Tractor Supply Company (TSCO) Q3 2022 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen, and welcome to Tractor Supply Company's Conference Call to discuss Third Quarter 2022 results. [Operator Instructions] Please be advised that reproduction of this call in whole or in part is not permitted without written authorization of Tractor Supply Company. And as a reminder, this call is being recorded. I would now like to introduce your host for today's call, Mrs. Mary Winn Pilkington, Senior Vice President of Investor and Public Relations for Tractor Supply Company. Mary Winn Pilkington, please go ahead.

Thank you, operator. Good morning, everyone. Thanks for taking the time to join us today, and I hope everyone is doing well. On the call today are Hal Lawton, our CEO; Kurt Barton, our CFO. After our prepared remarks, we'll open up the call for your questions. Seth Estep, our EVP and Chief Merchandising Officer; will join us for the question-and-answer session. Please note that we've made a supplemental slide presentation available on our website to accompany today's earnings release. Now let me reference the safe harbor provisions under the Private Securities Litigation Reform Act of 1995. This call may contain certain forward-looking statements that are subject to significant risk and uncertainties, including the future operating and financial performance of the company. In many cases, these risks and uncertainties are beyond our control. Although the company believes 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, and actual results may differ materially from expectations. Important risk factors that could cause actual results to differ materially from those reflected in the forward-looking statements are included at the end of the press release issued today and 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 statements will remain operative at a later time. Tractor Supply undertakes no obligation to update any information discussed in the call. Given the number of people who want to participate, we respectively ask that you limit yourself to 1 question. If you have additional questions, please get back in the queue. It's now my pleasure to turn the call over to Hal.

Thank you, Mary Winn, and thank you to everyone for joining us this morning. On behalf of Tractor Supply, I'd like to extend our deepest sympathies and support to our communities and team members impacted by Hurricane Ian. Our store teams, our distribution centers and the store support center have done a tremendous job supporting our customers and communities during this tragic time. The team's dedication at times like this helps make us the dependable supplier our customers can count on. I'm thrilled to report that just over a week ago on October 12, we closed on the transaction to acquire Orscheln Farm and Home. We welcome the Orscheln team to Tractor Supply. We're very pleased with the 81 high-quality locations that will be converted to Tractor Supply over the next 15 months. While agreeing to the remedy with the FTC took longer than we anticipated, the outcome is in line with our expectations. We are committed to providing customers in the Midwest region with an expanded product assortment, a meaningful loyalty offering and enhanced digital shopping experience and so much more that Tractor Supply is able to offer. Two and a half years have passed since COVID emerged in the United States. With this quarter's results, we have now posted 10 consecutive quarters of exceptional sales growth. And from my perspective, the highlight of this impressive track record continues to be the consistency of our results and the broad-based strength of our performance. Our 3-year comp sales stack in the third quarter was approximately 46%, in line with the second quarter. And including new stores, our overall revenue growth on a 3-year basis has increased 65%. Our addressable market continues to benefit from numerous secular trends that we believe are structurally sound. Additionally, by all measures, we are gaining substantial share in our market. We've had tens of millions of new customers shop us, the past 3 years. We've retained the majority of these customers and have a substantial portion have become active members of our Neighbor's Club program. I commend the team for stepping up to every challenge that has come at us over this time period. They've done a tremendous job, maintaining their focus on the factors that we can control and all the while expanding our competitive moat through the advancement of our Life Out Here strategy. We continue to operate in an ever-changing and challenging macro environment, which convey for a new recession, but from our view real economic growth in the near to medium term will remain flattish and tepid. On the positive side, a great sign is that we're seeing moderation in supply chain bottlenecks. However, inflation remains persistent and elevated and we anticipate this to continue well into 2023 with some moderation in the back half of 2023. At the same time, the labor market continues to remain very constrained, and we expect that this will remain the case for the foreseeable future, particularly on the front line. And as we move into next year, the labor market will be a key determiner of our country's ability to return our economy to sustainable conditions. Turning to our third quarter performance. The Tractor Supply team delivered another quarter of record results. with net sales of 8.4% growth. Comparable store sales increase of 5.7% and diluted earnings per share of $2.10. Our business continues to be incredibly resilient, and the quarter unfolded much like we anticipated. Now let's go through some of the highlights for the quarter. Our comparable store sales growth was driven by strong ticket growth of 7%, partially offset by a transaction count decline of 1.3%. As we shared entering the quarter, we anticipated that the drought would take some of the upside potential off our sales performance, and that was exactly how the quarter played out. By our estimation, less favorable weather negatively impacted our comp sales by about 150 basis points. As the drought and the heat conditions abated, we exited the quarter with strong momentum. All months of the quarter comped positive. August comp sales were stronger than July and September was the strongest month of the quarter, and we had flat comp transactions in the month of September. E-commerce achieved sales growth in the high single digits, and we continue to build out our ONETractor capabilities. During the quarter, we added an app features such as My Pet and upgraded our in-store mode. And we also rolled out inventory quantity visibility at the store level across all our digital properties. For the sixth consecutive quarter, we continued to see our consumable, usable and edible products outperform our overall comp sales results. And this is the third consecutive quarter for C.U.E. to run at about 3x the rate of our overall comp sales performance. This strong performance was driven by dry dog food and feed for poultry, equine and wild birds. C.U.E. continues to be one of our structural advantages. And these products represent the strength of our core business and what drives trips and footsteps into our stores. Our outperformance in year-round categories offset the declines in our late spring-summer seasonal product and big ticket categories. We continue to gain share across all our categories, both in-store and online. Our Neighbor's Club membership this quarter exceeded 27 million members, and it represented nearly 75% of our sales for the quarter. Neighbor's Club continued to successfully help migrate customers up in their spending with us. And during the quarter, we reached an all-time high in high-value customers. In August, we rebranded Petsense to Petsense by Tractor Supply. In August, we also rolled out the Neighbor's Club program to Petsense by Tractor Supply stores. This expansion will deepen relationships with our existing customers and helped attract new pet customers to both banners. And while it's early, we are very pleased with our customers' response to these initiatives, with our Neighbor's Club membership already representing over 35% of sales at Petsense. For the third consecutive quarter, our overall customer satisfaction scores hit a new all-time high as we continue to invest in our team to provide best-in-class customer service. We ended the quarter with our inventory in great shape. As we said many times, if anything, we'd like to have more inventory. And we're now working hard to grow inventory in targeted categories to improve our in-stock position and serve as that dependable supplier for our customers. We continue to stay true to our EDLP routes, and our promotional activity in the third quarter was below the prior year's third quarter. We've made significant progress in our Life Out Here strategy. We now have over 500 stores that are in our Project Fusion layout and our Garden Center transformation is now active in over 260 locations. We continue to be pleased with the strategic benefits and financial returns of these store level investments. Given our performance through the third quarter, our acquisition of Orscheln Farm and Home and our outlook for the fourth quarter, we are raising our sales and earning guidance for 2022. Kurt will share more details on our improved outlook later in the call. Stepping back, Tractor Supply is a unique, highly differentiated retailer. Our resilient need-based business model has a proven history of growing through vary economic conditions. Our customers and team members are dedicated to the Out Here lifestyle, and they prioritize it as it is their authentic lifestyle. Our customers over-index as homeowners, landowners, pet owners and animal owners. We believe that the structural macro trends that have been benefiting us are long term and sustainable. And as the market leader, we have substantial advantages and continue to gain share. The investment in our Life Out Here strategy is reaching critical mass and furthering our competitive advantage. Simply said, Tractor Supply has never been stronger. And with that, I'll now turn the call over to Kurt.

