Tractor Supply Co (TSCO) 2006 Q2 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to the Tractor Supply's conference call to discuss second quarter results.

[OPERATOR INSTRUCTIONS]

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

Thank you, operator. Good afternoon, everyone, and thank you for joining us for Tractor Supply's conference call to discuss second quarter results. 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 with that out of the way, I'm pleased to introduce Jim Wright, President and Chief Executive Officer, and Tony Crudele, Chief Financial Officer of Tractor Supply Company. Jim, please go ahead.

Good afternoon, everyone, and thank you for joining us. With me today also is Jerry Brase, our Senior VP of Merchandising, and Stan Ruda, SVP of Store Ops. Joe Scarlett is calling in and will be available for the Q&A session.

Overall, we are delighted with our execution of store growth initiatives and expense management. These allowed us to generate strong year-over-year growth in margins and in our bottom line. However, we are disappointed for the sales growth for the quarter.

I'd like to provide a brief overview of some key drivers of our second quarter results. Sales, similar to recent quarters, average ticket was up, but traffic was down. Weather, on a chain-wide basis, was neutral for the quarter. On the comp sales side, our comps for the quarter were below our expectations. The comp result was driven by a combination of several factors. One, generator sales in the state of Florida. We cycled last year's tax-free hurricane prep events. We prepared for it, we advertised it, and the consumers simply did not show up at the same level as last year.

Macro trends impacted our demand for big-ticket items. I'll have more on that later. New product launches in the second quarter were lower than the prior year. We've talked previously about our customers not being impacted by macro trends to the same extent as perhaps they are in some other retail chains. However, while this fundamental theory still holds true, our customers continue to make basic need purchases. For example, feed and pet food were up well in the second quarter, but we did see some pressure on large-ticket items. We do see these macro trends impacting spending habits, again primarily on higher-ticket items such as air compressors, welders, and riding lawn mowers.

Specifically, we are seeing customers from our lower income demographic defer large-ticket purchases, while our more affluent consumers continue to purchase premium big-ticket products. For example, we experienced much stronger sales in zero turn and premium riders than we did in opening price point and mid price point riders. In fact, our average rider selling price is up nearly 9% for the quarter.

Looking at historical sales trends in the rider category, we've always seen that high-end models sell earlier in the quarter. That being the case, it wasn't until late in the quarter -- in fact, June -- when the softness in the low-end units was confirmed. This timing allowed only a small window for us to react with other products and promotions. We believe, based on industry shipments of riders, that we actually gained share during what was a very soft season in riding lawn mowers.

On the inventory side, while our average store inventory is up 6% per store, our in-stock and service levels are at all-time highs. Additionally, inventory is well balanced by category, by region, and by store volume levels, and we face no unusual markdown exposure.

On the margin side, we were able to improve margins as a result of product mix, imports, and reduced clearance markdowns. On new store growth, we opened 17 stores in the quarter, which puts us squarely within our goal of opening approximately 60% of our new stores in the first half of the year. Having successfully accomplished this goal, we were able to -- we will be able to capitalize on the benefits in the second half of this year, as these stores will be very well positioned for the important late Q3 and Q4 selling season.

In addition to new tractor supply stores, we completed a reset of one Del's store, adding depth and breadth to pet/equine clothing and footwear, as well as seasonal categories. Early results are promising, and we are now in the process of converting an additional seven Del's stores to the expanded format during this quarter.

I will go into greater detail on what we learned from our Q2 results and how we will drive our business in the back half of this year after Anthony provides us with more detail on our financial results. Anthony?

Thanks, Jim. Good afternoon, everyone. As you know, we delivered a solid bottom line in what was a difficult selling environment this quarter.

Earnings per share increased from $0.87 to $1.05 or a 20.7% increase. This is inclusive of approximately $2.6 million of stock option expense recorded pursuant to FAS 123R. This amounted to approximately $0.04 per share.

The comp sales for the period were 52 basis points. We had one less comp day in the quarter as a result of the Easter shift. We estimate that this had an approximate 120-basis-point impact on Q2 comps.

As Jim noted, sales were soft in the rider and emergency response categories. We estimate that the shortfall in these categories alone accounted for approximately 150 basis points of the decline in comp sales. Also, comps normalized for cannibalization would have been approximately 50 basis points higher. Non-comp sales, excluding relocations, were approximately $90 million, or 12.6 percent of the quarter's sales. This does not include relocated stores, which are excluded from the comp store base until they have cycled a full year.

Let me remind you that we're coming off a 53-week year, and the prior year fiscal period does not align with the same-store sales measurement period. This accounted for approximately 64 basis points of the quarter-over-quarter sales increase.

