Good afternoon, ladies and gentlemen, welcome to the Tractor Supply Company's conference call to discuss second quarter 2013 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. If anyone should require assistance during the call, please press the star and zero on your touch-tone phone. Please be advised that reproduction of this call in whole or in part is not permitted without prior written authorization of Tractor Supply Company. As a reminder, ladies and gentlemen, this conference is being recorded. I would now like to introduce your host for today's conference, Ms. Jennifer Milan of FTI Consulting. Please go ahead.
Thank you, operator. Good afternoon, everyone, 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, it can give no assurance that such expectations or any of its forward-looking statements will prove to be correct. Important risk factors that could cause actual results to differ materially from those reflected in the forward-looking statements are included in the company's filings with the Securities and Exchange Commission. The information contained in this call is accurate only as of the date discussed.
Investors should not assume that the statements will remain operative at a later time. Lastly, Tractor Supply Company undertakes no obligation to update any information discussed in this call. Now, I'm pleased to introduce Greg Sandfort, President and Chief Executive Officer. Greg, please go ahead.
Thank you, Jen, good afternoon, everyone. Thank you all for joining us on today's call. With me today is our CFO, Tony Crudele. We are delighted with our results and our level of execution in the second quarter. Despite a late start to spring with cooler weather early in the quarter, our team made the necessary adjustments to address those shifts while delivering improvement in sales and operating profitability. Our performance in the first half of 2013 demonstrates the continued strength and stability of our core business model. At Tractor Supply, we continue to focus on our sales-driving and margin-enhancing strategic initiatives. Through our expansion of our exclusive brand offerings, better localization of our assortments, and the improvements in our supply chain capabilities, we are increasing our market share and improving our profitability as a company.
Our previous call in late April, we discussed that the second quarter had started with much cooler weather. As we had anticipated, we experienced a slower sales ramp into spring. We adjusted our plans accordingly for this shift. Although we felt we did not recapture as much of the postponed spring seasonal sales from the first quarter as we would have liked, we are pleased with our team's ability to deliver strong comp store sales increases over a year ago. While certain big-ticket seasonal products, such as riding lawn mowers, did not rebound as we had hoped, we experienced very strong sales trends in our C.U.E. categories, our new live goods and garden products, poultry as a category, and apparel and footwear.
More importantly, our teams managed our seasonal products effectively. We finished the quarter well-positioned with current high-quality inventory as we enter the back half of the year. Now let me discuss our second quarter results in a bit more detail. Regarding sales drivers, our C.U.E. categories, the consumable, usable, and edible part of our business, remain very strong. These are need-based items that are driving repeat footsteps into our stores. The repair and maintenance parts business for outdoor power equipment, a C.U.E. category, has trended above last year's sales levels, reinforcing the behavior that our customers are repairing their products to extend their life versus replacing them. C.U.E. remains a foundational piece of our sales-driving strategies, and we work diligently every day to enhance and expand these products to meet the changing needs of our customers.
Another strategic area of focus for us is driving sales in our drive aisle and center court areas, where we strive to maximize sales per square foot. We utilize this space to host special events and to introduce new and seasonally appropriate products. This not only enhances our customers' shopping experience and expands the overall size of the customer's market basket, it also signals to our merchant teams what products our customers have the most interest in purchasing as we build forward assortments. One such event was our garden event, which provided our customers with a selection of new products and great everyday values on seasonal commodities such as seed, soil, and fertilizers. Additionally, we hosted a poultry event during the same period labeled Chick Days. During this event, we provided our customers with a wide array of items related to raising poultry.
Both of these planned events performed well, delivering results above the prior year. Our introduction of newness into our stores utilizing our test-and-learn approach continues to gain momentum. One great example is our live goods program, which we began testing about three years ago. In this category, we expanded our assortments of bedding plants, vegetables, seedlings, herbs, and fruit-bearing trees. Our customers have responded well to our offerings. We are very optimistic about the potential for further expansion of this business over time. Our exclusive brands continued to exhibit growth during the second quarter and accounted for roughly 29% of our sales mix. Exclusive brands are an important differentiator for Tractor Supply and a key initiative in driving increased footsteps, customer loyalty, and improved profitability. During the second quarter, we continued the expansion of our 4health exclusive brand dog food through the introduction of grain-free products.
Customer response has been very positive. This is an expansion of our super premium assortment, which continues to be one of the fastest-growing segments in our pet food category. We also added several other new products to our pet health department with similar positive responses from our customers. To summarize, I am delighted with the team's ability to manage through the numerous variables and seasonal shifts we faced during the quarter. The diligent work of our teams, both at store level and at the store support center, was exceptional, resulting in solid comparable store sales, transaction count improvement, and another quarter of double-digit growth and profitability. I will now turn the call over to Tony to review our financial results and discuss our outlook for the remainder of 2013.
Great. Thanks, Greg, and good afternoon, everyone. For the quarter ended June 29, 2013, on a year-over-year basis, net sales increased 12.7% to $1.46 billion, and net income grew by approximately 15.9% to $123.6 million or $1.75 per diluted share. Comp store sales increased 7.2% for the second quarter compared to last year's increase of 3.2%. As Greg discussed, although there was a much later start to the spring this year, spring did finally come and correspondingly drove solid sales performance. Although we believe we did not recapture all the postponed seasonal sales from the first quarter as a result of the delayed spring, we did plan for the seasonal shift between quarters and managed accordingly to deliver strong performance for the second quarter and the first half overall.