Thank you, Hal, and hello to everyone on the call. Our business continues to be incredibly resilient. This is a business that was built for all economic environments with stability in both revenue and earnings over multiple decades. Comparable store sales have been remarkably consistent across all 3 quarters year-to-date. All regions of the country once again delivered positive sales comps. The geographic diversification of our store base worked to our advantage this quarter. The South Atlantic and Mid-Atlantic were our best-performing regions. As expected, we did experience softer performance in select regions of the country impacted by the severe heat and drought in particular, in the Far West and Texahoma regions, which, while positive, lagged the chain average. For background, July was the second hottest in 30-plus years. And during August, about 40% of the U.S. was under extreme drought conditions. As Hal shared, we believe that the less than ideal weather weighed on our transactions as well as our big ticket sales. Much like the second quarter, retail price inflation contributed about 12 points to our comparable store sales as the team continues to navigate the ongoing cost pressures across the supply chain. The comparable average ticket growth of 7% benefited from inflation, partially offset by declines in big ticket sales and average units per transaction. Big ticket sales performance, while positive on a 2-year stack was impacted by the severe drought and cycling 2 hurricanes in the prior year. We saw the largest impact in categories such as generators, 0 turns and trailers. Moving on to gross margin. For the third quarter, our gross margin declined by 32 basis points to 35.6% of sales. Our price management actions and our other margin-driving initiatives were able to offset the pressures from cost inflation and higher transportation costs. With the continued robust growth in our C.U.E. categories, we saw pressure on our gross margin as C.U.E. runs below chain average on gross margin rate. In regard to inflation, while moderating, we continue to see increasing costs in the commodity inputs in our product categories, as well as underlying variables like higher labor wages and transportation costs impacting both us and our vendor partners. We have remained agile and nimble to manage all the complexity of today's environment, effectively managing cost increases at the SKU level through our price management actions and other margin driving initiatives. The team has also been working to capture efficiencies in the supply chain to reduce miles continuing to limit promotions and leaning into the more efficient value provided through Neighbor's Club. SG&A expenses, including depreciation and amortization, increased 9% to the prior year's third quarter. As a percent of net sales, SG&A expenses increased 16 basis points year-over-year to 26.3%. This increase was in line with our expectations, primarily attributable to our strategic growth initiatives, including depreciation and amortization; and hourly wage and benefit investments in both our stores and our distribution centers. These items were partially offset by a moderation of COVID-19 response costs, more normalized incentive compensation and leverage in our occupancy and other costs from the increase in comparable store sales. Diluted EPS was $2.10, an increase of 7.7% from the third quarter of last year. Our balance sheet remains incredibly strong. At the end of the quarter, merchandise inventories were $2.7 billion, representing a 19.2% increase year-over-year in average inventory per store. The increase reflects growth to support the robust sales trends along with the impact of inflation. Looking at our inventory growth on a 3-year stack, it represents a 30% increase in average inventory per store compared to Q3 2019, meaningfully below our sales increase over the same period of time. There continue to be select product categories where we are still pursuing inventory, especially in C.U.E. Stepping back, we believe our inventory position is in good shape. Our strong balance sheet and the consistency of our free cash flow continue to be a position of strength for Tractor Supply, allowing us to invest in the business for growth and return cash to shareholders. To further our financial flexibility, we just entered into a new 5-year credit agreement on September 30 that increases our senior credit facility from $700 million to $1.2 billion. We also added 2 new banks to our banking group, including a minority-owned bank. Moving now to our updated guidance for fiscal 2022. Our updated guidance reflects the strong results for the first 3 quarters of the year and the positive momentum we see in our business continuing into the fourth quarter. In addition, we are incorporating the impact of our recent acquisition of Orscheln Farm and Home. We are forecasting fiscal 2022 net sales of $14.06 billion to $14.12 billion including about $75 million in sales from Orscheln. This is the first time in the history of our company that annual sales are forecast to be above $14 billion. Comparable store sales growth is anticipated to be in the range of 5.4% to 5.8%. For the year, we now forecast an operating margin of 10.1% to 10.5% in line with our prior guidance, but with modest pressure from the acquisition as the sales and earnings benefit from Orscheln Farm and Home are offset by incremental transaction expenses and early integration costs. We anticipate the impact of Orscheln to be relatively neutral to operating income, while we expect a modestly negative impact on net income due to the interest expense associated with funding the acquisition. Diluted EPS is now forecast in a range of $9.55 to $9.63. This compares to our previous earnings range of $9.48 to $9.60 per diluted share. We entered October with momentum. With this updated guidance, we are forecasting comparable store sales growth for the fourth quarter of 5% to 7%. We now expect to open approximately 60 to 70 new Tractor Supply stores, which is modestly below our outlook as we entered the year. We continue to be on track for 10 Petsense store openings in 2022. Given the conditions of the real estate and construction industries, the cadence of store openings for Tractor Supply has shifted a number of the openings into the fourth quarter. I give the cross-functional teams a lot of credit for completing over 250 projects this year as they lay the foundation for 2023 and beyond. Our new store pipeline continues to be solid and we expect to improve the cadence of openings in 2023 with more balance throughout the year. We remain committed to returning cash to shareholders through the combination of growing dividend and share repurchases. For 2022, we remain on track for anticipated share repurchases in a range of $750 million to $800 million. As is customary, we will provide our full guidance for 2023 at our fourth quarter earnings call. We are early in our planning cycle for the next year. I thought it'd be helpful to set the stage and share some preliminary insights and color into our thought process, given that there are a few moving parts between 2022 and 2023. Our business model has stood the test of time and has proven to be resilient. We have significant confidence with 2023 on the horizon. We are well positioned for any consumer and economic environment. Further, we have consistent structural trends that will continue to benefit us. We continue to invest in our Life Out Here value strategy to capture this growth. Now the discrete items that impact our earnings in 2023 are the lapping of the 53rd week benefit this year, and the accretion from Orscheln acquisition. As I've shared previously, we forecast that the 53rd week will add approximately 1.5% growth in net sales and about $0.15 to the EPS this year. As you saw our press release earlier this month, we expect the Orscheln acquisition to be accretive to diluted earnings per share by at least $0.10. When adjusting for the 2022 benefit from the 53rd week and the accretion from the Orscheln acquisition, we plan for 2023's performance to be consistent with our long-term EPS guidance of 8% to 11% with our bias at this point in planning towards the midpoint of our range. Despite what might play out with the economy, this needs-based demand-driven characteristics of our product offering support our ability to deliver on our long-term outlook. We are making great progress towards our long-term financial goals, and we look forward to sharing with you our 2023 plans in more detail at our fourth quarter earnings call in January. Now to wrap up, we are continuing to separate Tractor Supply from the competition. In prior cycles, we have made investments that strengthened the company. We believe the current environment is an opportunity for us to lean into our strengths and further expand our lead for years to come. And with that, I'll turn the call back over to Hal.

