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Tractor Supply Company Q3 2007 Earnings CallTranscript

posted on: October 24, 2007

Tractor Supply Company (NASDAQ:TSCO)

Q3 2007 Earnings Call

October 24, 2007

Executives

Karen O'Brien - Financial Dynamics - IR

Jim Wright - President and CEO and Director

Tony Crudele - EVP, CFO and Treasurer

Stan Ruta - EVP Store Operations

Analysts

Brad Thomas - Lehman Brothers

Erika Maschmeyer - Robert W. Baird

Peter Benedict - Wachovia

Jack Murphy - William Blair

Mitch Kaiser - Piper Jaffray

Joan Storms - Wedbush Morgan

Jay McCanless - FTN

Brian Nagel - UBS

Dan Wewer - Raymond James

Matt Nemer - Thomas Weisel Partners

R.J. Hottovy - Next Generation Equity

Operator

Good afternoon, ladies and gentlemen, and welcome to the TractorSupply's conference call to discuss second quarter results. At this time, allparticipants are in a listen-only mode. Later, we will conduct a question andanswer session and instructions will follow at that time. (OperatorInstructions)

I would now like to introduce your host for today'sconference, Ms. Karen O'Brien of Financial Dynamics. Please go ahead.

Karen O'Brien

Thank you, Operator. Good afternoon, everyone, and thank youfor joining us. Before we begin, let me take a moment to reference the SafeHarbor Provisions under the Private Securities Litigation Reform Act of 1995.This conference call may contain forward-looking statements that are subject tosignificant risks and uncertainties, including the future operating andfinancial performance of the company. Although the company believes that theexpectations reflected in its forward-looking statements are reasonable, theycan give no assurance that such expectations or any of its forward-lookingstatements will prove to be correct.

Important risk factors that could cause actual results todiffer materially from those reflected in the forward-looking statements areincluded in the company's filings with the SEC. The information contained inthis call is accurate only as of the date discussed. Investors should notassume that the statements will remain operative at a later time. Lastly,Tractor Supply Company undertakes no obligation to update any informationdiscussed in this call.

Now I am pleased to introduce Mr. Jim Wright, CEO of TractorSupply Company. Jim, please go ahead.

Jim Wright

Thank you, Karen. Good afternoon, everyone. I am here todaywith Tony Crudele, our CFO, and Stan Ruta, EVP of Store Operations. As youlikely saw in the release that went out this afternoon, we've hired GregSanford as our new EVP of Merchandise and are excited to have him on board onthe team. Greg is not on this call today with us. I'll speak more about hisappointment later in the call.

Greg is replacing Jerry Brase. I'd like to take a moment tothank Jerry for his contributions, his hard work and dedication to TractorSupply over the years, and we wish him all the best in his future endeavors.

I'd like to begin today's call with a brief review of thethird quarter including some of the trends we experienced and the progress wemade on initiatives during this period. Then Tony will review the financialresults, and I'll resume with a discussion about the holiday season and some ofthe plans we're making sure to ensure success for the remainder of this yearand beyond.

During the third quarter unfavorable weather,category-specific trends, and general macroeconomic issues created difficultselling conditions for certain merchandise categories. Although the environmentis challenging right now, we were able to navigate through some of theheadwinds due to our resilient business model, our loyal customer base, and ourdedication to serving their needs.

As a result, total sales increased to $629 million;same-store sales grew by 1.9%; and gross margin improved slightly, resulting inEPS of $0.34 a share.

Looking at the performance by category is a bit moredetailed. Our core lifestyle categories, particularly pets, large animalsupplies and feed continue to drive increased transaction counts and producehigher comparable store sales. These categories drive our repeat business.

As you know, we've been testing a new pet format in alimited number of stores. We made the decision earlier in the year to roll outsome of the best-performing SKUs from that test throughout the chain. These newSKUs added very nice comps to this entire category in the quarter.

I was also pleased with strong components in coolingproducts in the third quarter and our decision to delay markdowns in thecooling category helped sustain our margins. Outdoor recreation merchandisealso performed well due to new product flow and the continued refinement of ouroffer in that category.

However, seasonal and cool weather dependent categoriesperformed well below our expectations during the quarter, and they includedoutdoor power equipment, which continues to experience year-over-year declinesas a result of drought conditions in the Midwest and the South and generalindustry trends in this category.

Despite the soft sales, however, our stringent inventorymanagement has us well positioned for the off-season. We face no unusualmarkdown or inventory carryover risk in the outdoor power equipment.

Additionally, early sales of cold weather categories such asheating and cold weather apparel were lower than prior years as above-averagetemperatures in September delayed fall shopping. For comparison, September of2006 was the coldest December in about two decades, while this September wasthe fifth warmest in the last 100 years.

Finally, we continue to be pleased with the performance ofDel's. The comps coming from Del's led the way for the growth this quarter, andthe format is working well. We've now opened three new stores. We continue tomonitor the sales ramp-up and experiment with marketing in the new markets.

During the quarter, we made progress on a number ofinitiatives designed to help us increase consumer loyalty, drive revenuegrowth, and reduce operating costs over the long term. For example, we'vecompleted the next milestone with our point-of-sale system. As you'll likelyrecall, we installed the hardware for POS last year. During the third quarter,we began to roll out our backroom enhancements, and we'll have this completedbefore, Thanksgiving.

This initiative will provide our stores with the capacity toreceive merchandise more efficiently and to improve their inventory controlprocess greatly. Any time saved will be reallocated to customer service.

Additionally, our CRM initiative, which will provide us witha single view of our customers across multiple channels and enable us to reachour customers more efficiently, is demonstrating preliminary success. As Idiscussed in our last call, we've been testing and evaluating our marketingcommunications. As a result we believe they're shifting. Some of ouradvertising spends from television to direct mail is a more efficient way toreach our customers and to drive sales.