The animal and pet categories continue to be the main drivers of our business, with strong comps that were above the chain average. Seasonal categories such as live goods, certain gardening categories, outdoor recreation, and rubber footwear all performed well above company average for the quarter and the season. Comp transaction count increased for the 21st consecutive quarter, gaining 4.8% on top of a 2.9% increase last year. With the delayed spring and the continued strength of feed and pet products, C.U.E. products, which serve our customers' basic and functional needs, continued to be the key driver of the transaction count increase. Average comp ticket increased by 2.3% versus last year's 11-basis point increase. The increase was driven by inflation and mix, and to a lesser extent, big-ticket sales. A few key points about the quarter. Despite the slow start to the quarter, sales were consistent with our expectations.
Adjusting for the $38 million pool forward of sales into the first quarter from the second quarter last year, comparable sales to this year would be very consistent for each quarter in the first half, with a year-to-date comp of 4.2%. On a regional basis, our warmer regions performed the best, as they were the least impacted by the delayed spring weather, and all regions generated positive comp sales. As we had anticipated, April was the softest month of the quarter, with May delivering the strongest comp store sales gain. All three months achieved solid positive comp sales. Big Ticket delivered a solid comp sales increase but was below the chain average. For the quarter, we did have a comp sales increase in the riding lawnmower category, which resulted principally from the weather-related sales shifts between quarters compared to last year.
For the overall season, the riding lawnmower industry continues to be sluggish, which was reflective of our first half performance in that category. We estimate that inflation was approximately 140 basis points and was within our projected range of 1%-2% for the full year. Import sales increased 25% and represented 10.8% of the sales mix. Exclusive brand sales also increased by almost 25% and represented 29% of total sales. Turning to gross margin, which as a percent of sales decreased by 18 basis points to 34.8%. This was consistent with our outlook, as we anticipated that gross margin would be flat to slightly down in the first half of the year. Our initial direct margin continues to improve significantly as a result of our initiatives around price optimization, markdown management, and strategic sourcing.
The largest factor offsetting the benefits from our margin-enhancing initiatives was merchandise mix, which we estimate had a negative impact of approximately 40 basis points. This was primarily related to C.U.E. products , which continue to make up a larger percentage of our sales compared to prior year. We continue to manage gross margin dollars per unit, which again increased in our C.U.E. Categories this quarter. Freight increased approximately 16 basis points, principally as a result of the continued mix shift to freight-intensive C.U.E. products , as well as costs related to increased import activity. We also opened a smaller percentage of new stores relative to the total store base in the first half of this year compared to last year. We estimate that this had a negative impact on gross margin in the quarter of approximately 10 basis points, as new stores generally run a stronger margin.
For the quarter, SG&A, including depreciation and amortization, was 21.2% of sales, reflecting 63 basis points of improvement from prior year's quarter. As we have discussed in the past, although our increasing mix of C.U.E. sales impacts gross margin rate, it also provides us with an increasing sales base that allows greater leverage of SG&A expenses. We continue to effectively manage and leverage store-level operating expenses. Even in light of a very strong sales quarter, our incentive compensation program provided 13 basis points of leverage. We are particularly pleased with our ability to leverage SG&A despite the additional costs related to our DC and data center relocations, which we estimate negatively impacted EPS by approximately $0.02 for the second quarter. Our effective income tax rate increased to 37.4% in Q2 compared to 37.2% last year.
The increase was due principally to higher effective state tax rates and reduced federal tax credits, as well as a smaller percentage of incentive stock option disqualifications relative to a higher taxable income base. Turning to the balance sheet. At the end of Q2, we had a cash balance of $56 million compared to $179.1 million last year. During the second quarter, under our stock repurchase program, we acquired approximately 177,000 shares for $19.4 million. Our stock performed very well during the quarter, which limited the purchases under our matrixed 10b5-1 plan. We estimate that the share repurchase program did not have a material impact on EPS for the quarter. Average inventory levels per store at quarter end were 4.7% higher than last year, while annualized inventory turns increased by 10 basis points and 3 basis points for the quarter and year to date, respectively.
We are pleased with the productivity of our inventory during the quarter, despite later inventory carry in a number of spring categories related to the later extended spring season this year. Additionally, we shifted some Q3 receipts to the end of the second quarter this year and also carried additional inventory to support the transition to our new Southeast distribution center, both of which contributed to our higher inventory levels at quarter end. Overall, we do not anticipate any markdown exposure in Q3 outside of our normal clearance activity. In fact, we believe we are in better position than last year to clear our spring inventories productively given our improved inventory turns, as well as improved moisture levels and fewer drought-affected regions relative to last year. Capital expenditures for the quarter were $49.3 million, compared to $33.8 million last year.
We opened 26 stores this quarter, compared to 18 stores in the second quarter of 2012. The increase in capital spend relates to the construction of our relocated Southeast distribution center and the construction of our new store support center. Turning our attention to the full-year outlook, as a result of our stronger-than-expected operating performance in the first half, we are increasing our net income expectation for the full year 2013. We now expect net income to be in the range of $309 million-$315 million, or $4.36-$4.44 per diluted share. This compares to our previous guidance of $304 million-$310 million, or $4.32-$4.40 per diluted share. We now expect full-year sales to range between $5.1 billion and $5.17 billion, compared to our previous expectation of $5.07 billion-$5.17 billion.
Correspondingly, same-store sales for the year are expected to increase 4%-5% to our prior expectation for an increase of 3%-5%. Based on the volume of our share repurchase program year to date, we are also adjusting our estimate for full-year diluted shares outstanding to approximately 70.9 million. While we do not see any changes to our estimated range for capital expenditures of $240 million-$250 million, we are trending at the lower end of the range. The new store pipeline is full, and we continue to track very well to our full-year goal of 100-105 new stores.
