Waco Distribution Center expansion in that quarter.

During the second quarter we made limited purchases under our stock repurchase program. We purchased approximately 21,000 shares for $742,000 for a cumulative total of 214 million since the inception of the program in February 2007. The share repurchase program did not have a significant impact on EPS for the quarter or year-to-date results.

We are extremely confident in our cash flow and liquidity position and believe it is important to maintain our prudent balance sheet management in the current environment.

Turning to our outlook for the full year. In our business update release earlier this month we raised our previous financial expectations for full year net income to a range of $2.78 to $2.98 per diluted share compared to our original guidance of $2.58 to $2.74 per diluted share. We expect full year sales to range between $3.15 billion and $3.25 billion compared to our original expectations of $3.2 billion to $3.3 billion.

Correspondingly, same store sales for the year are expected to be flat to a decrease of 2% compared to original expectation of an increase of approximately 1.5% to a decrease of approximately 1.5%.

So let me discuss a few of the underlying assumptions included in our estimate for the back half. With respect to sales, customer spending has generally remained in line with our expectations in the first half of the year. Although July sales have gotten off to a slow start we continue to see our customers shopping our stores for a wide variety of functional, nondiscretionary items that are very relevant to their lifestyle. They continue to limit discretionary purchases and search for compelling values.

Economic forecasters are projecting unemployment will increase further in the second half and we are not immune to the negative impact this has on consumer spending. We will be cycling a very difficult sales comparison in Q3 as inflation became more prevalent last year. Also in Q3 last year we had a very high level of emergency response sales related to Hurricane Ike and had above average pre-sales of heating stoves and fuel. Oil and gas prices are lower and accordingly there is less incentive to install or utilize alternative heat.

At the same time, there is less dependency on big ticket items in the second half of the year than in the first half. Although we have a variety of large ticket items throughout all the seasons, as we move into the fall season we believe that many of the fall and winter items will face somewhat weaker headwinds than we had in the first half. In general, retail sales have been relatively consistent since the fourth quarter last year and as such we believe the comparisons will ease as we move into the fourth quarter.

Overall, we believe if our sales are somewhat softer as we expect we will be able to offset this through the related freight savings and strong gross margin management and reduced marketing spend. With respect to gross margins, we expect some gross margin pressure as we move into the second half of the year. Although we will be cycling against a very heavy inflationary period last year, we believe the more significant cost reductions we have negotiated have cycled through our moving average cost base.

We anticipate that inflation impact will be limited while the possibility of significant deflation has been substantially reduced because retail prices have been firm and we have been managing gross margins effectively. We anticipate freight will continue to have a favorable impact on margins. Fuel prices remain well below last year’s prices and although fuel prices began to decline in the latter part of 2008 the P&L benefit was delayed as the freight costs are capitalized into inventory. Additionally, we believe that our initiatives to increase the efficiency of transportation and freight will continue to gain traction.

With respect to LIFO, based on our expectations for year-end inventories and mix we are currently estimating a full year LIFO provision of $13.1 million compared to our full-year estimate of $14.1 million at the end of Q1. As you will recall, the LIFO provision is dependent upon a combination of year-end inventory levels and mix of product as well as the inflation rates for various product categories. We continue to project a LIFO provision despite various cost reductions in several key product categories because we will have a net increase in aggregate total inventory. This is driven by our mix which continues to shift to fresh, faster turning goods as well as our store base expansion.

As a result, we are adding merchandise that has higher inflation indices than the existing company averages and this creates a LIFO provision even as inflation moderates and inventory per store declines.

We were pleased with our SG&A expense management in the quarter. SG&A leverage will not be achievable in the second half of the year on the flat to negative annual comp sales forecast. Especially as we cycle some of our cost savings initiatives implemented last year. Also as a reminder we are on track to roll out a good portion of our POS system this year and expect to incur additional payroll in Q3 and Q4 to support this implementation.

Consistent with our approach in the first half, we will continue to benefit from negligible television spend and continued efficiency in our advertising spend. It is important to note that the second quarter has historically been the quarter where we spend the most TV advertising. Marketing spend in the third quarter has been significantly lower and in the fourth quarter moderately lower when compared to Q2.