Thanks, Kurt. Tractor Supply is a business with momentum. As our customers prepare for cooler temperatures and the calendar shift to the fall and winter season, our stores are ready for the change. From key categories like heating and insulated apparel, our merchants have brought newness with compelling value. In our C.U.E. categories, we have the right selection and are in stock as we continue to support our customers' lifestyles. This year, we expanded our Halloween and Harvest Decor program with a great lineup to capitalize on our customers' love of decorating their homes with seasonal indoor and outdoor decor. With more than 260 Garden Centers, we're showcasing the fall harvest season with everything from pumpkins to mums, and will be ready for the transition to the Christmas holiday season with an expanded offering of outdoor decorations. Despite the economic outlook, we are optimistic about holiday-related sales. From the calendar perspective, it's a good setup with 30 days this year between Thanksgiving and Christmas, with Christmas falling on a Sunday. We have a strong day after Thanksgiving game plan and compelling offers planned throughout the season. Given the increasing financial constraints facing American consumers, we're excited in the coming weeks to introduce the Tractor Supply Visa Credit Card. This new co-brand credit card will help our consumers earn more on their everyday purchases, both in-store and anywhere Visa is accepted. With the Tractor Supply Visa Card, customers receive access to all the perks from the private label TSC personal credit card that they have such as 5% rewards on Tractor Supply purchases or special financing on purchases at $199 and up, but they also will receive 3% in rewards on gas station, grocery and vet purchases and 1% in rewards on all other purchases. And all consumer card members with Tractor Supply received Neighbor's Club Preferred Plus benefits. This is exciting progress on our journey to driving sales, building loyalty and adding more value to our Neighbor's Club membership and reducing tender expense through our credit offerings. 2022 is shaping up to be another great year for Tractor Supply. With one quarter to go, we are on track to achieve several monumental milestones in the growth of our company, including annual revenues in excess of $14 billion, a store base of over 2,100 Tractor Supply locations and a highly engaged workforce of 50,000-plus team members. That said, we are not resting on our laurels. We have robust plans in place for 2023 to continue on our life out here strategic journey. As we enter the new year, the transformation of our business has significant momentum. Investments such as Neighbor's Club, our FAST program and our mobile app are at scale on providing dividends. Our store investments are reaching scale, and we have compelling new growth vectors such as the integration of Orscheln and many other opportunities on the list. With a healthy total addressable market of $180 billion, Tractor Supply is well positioned to continue to gain market share while fulfilling our purpose as a company. As we enter one of the busiest peers in retail, my thanks and sincere appreciation go out to each of our 50,000-plus Tractor Supply team members for their dedication to our mission and values. And with that, operator, we'd now like to open the line for questions.