Inflation has tracked as expected, we continue to estimate that it will be approximately 1%-2% for the full year, with the back half projected to be in the 0.5%-1.5% range as we begin to cycle the high corn prices from a year ago. With respect to margin for the full year, we continue to expect to achieve slight gross margin rate improvement through the execution of our key gross margin initiatives. We believe we have easier comparisons to the clearance activity we experienced last year, we will also be cycling some emergency response activity in Q4 last year related to Hurricane Sandy. We expect that the mix shift to our Q products, which carry a margin rate below chain average, will continue to present a headwind but should start to moderate slightly.
We also expect freight costs to remain a headwind due primarily to the continued mix shift to the more freight-intensive C.U.E. products as well as increased import container volume. With respect to SG&A, we expect to have a drag in the second half of the year of approximately $5 million-$6 million, or $0.04-$0.05 in EPS. Related to the relocation of our Southeastern distribution center and our corporate data center, which for the most part will be expensed in SG&A in Q3. We also saw an uptick in our medical and other fringe benefit expense trend line and have forecasted a larger increase in the back half of the year. As a result of the impact of the DC and data center charges and the fringe benefit increase, we expect to have a flat to very slight SG&A leverage in the back half of the year.
Based on the above discussion, we anticipate that our target EBIT margin improvement will be driven more by gross margin rate improvement than by SG&A leverage in the back half of the year. For the full year, we are increasing our forecast effective tax rate to 36.7% from our previous guidance of 36.5%. The increase relates to the higher effective state tax rates and a smaller percentage of incentive stock option disqualifications relative to a higher taxable income base this year. To conclude, we again executed very well in the second quarter despite a slower start to the quarter than we would have liked. The core business is very strong, and we saw seasonal sales accelerate as the weather warmed, producing solid financial results for the first half overall and positioning Tractor Supply for a healthy summer selling season.
With that, I'd like to turn the call back over to Greg.
Thank you, Tony. Regarding the current retail environment, we have seen relatively no change from recent quarters with the behavior of our customers. They continue to purchase conservatively, seeking compelling values based upon need rather than want. We continue to adapt our assortments to meet their changing needs while continually elevating our in-store experience. Before I close, I would like to provide an update on a few of our company's current initiatives. Our new distribution center in Macon, Georgia, which is the relocation of our Southeastern distribution center in Braselton, Georgia, is now complete and operational. The facility is currently receiving inventory, and we expect to begin shipping to stores from this location later in the third quarter.
Construction of our new store support center in Brentwood, Tennessee, which will enable us to consolidate our three leased store support center locations into one owned facility that will accommodate our growth for many years, is on track, and the project is scheduled for completion in the back half of 2014. The functionality enhancements to our website continue, and while there is still much more to do, we are encouraged with our results thus far. We have completed the upgrades to our website for drop shipment of products from vendors to customers. Our Franklin DC is functioning well as our online in-house fulfillment center, and we are adding more SKUs each quarter to expand both the breadth and the depth of our product offerings. Our annual square footage growth continues at approximately 8% as we further expand into the West.
We now have a number of stores open in the West, and we see more growth for this region over time. We currently operate stores in Arizona, Colorado, New Mexico, California, and soon to be operating our first stores in Wyoming and Nevada. Looking forward to the second half of the year, I am confident about our plans and the forward momentum we have as a company. We are executing at a high level, making continued progress on our sales driving and operating margin enhancing initiatives, and we are regularly introducing product newness into all our stores to ensure our customers stay highly engaged with the Tractor Supply brand.
In closing, I would like to thank all of our Tractor Supply team members for their ongoing hard work, passion for our customers, and commitment to our company, with special recognition to all our Oklahoma team members impacted by or helping those impacted by the recent tornadoes. Our team members are the driving force behind Tractor Supply's growth, and we all look forward to a successful second half of 2013. Operator, I would now like to open the call for questions.
Thank you. Ladies and gentlemen, at this time, if you have a question, please press star then one. Please limit yourself to one question and one follow-up question. If your question has already been answered, you may remove yourself from the queue by pressing star two. If you're using a speakerphone, please pick up the handset before pressing the buttons. Once again, that is star one if you'd like to ask a question. We'll pause for just a moment. We'll take our first question from Dan Wewer with Raymond James.
Thanks. Greg, in five of the past seven quarters, gross margin rate has been flat or slightly lower. I know that you're expecting margin to improve during the second half of the year. Do you think that we're possibly at the point where future significant gains in gross margin may be unwise and perhaps it's best to start returning some of those efficiencies to customers to drive market share?
Dan, great question. Let me answer it this way. The mix of our business continues to shift in a positive way to C.U.E., which is the key drivers of our customer base. Really, it's kind of the basis of how we structured the company about probably back in 2008 or 2009 when we made some changes to some of the assortments. Gross margin rate, on just a straight topic conversation, is something that shifts between quarter based upon not only mix, but other factors and other variables. As Tony mentioned in his comments, our direct margin is actually increasing at a very nice rate, and that's the positive side of gross margin. We're still fighting some headwinds with rate. We're still fighting some headwinds with overall mix. We believe we'll start to normalize more of that as we get into third and fourth quarter, as we cycle through.
I believe we have a better handle on what's happening now as we go forward. I would agree with you that the steep incline that we've seen maybe in the past three to four years may not be the same as we go forward. We still are confident, though, we can still get the 20 basis points or so, as we said, each year. Remember, our new operating margin goal is still targeted at 10.5%.
Right. Just a follow-up question for Tony on the new store growth and square footage. It looks like square footage is up about 7.3% year-over-year. In your prepared comments, you noted that it would probably wind up the year at around an 8% growth. Could you discuss why the store openings, I guess, are somewhat backloaded, and how that might impact your expenses in the second half of the year?