Before I turn the call over to Tony, I'd like to sum up thethird quarter by saying that I'm pleased. We're continuing to make progressagainst our goals, even in light of a very challenging retail environment.Tony?

Tony Crudele

Thanks, Jim. Good afternoon, everyone. As Jim stated, thiswas a challenging quarter, but we are pleased with our results given theweather conditions and the general economic pressures. Earnings were onlyslightly below our internal plan for the third quarter.

Sales for the third quarter ended September 29, 2007fincreased 12.5% to $629 million compared to last year's third quarter sales.The total comp sales for the period was 1.9%, non-comp sales were approximately$71.3 million, or 11.3% of sales.

Overall sales in the early part of the quarter werenegatively impacted by dry conditions in certain regions of the country and thecontinued negative industry pressures at outdoor power equipment. As the warmweather persisted through the end of September, we experienced the decline incomp sales of cold weather-related products specifically heating and insulatedouterwear.

With respect to regional sales trends, comp sales were thestrongest in the Southwest where the moisture levels were above average; salesin the Midwest, specifically the states west of the Mississippi River, wherethe weather impact was more neutral, comps were above company average as well.Comp sales were the weakest in the drought-impacted Southeast.

Total comp sales were positive all three months with Augustbeing the strongest month in the quarter. Del's comp sales were well abovecompany average in the low double digits. We estimate that the cannibalizationimpact on comp sales was slightly above 1 percentage point, which is consistentwith our expectations.

We continue to grow our customer traffic as comp transactioncounts were up 2.8% for the quarter. Comp transaction count even increased inour markets that had been most affected by the drought. This is driven by thestrength and continued growth of our core consumable business.

Average ticket on a comp basis decreased by approximately 85basis points, primarily as a result of the decline in rider sales andbig-ticket items. When analyzing the big-ticket shortfall, the decreaseresulted from a unit decline, which we believe is due to the economicenvironment, mostly driven by the items that can be correlated to housing.

We estimate the shortfall in these big-ticket categoriesimpacting comps negatively by 1.5 percentage points.

Gross margin improved 30 basis points. Overall, our mix wasfavorable primarily as a result of lower volume in rider and heating sales, wetend to have gross margin below the chain average. In addition to the favorablemix, our direct margin rate improved to better buying and increased imports. Ona year-over-year basis, import purchases essentially doubled for the quarterand on a trailing 12-month basis, imports rose to approximately 6.9% of cost ofpurchases, up from 3.9 percent at this time last year.

Our improved gross margins were partially offset by a slightincrease in shrink, freight expense, including the additional increase from theimport activity was flat compared to the prior year as we cycled the change inmethodology for estimating freight capitalization’s, which we implemented in Q3last year.

SG&A, including depreciation as a percentage of saleswas 26.9%, an 80-basis-point increase from the same quarter in the prior year.This de-leveraging resulted principally from payroll and occupancy from newstores that generally have lower sales volume in our mature store base.

We opened 21 stores in the third quarter compared to 18 inthe prior year's third quarter. Year-to-date we have opened a total of 63stores compared to 64 for the same period last year. We expect to open 23 to 25stores in the fourth quarter for a total of 86 to 88 new stores in 2007.

As we mentioned last quarter, we continue to make progresson our real estate strategy to position the company to leverage occupancyexpense as we continue our expansion. Future stores approved this quarter --occupancy as a percent of sales improved 150 basis points versus those storesthat we approved at this time last year.

We have shown greater than 100-basis-point-improvementconsistently for three consecutive quarters of our new-store approvals.

Our planning and development process is typically about 12to 24 months, as such, this is a long-term initiative, but we believe thatwe've made great progress and are heading in the right direction.

Now, turning to the balance sheet -- at the end of thequarter, we had outstanding debt of $88.6 million. The end of the third quarteris typically one of our higher borrowing periods due to seasonal inventorybuilds as we prepare for the fourth quarter.

On a per-store basis, inventory levels excluding Del'sincreased approximately 3.7% at the end of the quarter. Our calculation isbased on average cost and excludes in-transit inventory and inventory held atunopened stores.

In-transit inventory at the end of the quarter wasapproximately $21 million compared to $28.4 million in the prior year. Thisreduction in in-transit inventory year-over-year results bringing in inventoryearlier than in the prior year to be better prepared for the start of the Q4selling season.

Additionally, our inventory growth reflects theyear-over-year impact of our clothing reset, expanded animal health and petassortment, and inflation.

Based on our calculation of inventory turns on a cost basis,on the surface it appears to be a disappointment that we haven't made moreprogress on improving our inventory turns, which decreased 12 basis points fromlast year.

However, as we analyze the drivers behind the higher Q3inventory, the increase is more related to better execution in bringing in ourseasonal merchandise, the weather impact on sales in certain categories, andinventory allocation to growth categories such as clothing and pet products.

As we drill down, we have taken several actions that arebeginning to gain traction. This includes better exit strategies on one time,special buys, and less productive inventory. We also have made solid strides inreducing the inventory levels of new stores in our testing and inventorybalancing process to markets where we're opening new stores.

Additionally, Stan Ruta and his team have designed arigorous training program as part of our E3 inventory management forecastingsoftware, and we are seeing better utilization of this software.

Although we can quantify the factors impacting our inventoryproductivity, we are not satisfied as we strive for continuous improvement intractor supply. So we still have a ways to go to drive inventory productivityto an acceptable level. We expect Greg Sanford and the merchandising team tomake progress in this area over the next 12 months.

We did experience an increase in accounts payable financingof our inventory from approximately 36.1% up to 38.7% resulting principallyfrom better accounts payable management and vendor dating. Given thesignificant increase in imports, we are satisfied with the progress we aremaking.

Year-to-date capital expenditures were approximately $68.4million. This is consistent with our full-year forecast of $100 million to $105million, which we revised on our Q2 conference call to account for thepurchases of two of our leased stores.