We continue to expect to open 70-80 new stores this year. We opened 41 stores in the first half of the year. We have been aggressive in managing our capital and limited our capital spend to store growth and essential strategic initiatives. We now expect that capital expenditures will range between $75-80 million, down from our original projection of $85-95 million.

To conclude we are confident our ability to execute our retail strategy and serve the functional needs of the out here customer will be the key differentiators as we manage through the remainder of the year.

Now I would like to turn the call back to Jim.

James Wright

Thanks Tony. Given our performance in the first half, our team has certainly proven we can adjust and win in the current environment. Through very deliberate actions we have been able to enhance our organizational efficiency, strengthen the leadership team while all the time doing more with less. We plan to carry the momentum into the second half of the year. With that in mind we do recognize the state of the macro environment remains challenging and overall consumer sentiment is low.

Tractor Supply will remain nimble and act quickly on factors outside of our control to maximize our performance. We believe we have an opportunity to capitalize in the current marketplace and those trends by meeting the everyday needs of our customers as we continue to focus on executing our retail strategy. As you have heard us say before we are committed to providing the best service in our stores and solidifying our position as the authority on the out here lifestyle. We are pleased that year-to-date our total customer loyalty score has increased 400 basis points. This hard earned position must be protected and re-earned daily and we are dedicated to that effort category by category and store by store.

Let me provide you with some more detail on some of our programs. First, we are planning some changes to enhance the shopability of our in-store presentations to help our customers find the products they need and make their buying decisions.

For example, we have recently reorganized our tool section by brand to make it easier for customers to find brands such as Dewalt, Master Hand, Kawasaki in one central location. Additionally, we are strategically placing more of our CUE items in the traffic flow. However, our merchandise assortment will remain focused on the value oriented, needs driven consumer. With that in mind our CUE categories will continue to be the primary traffic drivers.

In addition, we are repositioning our C.E. Schmidt private label footwear assortment to respond to a more price conscious consumer. We also expect replacement parts to continue to benefit from the postponement of big ticket item purchases. As Tony discussed, we do believe our heating category will face potential headwinds as we face stronger and earlier sales from the alternative heating in the third quarter of last year.

That said, we are planning carefully and believe we will recover any drag in the heating category in Q4. At the same time we will focus aggressively on managing expenses that do not affect our customers’ overall shopping experience. We will look for areas that drive further efficiency such as marketing and transportation.

Additionally, we will optimize our inventory initiatives through programs such as 20/250. Turning to Del’s, our teams are working closely to ensure we are appropriately managing some top line pressure as a result of less inflation this year compared to 2008. However, we expect this business which exceeded plan in the first half of the year and to continue to meet expectations. As such, we remain comfortable in our position and remain delighted with the leadership and the appearance of the Del’s stores.

Before we open the call for questions let me take a moment to reinforce why we think Tractor Supply Company is unique and well positioned to succeed now and in the future. First, we serve a unique niche. Our customers depend on us to support their everyday needs. We continue to develop a deep understanding of our customers and how we can better serve their needs. This combined with a strong business model enables us to expand our store base and grow in this market.

With that in mind we enjoy limited and fragmented competition. Therefore we are able to meet the functional and nondiscretionary needs of those living the out here lifestyle. We bring efficiencies to our market and are very pleased to say during these challenging times our customers are returning to our stores more frequently than ever. We have a sound financial in place with excellent capital structure. Our balance sheet is strong and we have no long-term debt. Lastly, we have a seasoned management team that has successfully navigated through many retail cycles.

In short, we continue to be a growth company. We continue to collaborate across all levels of the organization to provide our customers with relevant merchandise, a one of a kind shopping experience, while increasing both our top and bottom line and enhancing our overall organization for both the current term and the long-term.

Operator that concludes our prepared remarks. We would now like to open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from the line of Peter Benedict – Robert W. Baird.

Peter Benedict – Robert W. Baird

Can you talk a little bit more about the ad spend savings? Maybe put some numbers around how much was actually eliminated versus reallocated over to the direct marketing?