Sure. You're absolutely correct. The first half grew a little bit slower than we had originally anticipated. Some of it has to do with the wet weather and pushing back some of the stores. Some of it has to do with, obviously, some lease negotiations that pushed out some of our deals. We do anticipate easily hitting our number of the 100-105, and they will be a little bit more backloaded into the October and even potentially November timeframe. From an expense standpoint, when it comes to the pre-opening, those costs have been relatively flat with last year, so that you, again, from a model standpoint, can predict those. As I noted in my comments, in the first half of the year, by opening up fewer stores on a percentage basis, it has a slight impact on margin.
We would expect in the back half, that would help margin slightly.
Okay, great. Thank you.
We'll take our next question from Peter Benedict with Robert W. Baird.
Hey, guys. It's actually Justin Kleber for Pete. Thanks for taking the question. First for Greg, just on the traffic number, obviously another strong number here. Can you guys maybe just discuss the frequency of your average shopper, how that's evolved and changed over the past few years? Is the visitation gap between your best and maybe your average customer becoming wider, or do you think it's narrowing?
Great question, Justin. We typically don't talk to some of those specifics. What we can tell you is that the number of trips that the consumer seems to be making to our store is growing. It's more consistent than it was in the past. I think it ties itself around the C.U.E. strategy. These are consumable, usable, edible, necessary items. As long as we can keep the customer engaged there, I also will tell you, I think it's a gain of market share across many of those categories. We've become that most dependable supplier of. That's what's driving it. We've got some statistics. We do track at our best customers at the very high end of the scale and what I'd call probably our more moderate customer usage, and we're seeing more footsteps, clearly.
Okay, that's great. Tony, just some clarification on the guidance. It looks like the earnings grew about 18% in the first half of the year on a comp slightly over 4%. Your second half guidance seems to imply a comp of at least 4%, but the earnings growth looks to be about 13% at the midpoint. Is that deceleration simply the DC, the data center cost, and the healthcare issue you noted, or is there something else that we should be aware of? Because I would have thought the inflection in gross margin you're expecting would offset some of those headwinds in the second half.
Yeah, you're correct. The gross margin does offset some of the SG&A expense. The real holdback or headwind is the anticipated cost of transitioning to full operations on the distribution center and then the subsequent relocation of our data center. One of the big driving numbers is we're just going to be running duplicate rent for both of those locations until the end of the year. We'll be able to cycle some of those costs as we move into next year.
Okay, that rent, is that included in that $0.04-$0.05 that you called out, or is that?
Yes, it is.
Okay.
That's included, as well as there's temporary labor that's included, and there's obviously some handling and movement of product between the former DC, the lease location, and the new location. Those are really the largest expenses.
Okay, thanks, guys.
We'll go next to John Lawrence with Stephens.
Yeah. Good afternoon, guys.
Hey, John.
Greg, would you comment just a little bit, you mentioned recently a lot about regional assortments? Would you talk a little bit about that and the program of how much of these stores are now getting inventory regionally versus from other methods?
John, we have become a little even more refined than just talking about regional. We're really talking now about local. Localization is really our new moniker, if you would want to call it that. It's because as we've moved into different parts of the country, stores that are, and I'll give you an example, stores that are in a mountainous region versus stores that are maybe in the valley. They may be in the same state, but they act very differently. The needs are very different. I had mentioned before that we have about 600-plus different types of assortments out there in our stores based upon the locations and the regionalization. We've now taken it a step further, John, and we're now really looking at the local level. A lot more input from the management teams in the field.
We still have a lot of work to do, but we do our homework before we go into a new area of the country, and we are understanding the needs of that market much better. A lot of work there. A lot of assortment planning and planogramming work that's done well in advance of those stores opening.
Great. Thanks. Secondly, left-hand side of the store, tools, et cetera. I know you've been doing a lot of work there the last several years. Anything to update there that's going on?
Well, if you've been in our stores recently, you'll note that we are expanding what we call the hardware set, and we're revamping it, where we're making some moves to shift product categories around, place some new products into that area. This year, we'll be moving several hundred stores into that new format. We've tested it for a few years now. We're happy with the results, and you will see the left-hand side changing a bit, and that whole hard lines component still having seasonal towards the front and then placing the hardware component in a little different setting, you may call it. We've also done some work in the back there within the automotive and truck and tool.
Great. Thanks.
We'll continue to get work. Yeah.
Great. Thanks. Last question on cross-dock, on the feed. Any update there in Texas?
The current test is complete. We're very happy with the results, we are currently beginning a process of trying to locate a facility in the same region to actually start to roll this process forward.
Great. Thanks. Good luck.
You're welcome. Thank you.
We'll take our next question from Michael Lasser with UBS.
Good evening. Thanks a lot for taking my question. First, on the gross margin side, I think last quarter you had 65 basis points of pressure from the mix shift to C.U.E . This quarter was 40 basis points, and yet the overall gross margin degradation was about the same. Can you connect those two points? Did you see less of a benefit this quarter from some of your gross margin initiatives?
Michael, this is Tony. We saw actually about the same increase when it came to the direct margin piece, but there's obviously so many other variables as far as the way we look at margin internally. I highlighted the larger pieces, in particular, sort of the impact that we get from the new stores and also the way we manage markdowns during a particular quarter, and then some of the programs that we put together with our vendors. That all comes into play and can impact a particular quarter. From a standpoint of our initiatives, they are really driving a very strong initial direct margin on the products that we're bringing in now. We're very pleased with how that is working and truly just sort of relates negative or the degradation really is a result of the mix of the product.
The rate of improvement from on the direct side was similar in the second quarter to what it was in the first quarter?
Correct.
Okay.