Turning to third quarter, we repurchased 645,000 shares fora total of $31.2 million under our stock repurchase program. For the year, wehave repurchased a total of 1.9 million shares totaling 94.9 million. Weestimate that the share repurchase had a de minimis impact on third quarterEPS. We currently have approximately 105 million remaining under our currentstock repurchase program.

Subject to prevailing market conditions we expect tocontinue to make additional purchases through the next two and a half years ofthe programs.

As we head into the fourth quarter, and there are severalfactors that we have evaluated. We are pleased with the store traffic that wehave generated throughout the year in a relatively tough retail environment. Atthe same time, we must be sensitive to the economic concerns that retailersface heading into the fourth quarter this year. We are very well prepared forthe quarter but recognize that our fourth quarter is very dependent on coldweather.

The quarter has gotten off to a warmer start than we wouldhave preferred, however, weather forecasts or for slightly favorable weatherpattern relative to last year. We have tempered our forecast to be more weatherneutral and factor in the slower sales trends that we experienced in the lastfew weeks of September and October.

For these reasons, we have revised our full-year earningsguidance to range from $2.37 to $2.43 per diluted share. We expect this year'ssales to be approximately $2.68 billion to $2.7 billion based on the assumptionthat full-year same-store sales growth will be 2.5% to 3%, which translates tozero to 2% comp sales increase for the fourth quarter.

That concludes my prepared remarks, and I'll turn it backover to Jim.

Jim Wright

Great, thanks, Tony. As Tony just discussed, we haveadjusted our outlook for the remainder of 2007. We believe it's appropriate tohave a more conservative outlook for performance for the remainder of this yearbased on the delayed onset of colder weather of the season and the externalpressures on the consumer.

We remain challenged by unseasonably warm weather, to date,in this quarter. However, our stores are very well prepared for the winterselling season. Stan Ruta and his team have consistently refined our storeoperation strategy to ensure that we're providing our customers with anexcellent shopping experience and great customer service.

We recently strengthened our field management with thepromotion of George Van Eron and C.R. Gaines to the position of Divisional VicePresidents of Store Operations. Both of these gentlemen were very successful intheir prior positions as regional VPs. I'll tell you, we have seven regionalVPs who will report to C.R. and George, allowing a greater focus on storereadiness, people development, and execution.

This move will also allow Stan additional time to focus onour objectives of optimizing real estate, supply chain, and field executivedevelopment.

Looking ahead, I'd like to discuss some of the activitiesand opportunities that we expect will benefit the company during the fourthquarter and over the long term. Let me begin by discussing the appointment ofGreg Sanford as our new EVP of Merchandising and CLO. Greg has extensiveexperience and has delivered very successful results for national chains suchas specialty retailer, Michael's, as well as major department stores includingSears and Federated.

His understanding of private branding, sourcing inventorycontrol, pricing dynamics will allow us to increase our sales and margin. Whileat Michael's, Greg improved the in stock position of the store's basicassortment products, improved margin through price optimization and simplifiedthe seasonal merchandise changeover process.

Additionally, Greg served as president of Michael's for a16-month period during the following the company's take private transaction.Greg brings a tremendous amount of leadership and knowledge to our team, and weare pleased that he is on board.

Greg will play an integral role as we focus on enhancingthree key aspects of our merchandising performance first. We've recently begunto implement a new price optimization strategy. While we've operated amulti-zone pricing strategy in the past, we expect price optimization willimprove our same-store sales and gross margin, going forward.

Second, we recognize a need to improve our inventory turn.With renewed focus on this initiative, we expect to begin moving to achieve ourlong-term inventory target of 3.3 turns.

Finally, we'll continue to accelerate our direct sourcingand private label strategies. We are on track to reach our long-term targets ofincreasing direct sourcing from today's 7% of sales to 15, and private labelfrom the current 18% to 25%.

While we will be focusing on improving our metrics, weexpect that the planned department reset and other merchandising initiativeswill continue seamlessly with Greg on board.

We are still evaluating the data from the 41 stores we aretesting the new concept for hardware, truck maintenance and tools. We lookforward to sharing results, early result with you on our next call.

However, we are excited about the look of the left-handside. We've received good feedback from our consumers. We've identified certainareas of refinements and we'll continue to make adjustments as we work toperfect this concept before we roll it out to an extended number of stores inthe third quarter of next year.

As Tony mentioned, Stan and his team are making solidheadway in reducing our occupancy costs. Our new store-opening plan is balancedto leverage our distribution centers, supply chain and our field managementeffectively. We continue to open new stores in existing states and experienceda slight about a 1% cannibalization in the quarter.

We also entered Louisiana, Maine and New Hampshire duringthe third quarter, and although still early, we're excited about potential forprofitable sales in these states.

To-date, the group of new stores opened in 2007 haveexceeded our expectations for sales and we look forward to opening theremaining 23, 25 stores this year.

Now, we'll continue to target 13% unit growth annually andwe're committed to reaching our long-term goal of more than 1,400 TractorSupply stores.

In addition to building out our stores, we continue toexecute our multi-channel strategy to ensure that our customers can shopTractor Supply when and where it's convenient for them.

We are excited to be launching our e-commerce site laterthis month ahead of the holiday season. As of today, we are aggressively betatesting the new site and are currently processing orders on a limitedassortment.

I'd like to take this time to thank Steve Brown for headingup this initiative. Since he joined us as Vice President of Multi-Channel inJune of 2006, as Steve and his team have done a wonderful job. I'd also like tothank our IT staff for supporting this significant initiative.

As we prepare to launch the new e-commerce site, we'realready planning the next phases of multi-channel to leverage the TractorSupply brand as the authority on the Out Here lifestyle.

At the end of this multi-year plan, we expect to havedeveloped rich and actionable customer information, improve the reach andeffectiveness of our marketing communications, refined our product servicesselection including increased special order capacity and had to have gainedshare of spending by customers who live out here.

