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Tractor Supply Company Q3 2007 Earnings Call Transcript

posted on: October 24, 2007

Tractor Supply Company (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 Tractor Supply's conference call to discuss second quarter results. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session and instructions will follow at that time. (Operator Instructions)

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

Karen O'Brien

Thank you, Operator. Good afternoon, everyone, and thank you for joining us. Before we begin, let me 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, they 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 SEC. 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, CEO of Tractor Supply Company. Jim, please go ahead.

Jim Wright

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

Greg is replacing Jerry Brase. I'd like to take a moment to thank Jerry for his contributions, his hard work and dedication to Tractor Supply 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 the third quarter including some of the trends we experienced and the progress we made on initiatives during this period. Then Tony will review the financial results, and I'll resume with a discussion about the holiday season and some of the plans we're making sure to ensure success for the remainder of this year and beyond.

During the third quarter unfavorable weather, category-specific trends, and general macroeconomic issues created difficult selling conditions for certain merchandise categories. Although the environment is challenging right now, we were able to navigate through some of the headwinds due to our resilient business model, our loyal customer base, and our dedication 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 in EPS of $0.34 a share.

Looking at the performance by category is a bit more detailed. Our core lifestyle categories, particularly pets, large animal supplies and feed continue to drive increased transaction counts and produce higher comparable store sales. These categories drive our repeat business.

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

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

However, seasonal and cool weather dependent categories performed well below our expectations during the quarter, and they included outdoor power equipment, which continues to experience year-over-year declines as a result of drought conditions in the Midwest and the South and general industry trends in this category.

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

Additionally, early sales of cold weather categories such as heating and cold weather apparel were lower than prior years as above-average temperatures in September delayed fall shopping. For comparison, September of 2006 was the coldest December in about two decades, while this September was the fifth warmest in the last 100 years.

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

During the quarter, we made progress on a number of initiatives designed to help us increase consumer loyalty, drive revenue growth, and reduce operating costs over the long term. For example, we've completed the next milestone with our point-of-sale system. As you'll likely recall, 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 completed before, Thanksgiving.

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

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

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

Tony Crudele

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

Sales for the third quarter ended September 29, 2007f increased 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 were negatively impacted by dry conditions in certain regions of the country and the continued negative industry pressures at outdoor power equipment. As the warm weather persisted through the end of September, we experienced the decline in comp sales of cold weather-related products specifically heating and insulated outerwear.

With respect to regional sales trends, comp sales were the strongest in the Southwest where the moisture levels were above average; sales in the Midwest, specifically the states west of the Mississippi River, where the 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 August being the strongest month in the quarter. Del's comp sales were well above company average in the low double digits. We estimate that the cannibalization impact on comp sales was slightly above 1 percentage point, which is consistent with our expectations.

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

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

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

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

Our improved gross margins were partially offset by a slight increase in shrink, freight expense, including the additional increase from the import activity was flat compared to the prior year as we cycled the change in methodology for estimating freight capitalization’s, which we implemented in Q3 last year.

SG&A, including depreciation as a percentage of sales was 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 new stores that generally have lower sales volume in our mature store base.

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

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

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

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

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

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

In-transit inventory at the end of the quarter was approximately $21 million compared to $28.4 million in the prior year. This reduction in in-transit inventory year-over-year results bringing in inventory earlier than in the prior year to be better prepared for the start of the Q4 selling season.

Additionally, our inventory growth reflects the year-over-year impact of our clothing reset, expanded animal health and pet assortment, 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 more progress on improving our inventory turns, which decreased 12 basis points from last year.

However, as we analyze the drivers behind the higher Q3 inventory, the increase is more related to better execution in bringing in our seasonal merchandise, the weather impact on sales in certain categories, and inventory allocation to growth categories such as clothing and pet products.

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

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

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

We did experience an increase in accounts payable financing of our inventory from approximately 36.1% up to 38.7% resulting principally from better accounts payable management and vendor dating. Given the significant increase in imports, we are satisfied with the progress we are making.

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

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

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

As we head into the fourth quarter, and there are several factors that we have evaluated. We are pleased with the store traffic that we have generated throughout the year in a relatively tough retail environment. At the same time, we must be sensitive to the economic concerns that retailers face heading into the fourth quarter this year. We are very well prepared for the quarter but recognize that our fourth quarter is very dependent on cold weather.

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

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

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

Jim Wright

Great, thanks, Tony. As Tony just discussed, we have adjusted our outlook for the remainder of 2007. We believe it's appropriate to have a more conservative outlook for performance for the remainder of this year based on the delayed onset of colder weather of the season and the external pressures on the consumer.

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

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

This move will also allow Stan additional time to focus on our objectives of optimizing real estate, supply chain, and field executive development.