Anthony Crudele

I can touch on that. We don’t get too granular when it comes to the marketing dollars. The majority of the savings was translated directly to the bottom line and we eliminated principally all television ad spend. So in the 110 basis points I quoted reduction I would say principally the majority was that. There were some additional savings relative to other programs that our new SVP, John Wendler, had analyzed and we had eliminated as well. The reallocation was probably much less proportion of the 110 basis points.

Peter Benedict – Robert W. Baird

As we look to the second half of the year I know you said you didn’t think you would be able to leverage SG&A on the comp outlook you have. What kind of comp would you need to leverage the expense profile in the back half?

Anthony Crudele

That is a difficult question to answer. Depending on if we move back to a more normalized situation our response would be more in the 2-2.5% range. That could be less if we continue in a more difficult environment where we continue to focus on cost reductions and cost savings. I would say in a normalized environment the numbers would be around 2-2.5% range.

Peter Benedict – Robert W. Baird

On the inflation impact, you said it was up 300 basis points, is it right you are not expecting any deflation in the back half of the year? I mean, as you start to go against the peak numbers of the third quarter do you think net/net you are going to have flattish pricing year-over-year or do you think you could actually incur some deflation in the back half?

Anthony Crudele

Clearly on a category to category basis it will change dramatically. On an overall basis we are looking somewhat flat to potentially 1% when it comes to inflation. A lot of it really has to do with the mix of the merchandise as we shift more to the CUE items and the pricing that relates to the CUE items relative to last year.

Operator

The next question comes from John Lawrence – Morgan Keegan.

John Lawrence – Morgan Keegan

Can you comment, in this environment I don’t know if you can comment, so much of your history has been able to find new products to put into the mix. Can you talk about in this environment how much more difficult is it to find those new products you can put in different categories?

James Wright

As you have seen, our inventory has gone down now for seven consecutive quarters. We have done a tremendous job of purging our stores of what may have been some of our more aggressive testing practices in the past. Today we find ourselves in the terrific position of having floor space, shelf space and inventory dollars available to invest. Frankly we are now looking to more aggressively begin testing and resuming the [Andy Grove] phrase you have heard me use from time to time, “Fail often, early and cheaply.” I think there certainly is merit in testing new products and new offers with our customers. Greg do you have a follow-up on that?

Gregory Sandfort

We continue to find new product out there particularly in some of those core categories that support the out there lifestyle. There is no lack of newness in the market. As a matter of fact we just came through a session when we had open buying days and we had record turnout of new vendors with new products attending. As Jim said we are in a great position right now with inventories to react to things and if anything the faucet has been turned back on for looking at and bringing into the assortment much newness here by the third and fourth quarter.

John Lawrence – Morgan Keegan

A follow-up there, if you look at the two private label categories, Ranch Hand and C.E. Schmidt, would both of those product lines be expanded for the second half?

Gregory Sandfort

Two things. One is C.E. Schmidt will be expanding. We will be adding the Missy component to that with a launch this fall. So that is a major expansion. Also on the Ranch Hand side we really have taken a hard look at where that product category makes more sense. It really is in the home accent/home décor side. We have really done a great job with this fall’s assortment with narrowing the focus, looking at price points to make sure we are competitive on a day in and day out basis and I believe the customers will respond appropriately.

Operator

The next question comes from Dan Wewer – Raymond James.

Dan Wewer – Raymond James

I appreciate the help on impact of LIFO with margin rate. Can you provide us some similar details on the impact of freight and how much that benefited gross margin rate? Then within the freight savings, how much of that do you believe is permanent for the initiatives you are implementing and how much is reflective of the drop in diesel prices year-over-year?

Anthony Crudele

Generally freight has been consistent through much of the year is in the 40-50 basis point improvement range. I would tell you that the majority, and by majority I mean 90-95% range, of that improvement is related to diesel fuel. The majority of the initiatives we have in place as far as transportation we believe has a significant benefit but it is fairly limited when it comes to the impact it has had on a year-to-date basis. We do expect to capture some of that as we move forward. For example we just renegotiated with our carriers and that was implemented in effect as of the end of June. We have some initiatives in place to get some additional benefits. Year-to-date the savings have been principally related to diesel prices.