In closing, I'd like to reiterate that while the overallretail environment is challenging and consumer spending may be lower in theholiday season this year than last, we have confidence in our resilientbusiness model and our focus on the strong niche market we serve.

Our customers are living the rural lifestyle they enjoy notjust partaking in a fad. As such, they have consistent needs to fulfill,thereby making Tractor Supply a true destination store and isolating us, to adegree from the challenges that others are facing in the retail marketplace.

As we enter the final quarter of the year, we are excitedabout the future. Our stores are set and are in great shape for the upcomingholiday and winter selling season. Our long-term strategic initiatives arebeing implemented well and we expect our efforts to drive sales, expand grossmargin and control expenses all of which will contribute to operating marginexpansion beginning in 2008. Our leadership team is strong while we continue toinvest in our business and we look forward to the opportunities ahead forTractor Supply.

And at this time, I'd like to open the call for yourquestions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from BradThomas from Lehman Brothers. Please go ahead.

Brad Thomas - Lehman Brothers

Yes. Thank so much.

Jim Wright

Hi, Brad.

Brad Thomas - Lehman Brothers

You listed a number of factors that clearly had wins in thethird quarter and are reasons for worry about the fourth quarter. As we thinkabout the housing market, the consumer, in general and the weather, I think theone that we can be optimistic that may improve is the weather.

Could you maybe quantify how much upside to the fourthquarter there may be if the weather does get colder or maybe looking back atthe third quarter, how much do you think your comps were impacted by thedrought conditions?

Jim Wright

If we look at, in Q3, if we consider drought and outdoorpower equipment’s and also big-ticket, Tony or just those two?

Tony Crudele

Including big-ticket.

Jim Wright

Including big-ticket. So drought big-ticket, which we defineas above $500 and outdoor power equipment, it was about a 0.5 to 1.7 compsnegative impact on the quarter.

Looking into the fourth quarter, we would, I think, have asimilar kind of variation if we got great weather, we'd have some upside.

Brad Thomas - Lehman Brothers

Okay. Great. And then just a follow-up on the occupancyexpenses. It sounds like the new stores, you're seeing nice results in terms ofwhere the occupancy expense are coming in. Could you give us a little bit morecolor on how the sales are turning for those new stores?

Jim Wright

Well, the occupancy of that cost that we're speaking to arethose stores that we have approved going forward in '08 and in a few cases '09.So it's stores we've approved this year vis-à-vis stores we approved in thesame period last year and for last three quarters, our approvals have beenabout 100 basis points, a little more lower as occupancy cost to sales.

Now, with regard to stores that we have opened this year,they continue to meet all of our hurdle rates and we are pleased.

Brad Thomas - Lehman Brothers

Got it. Okay. And then just, lastly, as we think out a wayand the opportunity on the expense line in particular, I know the golden mileversus the silver mile opportunity is a big one as well as anniversarying someof the expenses with the website this year. Could you help us think of theorder in terms of the magnitude that we should look for expense savings?

Tony Crudele

Yes. Brad, this is Tony. When we look at 2008, we'd like toturn back to our general guidance, which is looking for a 15 to 20 basis-pointof EBIT margin improvement each year and we'll achieve that by moderating theoccupancy costs and continuing to drive our product margin or gross margin.

So you'll see the majority of efficiency of productivitycoming from the gross margin line and by moderating the occupancy line, weanticipate getting that 15 to 20 basis-point EBIT margin improvement overall.

Brad Thomas - Lehman Brothers

Great. Okay. Thank so much.

Operator

Our next question comes from David Cumberland from Robert W.Baird. Please go ahead.

Erika Maschmeyer - Robert W. Baird

Hi. This is actually Erika Maschmeyer for David Cumberland.

Jim Wright

Hi, Erika.

Erika Maschmeyer - Robert W. Baird

Hello. Could you provide some color on the pet segment andwhat area drove the strength there?

Jim Wright

Yes. Sure. We continue as you probably know, we have beeninvesting and expanded early this year, we expanded the pet department in anumber of stores, began to assess the result of higher shelf size, moreallocation of space, some use of off-shelf display and particularly a number ofnew SKUs.

What we discovered of all those things, the one that madethe biggest impact on our business was these new and different SKUs that cameacross everything from more holistic feed, some expansion of branded pet food,animal health, animal training and the flea and tick control products.

We then took the best of those SKUs and took them across thechain and saw they played very well to our consumers in the rest of the chain.So as I'm sure you've heard us say that the pet department has been increasingat a comp above the chain for a number of years now and when we look at ourrelative penetration and national market share.

We still have a few categories that we actually have somesure data and also when we look at our internal research, the number ofpet-owning consumers who are buying pet product from Tractor Supply, Erika, wecontinue to see significant upside, going forward.

Erika Maschmeyer - Robert W. Baird

And just a follow-up there do you have, did you expand thepet area in 100 stores in Q3?

Jim Wright

No. What we actually, what we did is we expanded vertically.We went to a higher fixture, I'm sorry, we went to a lower fixture and captureda little bit of space in the -- from the midway of the stores. But for theoverall, the actual footprint stayed about the same. What we did expand was thenumber of SKUs by about 900, I believe.

Erika Maschmeyer - Robert W. Baird

Okay.

Jim Wright

Yes.

Erika Maschmeyer - Robert W. Baird

And then the extended apparel department given the warmweather and weakness in the category, do you think that actually hurt yoursales for the quarter and are you still expecting 500 stores with the extendedapparel by year-end?

Jim Wright

Yes. The 500 stores are done, that's done, and we have an A,B, and a C size set. We will, the small set we have is a C and we've got, Iguess, a few more of the small stores to go in Q1 of next year, perhaps another100. That will be more of a refresh within the space as opposed to expansion ofthe space.

We remain very dedicated to clothing, very excited aboutclothing, but this time of the year, frankly, it's much more about the weatherthan it is about the offering.