With respect to the regional sales trends, comp sales were above company average in the Mid-South and Southwest. Comps were below company average in the central Mideast and Southeast. Average ticket was approximately $47 and on a comp basis increased 80 basis points, while we had a slight decrease in comp transaction count of 36 basis points. We believe the transaction decrease was impacted by economic headwinds, not dissimilar to Q3 of 2005. However, after analyzing the numbers, we believe that we did an excellent job of moving the consumer up the pricing continuum. As Jim discussed, we continued to have strong sales trends in the high end of the high-ticket items. It is at the lower end of the big-ticket price continuum where the customer is willing to defer the discretionary purchase.

We had a solid gross margin performance for the quarter as overall margins improved by 90 basis points. This was the result of improved initial margins and improved shrink results, offset partially by increased freight costs. Our initial margins improved based on better managed markdowns and increased importing over prior year. Additionally, we had a favorable sales mix among our categories, principally as a result of the shortfall in the rider and emergency response categories, which tend to have gross margin at below chain average.

SG&A, net of the $2.6 million FAS 123R stock option expense as a percent of sales, was slightly favorable compared to prior year. FAS 123R expense was higher than previous guidance as the result of additional stock option grants for new employees and restricted stock grants under our Board compensation program. We expect FAS 123R expense to be approximately $0.07 per diluted share in the second half of the year.

In the quarter, we recognized revenue of approximately $1.3 million from revising our estimation for unredeemed gift cards. The revision is consistent with prevailing retail industry treatment. This was a non-recurring charge and should not be reflected in the back half of the year. Additionally, SG&A benefited from the shift to marketing into Q1 of approximately a million 2, which was discussed on our last conference call.

Although we leveraged overall SG&A for the quarter, excluding the stock option expense, we did not leverage store operating expenses as much as we had anticipated, as a result of the weak comp sales and the significant growth in the less productive new store base. As discussed on previous calls, we do not anticipate leveraging store personnel and occupancy this year, which will continue in the second half of the year. That said, we were pleased with the leverage that we received from our four-wall distribution center costs, our store support center, marketing, as well as our field management group, as we efficiently integrated our new stores into our network.

Pre-opening expense was consistent on a year-over-year basis as we opened 17 stores and relocated six stores compared to 19 new stores and two relocated stores in the prior year. Pre-opening costs were approximately $2 million, including lease expiration costs for relocated facilities. On a per-store basis excluding the lease expiration cost, pre-opening was approximately $80,000 per store, which is consistent with our new store opening program.

Interest expense for the quarter is up year over year, primarily as a result of additional borrowings for seasonal build-up of inventory, increased borrowing rate over last year, and accrual of interest related to the settlement of federal income tax and state sales tax audits. Our effective tax rate was at 37.1% compared to 36.2% in the prior year. The increase in tax rate resulted primarily from the non-deductibility of certain stock option expense pursuant to FAS 123R.

Now looking at the balance sheet, our inventory levels on a per-store basis, excluding Del's and including some unopened stores that were carrying inventory, increased approximately 6%. This results from several factors. Of our new stores that we opened over the past one-and-a-half year, generally they have been bigger, and they include the expanding [sic - see Press Release] clothing sets. The new stores on average have a higher inventory carry. In the same vein, we've rolled out 165 of expanding clothing sets since last year. These stores have net $30,000 of inventory increase compared to those stores without the expanded set. We're also absorbing some inventory in our supply chain from the new DC that opened in Waverly, so that had an impact on inventory for the quarter. Additionally, we've had -- we have associated freight increases and commodity-based increases that translated into higher inventory amounts.

We've discussed in the past of we are in year one of the implementation of E3 forecasting replenishment software, which we believe provides better upfront flow of merchandise. As Jim has mentioned, we are better overall in stock position and are better positioned as we move into the Fall set, especially given the difficulty in meeting demand last year for heating-related product.

Based on our inventory turns calculation, on a cost basis we had a slight decrease in the first half of the year of nine basis points. We have a stated goal of 15 basis point annual improvement,. And as a result of soft sales in Q2 and the points mentioned above, we expect turns to be slightly off our stated goal on a full-year basis compared to prior year. We did experience a decrease in accounts payable financing of inventory from approximately 52% down to 45%. This reduction is the result of the reduced turns and increased direct imports supported by letters of credit.