It was very strong performance. As we look out, we're anticipating that the headwind that we do get from the C.U.E. items should start to moderate and should decrease slightly.
Why is that?
Well, one, as we cycle some of the higher costs from last year, with the anticipation that some of the pricing will come down in some of the feed categories in particular, you have an opportunity to be able to better manage the rate. In times of escalating prices, we'll manage, as we've talked in the past, to try to get a certain dollar per bag or dollar per unit. As we go through lower inflation or potentially deflation in some categories, we'll still manage to that same dollar per unit, but that dollar per unit now returns you a higher margin rate. We believe the degradation that we'll get from that headwind will be a little bit less or start to moderate in the back half.
Okay. My last question on that point. We've seen some volatility in commodity prices, grain prices, corn prices. What sort of impact is that having on your customer, and what have you assumed about that into the back half of the year.
Yeah, there has been some volatility. Some of it has been more conversation than actualization. It's been a little bit more steady than you would suspect. As we look into the back half, like I just previously mentioned, we do expect some of the prices to be lesser than they were last year, although we have yet to see that sort of precipitous decrease in any of the particular grains that we deal with. As I had stated previously, we would expect that that would benefit margin rate in the back half of the year.
Will it have an impact on the amount of income that your customers are going to have, such that they may have less to spend in your stores?
It's a possibility, right now, we don't anticipate it having a significant impact. Obviously, we'll have to work through that as we see the environment and the economy in the back half of the year. As we've said in the past, it generally has more of a trickle-down effect into the economies that we deal with in the Midwest. It tends to be a little bit more isolated and generally would not have a significant impact.
Okay, thank you for all the helpful commentary.
Thank you. You're welcome.
We'll take our next question from Matthew Fassler with Goldman Sachs.
Thanks a lot. One cleanup question to start with. You talked about the investment from the DC relocations, et cetera, and expansions in the second half of the year. Did you give that number for the second quarter?
Yes. It was about a $0.02 impact on EPS.
Got it. That's helpful. Secondly, if you could just comment on essentially what you saw in June. Obviously, April was a challenging month given the later start to spring. We heard a lot about precipitation in June in certain parts of the country. What impact did that have on your business in the quarter, and how does that influence the set-up for Q3?
Well, as I had said in my comments, all three months were strong comps relative to, obviously, the overall quarter. That's the detail that we provide for June. The other thing that I would comment on is that we believe that this year there has been more moisture. We believe that also when it comes to drought, it's much more isolated, and it's isolated more in sort of the Southwest area of the country. Last year, it extended much more into the Midwest. We believe that the weather conditions do provide for a little bit more extended spring/summer selling season. We think that bodes well, obviously, for the June performance as well as into some of the July performance.
Also as an editorial, I would say that any type of spring performance does start to moderate significantly as we move into July and the August timeframe. It becomes a much lesser portion of our sales.
Thanks, Tony.
We'll go next to Scot Ciccarelli with RBC Capital Markets.
Hi, guys. Thanks for taking my questions. I have a couple of high-level questions on the topics of market share and competition. With respect to some of the bigger box national retailers that maybe don't focus solely on the farm and ranch segment that you do, but do have some overlap with you guys in certain product categories, are there any signs of those retailers are seeing the strong sales growth that you've been putting up and have any interest in expanding their assortments in those areas? Secondly, with respect to some of your smaller, more regional competitors that do focus on your core rural customer, are you seeing any actions from those companies on market share, whether it's more competitive pricing or potentially even increasing their own new store growth plans?
Let me start with the first. This is Greg. Interest or signs of interest from the large box retailers that may sit around us. On occasion, we will see one of the or several of these guys will get into some of the businesses in a small way, looking at it as, I believe, potential foot driver for them. The difference is that we're in these businesses to stay, and our customers understand that about Tractor Supply. If someone else would want to jump in and jump out of a business, that doesn't make you an authority. I think over the long haul, what we see is the customers continue to come back to us.
We have not had anyone that we can tell as far as our core customer base would be moving to a big box or something like that to buy some of these products because they really don't have the expertise to talk to them and to really sell them to the consumer. The second piece about regionals. Some of the regionals, when we move into their markets, have a tendency to believe that it's about price, and our belief is it's about a better store, a better assortment in that store, and it's about a great customer experience along with a fair price. Most of them compete on a high-low basis. We do not. We compete on an everyday price basis with some promotions. They have a tendency to try to play the price game. We will, in many cases, play the match game for a period of time.
In the overall scheme of things, we tend to win that battle. I'll also tell you that in some instances, as our growth of store base has expanded, many of what I'll call the smaller independents who are specialty retailers in either feed, maybe it's a pet operation, maybe it's a tack operation, maybe it's something that is just in three-point equipment, we have a tendency to be that store that can draw that consumer to one location and make the purchase
Versus having to go to multiple locations. We somewhat, and I'm, I guess, out-man them from a standpoint of our assortment, having a one-stop shop. Number of factors. We continue to run our game and play our game and we continue to improve what we do, I think we will continue to win.
Okay, got it. Thank you guys.
We'll go next to Denise Chai with Bank of America Merrill Lynch.
Okay, thank you. Could you talk a little bit about some of your progress in newer markets like Colorado, where you've been operating now for a bit over a year? Any early learnings? What do you see some of the key differences from your core markets in terms of the customer and also the competitive environment?
This is Greg. I'll speak to that. We studied the Colorado market and we'll study any new market for a period of time before we'll open our first store. What we found was that the consumer was being underserved in some aspects, that there were some requirements that were expected of us if we were going to compete with those independents. Then what were the points of differentiation that we could exploit versus what that competitor originally was doing. That's a little bit of the simplification of how we go about it, but we have had great success in Colorado and in a number of other states as we've expanded because of using that formula.