[Operator Instructions] Our first question comes from the line of Elizabeth Suzuki with Bank of America, Merrill Lynch.

So you mentioned that you would have liked to have had more inventory, do you think that you left any sales on the table as a result of being out of stock?

Liz, thanks for joining the call. I think we're doing an excellent job on navigating inventory and managing it. We don't feel like we're leaving any sales on the table because of it. But I think we are, at times, incurring some higher cost to run the inventory through our supply chain than we might otherwise. And also just on the labor side, having to work the back room a little bit more frequently than normal. The team has done an excellent job on it. But if you look at kind of weeks of supply and kind of pallet low quantities, we would be looking to continue to add inventory in our core C.U.E. businesses. As we talked about, this is the third consecutive quarter where our C.U.E. business has performed at 3x the chain average, dry dog food running well above 20% comps and other feed categories running very strong as well. And so it's just all about keeping up with the customer and then building our supply chain for the future to make sure that we can continue to move these billions and billions of pounds of food and feed that we do every year and maintain as lower cost as possible. We're very excited about our Navarre, Ohio, D.C. opening up early next year that will give us a little more streamlined supply chain and capacity to continue to serve our customers in Life Out Here.

Our next question comes from the line of Peter Benedict with Baird.

Appreciate some of the thoughts you guys gave here, at least initially around next year. Hal, I think we can appreciate how strong your business is. A lot of uncertainties on the macro front. You alluded to that early in your comments. How do you think about -- and maybe for Kurt as well here, just the company's ability to still land in that earnings algo in the event we get a tougher economic environment maybe than what your base case is, where are the levers? How do you think about managing the business in that environment? That's my question.