Erika Maschmeyer - Robert W. Baird

Okay. Thank you.

Operator

Our next question comes from Peter Benedict from Wachovia.Please go ahead.

Peter Benedict - Wachovia

Hi, guys. Thanks for taking my call. Tony, a couple ofquestions, can you let us know what the stock option expense was in the thirdquarter and what you were thinking about in expense for this year? Do you thinkthat revolver will be down to zero by the end of the year?

Tony Crudele

We originally had targeted the revolver to be down aroundthere, however, with the stock repurchase program in place, we would anticipatehaving some borrowing, somewhat moderate, say, around the $50 million range.

Peter Benedict - Wachovia

Okay. And do you have a stock option expense for thirdquarter?

Tony Crudele

We do for the quarter it was slightly under $3 million.

Peter Benedict - Wachovia

Okay. And then, Jim, can you talk a little bit about theprice optimization test that you're going to be doing here in the fourthquarter? How broad will it be and what can you tell us about that?

Jim Wright

Sure. What we are doing, first of all, we have not purchaseda software and don't see a need to buy software, going forward, our ERP is SAP.We have today four tiers of pricing and we have 17 different price zones. So wehave the flexibility to price according to the competitive metrics in each ofour markets.

The price optimization software is a multimillion-dollarinvestment and gives us a level of refinement that we really don't think weneed just yet.

So, having said that, where we're going today is we arelooking at SKUs in various price ranges, and we are beginning to move them tomore logical retail selling prices. We've had a strategy for a number of yearsof using odd-penny prices and we went back out and talked to our, actually toour store managers and said, if we're selling something today for $61.23, arewe selling it less if we sold it for $62.49, which is more of a retail pricepoint or even $64.99? And they said, well, no and we've always kind of wonderedwhy we had that $61.31 price point.

So we are beginning to test those. We are using a couple ofour price zones as control zones because the key, obviously is to maintainunits while you increase margin. And we'll just continue to work throughcategories, regions and testing the elasticity of various price points againstcontrol group.

Peter Benedict - Wachovia

Could you give us a sense of maybe the percentage of SKUsyou're going to test in the fourth quarter?

Jim Wright

Not really, no.

Peter Benedict – Wachovia

Okay. Thanks for answering and good luck.

Jim Wright

Thank you.

Operator

Our next question comes from Jack Murphy from William Blair.Please go ahead.

Jack Murphy - William Blair

Thanks. Just a few questions -- first just circling back, afollow-up on the occupancy costs. In the past, you talked about around a 50basis-point drag in '07, and then maybe cutting that in half in '08. Given whatyou're seeing on the stores that are approved, how do you feel about thosekinds of parameters right now?

Tony Crudele

Generally, that's still our target, Jack. I think that weare definitely moving towards that. As I said earlier, the program -- a realestate program can go out as far as 12 to 24 months. As we look to next-year'sstore base, probably 25% maybe 20% of those stores were approved prior toreally pushing towards this new initiative.

But given where we're at and where we expect to be and theprogress that we've made, I think we can reasonably hit that goal.

Jack Murphy - William Blair

Then, second, the merchandising initiatives for a minute. Ithink you said that you tested the left-hand side of the store, reset in around41 stores, and -- but then I think you also said in the release that tools weresomewhat disappointing. I wonder if you can just kind of square those few thingsa little bit. Are you seeing any kind of noticeable difference in those 41stores in terms of that performance in that tool category?

Jim Wright

It's very, very surprise. We did one store early on that we-- a prototype store of the 41 was done in August, completed in earlySeptember, so we have four weeks of data and based on that I can say,"Yes, it looks better there." On the other stores they really werenot completed until Q4, the beginning of October. So we're going to have to waitand see.

Jack Murphy - William Blair

Thanks.

Operator

Our next question comes from Mitch Kaiser from PiperJaffray. Please go ahead.

Mitch Kaiser - Piper Jaffray

Hi guys. Can you hear me converse. On the private labelprogram and direct sourcing, could you remind us -- I know you provided uswhere we're at and where the targets are -- could you remind us of the margindifferential that we might be able to see from private labor and directsourcing and make sure that we're not double counting those?

Jim Wright

Yes, first of all, there is overlap, and we say 7% going to15% in direct sourcing, and 18 going to 25 private label but you can't addthose together, so they are -- in some cases both one and the same. On privatelabel, generally, and this isn't always the case, but generally when we move toprivate label, our objective is to offer the consumer a price that is 25% to30% lower and hopefully maintain the same margin dollars per unit. So to adegree, it depends a little bit on the category as to how much a rate changethat will be.

But, generally, there is some rate left. I can't say I'veadded it up across all private label, I just know that it's accretive. When welook at direct import, if we were to maintain the domestic selling price, lookat the import landing cost, the delta could be as much as 800 basis points.But, frequently, as we take it to market, we may share some of that costreduction with the consumer and go for market share.

So, again, if we were to roll that all up, I would certainlysay it's something less than the 800 ultimate potential.

Mitch Kaiser - Piper Jaffray

Okay. And I didn't hear a timeframe -- over what time perioddo you think you could achieve those targets?

Jim Wright

Our objective, I think we announced a year ago, it was afive-year objective. We have four out?

Tony Crudele

Yes, it's four years on both of those, for the most part.

Mitch Kaiser - Piper Jaffray

Okay, okay. Fair enough. And I know you mentioned the comptrends, but five months saying that August was the best, and then I think Iheard you say that weather certainly hurts late September into October. Couldyou just give us a sense for how things are running, thus far, in the fourthquarter or don't you want to comment on that?

Tony Crudele

Well, as I said in my prepared remarks, definitely thewarmer weather at the end of September hurt that period, although throughoutthe quarter, fairly consistent comps with August being the stronger. But thatwarm weather did move in throughout October as we've experienced, and mostpeople have noted. So it has had a negative impact where sales are less thanwhat we had anticipated going into the quarter.