Dan Wewer – Raymond James

Other retailers are telling us that they are seeing better same store sales in states that have lower employment. For example Nebraska and Kansas. On the other hand the same via the worse performance in states with the highest unemployment rates. When you look at your regions do you see that kind phenomenon?

James Wright

We have seen some correlation but not nearly as direct as perhaps some of the retailers you are speaking of. We have actually taken it down to looking at Michigan and Ohio for example, trends related to the proximity of a closing or a plant at risk. There is certainly a correlation but I would not say it is as significant for us as it might be for others.

Dan Wewer – Raymond James

The last question I have is going back to pricing. PetSmart has been calling out their increasing their promotional intensity to drive traffic. I know there is not a huge overlap between your chain and theirs but there is some overlap. Are you seeing any impact on their pricing strategy on your pet sales, which I know you called out being strong, but are you seeing an impact in those regions or in pricing in stores that are nearby?

James Wright

No, we know the markets we share with them which are much fewer than you might expect in the trade area level. We also track our trends in those markets. At this point in time we see no reaction to their efforts impacting our trends.

Operator

The next question comes from Analyst for Alan Rifkin – Bank of America.

Analyst for Alan Rifkin – Bank of America

My question revolves around your 20/250 initiatives. You have clearly been making good progress with that but my question is in time do you think there will be any meaningful impact or benefit I should say on gross margin end or is that initiative mainly a function of sales and inventory burn? Just a follow-up question, as you are expanding your private label goods, notably the C.E. Schmidt, any other progress you have been making on the import goods side?

Gregory Sandfort

First of all on the impact of 20/250, it is a list that we have developed that really is the core CUE items as we have been talking about and what happens is as you improve your stock position and the customers continue to come back and find we are always in stock in these items, we start driving more volume which then relates to some efficiencies and some cost concessions that we can and have asked for. That is number one. There is some margin gain over there over time.

Number two, on the import side and private branding, we continue to work that process. We have over the next probably 2-3 years a relatively aggressive plan to take in the key categories again that are part of the out there lifestyle, the fencing categories, feed and so on and so forth, the repair and maintenance and tractor and so on and so forth, those are the areas we will focus on. We already have plans in place to grow the penetration of private brand. We already mentioned about C.E. Schmidt and some others but there is some margin extension but it is still a little ways in front of us. It is probably another good six months before we will start to see that.

Operator

The next question comes from Robert Higgenbotham – Goldman Sachs.

Robert Higgenbotham – Goldman Sachs

I wanted to dig into gross margin a little bit more if we could. When you look at your FIFO gross margin trends, the year-over-year improvement accelerated by about 50 basis points. It sounds like maybe you got some incremental impact from freight but I’m wondering if you could provide a little bit more color in terms of what changed quarter-to-quarter and maybe if you could throw whatever the mix impact might be into that? Then I have a follow-up on expenses.

Anthony Crudele

Robert we tend not to give too much detail around the gross margin but directionally let me go over some of the comments in the prepared statements. Freight obviously was the biggest driver and as I stated earlier generally in the 40-50 basis point range. Shrink, we had very good shrink performance this quarter as well as in the first quarter so that was a driver again to a lesser extent than freight. As I mentioned in my remarks we have been working with the vendors and have been pushing very hard as far as getting the discounts as well as working with them on vendor support when it comes to pushing merchandise through the system and some of the various promotions we had in place. As far as margin goes that was a benefit as well.

Then when it comes just to the freshness of merchandise, as we cycled through last year we really came into the quarter with very fresh merchandise which obviously reduces mark down exposure. I would say the last three that I mentioned other than freight and the 30-40 basis points all were in the general category in somewhere between 10-15 basis point range.

Robert Higgenbotham – Goldman Sachs

A follow-up on gross before we get to expenses, when you get to price negotiations and you look at the impact of deflation on your business overall, first of all, how far are you into price negotiations across your vendor base? As I think about the impact on your margin rate should I think about that more on your ability to further enhance those price negotiations or would the impact come more from your ability to hold retail?