Yes. Thanks for joining the call today. Good to talk with you. We feel very confident in our ability to deliver 2023 and continue to deliver on our long-term targets. If you look at the consistency of our business this year with a 5.1, 5.5 ,5.7 comp, a strong outlook for Q4, very consistent in an economy this year that you would argue really is stagflation kind of flattish, real growth, high single-digit inflation. And as we look towards next year, our expectation, it will be much of the same. What I would say -- and consequently, our business will continue to be very resilient and stable. And the other thing I would add is, as we talked about in our prepared remarks, I mean many of our investments are just now starting to reach significant scale, and we expect that they will pay substantive dividends next year. We're now at over 500 stores and our Fusion layout seeing very strong results there. Many of those will be comping for the first time next year. Same thing on Garden Centers, 260, many of those came online just at the beginning of this year. We expect they will, just like we saw in the first year class, they will have a new store kind of maturity curve like sales growth. And so we expect really strong results out of those Garden Centers as we head into next year. We've gotten much better at rolling out our remodel programs, and we've got a number of Garden Centers queued up for implementation and execution before we get to spring of next year. So we feel like the economy is stable. We -- our outlook on the economy is not much different than what it is right now. We expect our business to continue to be very resilient and allow us to deliver our long-term targets. And as I said, our Life Out Here strategic initiatives are really reaching scale now and the benefits that we've talked about are starting to kind of really add up across our store base.

Our next question comes from the line of Scott Mushkin with R5 Capital.

So I just wanted to -- you guys continue to kind of expand out your TAM and maybe I've missed it over time, but we've been coming across a lot of vet clinics in your stores. And I was just wondering what -- is that a big initiative, again, maybe I've missed it? And when do you think that can add kind of as we go forward?

Yes. Scott, it's good to talk to you today, and thanks for joining the call. The vet clinics are a core part of our fusion kind of menu. And as we go in to execute a Fusion store, we look at the existing mobile clinic activity. And if it warrants -- given the frequency of business and the customer count, if it warrants a stand-alone vet clinic, we are putting those in. And they've been very successful and are just really another value-added feature to support our pet business. As we talked about, we are gaining substantial share in pet. For the last handful of quarters, we've run 10 to 15 points above the market growth rate in pet. And even as you're hearing others talk about the pet business starting to moderate, we aren't seeing that at all in our business, and it's because we're gaining substantial share. That share gain starts with the core basics of great customer service, in-stock, the right price, strong private label brands, but then it's certainly augmented with our other offerings, whether it's pet wash, whether it's the vet clinics and our Rx solutions, which are available online. And the pet business is a strong source of growth for us, and we expect it will continue to be as we go forward.

Our next question comes from the line of Steven Forbes with Guggenheim Partners.

I wanted to focus on member trends. So Hal, curious if you can discuss any incremental learnings around retention or repeat behavior, specifically as it pertains to the 2020 member cohort as they approach their second anniversary. And then maybe just quickly comment on whether you view the 2021 or 2022 cohorts any differently?

Yes. Thanks for the call and the question. We continue to be very pleased with our Neighbor's Club program. And more broadly, our customer relationship management that we've had over the last 3 years that the Neighbor's Club rollout that we did nearly 2 years ago now -- 1.5 years ago now has exceeded our expectations. We've had tens of millions of new customers shoppers over the last 3 years and the majority of those customers continue to shop at Tractor Supply. And a majority of those that have continued to shop at Tractor Supply have also joined our Neighbor's Club program and been a big driver of our membership growth. As we mentioned in our prepared remarks, we had the highest level of high-value customers this quarter that we've ever had. And a lot of those are new customers that have grown with us over the last 2 and 3 years. And as we gain new customers also in '21 and '22, they are following that kind of continued kind of above historical average performance, both in their kind of average purchase sizes in a year, their frequency of purchase with us and also the expanding number of categories that they're shopping with us also. I think this has been a big area of success for us and it's really what's been able to create that foundation for us to have held the 65% growth in sales we've had over the last 3 quarters. I mean last 3 years. And you think about a lot of other businesses that had similar new customer growth that have given back much of that growth. And that's not been the case with us. I mean we firmly believe that the secular trends that have benefited us had are structurally sound, that the share gains we've gained are structurally sound and a lot of it has to do with our very sophisticated CRM capabilities that are far and away kind of best-in-class overall in retail and certainly in our market.

Our next question comes from the line of Chris Horvers with JP Morgan Chase.

So can you talk a little bit more about the shape of the quarter? With September 7 comp, and as we look forward, should the inflation lift moderate along the lines of the comparisons, but then traffic turned slightly positive? Or does the persistence of wage inflation lead to acceleration in the inflation stacks over the next 3 or 4 quarters as you can see it today.