Mitch Kaiser - Piper Jaffray

Okay. So you've got it flat to 2 on the comp for thequarter? You're probably running a little bit light of that, then? Is that afair assumption?

Tony Crudele

Sorry, could you repeat that again?

Mitch Kaiser - Piper Jaffray

I think you've guided the fourth quarter comp flat up to --is it a fair assumption that we might be running a little bit below that atthis point?

Tony Crudele

We have incorporated the first part of October into ourguidance.

Mitch Kaiser - Piper Jaffray

Okay, fair enough, and I think you have easy compares fromlast December, that's correct, right? If I remember correctly?

Tony Crudele

Generally, that is the case. As we look at November,November, it appears, based on our projections, that it will be colder thanlast year and colder than normal. As we look at December, it will be colderthan last year but it will still be warmer than a normal December. But,generally, it is true that the next two months should be more favorable thanOctober has been.

Mitch Kaiser - Piper Jaffray

Okay. Thanks. Good luck.

Tony Crudele

Thank you.

Operator

Our next question is from Joan Storm of Wedbush Morgan.Please go ahead.

Joan Storms - Wedbush Morgan

I heard [indiscernible] on the holiday season, and I knowthat the high-tech vans are a level of percentage of your business. That’s perme and then also how much more of your private label would be put?

Jim Wright

You were breaking up a little bit, Joan, but I think yourquestion was how important is big-ticket in Q4 relative to the rest of theyear, and the answer there would be principally in installed heating in Q4, thefront end of Q4 that we sell installed wood stoves and pellet stoves at northof $1,000, several that are in the multi-hundred-dollar range. So that's very,very important. We need the advent of cold weather early to move those out atfull margin.

Then as we go into private brand later in the quarter, whichI believe was the second part of your question -- all of our toys are eitherprivate brand or unique to Tractor Supply. We may not brand them, but it's acontrolled product for us. In clothing, C.E. Schmidt is a private brand labelof ours, very, very important to us in cold weather gear. And all of our giftsare unique to Tractor Supply under our private brand label, Red Shed.

Joan Storms - Wedbush Morgan

And then so -- for the private brand -- well, I guess that'sfine. Can I ask, like, one follow-up question? I know you have very few storesin California. I'm just wondering if there's anything. Yes, we have all thefires going on out here, is there anything endangered to that?

Jim Wright

No, our stores in California -- we have 10 open now, Joan,and probably end the year with, I think, 12. At this point in time, our storesare well isolated. They're in, for the most part, in the Central Valley andwell north of where the majority of the fires are right now. So we're notseeing any recent impact on our business.

Joan Storms - Wedbush Morgan

Okay. Thank you.

Jim Wright

Welcome.

Operator

Our next question comes from Jay McCanless from FTN. Pleasego ahead.

Jay McCanless - FTN

I wanted to ask first, actually, to follow-up on the WestCoast question. I didn't hear any mention of the planned distribution centerout there. Where do we stand on that now?

Jim Wright

At this point in time, it would still be later '09 or '10,and we may very well rent smaller space before we actually put the CapEx out tobuild. We have done that in the past. If you go back far enough in the company,we rented 50,000, 100,000 then 160,000 square feet in Waco, Texas, before weopened a 325,000 square foot D.C. there in 2003. So we may very well move inthat direction and if we did that, that would push out our CapEx perhaps a fewmore years.

The key decision point in moving to a distribution center onthe West Coast has to do with our ability to source product on the West Coast.If we have long stem miles from the vendor to the D.C. we will save a greatdeal just by reducing stem miles from the D.C. to the stores. So we are workingnow to move some of our vendors to the West Coast and to locate vendors who arecapable of serving us on the West Coast.

Jay McCanless - FTN

I guess the follow-on to that is if you're waiting until alater time or if you're going to do a rented facility. What does that imply forthe growth rate of Del's and also what implications does that have for theoverall Tractor Supply growth rate in the areas that you expand?

Jim Wright

Sure, a very good question. First of all, Del's has its own65,000-square-foot distribution center, and so there is, at this time noimplication on the growth of Del's. And then we are staging the growthconservatively in California, and our plan is to continue a modest rate ofgrowth, to leverage our supervision we have in California, and then toaccelerate the growth -- actually, we'll accelerate the real estate activityahead of -- or concurrent with expanding the D.C. capacity.

So I guess the answer to the question is California will bea slower growth market for us for the foreseeable future of 18 months or sountil we get D.C. capacity and vendor capacity.

Tony Crudele

Jay, this is Tony. Additionally, we are assessing expandingthe distribution network in our Waco D.C., and as we give guidance as we comeinto next year, we'll talk a little bit more about the CapEx and expanding thatfacility to serve our growing store base in the Texas area.

Jay McCanless - FTN

Okay, great. And then one quick follow-up question -- withthe commentary that you had about inventory and about focusing on inventorymanagement and making it work a little bit harder for you, would you all bewilling to give us what you think the optimal inventory is for an averageTractor Supply store during, say, a get-ready quarter, first quarter or thirdquarter and then also during a selling quarter on a per-store basis?

Jim Wright, Tractor Supply Company - President and CEO andDirector 57

No. Only because I don't have that in front of me, I guessprobably the best way to look at it is that we do front-load our business. Oneof the reasons that we finished Q3 a little higher than we did a year ago is wehad made the -- we toured our stores last in September, we're disappointed withour category preparedness, vis-a-vis some of the competition, so we decidedthis year to put the product in a little deeper a little earlier and,unfortunately, we were not rewarded with the kind of selling weather we wouldhave chosen.

The best thing for us to day is that our objective is tomove -- this year we're going to be at 2.6, 2.7 turns. Our objective is to movethat to 33. We believe it's possible, and that's probably a four- or five-yeartrip that we believe will be made in about 15 basis points a year once we getthe team in place and the disciplines in place to move against that objective.