Anthony Crudele

I think currently it will come more from the ability to hold retail because as we continue to move through the cost reductions we have received and it continues to work through our costing model we should be able to get some benefits there. As it relates to our cycling through vendor meetings, we have a program as we cycle through most vendors over a three year period, but key vendors we cycle through at least once a year. We believe we have hit all the key vendors since last fall through the first quarter and we have constantly been working with those vendors. I would feel very comfortable in saying that we have worked with a majority of the vendors to recoup cost reductions in those key categories where we saw price inflation in the cost of merchandise last year.

Gregory Sandfort

We are negotiating working on price every day. It is a daily exercise. As commodity prices move we are moving along with that in negotiations with the vendor community.

Robert Higgenbotham – Goldman Sachs

On expenses, you had one less selling day. In other words the stores were closed. How should I think about the impact to expenses during the quarter?

Anthony Crudele

Generally the impact would be very limited. I wouldn’t allocate very many basis points at all to that. Sunday is a shorter day for us as far as payroll goes and a lot of times those sales will be spread throughout the day before and the day after so we will have some additional payroll allocation relative to those days. Net/net there is a slight positive impact but it is very limited.

Operator

The next question comes from Analyst for Mitch Kaiser – Piper Jaffray

Analyst for Mitch Kaiser – Piper Jaffray

If I did hear you correctly you made the comment that July was currently off to a slow start. I wanted to see if that is the case if there is anything unusual going on in the quarter with regards to either rain that you may be able to comment on?

James Wright

July last year we had a normally positive, early sales of principally heating fuel and also wood burning and wood pellet burning stoves. So it was a very unusual event last year. Consumers had a lot of emotion around the anticipated cost of heating oil and propane. So that was one factor. The weather has been probably a neutral force across the chain. We do continue to see some headwinds on just general big ticket sales.

Analyst for Mitch Kaiser – Piper Jaffray

The heating fuels, I know last year you had very strong sell through in Q3 and I think last year you thought maybe there was some pull forward out of Q3 and out of Q4. When you are thinking about that category for the back half of the year are you now thinking about it being flat? In other words down Q3 and potentially up in Q4?

James Wright

Generally we feel much better about the half than we do about the third quarter. Last year we were in a very poor inventory position in Q4 that we will recoup quite a bit on anything we miss this year in Q3.

Analyst for Mitch Kaiser – Piper Jaffray

On expenses, at the Analyst Day I know you talked about your initiative around the tractor value system and being able to manage down about $3 million in expense regarding distribution of merchandise to the stores. As your meetings have progressed have there been any other initiatives that have come up that you might be able to discuss with us today?

James Wright

I won’t give you any dollars but I am frankly delighted with our TVS or lean initiative. We have certainly identified value to be captured going forward. It comes to us rarely immediately but frequently after we go forward and initiate the plans that our TVS process does develop. It has also helped us a great deal frankly with how we work and how we work with waste. I can’t really give you any numbers but I am really delighted with the progress we have made. We are now three years into our lean initiative and that is generally around the time that companies begin to get traction and I would say we are certainly on the track.

Operator

The next question comes from David Magee – SunTrust Robinson Humphery.

David Magee – SunTrust Robinson Humphery

You mentioned earlier about some new products coming down the pipe that have some excitement. Would you care to talk about which categories they would be in? Is it the gift side? Is it the home?

Gregory Sandfort

It is primarily in the seasonal category and we won’t get much more specific than that. I will tell you the seasonal categories are where we are seeing a lot of newness. We are finding in the apparel and footwear elements some interesting new products that will also be introduced. Generally it is seasonal where you will see most of it.

David Magee – SunTrust Robinson Humphery

Secondly, your tracking numbers look very good. Is it in part because of consolidation out there? I would think that a lot of your smaller competition would be under a lot of stress right now.

James Wright

We are seeing some of the small, particularly on the feed side, the small feed stores frankly they have been consolidating for a number of years. We are seeing some acceleration in that consolidation but I would frankly attribute most of our increased traffic to two fundamental initiatives of ours. One, the constant focus and now for the last seven quarters the measurement of customer satisfaction on all of the initiatives that follow along the scoring system.

Secondly, our CUE item initiative which stands on many legs. One is obviously the assortment. Two the pricing. Three, the promotion of those more frequently purchased goods.