Yes. Good morning, Chris, and how are you? We had -- we exited -- as we mentioned, September was our strongest month of the quarter. Outperformed relative to the overall average, obviously, and had flat comp transactions. It has -- we have had that momentum continue and even a little bit more coming into the fourth quarter here. It's certainly been cooler weather for the first month of the quarter here. And that's driven nice heating sales and insulated outerwear sales and heating fuel sales. As you know, some big businesses for us in the fourth quarter are propane and wood pellets. And just given the high energy costs that are out there, the cooler weather that's already begun, the angst that our consumers have around inflation, some of the concerns around how European energy prices might be back in the United States. We are very optimistic about how those categories will play out in the fourth quarter. And also optimistic around how the flat comp transactions in September will play out for the fourth quarter as well for us. And we feel like if you look back over the first 9 months of the year, there are numerous months where we had flat or positive comp transactions. And the ones where we didn't, you really can identify them through either stimulus in March and April of last year or whether it was the drought and heat-related activities or the delayed spring through Q1 and Q2. But if you look at January, February, et cetera and then you look at how we exited in Q3 and a couple of slices of month in Q2 where we had flat deposit and comp transactions, we feel very good that those sorts of trends will extrapolate into Q4. As it relates to inflation, we do anticipate that there will be some moderation towards the back half of next year. But if you look at our 2-year stacks on inflation and carry that into the first half of next year, we do anticipate that inflation will remain at elevated rates through at least the first half of next year. And I think that's reasonably consistent with the overall kind of macro U.S. outlook as well. But we do feel really good about our comp transactions now as we head into the fourth quarter and the momentum that we have going into the fourth quarter.

Our next question comes from the line of Scot Ciccarelli with Truist.

So Hal, previously, I think you touched a little bit on this earlier, maybe on Peter's question. And historically, you guys provided some expectations regarding the impact of your fusion remodels and side lot transformations. And now with some, let's call it, significant experience under your belt, I was hoping you could potentially update us on any other stats that you're kind of seeing out of these initiatives? Maybe any other important learnings that you've been able to conclude.

Scott, and thanks for joining the call, and thanks for the question. We continue to be very pleased with our store remodel program. And on the sales side, they continue to perform at the level of results that we articulated at the beginning of this year. So that's for a combo store that has both Fusion and side lot inclusive of a garden center. They're performing in the high single-digit lifts year-over-year kind of pre post net of control. . And when you look at a store where we've only done Fusion, they're performing in that mid-single-digit lift. And as we all know, it hasn't been in retail for decades now. When you first start a store remodel program, because you're handholding it, you're going to get a nice lift. But then as you start to scale. A lot of times, those lifts will start to diminish and moderate a bit, that has not been the case with us. we're now at 500 Fusion stores and over 260 garden centers, and we continue to see that same type of lift even as we reach scale, real tribute to our team on the execution, operations and then ensuring that we've got the right programs as we roll those out. Other learnings, our customers are taking note of these remodels. We're seeing on our customer satisfaction surveys, we're seeing overall increases after the remodel. We're seeing kind of questions like the condition of the store, the appearance of the store, many of our customers qualitative will ask if we've updated the store and they notice it. And the same thing on the garden centers. We're seeing many new customers shop our business once we roll out a garden center, much higher female penetration, much higher millennial penetration. And we're seeing it be a driver of footsteps into our store to kind of starting the next kind of version of C.U.E. category in our business and that being live goods. I think the big learning force has been on cost. We continue to challenge ourselves on our rollout timing and our costs. We continue to reduce the length of time required to roll one of these out that minimizes the disruption cannibalization, and we're also continuing to bring down the cost through optimization of our fixtures, optimization of our construction plans and particularly on the garden center, our designs there. So if anything, we feel like the performance is better than it was 9 months ago, kind of equivalent, if not better, sales lift and customer reaction. And we continue to find ways to bring costs down on the program. So we're very pleased with the remodels and excited to continue to roll it out to the next set of stores next year and continue to bring into our whole store base.

Our next question is from Simeon Gutman with Morgan Stanley.

I wanted to ask about strategic growth initiatives with regards to either CapEx and SG&A as it flows through the P&L. Can you give us a sense, is the business at the top of a spending cycle now with a lot of the changes that have brought in over the last few years? Or do investments in SG&A, do they step up? Do they moderate? Or do they decelerate from here?