The year-over-year increase in net property and equipment principally results from investment in new stores. The capital expenditures for the first half were approximately $43 million. We're tracking generally at the high end of our guidance of $80 million. Additionally, we have better visibility on our hardware requirements for our POS implementation. We now anticipate rolling out hardware to the stores in advance of our POS implementation next year. Therefore, we project there'll be an incremental increase to our CapEx for the year of approximately $16 million. That will bring us, our expected CapEx, to run approximately $96 to $98 million for the year.

Now turning to full-year guidance, we stated in the release that because of our sales levels in the quarter we now anticipate net sales for fiscal 2006, which again is a 52-week year, to be in the range of $2.340 billion to $2.380 billion. This compares to our previous range of $2.350 billion to $2.4 billion. Included in our sales projection is a comp-store sales increase of approximately 2% to 3%, which compares to our previous guidance of 3% to 4%. Our updated guidance now represents an increase of 3.2% to 15.1% over fiscal 2005, which was again the 53-week fiscal year.

Our new store opening projection has not changed, and we continue to target opening 78 to 80 new stores and relocating another 19. Our previous bottom line range reflected net income of $95 million to $99 million and earnings per share of $2.32 to $2.39 per diluted share, which included stock option expense. As highlighted in the press release, our stock option expense projection for the year has increased and will now total $0.14 per share for the full year, which is $0.03 higher than we had originally projected. We now anticipate being at the low end of our previous range as adjusted for the additional $0.03 in stock option expense. This is primarily due to lower sales in the second quarter, which is typically our most productive quarter with respect to SG&A leverage. We will also be impacted by higher than expected freight costs in the back half of the year due to increased gas prices.

Additionally, I'd like to remind you that in the back half of the year we are also being impacted by planned higher SG&A costs, including personnel, as we continue to invest in the business and build out our future leadership team. We will have the leveraging of SG&A, specifically occupancy costs, in the second half of the year due to both the significant increase in the new stores in the first half of the year, which are less productive than our mature stores, and the impact of one less sales week in the year. We will also continue to have a higher effective tax rate on our earnings as a result of FAS 123R adopted.

And with that, I'll turn it back over to Jim.

Thanks, Anthony.

Though our sales are soft for the quarter, we understand the basis for the current comp sales environment and are proactively taking action to return to a more normalized level of comp sales production for the remainder of the year. We plan to do this by introducing a number of product launches in the third and fourth quarters. We frankly have a great pipeline for the second half.

As example, we'll be launching the first 13 SKUs of a private brand premium quality tool line, [Master Hand]. The first categories to be launched will be handheld power tools and mechanics' tool cabinets. Prespexa and the performance of this product is set to meet or exceed leading national brands, and they'll be priced at about 80% of the prevailing national brand of retailing, retail. While we recognize it will take time to build the Master Hand brand, we are excited to bring this valuable new product to our customers. In time, we believe that Master Hand has the potential to expand to over 100 tool SKUs for Tractor Supply over the next few years.

Another new product launch that we're excited about is the introduction of C.E. Schmidt footwear line this year. There'll be four lines and a full-size range of SKUs. Now the value and features of this line are really very compelling. Additionally, last week I had a chance to review our Q4 gift and clothing sets and was very pleased with the assortment and the value that we'll be offering. Our expanded clothing sets performed very well in Q2, and we are rolling this department out to an additional 80 stores in the second half, and by yearend we expect to have approximately 270 stores with the expanded clothing set. We're also testing a set that will fit into smaller stores, in about ten or so stores, as part of that 80-store test. Pending their success, it will expand ultimately the number of stores that can go to market with the dramatic new clothing assortment.

As you can see, we're accelerating the pace of change and are very cognizant of the pressure on the low end of our customer base. Having said that, we're going to adjust our assortments, our in-store inventory on certain products, in response to the slowdown in big-ticket sales. We believe these efforts will drive both our sales growth in the later half of this year as well as prepare us for any continued consumer shopping pattern pressures.

Q3 and Q4, I would note, are not nearly as driven by big-ticket items as Q2 is. We believe this will also help mitigate the trends we saw in the second quarter. Additionally, we are reviewing our promotional calendar and item selection for the remainder of the year.

Despite headwinds that we face in the quarter, we continue to invest in key growth initiatives, as we've outlined previously, and we have remained firmly on-track to execute against our opportunity. Specifically, we've continued to invest in a new-store opening strategy, both in site selection and in our real estate teams. We are hiring for the future, and the store management pipeline is as strong as ever. We've also been building our leadership team and our bench strength. We continue to make progress on our growth strategy and recognize that we need to enhance our infrastructure to properly support our long-term growth.