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

His understanding of private branding, sourcing inventory control, pricing dynamics will allow us to increase our sales and margin. While at Michael's, Greg improved the in stock position of the store's basic assortment products, improved margin through price optimization and simplified the seasonal merchandise changeover process.

Additionally, Greg served as president of Michael's for a 16-month period during the following the company's take private transaction. Greg brings a tremendous amount of leadership and knowledge to our team, and we are pleased that he is on board.

Greg will play an integral role as we focus on enhancing three key aspects of our merchandising performance first. We've recently begun to implement a new price optimization strategy. While we've operated a multi-zone pricing strategy in the past, we expect price optimization will improve 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 our long-term inventory target of 3.3 turns.

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

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

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

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

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

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

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

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

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

We are excited to be launching our e-commerce site later this month ahead of the holiday season. As of today, we are aggressively beta testing the new site and are currently processing orders on a limited assortment.

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

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

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

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

Our customers are living the rural lifestyle they enjoy not just partaking in a fad. As such, they have consistent needs to fulfill, thereby making Tractor Supply a true destination store and isolating us, to a degree from the challenges that others are facing in the retail marketplace.

As we enter the final quarter of the year, we are excited about the future. Our stores are set and are in great shape for the upcoming holiday and winter selling season. Our long-term strategic initiatives are being implemented well and we expect our efforts to drive sales, expand gross margin and control expenses all of which will contribute to operating margin expansion beginning in 2008. Our leadership team is strong while we continue to invest in our business and we look forward to the opportunities ahead for Tractor Supply.

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

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Brad Thomas 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 the third quarter and are reasons for worry about the fourth quarter. As we think about the housing market, the consumer, in general and the weather, I think the one that we can be optimistic that may improve is the weather.

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

Jim Wright

If we look at, in Q3, if we consider drought and outdoor power 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 define as above $500 and outdoor power equipment, it was about a 0.5 to 1.7 comps negative impact on the quarter.

Looking into the fourth quarter, we would, I think, have a similar 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 occupancy expenses. It sounds like the new stores, you're seeing nice results in terms of where the occupancy expense are coming in. Could you give us a little bit more color on how the sales are turning for those new stores?

Jim Wright

Well, the occupancy of that cost that we're speaking to are those 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 the same period last year and for last three quarters, our approvals have been about 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 way and the opportunity on the expense line in particular, I know the golden mile versus the silver mile opportunity is a big one as well as anniversarying some of the expenses with the website this year. Could you help us think of the order 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 to turn back to our general guidance, which is looking for a 15 to 20 basis-point of EBIT margin improvement each year and we'll achieve that by moderating the occupancy costs and continuing to drive our product margin or gross margin.

So you'll see the majority of efficiency of productivity coming from the gross margin line and by moderating the occupancy line, we anticipate 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 and what area drove the strength there?

Jim Wright

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

What we discovered of all those things, the one that made the biggest impact on our business was these new and different SKUs that came across 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 the chain 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 increasing at a comp above the chain for a number of years now and when we look at our relative penetration and national market share.

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

Erika Maschmeyer - Robert W. Baird

And just a follow-up there do you have, did you expand the pet 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 captured a little bit of space in the -- from the midway of the stores. But for the overall, the actual footprint stayed about the same. What we did expand was the number 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 warm weather and weakness in the category, do you think that actually hurt your sales for the quarter and are you still expecting 500 stores with the extended apparel 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, I guess, a few more of the small stores to go in Q1 of next year, perhaps another 100. That will be more of a refresh within the space as opposed to expansion of the space.

We remain very dedicated to clothing, very excited about clothing, but this time of the year, frankly, it's much more about the weather than 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 of questions, can you let us know what the stock option expense was in the third quarter and what you were thinking about in expense for this year? Do you think that revolver will be down to zero by the end of the year?

Tony Crudele

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

Peter Benedict - Wachovia

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

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 the price optimization test that you're going to be doing here in the fourth quarter? 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 purchased a 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 we have the flexibility to price according to the competitive metrics in each of our markets.

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

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

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

Peter Benedict - Wachovia

Could you give us a sense of maybe the percentage of SKUs you'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, a follow-up on the occupancy costs. In the past, you talked about around a 50 basis-point drag in '07, and then maybe cutting that in half in '08. Given what you're seeing on the stores that are approved, how do you feel about those kinds of parameters right now?

Tony Crudele

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

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

Jack Murphy - William Blair

Then, second, the merchandising initiatives for a minute. I think you said that you tested the left-hand side of the store, reset in around 41 stores, and -- but then I think you also said in the release that tools were somewhat disappointing. I wonder if you can just kind of square those few things a little bit. Are you seeing any kind of noticeable difference in those 41 stores 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 early September, 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 were not completed until Q4, the beginning of October. So we're going to have to wait and see.

Jack Murphy - William Blair

Thanks.