Operator

Our next question comes from the line Brian Nagel from UBS.Please go ahead.

Brian Nagel - UBS

Hi, good afternoon. I have a few questions with regard tosales trends and specifically the weather. If you look back here in Q3, werethere any markets where the weather actually did turn to more normal and morefavorable and did you see a resulting improvement in your sales trend at thosestores or in those markets?

Jim Wright

Texas cycled from a drought last year to plentiful rain thisyear, and we saw the categories involved with cutting hay and baling hay andmowing grass do extremely well. Conversely, we saw categories that we do wellwith in a drought, hay and animal feed and alfalfa cubes and animal stressmedicines go the other way.

What's unfortunate for us is the Southeast was involved in adrought, so we did not get the things that deal with cutting grass and cuttinghay, and there's few animals in the Southeast, so we also did not on relativebasis compared to Texas get the benefit of the animal stress product. But, inmy mind, is we look at the business not only by region but by day. When it getscold, our business moves and moves day-to-day.

Brian Nagel - UBS

Okay, and then so as we move here into Q4 and assuming thatthe weather does turn at some juncture, sooner rather than later, maybe, do youthink there's a great deal of pent-up demand or are a lot of those sales in Q3now lost?

Jim Wright

Nothing is lost yet, but obviously the later you get intoNovember, the more likely you are to have lost some sales also to achieve yoursales at a reduced margin.

Brian Nagel - UBS

Okay. And that leads to the final question -- you guys did agood job of managing your gross margins well in Q3, despite weaker sales. Didthe potential markdown risk go higher in Q4 if the weather were to remainunfavorable for a longer period of time?

Jim Wright

No, we are already beginning to -- one of the reasons wepulled the comps down a little bit for Q4 is we've already canceled some orderson heavy outerwear. Now, if it turns to be a terrific season, we can go backand get the product. But we're taking a very conservative approach, a measuredapproach on the inventory side, and then we'll be very dynamic as we begin tomove through our markdowns recognizing that you make money on the first one noton the fourth one.

Brian Nagel - UBS

In your traditional seasonal category, I guess in the frontof that left-hand side of your store -- how weather dependent is that?

Jim Wright

This time of the year, the front left is really set in giftand heating. The gift we feel very good about. We actually are looking at ourgift run rate right now, and we're really pleased with how we're doing withtoys and gifts thus far.

The heating is a question mark, and we simply need somebitter cold weather to get that category started.

Brian Nagel - UBS

Okay. And then the final question is on the expense side. Itlooks like most of the increased SG&A margin is a result of the weakercomps, but if you look over the last three quarters or so, your expense growthhas increased by 1 or 2 percentage points a quarter. Is there something toexplain that?

Tony Crudele

Yes. Really, if you look at the numbers, it's the occupancyof the new stores, which causes the deleveraging. Other than that, we actuallyare tracking well below our plan when it comes to the expense side of thebusiness.

Operator

Our next question comes from Dan Wewer from Raymond James.Please go ahead.

Dan Wewer - Raymond James

Thank. Tony, you had noted that inventory per store excludingfreight and transit was up 3.7%, but the figure on the news release suggestsit's closer to 5%. I wasn't sure how to square those two.

Tony Crudele

Yes. It's actually very easy to square. I also noted that itexcluded Del's. So the Del's inventory, when you put that in, it will get youfrom the 3.7 to the 5. Last year, if you remember, at this time we had juststarted a re-fixturing of Del's, and we loaded in some inventory since then. Sowhen you look at Del's on a year-over-year basis, they've had significantinventory increase, and that's what the differential is.

Dan Wewer - Raymond James

Is the inventory increase at Del's more or less than thatlow double digit comp that they're achieving?

Tony Crudele

It is above the double-digit comp. But, again, you have tolook at it as, really, a retooling of that format as we added some closing andother pet supplies and items to really enhance the Del's shopping experience.

Jim Wright

Dan, this is Jim. Del's turnover as we purchased it, themodel we purchased, had higher turnover velocity than Tractor Supply. We haveadded test categories with a full complement -- not really at the TractorSupply level, but a pretty good complement of equine path, expanded pet, and clothingand seasonal.

I just had a meeting this afternoon with Boyd Full who runsthat for us, and we are now rationalizing that after we've had 12 months ofhistory, we're being rationalized that inventory looking at this productivityof four foot by four foot.

So as a snapshot yesterday, comp inventory is running abovecomp sales. We're delighted with comp sales, we have a lot of learning, and westill -- Del's still is turning inventory faster than Tractor Supply.

Dan Wewer - Raymond James

And just a follow-up on Brian's question on the gross marginassumption in 4Q. So if we're entering the period with about a little less than4% more inventory in comparable stores than a year ago, and it looks like thecomp guidance for 4Q is around flatter, a slight increase, are we taking intoaccount the possibility of clearance markdowns impacting gross margin rate, andthat's reflected in the guidance given this afternoon? Or is it just simply thelower guidance is only the lower revenues and the expense to leverage and astable gross margin rate?

Tony Crudele

As you've seen throughout the year, we have been able toimprove margin in each of the quarters, although the first quarter was moreflat. We would anticipate to have margin improvement year-over-year becauselast year there was significant margin pressure. However, our guidance doestake in consideration and, obviously, we do sensitivity analysis, and ourguidance does reflect the potential for lower-than-planned gross margin.

Dan Wewer - Raymond James

I've just got one other item -- on the goal of gettinginventory turns to 3.3, would that require a change in tractor strategy ofcarrying some of the unusually slow-turning items that you feel is importantfor you to be relevant to your customer?

Jim Wright

Absolutely not there are items that we look at at 0.7 turns,and we're very glad we've got them, and they're going to stay with us becausethey define who we are, and they're very important to that core customer whocomes in every 16 months for one of those items. We don't have many of those,don't want to add a whole lot more, but we believe it's very, very important tous.