With that in mind, we've recently hired Steve Braun to spearhead our multi-channel initiative. Steve has just completed a rigorous orientation program and is currently working on the details of our multi-channel strategy. We'll have more information to share with you and discuss in detail at the end of this quarter. What I can reiterate now is that the Tractor Supply store will be at the center of our multi-channel initiative. We continue to believe that one of the greatest value-adds we can create with multi-channel will be helping our stores become more efficient at special orders while concurrently reaching a broader customer base through both the Internet and catalog. We'll be offering both our current and new customers access to our products, the endless aisles of our DCs, and the expanded list of availability through our vendors.

We also plan on having a director of global sourcing join our company on August 1st. The new director of global sourcing and Steve join a solid team of new additions, including Alex Stanton and Roger Hartley that we've previously announced. Each of these executives brings extensive experience within their fields and provides added depth to our leadership team.

We've also been making great progress with Del's. In addition to the reset activity I previously mentioned, we are pleased with Del's sales performance. Last month I met with all of their store managers. They're an enthusiastic and customer-centered team. They've embraced the transition to Tractor Supply and are very excited about our collective future.

Look at the broader picture. Despite the current challenging comp environment, nothing has fundamentally changed in the industry or the lifestyle that we serve. We still view ourselves as in the third inning and strongly believe that our proven strategy, superior business model, favorable long-term trends combine to form a compelling business proposition with significant opportunity for sustainable growth. We remain on track to meet our long-term objectives, with a plan in place to reach 1,300-plus Tractor Supply stores. The core infrastructure's in place to reach that objective. More importantly, the demographic trends that are driving our business continue to support our business model, are still strong, continue to expand. We remain committed and enthused by executing against our strategy both in the second half of this year and for the long term.

This last week we held our summer leaders meeting with the top 70 team members from the field and the top 70 from the store support center. The meeting was very productive, and everyone left energized and geared up for the balance of the year. We are ready. We are focused. And, frankly, I look forward to our next call. But before that, we will open the floor for our questions-and-answers.

[OPERATOR INSTRUCTIONS]

Our first question is coming from Edward Yruma of J.P. Morgan. Please go ahead.

Hi. Thank you for taking my question. You know, understanding and I know you've made some comments about repositioning your merchandise mix, given some of the concerns with the lower-end consumer. Should we then extrapolate and can we expect markdowns for certain types of merchandise categories, particularly lower-end riders?

No. Actually, our rider inventory, Edward, is in great shape. I believe, Jerry, we are actually below LY or below plan?

Significantly below last year, Jim.

We're actually below last year, so we're in great shape. And as I mentioned, even though our inventory's up 6%, we face no markdown pressure as a result of the inventory, nor do we face any as a result of any action we have to take due to consumer shopping pattern shifting.

Great. And can you talk a little bit about the advertising strategy going forward? I know you've kind of talked about some changes you're going to need to drive store traffic. Was the "call to action" at the end of your current advertising campaign not as successful as you had hoped? Or what can we expect to see kind of going forward?

Yes. Frankly, our current television campaign, which we ran for the 8- or 9-week flight this Spring and will be repeating for a 7 or 8-week flight this Fall. We got the -- the research is back. That -- the TV ad is really broken into -- the 30-second ad is broken into two parts. The first 23 seconds are about the lifestyle and stopping consumers, getting their attention, and that piece of it. The creative part of the ad,has received absolutely rave reviews, some of the best scores I've ever seen. The seven-second tag at the back I was not happy with, frankly, and we are revising that as we speak. At the very end, the last two weeks of the cycle, we tried something different on the specific -- actually we specifically offered a compelling value using a Tractor Supply gift card on premium pet food, and that two-week flight proved to much more responsive than what we had done earlier in the cycle.

So as a result, yes, your answer is correct or your assumption's correct. We are going to be revising that. And on print, we are -- we measure print very rigorously. We are now working through item selection in light of consumer patterns.

Great, and my final question. Could you give us a quick update on the performance of your California stores? Have the economics there been impacted, given the [sem] miles and kind of the rising gas prices? Thank you.

Sure. Yes, California, as we said before, is a very long supply chain, and most -- we've actually, as a result, we have recently moved the California stores from Waco to Waverly, which is a little bit closer, 150 miles, a bit closer on average -- allowed us to mitigate some of that. But California continues to perform well. It is dry in California right now, so we understand the impact in those, currently seven stores.

Great. Thank you.

Thank you. Your next question is coming from John Murphy of William Blair. Please go ahead.

Good afternoon.

Jack.

Before some big picture questions, just on the guidance. Just want to make sure I'm reading it properly. The prior guidance was $2.32. The incremental option is $0.03, so at the low end $2.29. That's the starting point?