Simeon, this is Kurt. Good morning to you and everybody on the call. In regards to our investment cycle, 2022, 2023 has really been viewed as, to your point, a peak in that investment cycle. We will be opening up Navarre, Ohio, as Hal mentioned earlier. We will be building the Maumelle, Arkansas distribution center in 2023, and we'll continue our path on this cadence for the existing store remodels under the Fusion program. So 2023 is really a bit of that peak. But it has been planned that way with the growth and depreciation that we've seen this year, roughly mid- to high 20%. We expect to see in 2023, about a similar year-over-year growth rate moderating net growth rate over time. So our SG&A is -- we've got great visibility to it. We feel confident to the point that Hal mentioned on cost. And the pressures from the investments, we also see the offsets to that in SG&A that we've got in regards to leveraging on these -- the comp sales. I am thrilled about the maturity and the development of the culture and the organization's view on profit improvement. We've got a lot of great things in the works right now, not only on the supply chain side and how we can continue to leverage the investments there to drive improvements in gross margin, but what we can do through procurement and how this organization is focused on driving efficiencies and productivities in the stores and in our distribution centers. So to wrap that up, yes, there continues to be pressure from investments in the business very much as we expected. But we've got also in the trend rate the expectations of the offsets to it, which is how we see SG&A generally playing flattish as a percentage of sales going forward.

Our next question comes from the line of Oliver Wintermantel with Evercore ISI.

I had a question regarding trade down if you've seen any of that within categories and if you expect promotions to step up in the fourth quarter?

Hey, Oliver. This is Seth. Thanks for joining the call. When we look at trends in the category today, we're not seeing any meaningful trade down at this time. In fact, if you look at our kind of portfolio strategy, we've got a very balanced portfolio across kind of opening price point all the way up to our premium segments within our category strategies. And we continue to see strength across all 3 categories. One of the things that's very encouraging though as well is north of our 20% store-owned exclusive brands that we have. We're really starting to see our customer base really dive into our exclusive brands. And our exclusive brand penetration in Q3 was up 130 basis points over the prior year as they're really navigating to our premium value-oriented segments or our exclusive brand and really driving loyalty. And that's something you'll see us continue to lean in on the balance of this year. But even more importantly, as we look into 2023 is how we continue to go after that loyalty factor relative to our portfolio of strategy and driving both innovation across all 3 product tiers and then really leaning into exclusive brands. On promotional cadence and activity, you'll see us very similar to last year. I mean we've got over 27 million members in our Neighbor's Club today. We're really leaning into that capability. We're really hitting our stride, diving into that data set, being very smart with our promotional activity, but also make sure that we're pulsing the market relative to Black Friday and some other things with just some great offers that we partner with some of our key suppliers on. So you see some messaging there as well, but our promotional activity should be consistent with what you've seen recently over the course of the last couple of years as we've really been focused on our EDLP approach and making sure we're gaining market share in our essential businesses.

Our next question comes from the line of Kate McShane with Goldman Sachs.

Just now that the transaction is closed, I wondered if you could talk any more about Orscheln and how you plan to integrate that and what you see in terms of the future for those 81 stores you are now taking on?

Kate, good morning. Thanks for joining the call. And thanks for your question on Orscheln. To start out, just reiterating my prepared remarks that we're thrilled to have Orscheln join Tractor Supply. While the transaction took longer than we anticipated, the outcome was very much in line with our original expectations on the remedy that would be necessary. We are already well underway to welcoming them into the company and starting to map out our plans for converting those stores to the Tractor Supply brand. We will be basically executing the Fusion and Garden Center remodel programs in those stores. And obviously, there'll be a little extra involved with them in terms of new signage for our nameplates and some updating of fixtures and painting of the walls and such like that. But we will -- our plan is to have all that accomplished by the end of next year. At the same time, we're excited to learn from Orscheln on a number of categories where they play differently than we do in terms of distortions. And on the same side, we think there's a lot of opportunity for us to take some of our best practices to them -- to their stores; one, in terms of -- and then driving dollars per square foot up closer to where we are because they're at about kind of 50-ish percent of where we are in dollars per square foot and because they are lesser dollars per square foot, the op margin percent on a per store basis is lower as well. So we're optimistic that we can raise that over time as well. And so there's some sales synergies over time, there'll be some op margin synergies over time. And then additionally, we'll be bringing our brand awareness to that business well over 80% unaided and aided together and things like our Neighbor's Club program, our digital capabilities. So we're really excited to have them join us. It gives us a great additional footprint in the Midwest. We're excited about transitioning those stores to the Tractor Supply brand and then bringing kind of the whole of Tractor Supply to those stores and ultimately and most importantly, to our customers there in that area of the country.

Our next question comes from the line of Chuck Grom with Gordon Haskett Research Advisors.

Most of my questions have been asked, but I was curious on supply chain, how you talked about some relief on that front. I guess I'm curious, the lag, and how long we should anticipate it? To start to see some freight relief ocean container cost start to show up in the P&L?