Operator

The next question comes from Jay McCanless – FTN Equity.

Jay McCanless – FTN Equity

Two questions. The first one, I was going to see if we could get an early read on the POS roll out and what, if any, effect it is having on the 20/250 plan?

Anthony Crudele

As far as POS roll out we have several stores in test and we anticipate that we will begin the roll out in the latter part of August. We are looking to a good portion of the stores prior to the holiday season and then we will complete the remainder of the stores in January and February timeframe. Relative to some of the benefits, I will let Stan speak to that.

Stanley Ruta

Benefits on the POS there are many, many benefits that we get from it but surrounding the customer experience just the quicker transaction speed on all transactions is going to benefit our customer experience. Specifically around the whole return process. We also get some big benefits around electronic storage of customer data at the company level that we can share with all stores and learn and become smarter about our customers.

We have a lot of increased security and more internal controls with the new system as well as real-time inventory. A lot of reporting and a lot of enhancements this new POS system is going to give us.

Jay McCanless – FTN Equity

The other question I have is the base consumables you indicated the people are coming in now and buying, what percentage of the SKU’s in 20/250 make up those base consumables? 50%? 60%? Something in that range?

Gregory Sandfort

I would say that a very high percentage is in that product. There are some seasonal products that move in and out based upon spring or fall but it is a very high percentage that will be in the consumable, we will call it CUE, category.

Jay McCanless – FTN Equity

Better than 80%?

Gregory Sandfort

I really don’t want to give you a specific number because it does move between seasons but it is a high percentage.

Operator

The next question comes from Joan Storms – Wedbush Morgan.

Joan Storms – Wedbush Morgan

I wanted to ask a question about with LIFO looking out towards 2010 if you have the negative impact to last year and the positive impact this year. Do you have any preliminary guidance you can give us for 2010?

Anthony Crudele

That is a little bit difficult to do. My crystal ball is pretty good for a six month period but after that it is a little bit more difficult. I would caution my remarks by first saying that clearly last year was an aberration. The $13-14 million mark relative to prior years where we have generally been in the $5-8 million range. I don’t think it is an extremely favorable year. I would expect at these inventory levels we would generally be in the $8-13 million range for the most part in most years unless there is significant inflation or deflation.

Operator

The next question comes from David Strasser – Janney Montgomery Scott.

David Strasser – Janney Montgomery Scott

As you are navigating through this environment you seem to be doing obviously a very good job doing it. There is cheaper real estate out there. How are you thinking, any difference in how you feel longer term about the opportunities more or less, opportunities from a square foot standpoint, in the next 3-5 years as you continue to navigate through this and square footage tends to go negative in the space?

James Wright

First of all we will be 75-80 stores this year. We expect the same level for next year. Some time early next year we will begin assessing the overall marketplace and how our base stores are doing which will give us an indication of cash flow and will allow us to set an expectation for the stores we will open in 2011. For the most part it is really being driven by our read of the future health, I guess, of the American consumer. At this point in time we see 70-80 stores for awhile.

Having said that, there has not been a significant change in the amount of product in total or land available or sites available for our growth. First, a lot of the things we all read about with retail failures, that is principally urban, suburban, mall based and strip mall based. Much less of that is happening out in rural America. There is not a tremendous inventory out there and then our developers are also facing headwinds of availability of capital and debt to build the properties.

David Strasser – Janney Montgomery Scott

I mean, are you seeing actually in this environment in the rural markets the square footage somewhat to what we are seeing in the more urban areas? Particularly in the home improvement area?

James Wright

No, I am not seeing that. Stan do you have any insight on space availability in rural America?

Stanley Ruta

For all of the real estate deals that we have approved so far, we are running about the same percentage of retrofit versus prototype as last year. To Jim’s point earlier, a lot of that space we are all reading about we are not finding it in the markets we serve and the markets we are in.

Operator

The next question comes from Andrew Wolf – BB&T Capital Markets.