That is correct. Your math is correct.

And then the tax rate, what would be the applied tax rate on that, roughly this 37 number?

This 37.1?

Yes.

Applied tax rate on --

On the guidance.

That is -- it's 37.1 for the remainder of the year.

All right, great. And then on the CapEx, given the boost from the point-of-sale spending, should we anticipate that the CapEx in 2007 would fall in absolute dollar terms because of that being sort of a one-time jump?

Yes. Relatively, the CapEx, the POS, you're correct. We will have some additional CapEx in 2007 related to the multi-channel e-commerce, but it should not be in the $16 million range. So there should be a reduction. So as we move forward, we're at around the $80 million mark. Our store expansion will increase and we'll have multi-channel, but I would expect to have a reduction from the $96 to $98 million that we're incurring this year.

Great, great. And then on the outdoor power equipment and the ride-on mower business, could you talk about how when you look in the data how you get comfortable about the macro impact versus the competitive impact? I mean I understand that you see it at the lower end as opposed to higher end. But looking at some of the big home improvement players, where they're expanding, any chance that that had an impact, and just when you look in the numbers what you see there?

Yes, Jack. On a weekly basis all year, each of us here, as we're receiving a report that shows us the unit dollar margin -- which relates to mix, obviously -- results by market, those cut markets, having neither lows nor [degoal], markets having either one of the two, markets having both. And frankly, through the first 26 weeks of this year and particularly in the important Q2, there was virtually no difference. I guess the widest gap was about a 2% -- a 2% lift and a 2% Del's, and the best-performing markets were those that shared, shared a market with both.

All right, all right. That's helpful. And a final question is just when you look at progression of the comp, could you talk about that, how it went through the three months of the quarter and then how the July period's looking?

Generally we do not give that guidance by month through the quarter. But we did -- we had commented that last year in April we were comping against a very strong comp period in '05 for April and had given some indication that that would be the weaker of the three months.

Okay. Thanks.

Thank you. Your next question is coming from David Cumberland of Robert Baird. Please go ahead.

Thanks. Hello, everyone. How did the earnings in the second quarter compare to the internal plan?

Well generally we don't give information about the internal plan. Having said that, we did expect, as I said in my statement, that it is a quarter that we tend to leverage SG&A, and our expectations were to leverage it more than we did. So relative to that piece, we fell short from our internal plan.

Understood. And then on the gross margin improvement, you cited several drivers. Was the contribution roughly equal on those? Or did one or two of those account for most of the increase?

Again, we tend not to get that granular and give specifics. Each one that was mentioned was a significant factor relative to the margin. So I wouldn't say they were equal, equally weighted, but they were all impactful.

And then finally on the benefit from the gift cards, had that been factored into the guidance provided at the start of the year?

No, it wasn't.

That's it. Thank you.

Thank you. Your next question is coming from Dan Wewer of Raymond James. Please go ahead.

Dan.

Thank you. Appreciate giving the same store sales trends by region. Curious if you could also talk about new store productivity in the midwestern states, the stores being supported by the Waverly, Nebraska distribution center, and if those are running in the same level with your other regions.

Well again, we tend not to refine it to that extent. We have discussed that generally the stores in that region are lower volume stores and will be less productive. As a whole, the new stores are trending as we would have expected, and based on our approvals through our Real Estate Committee. So we are trending based on expectations; however, generally that region of the country will have lower-volume stores and will tend to be less productive than chain average.

Okay. Anthony, a second question, or Jim. You'd mentioned that you expect to lever SG&A more than you had achieved. Is that due to the shortfall in the same-store sales growth? Or if you look at the dollar per store, let's say, did that come in higher than what you had wanted?

Yes, it clearly came from the comp-store sales shortfall.

Okay. And then the last question I had, trying to understand the occupancy expense trends. So rents are increasing because you opened the stores earlier in the year. And then as I also recall, during the first quarter the front-loaded store openings added about $0.03 in pre-opening expenses as well during that quarter. I'm just trying to figure out. When does the payoff materialize from opening stores earlier in the year?

I think there's clearly the payoff by opening them up earlier because we have a full year of sales. And the sooner we get them to maturation, the better we are. So it's really a combination. I think it's impactful because of the new stores, but it's really, it's all the stores in the past couple years, until they reach maturity. And each store has a different rate, but generally we look at three to fouryears. So as we add these stores to the base, and continue to add at about a 13% clip, we'll tend to have it be leveraging until the comp-store base gets large enough and the comp sales increase to be able to -- generally I want to take finance that increase in the occupancy.

So it's really based more on the new stores growing to maturity.