Okay, great. Thank you. Going back to your 25% growth in exclusives, could you talk about what categories are driving this? I saw that you were advertising your expanded paint and tool assortment. Is this another opportunity to put more exclusives into the stores?
The exclusive brand categories are growing for several reasons. One is we're offering the customer a far better value equation for their hard-earned money. Secondly, there are always gaps in anyone's assortment that can't be filled by a national brand, so we're able to use our exclusive brands to fill those gaps. I would say third, across the store, we're finding opportunities, but we don't try to force those opportunities. We test them first, let our customers respond. If they give us the positive response to allow us to take it to the next category or the next extension of products, we'll do that, and that's worked for us. It's been successful to this point, and that'll be our plan going forward.
Great. Thank you.
We'll take our next question from Chuck Cerankosky with Northcoast Research.
Good afternoon, everyone.
Hey, Chuck.
As you're looking at new store openings, any change in the real estate market out there? Any sense that supply is tightening or cost of sites is going up, things of that nature?
Yeah, Chuck. Tony. We have seen that some of the rents have been increasing, very modest, and it has not impacted our ability to identify locations and/or to obtain the required return that we would expect to get out of our new stores.
Do you cover that increased rent in the pricing of that individual location, or is it sort of the overall pricing of the chain?
It's going to vary from state to state, we're going to see different prices in the various states. Generally, we're going to cover that through the increased sales level that we would anticipate getting from that particular marketplace. As the economy rebounds, if the rents rebound, we're generally going to be able to drive some additional sales volume that would easily cover any additional rent expense that we would have to manage.
Okay. Somebody earlier might have said this, I want to get a clarification. Did you say the new store mix in the most recent quarter skewed to a somewhat lower size?
No, I would not say that. We opened a few less stores in the first half of the year relative to the prior year.
Got you. All right, thank you.
We'll take our next question from Jeff Black with Avondale Partners.
Yeah, thanks. Congrats, nice quarter.
Thank you.
Just to sharpen an earlier point, your gross margin guidance for the second half, is that premised on Q lessening as a headwind from that 40 basis points, or is it premised on the margin initiatives you're working on kind of offsetting in total the Q headwind? On the inventory, you mentioned that we had some more carryover, but you think there's less margin risk to the carryover. Could you just clarify what's really going on with the inventory build, at least from the 2Q stuff that's left over aspect? Thanks.
Yeah, Jeff, I'll take the inventory. We'll let Tony talk a little bit to gross margin. At the end of the quarter, we had already planned to have two facilities operating, Braselton and Macon. We had already indicated that there was going to be some carryover inventory, basically duplication of inventory for a period of time as we ended the quarter because we still would not be fully transitioned to Macon. That was some of the dollars. Some of the dollars were also an investment piece that we made as we saw the quarter start to open up with sales. We said, "Let's get ahead of it. Let's make sure that we keep the key categories driving business as they were." We made some, I will call it inventory investment forward to make sure that we stayed in the stock positions we wanted.
The last piece was something to do with, at the end of the quarter, we had some early receipts of third quarter that actually came in about, let's say, one week early by the end of the quarter. That shifted in, and that was probably the largest impact overall for the quarter. That's all forward inventory. It just arrived here about one week earlier than we would've liked, to be very honest. The way we book our inventories, if it's been picked up and it's in transit, it's going to get onto the books. That was a larger portion of it. We're in great shape for our transition out of spring and into summer and fall.
Good.
When it comes to gross margin guidance in the back half, as I had noted in the comments, we think we're up against easier compares. As Greg just mentioned, we like where we are relative to our inventory position, we believe that as we go into the spring clearance mode, we'll be able to manage those markdowns effectively. We, obviously, in the back half of the year, also are going up against some emergency response from Sandy. That last year carried a lower margin, we believe that's an easier compare as well. We'll be opening up a lot of new stores in the back half. That could have a slight positive impact.
In addition to seeing some of the impact of lower prices in some of the grains, we would anticipate that the headwind from the rate impact on margin could moderate as well, as well as the mix starting to moderate as well. A lot of different factors affecting the back half. I wanted to make it clear that we really expect to have some gross margin momentum in the back half that we had not experienced in the first half. With that additional charge for the DC and the data center impacting SG&A, the back half just will act a little bit differently than what we saw in the first half. I just wanted to make that clear to everybody.
Okay. Good luck, guys.
Thank you.
We'll take our next question from Chris Horvers with J.P. Morgan.
Thanks. Good evening. Following up on the inflation questions, you still expect about 100 basis points in the back half on inflation. Is that the chemicals business driving the positive move in the food category? It seems more like disinflation. Related to that, can you talk about the inflation outlook and maybe the horse side versus the dog side in the food category?
Yeah. We would anticipate there's so many different categories. We're looking at over 340 different categories, and they all react a little bit differently, so it's hard to isolate. We don't have anything that we're seeing that has a significant increase to it. We're probably looking at a very modest increase across the majority of the categories. Where we see that offset to bring it down from what we experienced in the first half, really is more on the grain side of the business and the animal feed. That's why we think it'll be a little bit less as we look at the back half of the year.
Understood. You would include the dog food in there as well?
Yeah. No. We look at the pet food side as generally being flat in the back half of the year.
Understood. Then on the live goods, can you talk about how many stores that you had live goods in during the spring season, where it compared to last year and how you think about the number of stores that you can and want to get that into? Do you think eventually down the road, there's a garden center perhaps on the side of the store using up some of the yard?