Operator

Our next question comes from Mitch Kaiser from Piper Jaffray. Please go ahead.

Mitch Kaiser - Piper Jaffray

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

Jim Wright

Yes, first of all, there is overlap, and we say 7% going to 15% in direct sourcing, and 18 going to 25 private label but you can't add those together, so they are -- in some cases both one and the same. On private label, generally, and this isn't always the case, but generally when we move to private label, our objective is to offer the consumer a price that is 25% to 30% lower and hopefully maintain the same margin dollars per unit. So to a degree, it depends a little bit on the category as to how much a rate change that will be.

But, generally, there is some rate left. I can't say I've added it up across all private label, I just know that it's accretive. When we look at direct import, if we were to maintain the domestic selling price, look at 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 cost reduction with the consumer and go for market share.

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

Mitch Kaiser - Piper Jaffray

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

Jim Wright

Our objective, I think we announced a year ago, it was a five-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 comp trends, but five months saying that August was the best, and then I think I heard you say that weather certainly hurts late September into October. Could you just give us a sense for how things are running, thus far, in the fourth quarter or don't you want to comment on that?

Tony Crudele

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

Mitch Kaiser - Piper Jaffray

Okay. So you've got it flat to 2 on the comp for the quarter? You're probably running a little bit light of that, then? Is that a fair 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 at this point?

Tony Crudele

We have incorporated the first part of October into our guidance.

Mitch Kaiser - Piper Jaffray

Okay, fair enough, and I think you have easy compares from last 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 than last year and colder than normal. As we look at December, it will be colder than 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 than October 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 know that the high-tech vans are a level of percentage of your business. That’s per me 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 your question was how important is big-ticket in Q4 relative to the rest of the year, and the answer there would be principally in installed heating in Q4, the front end of Q4 that we sell installed wood stoves and pellet stoves at north of $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 at full margin.

Then as we go into private brand later in the quarter, which I believe was the second part of your question -- all of our toys are either private brand or unique to Tractor Supply. We may not brand them, but it's a controlled product for us. In clothing, C.E. Schmidt is a private brand label of ours, very, very important to us in cold weather gear. And all of our gifts are 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's fine. Can I ask, like, one follow-up question? I know you have very few stores in California. I'm just wondering if there's anything. Yes, we have all the fires 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 stores are well isolated. They're in, for the most part, in the Central Valley and well north of where the majority of the fires are right now. So we're not seeing 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. Please go ahead.

Jay McCanless - FTN

I wanted to ask first, actually, to follow-up on the West Coast question. I didn't hear any mention of the planned distribution center out 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 to build. 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 we opened a 325,000 square foot D.C. there in 2003. So we may very well move in that direction and if we did that, that would push out our CapEx perhaps a few more years.

The key decision point in moving to a distribution center on the 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 great deal just by reducing stem miles from the D.C. to the stores. So we are working now to move some of our vendors to the West Coast and to locate vendors who are capable of serving us on the West Coast.

Jay McCanless - FTN

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

Jim Wright

Sure, a very good question. First of all, Del's has its own 65,000-square-foot distribution center, and so there is, at this time no implication on the growth of Del's. And then we are staging the growth conservatively in California, and our plan is to continue a modest rate of growth, to leverage our supervision we have in California, and then to accelerate the growth -- actually, we'll accelerate the real estate activity ahead of -- or concurrent with expanding the D.C. capacity.

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

Tony Crudele

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

Jay McCanless - FTN

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

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

No. Only because I don't have that in front of me, I guess probably the best way to look at it is that we do front-load our business. One of the reasons that we finished Q3 a little higher than we did a year ago is we had made the -- we toured our stores last in September, we're disappointed with our category preparedness, vis-a-vis some of the competition, so we decided this 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 would have chosen.

The best thing for us to day is that our objective is to move -- this year we're going to be at 2.6, 2.7 turns. Our objective is to move that to 33. We believe it's possible, and that's probably a four- or five-year trip that we believe will be made in about 15 basis points a year once we get the 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 to sales trends and specifically the weather. If you look back here in Q3, were there any markets where the weather actually did turn to more normal and more favorable and did you see a resulting improvement in your sales trend at those stores or in those markets?

Jim Wright

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

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

Brian Nagel - UBS

Okay, and then so as we move here into Q4 and assuming that the weather does turn at some juncture, sooner rather than later, maybe, do you think there's a great deal of pent-up demand or are a lot of those sales in Q3 now lost?

Jim Wright

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

Brian Nagel - UBS

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

Jim Wright

No, we are already beginning to -- one of the reasons we pulled the comps down a little bit for Q4 is we've already canceled some orders on heavy outerwear. Now, if it turns to be a terrific season, we can go back and get the product. But we're taking a very conservative approach, a measured approach on the inventory side, and then we'll be very dynamic as we begin to move through our markdowns recognizing that you make money on the first one not on the fourth one.