Right.

Okay, great. Thanks.

Thank you. Yourenext question is coming from Vivian Ma of CIBC World Markets. Please go ahead.

Vivian.

Thank you. Good afternoon. Hello?

Hello.

Hi. Just a couple of very quick questions. On the quarter's traffic, am I right in hearing that it's only declined 36 basis points on a comp-store basis?

That is correct.

Okay. So it seems to me that with the, it didn't look -- the issue in on the sales side is in the seasonal items. And in the past I believe that you've talked about sometimes the sales shift from one quarter to the next. And is this, given you seem to be a bit more cautious in the sales trend in the second half of the year, this doesn't seem like -- you don't think it's some of the sales is going to shift into the next quarter? And why would you think that the customer is just not buying it ar all?

Sure. Vivian, let me -- this is Jim -- address that. The weather for the quarter was neutral. So normally when we say sales shift from one to the next, it's because weather was, for example, it was too cold or too dry or whatever in Q2. We will sell some riding lawn mowers in the early parts of Q3. What happened this year is very different in the fact that premium and zero-turn riders sold pretty much as expected. But the opening price point and mid-tier trade-up did not sell. While they do normally sell later, there may be some opportunity. But I would not look for a significant shift of Q2 business into Q3.

Okay. Of the $0.02 in the benefit that you got on expenses in this quarter, how much of that was related to just the gift, the unredeemed gift cards?

It was a million 2, which would translate to a million 3. It translates to about $0.02, and that was related to all to the unredeemed gift cards.

Okay, okay. Okay. Because I thought the $0.02 include also the advertising, but it's all related to the gift cards.

Right. The advertising we had discussed in the last conference call, that the Blue Book --

Yes, that's already in the guidance, right?

Correct.

Okay. Okay, thank you.

Sure thing.

Thank you. Your next question is coming from Matt Nemer of Thomas Weisel Partners. Please go ahead.

Good afternoon, everyone. The first question is if the macro environment stays like this longer than expected, what can we expect in terms of changes to the product assortment? Can you go, can you move deeper into the high-end and reduce low-end exposure, or what could be the plan there?

Well, a couple things. First for the second half, we'll be much, much less impacted by this consumer behavior due to the fact that big-ticket goods are much less important to us. So we have a whole half to study this. If we determine that that consumer behavior is changing even after we cycle the Katrina impact, then the answer is yes, we will change a couple things. And we [work on] having [culling] values at yet acceptable margin at a price point that would hopefully compel consumers to purchase.

Bear in mind also that some of the riding lawn mowers that we believe are outsold in the industry this year, some of that is not indefinitely deferrable. So we're not at this point in time wringing our hands over what Q2 next year may look like.

Okay. And then on the big-ticket categories, can you somehow quantify the differential in margin between your bigger ticket items and lower value-priced items, if possible?

Yes, we just normally do not get that granular.

Okay. And then, just to follow up on advertising, can you maybe give us an update on what your plans are in the second half in terms of total dollar spending? Does that change at all? And maybe how does that look year over year or quarter over quarter?

Yes, I think we -- if I recall the plan in prior year, we are pretty level by quarter for the Q3, Q4.

Right.

Okay. And the advertising as a percent of sales will be virtually the same.

Okay. And then lastly, could you give us a little bit more detail on the gift card adjustment in particular? Is that a change in breakage assumptions, or what's sort of behind that?

That was correct. It relates to breakage, and it's difficult to outline in the press release. But in the retail environment, there's been, I want to say pressure, to recognize income from breakage of the gift cards much earlier in the process. We have been the gift cards for, I guess, 2.5 years now, and have reasonable data to be able to estimate what the breakage will be. And we made that adjustment in the second quarter. So --

Is that from direction, from the direction of your auditors or internally or both?

Actually, a combination. We are aware of it. We understand that there was a lot of discussion, specifically at the end of 2005 and in a lot of articles relative to pet buying in particular. And so we understood that it was an issue, and it was just really a matter of developing enough information to have a trend line to be able to make the adjustment. So we had determined during the course of the year, after we'd given the guidance, that Q2 would be the appropriate quarter to make that adjustment.

Okay, I think that's all I have. Nice margin performance in a tough environment. Thanks.

Thank you.

Thank you. Your next question is coming from R.J. Hottovy of Next Generation Equity. Please go ahead.

R.J.

Hey, how are you guys doing? Just two quick questions here. First one has to do with the product pipeline coming in for the second half of the year. You've done a good job outlining the premium tool and the holiday assortment. But in the press release it mentioned something about an enhanced product presentation in the pet department. I was hoping you could go into a little more detail there.