Chris, this is Greg. First of all, we had limited stores in 2012. We were still going through some more testing. This year, we had an excess of 500 stores with live product. I would tell you that we're finding that that side lot, if you want to call it, which is now our area for storage, can be productive if we can place the right products there. I won't give you an absolute on the fact that that's where live goods may wind up and will there be a garden center there, but I will tell you that we're pleased with the results. We're still looking at how we would position the business for next year if we take it to more stores in the chain.
It's a business that has to be run regionally, so we have to have the availability of product and the growers there to be able to service it. We do believe there's future growth in that category.
Thanks very much.
We'll take our next question from David Magee with SunTrust Robinson Humphrey.
Yeah. Hi. Hello, everybody.
Hi, David.
Just a couple of questions. Is it possible to assess what the longer-term penetration would be of the Q category? Is that something that you think will be growing rapidly throughout next year, or how do you all assess that?
Well, David, as you know, it's a number of different categories. It's not just feed, food, or whatever. There's a multiple of things that we have classified under Q. It's really the products that we would consider would be footstep drivers and what I would consider to be the most dependable supplier of. These are the items that customers can count on when they come to our store. Its overall penetration, in many ways, is growing because we are gaining market share from, I'm going to say, others around us. We're running a much more powerful business, a business that is well-priced day in and day out. With our new price optimization modeling, we're able to do that. I can't tell you today if there's a percentage or not.
I can only tell you that we see further growth as we go forward, but we also see it becoming more in our run rate of where we've been. At this point, we're happy with it because it is bringing a lot of footsteps. You saw that, with over a 4% increase in transaction count. The customers are continuing to come to us over time. That gives them the opportunity to shop other places within our store, and that's where we can build more margin. There'll be a balancing act as we go through the next couple of years.
Great. Thank you, Greg. Secondly, with the enhancements that you're making to the e-commerce site, any update with regard to your thinking on the ultimate profitability of that business and perhaps the penetration there, too?
Well, even some of the most developed retailers out there that have websites, they're doing sub 3% and 4% of their overall business on the web. In my thought process about the web, it's first just another vehicle for us to exchange either commerce information or just exchange commentary with the consumer. It's a way for us to understand what they're purchasing from us and why, and how we can go back to them and talk to them about things they're interested in. The commerce side of this is a little longer term from the standpoint of its ramp and its run, because you have to have a number of things, as I said earlier in my prepared comments, about having capabilities. We do believe that there'll be some business for us longer term.
I believe what it does, it probably drives more business for our stores than it will probably drive online by a great margin. The store business, we're a four-wall retailer, and this is just another way for us to exchange commerce, I believe, with the consumer. I'm going to tell you that we will not be probably any more than some of the best at retail today as far as % of overall sales.
Great. Thanks, Greg.
We'll take our next question from Adam Sindler with Deutsche Bank.
Yes, good afternoon, guys.
Afternoon.
Starting back to gross margins again. Just when we're talking about the back half of the year, really the comparison is not easy in the fourth quarter. It's not too much lower than what we saw in the second quarter. You're up 80 last year, in the second quarter up 50. On a run rate in the second quarter this year, you were probably about +50, +80, and then -20 or something like that, +60. As we look to the back half of the year, is most of that improvement going to be weighted to the third quarter? Then sort of for the year, how are you looking at gross margins? Are we looking flat for the year? Are we looking slightly up? What would you say about that?
As we look at the back half, we see a lot of the opportunity in Q3. As we move into Q4, the one thing about Q4 is that it is a lot of import activity. We have a potential of driving some gross margin improvement there. The new stores that we open in the back half of the year are weighted towards the fourth quarter as well. Then we always believe that we can go through the season more effective as far as managing the markdowns. We are hopeful that it'll be a little bit colder in December, and that will provide us the ability to manage through the holiday season some of our, obviously, insulated and cold weather products.
We definitely recognize that it is a tough comparison as we move into the fourth quarter, but we believe that there are some variables that we can be able to react and drive margin improvement in both the third and fourth quarter.
Okay. On the merchandise outlook, obviously live goods was very successful for you guys in summertime this year. Any sort of new tests you're working on for the winter?
Adam, there's always new tests. I've always said there's 40-50 ongoing. Yes, we will continue to bring newness to the stores. We'll continue to have testing, but I'm really not at liberty to tell you the specifics on it. I can only tell you, go visit our stores. You'll find it.
Got you.
All right, very good. Thank you. I appreciate it.
Thank you.
Bye.
We'll take our next question from Aram Rubinson with Nomura.
Hi, thanks. Good evening and great set of results.
Thank you.
A lot of questions have been asked, I'll focus my attention on kind of CRM. I know you guys have been working hard on understanding the makeup of your customer more over time. Can you tell us a little bit more about what you've learned so far? Specifically, I'm interested in the distribution of customer and visits and your best customers representing X% of sales. I'm wondering if you can give us any inklings there, I had a follow-up.
Let me give you some insight. This is Greg. We are spending quite a bit of time on understanding our consumer. We have developed a five-year roadmap, which we are now in the initial stages of starting to roll into that plan. The first thing we understood we had to do was pull all of our data together on customers, and we have it in a number of, I'll call it, buckets here in the company. We're doing that merge right now. Once we have that information, we'll be able to start talking to this customer and looking and cross-referencing as they buy one category, are they buying another category? If they're not buying into that category, why aren't they, and so on and so forth. We have some current learnings through some of the initial merge of some of the information.
We actually used that in the middle part of this year, during the July 4th period. We did change some distributions using that information. We had very positive results. We know the power of it. The matter of fact is we have to start to harness that. That's going to take some time. We do have a very rigorous process we put into place. We're in the first stages and now doing that first consolidation, and we'll be able to share more with you as time develops.