Brian Nagel - UBS

In your traditional seasonal category, I guess in the front of 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 gift and heating. The gift we feel very good about. We actually are looking at our gift run rate right now, and we're really pleased with how we're doing with toys and gifts thus far.

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

Brian Nagel - UBS

Okay. And then the final question is on the expense side. It looks like most of the increased SG&A margin is a result of the weaker comps, but if you look over the last three quarters or so, your expense growth has increased by 1 or 2 percentage points a quarter. Is there something to explain that?

Tony Crudele

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

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 excluding freight and transit was up 3.7%, but the figure on the news release suggests it'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 it excluded Del's. So the Del's inventory, when you put that in, it will get you from the 3.7 to the 5. Last year, if you remember, at this time we had just started a re-fixturing of Del's, and we loaded in some inventory since then. So when you look at Del's on a year-over-year basis, they've had significant inventory increase, and that's what the differential is.

Dan Wewer - Raymond James

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

Tony Crudele

It is above the double-digit comp. But, again, you have to look at it as, really, a retooling of that format as we added some closing and other 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, the model we purchased, had higher turnover velocity than Tractor Supply. We have added test categories with a full complement -- not really at the Tractor Supply level, but a pretty good complement of equine path, expanded pet, and clothing and seasonal.

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

So as a snapshot yesterday, comp inventory is running above comp sales. We're delighted with comp sales, we have a lot of learning, and we still -- 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 margin assumption in 4Q. So if we're entering the period with about a little less than 4% more inventory in comparable stores than a year ago, and it looks like the comp guidance for 4Q is around flatter, a slight increase, are we taking into account the possibility of clearance markdowns impacting gross margin rate, and that's reflected in the guidance given this afternoon? Or is it just simply the lower guidance is only the lower revenues and the expense to leverage and a stable gross margin rate?

Tony Crudele

As you've seen throughout the year, we have been able to improve margin in each of the quarters, although the first quarter was more flat. We would anticipate to have margin improvement year-over-year because last year there was significant margin pressure. However, our guidance does take in consideration and, obviously, we do sensitivity analysis, and our guidance 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 getting inventory turns to 3.3, would that require a change in tractor strategy of carrying some of the unusually slow-turning items that you feel is important for 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 because they define who we are, and they're very important to that core customer who comes 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 to us.

On the other hand, we do have many categories that are turning well north of a 3 or even a 4 that we believe we can accelerate. We have historically not been really good at promotional buys, seasonal buys, timing in and timing out, recognizing the velocity of categories by store. And that's where we think -- we pretty much know what we need to do, and Greg has pretty deep expertise in refining the inventory management on the buy side and then 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 up now that State Line is through with their liquidation. I'm curious if you're seeing the same thing?

Jim Wright

Again, we had 55 stores that had a State Line tack within 10 miles, so on a chain basis, it was not significant. When we look at those 55, I wish I'd had more than 55. We did pick up -- I'm sure we didn't pick up all their business, but we have certainly seen a growth -- I think the comps, that whole category is doing well for us. I believe the comps in those stores were 3 or 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 Weisel Partners.

Matt Nemer - Thomas Weisel Partners

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

Tony Crudele

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

Matt Nemer - Thomas Weisel Partners

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

Tony Crudele

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

Matt Nemer - Thomas Weisel Partners

Okay. And then can you prove -- Jim, can you provide any detail on the website launch? When does that actually go live beyond the beta test and you're probably not willing to put any numbers around it, but how many SKUs 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 be displaying the majority of SKUs that we have in the stores, but we will mark those 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 of our 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 a very quiet launch, and we'll be contacting our e-mail list and, over a period of time, and promoting the site to them so that we can continue to test the site. And as Jim alluded to, we expect to be live prior to the holiday selling season.

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, but they'll both -- you'll be able to get it through both, they'll be connected. So that should not be an issue if you go out there. But, currently, the site is not being redirected. The MyTscStore is not being redirected do the other site yet.

Matt Nemer - Thomas Weisel Partners

And is anything from the website implied in guidance at this point?

Tony Crudele

No, it's not.

Matt Nemer - Thomas Weisel Partners

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

Jim Wright

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

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 Next Generation Equity. Please go ahead.

R.J. Hottovy - Next Generation Equitytag

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

Jim Wright

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

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

However, having said that, if we look at what we've done with the left-side reset, we've actually gone up market with a couple of new lines of tools. Now, they're doing well, they're brand-new for us, and there's no comp basis for that business. So while we're selling them, we're pleased. I have no 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, energized team. We're going to get through the current climate conditions, and business conditions facing retail.

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

Operator

Ladies and gentlemen, that does conclude our conference call for 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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