Sure. Jerry?

R.J., this is Jerry. And just to respond to that, one of the things that we've done -- clearly, the fastest growing segment of our business the last couple of years has been the pet and animal segment of the business. We have completely revamped and altered the look and the statement in the pet supplies piece of our business -- and this is everything from bird, dog, cat, horse, equine, animal health-- and changed the shopping experience significantly in response to consumer feedback and focus groups that we have done collectively. We will be piloting this in the back half of this year in about, I believe it's 12 existing stores, as well as about 30 new stores. So by yearend we'll have about 42 stores that will reflect this new pet set. We believe we have the opportunity, R.J., to do for the animal categories, that are already growing very quickly at Tractor Supply, exactly what we've done with our expanded clothing sets in the clothing departments over the last year-and-a-half.

Do you have a CapEx estimate as to what it's going to take to implement this system for this year and next year?

We do, but I don't have that information with me at the present time on that, R.J.

Okay. And then my last question's more of a bookkeeping issue here. I was just trying to get a feel for the percentage of the sourced items, the imported items, as a percentage of total sales.

R.J., by yearend we will be at about 7% of our overall product mix. In terms of receipt of goods, it will be direct import from offshore. That will be up from about 4.5% last year, based on the most recent analysis that we've done of our overall product mix and sourcing assortment here.

Yes, R.J., this is Anthony. I just wanted to clarify that obviously we have a lot of conversation about that. And we reviewed and refined the methodology in the way that we monitor the imported products to make it much more easy for us to track it and report it. So we've always talked about sort of the 6 to 7% range. And when I recalibrated, we set it up at about 4.25 last year for '05, and we estimate that '06 will be about 7%. And we're still very comfortable with our long-term target of approximately 15%.

Thanks, guys.

Thank you.

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Your next question is coming from Anthony Lebiedzinski of Sidoti & Company. Please go ahead.

Good afternoon. A couple of questions. What percentage of your customers would you characterize as being on the, being lower-end customers?

Anthony, I don't have that number. We haven't determined the break. As we've mentioned several times, our average household income is around $55, $58,000. But we do know that we serve the $38,000 household income that also shops the auto parts stores and the dollar stores. I probably have that data, but I just don't have a number that I'm comfortable enough quoting at this time.

Okay, that's fair enough. And at the end of the quarter, how many stores have the new clothing sets?

It's 165.

165.

We'll end the year around 270 or so.

Okay. And you mentioned earlier regarding your inventory, you gave some metrics there. What would you say was your inventory on a per-square-foot basis, as you take into account that you're building out bigger stores now?

We tend to not do it by per square foot. The square footage grew very similarly to the new store unit growth in the first half, and on a per-store basis the inventories are up 6 %. So that would be generally consistent. I mean that would be your evening-out denominator as far as getting it to a per-store basis. Then you can just do the math on the square foot.

Okay. And then you mentioned a couple of new product areas where you're going to expand in the second half the power tools. And are you going to also offer any branded products, as well? Or are the new products really focused on private labels?

Anthony, this is Jerry here. One of the things that we did roll out in the first half that was very successful for Tractor Supply was the Husqvarna line of outdoor power equipment, two-cycle outdoor power equipment. It's been certainly a bright spot for us in some of the big-ticket categories. Again, that was a new initiative that will be benefiting sales throughout the entire second half because that was only rolled out in March of this year. So we are not turning a blind eye to opportunities with brand name product categories. It just happens to be that two of the major initiatives in the back half are in private label.

Okay, got it. And then as far Del's, I mean right now you have about 17 stores there. I mean now that you've had Del's for several months, what do you think as far as the expansion opportunities are in that second concept for you?

We still -- we have reopened one store. We opened -- we bought 16, we -- there was a store in Maui, Hawaii that we did not take. We reopened that store at the very end of Q1. It's performing well. We continue to plan to open another two stores between now and end of year, and then we will assess those. Those will be in markets that are contiguous to where Del's is today. The next test is a couple stores that are a ways out, where there is no halo effect of the Del's brand. So what we need to understand in both of those scenarios is how fast does the store take share and spool up the profitability. The answer to that question will then determine the speed at which we expand the chain.

And lastly, as far as the private label products, what is that as a percentage of sales? And are you still on track to do, to expand that to about 25% in a few years?

Anthony, again this is Jerry. We're currently at about 18% of our retail sales that are either private label or what we call "control brands." It's exclusive to Tractor Supply, and the goal is still to grow that over the next five years to 25% of our product mix.

Okay, great. Thanks.