On the other hand, we do have many categories that areturning well north of a 3 or even a 4 that we believe we can accelerate. Wehave historically not been really good at promotional buys, seasonal buys,timing in and timing out, recognizing the velocity of categories by store. Andthat's where we think -- we pretty much know what we need to do, and Greg haspretty deep expertise in refining the inventory management on the buy side andthen on the sell side.

Dan Wewer - Raymond James

There's one other item, also, Jim, I forgot to ask about --some of the other equine retailers have indicated their business has picked upnow that State Line is through with their liquidation. I'm curious if you'reseeing the same thing?

Jim Wright

Again, we had 55 stores that had a State Line tack within 10miles, so on a chain basis, it was not significant. When we look at those 55, Iwish I'd had more than 55. We did pick up -- I'm sure we didn't pick up alltheir business, but we have certainly seen a growth -- I think the comps, thatwhole category is doing well for us. I believe the comps in those stores were 3or 4 x the rate. But, again, it's only 55 stores.

Dan Wewer - Raymond James

Okay. Congrats on the fourth quarter.

Jim Wright

Thank you, Dan.

Operator

Our next question comes from Matt Nemer from Thomas WeiselPartners.

Matt Nemer - Thomas Weisel Partners

Just a quick follow-up question on the weather -- theguidance, the implied guidance for the fourth quarter -- can you just clarifywhat that assume for weather? Does that assume that the forecast, Tony, thatyou mentioned, and is that coming from Planalytics or some other source?

Tony Crudele

Yes. It does take that into consideration. We do usePlanalytics, and we do our best to try to balance out the October weather thatwe have experienced with the potential weather that we -- has been forecastedor provided through Planalytics.

Matt Nemer - Thomas Weisel Partners

Okay, great. And then my next question is can you give usany color on advertising spend in the quarter and then your outlook on thatexpense line, going forward?

Tony Crudele

When it comes to Q4, we would expect marketing to increasebut be relatively consistent on our A to S ratio for the entire year and be inline again for the fourth quarter -- to be consistent, but we would expectadvertising spend to increase over what we incurred in Q3, but consistent withlast year's Q4.

Matt Nemer - Thomas Weisel Partners

Okay. And then can you prove -- Jim, can you provide anydetail on the website launch? When does that actually go live beyond the betatest and you're probably not willing to put any numbers around it, but how manySKUs do you expect to have up online by the end of the year?

Jim Wright

Tony, do you want to take that?

Tony Crudele

Certainly. We expect to be around 3,500 SKUs. We will bedisplaying the majority of SKUs that we have in the stores, but we will markthose that are not carried at the -- through the multichannel distribution.We'll show them at store only. So it will be an opportunity to highlight all ofour SKU show or carry, but we'll have about 3,500 that we'll be selling.

We would expect to, over the next couple of weeks, have avery quiet launch, and we'll be contacting our e-mail list and, over a periodof time, and promoting the site to them so that we can continue to test thesite. And as Jim alluded to, we expect to be live prior to the holiday sellingseason.

Matt Nemer - Thomas Weisel Partners

Okay. And the URL is mytscstore.com, correct?

Tony Crudele

It will be tractorsupply.com, and it will move over, butthey'll both -- you'll be able to get it through both, they'll be connected. Sothat should not be an issue if you go out there. But, currently, the site isnot being redirected. The MyTscStore is not being redirected do the other siteyet.

Matt Nemer - Thomas Weisel Partners

And is anything from the website implied in guidance at thispoint?

Tony Crudele

No, it's not.

Matt Nemer - Thomas Weisel Partners

Okay. And then my last question is what's the timing of thechange in the chief merchandising officer, is that effective immediately or --

Jim Wright

Yes. We have -- Greg was announced today. He'll be joiningus on the 5th of November, and we have an interim plan, and Gerry has left thecompany.

Matt Nemer - Thomas Weisel Partners

Okay. Great. Good luck in the fourth quarter.

Jim Wright

Thank you very much. We have time for one more question.

Operator

And our final question comes from R.J. Hottovy from NextGeneration Equity. Please go ahead.

R.J. Hottovy - Next Generation Equitytag

Good afternoon. And just one quick question here -- youtalked about some of the big-ticket items have -- or big-ticket items that hadcorrelation to the housing market, having an adverse impact on comps, and Ijust wanted to get a sense of what that did for your purchases for next yearand what you're planning there? Obviously, we're stuck in a weak housing marketand just wanted to get a sense of that change in your thoughts or purchases fornext year.

Jim Wright

It has. We've looked at, and you really have to look at itby category. I'll not discuss it at that level of granularity, but we havewatched what the consumer is doing with big-ticket -- mostly, I guess it wouldbe tools and equipment categories. We have also seen what's happened at the midand lower price points, and we see ourselves moving a certain mix of ourinventory and promotional efforts slightly down market.

We believe the primary impact on the -- from housing hasbeen the heaviest of do-it-yourselfers and light commercial users and that,frankly, the homeowners are moving down market but are, in some cases, stillspending in those categories.

However, having said that, if we look at what we've donewith the left-side reset, we've actually gone up market with a couple of newlines of tools. Now, they're doing well, they're brand-new for us, and there'sno comp basis for that business. So while we're selling them, we're pleased. I haveno idea what we might have been selling in a normalized environment.

Thank you very much, and with that, we'll close the call.We, again, have a wonderful business model; we have a very competent, energizedteam. We're going to get through the current climate conditions, and businessconditions facing retail.

This is a growth company. We have got a wonderful niche. Ourconsumers continue to embrace the lifestyle. It's an aspirational lifestyle,and Tractor Supply is the authority on that lifestyle. Looking forward totalking to you at the end of Q4.

Operator

Ladies and gentlemen, that does conclude our conference callfor today. You may all disconnect, and thank you for participating.

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Source: Tractor Supply Company Q3 2007 Earnings Call Transcript

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