If I can just follow up, in the absence of kind of science on the CRM side, you've got kind of art, which is testing and experimentation, and some of those tests are working and some of them are not working. If we can use that as a proxy for CRM, can you tell us about where you see your bandwidth with customers, where you see them? Are there any obscure tests that are succeeding or any obvious wins that are failing? Just curious kind of where you're getting permission from that customer and kind of, let's say, shortcomings in that regard, too.
What I can tell you is that in some of our current learnings, we were spending some time about a year ago talking about the aware non-shopper. We weren't sure if this was a suburban or if this was a more suburban rural type of consumer that lived right on the edge. I can tell you what we found out in our current research is they actually live much closer to the store than we thought. These are these customers that don't shop us but would have an interest to shop us if they understood what was inside the box. That's just one segment of a number of things that we have learned. Now, how we're going to market to them will be different.
How we will attract them to the store will be different than our core customers who already know us and who already spend money with us. It's exciting news, and I'm very anxious to get more of this information and to take this data and convert it into information that we can use across the company.
Okay. Well, thanks, and best of luck in the back half.
Thank you.
We'll take our next question from Simeon Gutman with Credit Suisse.
Thanks. Greg, on price optimization, I think in the past, we've talked about four phases or four components to it, and I think promotional being the second bucket. I think, if I've got it right, that's kind of where the company is at or starting to pursue. Can you put some timeframe parameters around it? I'm not sure if one bucket of price optimization is more opportunistic than others, but where this one stands relative to others.
Well, first, let me set you straight on this. Price op, we're in the regular price component today, continuing to learn, continuing to refine. The second bucket will really be around clearance because it's the other component of our business. Since we do have some seasonal categories, we'll move to clearance next. Third, and the most difficult, will be promotion because we're not a highly promotional company, and when we do run promotion, whether it be something in preprint or on the Internet or with a coupon or whatever, there's a lot of variables there. That really is the most difficult. We are looking forward into 2014 to start to work in the clearance bucket. There's no exact timing yet because there's still some system upgrades we'll need to do, but it looks like we'll continue to stay with Revionics, and we'll be looking at that in 2014.
Okay, just a quick one for Tony. You mentioned the incentive comp program, that it provided leverage. Was that because of the program design, or is it because I think in the comments, that sales, you expected them to be a little bit stronger and maybe some of those numbers just weren't hit?
No, it's really generally how the program's designed. Each year, as we go into the year and put forth what we believe are fairly aggressive targets, both on a sales and an operating level for our team members out in the stores, we should be able to benefit from the incentive compensation program. This year is a little unique because of the way the sales fell last year versus this year, and we had such a strong first quarter and how we level out the incentive compensation. Coming into this quarter being a fairly strong sales quarter with the shift relative to last year, we did expect the incentive compensation to increase relative to the sales level, which it did. Again, with the more aggressive targets that we come in with at the beginning of the year, still provide us the opportunity to leverage that program.
If I can just clarify, if the business does a 7% comp, let's say, in the future, is the program designed to provide leverage?
At a 7% comp year-over-year, you'll probably have very limited leverage from the incentive compensation. There's a combination. You have to look at both pieces. One is the store piece, and then one is the store support center. Over a course of a year at 7%, it will provide leverage because at a store support center level, the incentive compensation is capped at a particular point. Net overall, you should get some leverage at a seven comp, and it's designed where the shareholder will benefit from a strong selling season.
Okay, thanks, nice results.
Thank you.
Thank you.
We'll go next to Matt Nemer with Wells Fargo Securities.
Hey, good afternoon. I just have one quick follow-up. Your accounts payable days are starting to stretch again after a long period of some compression. Has there been a change in philosophy around AP timing, or is this more of a product mix issue, and what impact could that have on the gross margin rate going forward? Thanks.
Yeah, Matt, there hasn't really been a change in the philosophy. We obviously try to be as aggressive as possible when it comes to the accounts payable and the payment terms. What you see is, included in the accounts payable is not only just merchandise payables, but also expense payables. Some of what you're seeing is timing. You also see, as we sort of lap versus last year, a little bit more consistency in that build because they're more comparable periods. Last year was a difficult comparison because we had added the extra week from the 53rd week before, so they weren't really apples-to-apples comparison.
As we go through this year, there will be some spikes as we go through and we see quicker turns on some of our C.U.E. items, that generally will hold back the accounts payable, and we will not be able to get the leverage that we'd like to get out of the accounts payable. To the basis of your question, there has not been a significant, either philosophical approach or change to the way the accounts payable is managed.
Okay, thanks so much.
We'll go next to Eric Bosshard with Cleveland Research.
The increased or slightly increased sales guidance for the year, can you just talk a little bit about what is within that, if that's market or market share growth, or if there's anything within specific categories that's contributing to that?
Yes, Eric Bosshard, it really relates to the strength of the Q product and the performance of the Q throughout the first half of the year. The majority of the sales driver is related to what we believe has been sales above expectations for the first half, and then to a certain extent, a little bit lesser extent, the back half, relative to the trend that we've seen when it comes to the performance of the base functional C.U.E. items .
Is that the Q category growing faster, or are you gaining incremental share, and if it's share, are there specific areas where you feel like you're making the most progress?
No. We're definitely at the combination of increased trips from our current consumer as well as additional market share.
Thank you.
There are no other questions at this time. I'd like to turn the conference back over to our speakers for any closing remarks.
Okay, thank you, operator. As you can see, we're very passionate about our business and the opportunities that still are ahead of us. We will continue to focus on our strategies to drive sales and grow operating profits. Thank you all for your continued interest and support of Tractor Supply Company, and we all look forward to reporting third quarter results in about 90 days.
Thank you everyone. That does.