Thank you. You next question is coming from Mike Wilcox of Banc of America. Please go ahead.

Hi. Thank you very much. Congratulations on a good quarter. Just kind of curious if could elaborate a little bit more on what you're seeing on a sales trend basis, and sort of what the 2 to 3% comp guidance implies in terms of acceleration in the back half. Then I might have a follow-up after that.

What we saw during the quarter again was driven by slightly down traffic, slightly up ticket, very, very definitive trends on any categories of big-ticket goods where there was a good, better, best, premium or branded product. And the pressure again was at the opening price point and the first step. And we saw that. We saw that behavior not only in the riding lawn mowers, as we mentioned, but other large-ticket categories like air compressors, as an example. And we'll watch and see how that augers in Q3, Q4, and adjust. We are adjusting on some expectation of that as we speak.

And then just maybe one or two follow-ups on that. Are there any calendar shifts to consider for comps, like the Easter shift in the back half? And what is sort of the impact of a 52- versus 53-week comparison?

Yes. I have looked at the next quarter and actually the second half. I do not believe that there is any comp adjustments other than that, obviously the 53rd week. So I don't think -- I think we're on a comparable basis.

And the second half of the question?

What's 53rd week impact on bottom line in this.

Yes. It represents about -- it looks like it's a 2% hit on sales, and therefore we generally will translate that at the 20% index. So it could have bottom line impact in that range.

So a back of the napkin calculation.

Going into a December, generally most retailers will track expenses on a monthly basis, and therefore an additional week provides significant leverage in that particular month and quarter.

Okay. And then just finally, can you talk I mean a little but about the gross margin sustainability that you've seen in the first half, and how your outlook for higher freight is sort of factored into your margin outlook?

Mike, we expect to continue to grow our gross margin as a result of many of the initiatives that Jim and Anthony spoke about earlier. Heavy dependence in the back half on expanded assortment of import goods that will continue to expand our margins. Doing a lot with pricing optimization. The marketplace is very dynamic right now in terms of pricing pressure that manufacturers are experiencing. So we as retailers are also seeing pricing adjustments pressure upward there. So lots of focus in that regard. A lot of pressure on the P&L as a result of the freight expense that we mentioned earlier, so we're very focused on making sure we've got that covered.

Mike, this is Anthony. Relative to the back half, I think the trend that you see where the majority of our EBIT margin enhancement has been coming from gross margin versus the SG&A leverage. And I would say that that trend will continue as we move into the back half of the year.

Okay. Thank you very much.

Yes. We have time for just one or two more questions.

Thank you. Your last question is coming from Joan Storms of Wedbush Morgan. Please go ahead.

Hi, Joan.

Good afternoon. Hey Jim, can you just go over on the TV ads again, in the "call to action," exactly sort of what you were putting on the back of the ad at the beginning of the run and then -- and how you fixed it and where you might be going with that in the future?

Sure. The first cut, the first cut we had was a series of a broad assortment of product categories. The attempt there was once we had gained the consumer's attention -- which, as I mentioned, we did -- show them a breadth of category and a breadth of product so that we truly represented or offered an assortment of products and categories for the [outgear] lifestyle. We used that for really most of the event. And then at the back end we shifted to a "call to action" where we said buy any -- I think our cut was any dog food, any premium dog food at a retail price above $20 ,and get a Tractor Supply gift card through the mail, which was obviously some breakage, for $10. And that had a very different level of performance, and frankly acceptable levels of breakage, to make the whole thing work, as compared to what we had done in the front.

The great thing about the seven-second tag is that we actually can produce that as late as three weeks prior to the run time. So next -- our next on-air time is early Q4. And we're beginning to look for the -- continue to discuss what the product will be, and I think even more importantly perhaps, what the offer will be in that seven-second close on the 30-second ad.

Okay, so it's selling the beginning when you were showing the breadth of product. You weren't necessarily -- were you offering sale prices on that, or--?

No, no. It was not item price. It was just --

Look at all the stuff we have.

Yes, exactly.

Okay. Okay, great. Thank you very much.

You're welcome.

Okay, well thank you all very much. Again, we are a company used to having just terrific, significant comp-store sales increases. We are not giving up on that. We're excited. We've got some plans that are in the pipeline. We've had, as you can imagine, a tremendous amount of conversation about what, in the rearview mirror. We've learned what we could do differently, how that applies to the second half; and importantly, how that goes into our planning for Q2 next year. We are still in only the third inning. We're excited. We're aligned and ready to go. So thank you for being with us. It's been a great trip and we're just beginning. So look forward to talking to you all in next quarter. Thank you very much.

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