Andrew Wolf – BB&T Capital Markets

I wanted to ask about your string of inventory reductions and kind of ask you to flesh it out a little bit about whether this is more of a SKU and item reduction or just a reduction of buffer stock. Is it mix? Or some combination thereof? Maybe help us understand proportionally where it is coming from. Secondly, as a follow-up, to the extent it is item reduction or SKU reduction and/or buffer stock reduction, could you or are you able to quantify whether any of the fall off in the average ticket is coming from maybe being out of stock on some items or having actually discontinued some items?

James Wright

I would attribute the primary drivers of where we are today versus where we were say seven quarters ago when we began to get inventory efficiency is that some is philosophical. We have taken over that period of time a different approach towards expectation of inventory productivity. That then runs through the fact we are going down a path on [inaudible] and have significantly staffed up in expertise on our E3 system. We have also begun to be much more accurate with forecasting both for seasonal front end buys and for ad goods. There has been some obvious shift as we talked about on the CUE items and the CUE items whether they be pet, food or animal feed, turn on a much higher velocity level than the base mix. So we are mix advantaged. We are philosophically in a different place than we were seven quarters ago throughout the entire leadership team.

We have also improved on our forecasting demand accuracy. Throughout all of that, across all categories including the big ticket goods we have successfully improved our in-stock position. Average ticket is absolutely not being impacted by our ability to be in stock on those great weekends when the customers are looking to purchase product.

Andrew Wolf – BB&T Capital Markets

Lastly, on the C.E. Schmidt footwear I think you mentioned some repositioning in that because of the value conscious consumer. Could you elaborate on that a bit because it is your private label offering? Is it pure price points or just getting more into basics, and away from more style oriented footwear?

Gregory Sandfort

Really what we are talking about is looking at the mix of product, number one. Remembering that C.E. Schmidt serves a work wear customer. Two, looking at the price value equation. C.E. Schmidt is an alternative to what I would call some of the other national brands that are priced a bit higher. So it is some SKU reduction, some SKU focus. What I would call getting back to what I would call the work wear segment versus some places where we may have to be honest strayed a little bit off with some styles that didn’t make as much sense to the consumer. So it is a pretty tight reevaluation but kind of a let’s get in business and stay in business on things that value to our customer and C.E. Schmidt from a price value equation is a terrific, terrific product. I feel very, very good about it. That is what the repositioning is all about.

Operator

The next question comes from Jack Balos – Midwood Research.

Jack Balos – Midwood Research

Regarding the new POS system, is that going to have certain advantages in terms of giving you better data of movement by SKU particularly or faster turning items that would make you more effective in supplying stores?

Anthony Crudele

I think that the real advantage is more the ease and facilitation at the front end. It does give us real time inventory at the store so the store can check and know exactly they are in stock but for the most part, we do have significant amount of information available today under our current POS system as far as SKU movement and it will not provide any significant additional benefits in that area.

Jack Balos – Midwood Research

Looking ahead to 2010, in terms of your advertising expenditure there comparing it to 2009, would you expect an increase going forward perhaps along with your store growth?

James Wright

Because we have moved to principally direct mail and print, the answer is yes. We will see the absolute advertising dollars grow in tandem with unit growth because every market will result in incremental spending. That said, however, we have recently changed agencies and our new agency has very deep competencies in the print multimedia which is obviously the newspaper itself. We expect to gain some efficiencies there. We are hitting more of the right potential and the current customers as opposed to those who were perhaps only fringe or non-customers. They also have deep capacity and capabilities in marriage mail and in direct mail. So we suspect that while advertising costs as a percent of sales will likely inch back up marginally in the future our impressions frankly will if anything increase against our most profitable target.

Jack Balos – Midwood Research

When did the agency start working for you?

James Wright

It started I think June 30th. We are very early in the process. We went with an RFP in January and wound out the existing contract through the first half and we are dark now until Labor Day. We will see some benefit of their work in Labor Day and by later in Q3 should be already beginning to gain benefit from their expertise.

Operator

There are no further questions. Please continue with any closing comments.

James Wright

Thank you all very much. Glad you are on this journey with us. We are delighted. I am personally delighted with the team and certainly with the results. We look forward to speaking with you at the end of Q3.

Operator

Ladies and gentlemen that does conclude our conference call for today. You may all disconnect.

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