Chuck, this is Kurt. On transportation costs, as Hal indicated, we are seeing both domestic and to an extent, imports those costs beginning to moderate as the demand on the overall global supply is starting to ease. So we are taking advantage of that. To your question about the timing of it. Two factors. One, it's got to work its way through the pipeline. So we could start to see cost in early to mid-2023, reflecting newer improved transportation costs. And that's from 2 factors, not only selling through the cost of goods that have the peak cost in them currently today. We work off of and advantage off of longer-term contracts. And so what the team is doing and has been doing as the demand on supply -- on the supply chain and transportation eases our negotiations on those costs. So as we begin to see overall contract prices come down, those will start to go through the pipeline. And in transportation, in the long term, 2023 and beyond, we do see that as one of the areas of efficiency, one of the areas that does help us and as part of our algorithm in gross margin expansion over time as we come off some of these peak transportation costs. But do see about a 6- to 9-month process not only to get inventory through the supply chain, but to be able to be working off of new and lower contracted costs.

Our next question comes from the line of Michael Lasser with UBS.

This is Atul Maheswari for Michael Lasser. I have a follow-up question for you on inflation. You mentioned that inflation is likely to moderate in the back half of next year. But what are the chances that there could be deflation, especially given there are signs that some costs are coming in. And if there is deflation, how would you expect your P&L to react to such backdrop? Because back in 2016 and '17, you're a few quarters of sluggish comp. Then because of some deflation, but how is the business today that will help you navigate the statuary backlog better than what you'd back at?

Yes, thanks for the question. We don't foresee a scenario of deflation in any near-term time horizon. '23 or into '24. If you look at where our retailers are now and just flow those through into the first half of the year, we're going to be at mid- to high single-digit inflation. And then fully expect that, that will moderate into the back half, both as we start to navigate reducing COGS increases but also, hopefully, as the economy PPI and CPI and other kind of inflationary indexes start to moderate as well. But I don't foresee at all a scenario of deflation in the near -- in any time horizon over the next few years. What I would say on some of those commodity-based products, we're well past just kind of core supply demand out there and the market is moving like they had 4, 5, 6 years ago in a normal environment. We're now in a market where even they've got higher input cost, whether it's fertilizer, and et cetera, that just has not come down. And even if it comes down, it's only coming down in a moderate way. They've got higher labor cost 10, 15, 20 points above a couple of years ago, and there's significant capacity constraints. I mean if you look at pet food, there are significant capacity constraints in the pet food market right now. So that's going to limit cost. That's going to limit any cost decreases that come. It's just the dynamics of the way the supply demand is shaping up right now. And then when you factor in non-U.S. markets and all the risk there, whether it's down in South America or certainly in middle -- in Eastern Europe with Ukraine and Russia and the difficulties in the war there, I just don't foresee a market at all where commodities are moderating to the point where they're driving substantive deflation in our business. That's just -- I don't see that in the cards at all.

Our final question will come from Brian Nagel with Oppenheimer.

The question I have. Clearly, I mean clearly, Tractor Supplies are performing remarkably well here. And this is despite some macro headwinds out there. I mean the question I have as we look into '23 or whenever, if macro conditions were to worsen and start to impact somewhat the trends at Tractor, are there levers or what were the levers that you -- either you could or you would pull either from a cost standpoint or maybe a merchandising perspective to better tailor your business to that type of environment?

Yes. Brian, and thanks for the question, and thanks for the remarks on our quarter. We're very optimistic around Q3 -- I mean around 2023. As I mentioned earlier, on the revenue side, many of our initiatives are just starting to really reach kind of scale that you can kind of “see from space.” You think about 500 Fusion stores now, 260 Garden Centers, the continued strong lift we're seeing with those as we round into next year, we anticipate that those will continue to help fuel our business, and if there is any sort of further degradation of the economy that they can help fill in some of those cracks. I also anticipate that our core competitors, if the economy weakens further, will face increasing financial difficulties, and that will only be further opportunity for us to go gain share. So we feel very good on the top side around 2023 in our ability to gain share and grow and do that within the context of our long-term guidance. And then on the cost side, while there's a bunch that goes in and goes out, while we performed well in the last 2 years and half off to the team for managing our operating margins, there's been a lot of inefficiencies in our cost base the last couple of years, higher container cost, higher freight costs, having to open up pop-up distribution centers freight arriving -- and not on the day and time that we anticipated in the back of the stores or having inefficient labor in our stores to do tasking. As we move into 2023, we fully anticipate that our business will be the most streamlined from a supply chain perspective, all the way from the manufacturer into the stores and on our shelves that it's been in 3 years. And so we're optimistic on that from a cost perspective, being able to help drive our overall profitability and our margins. And again, just very confident as we turn into 2023 near 1 quarter to go, but a lot of momentum as we enter Q4 here now, and we expect that, that will be the case as we transition into 2023.

Thank you for your questions. This concludes our QA session for today's call. I will now pass back to Mary Winn Pilkington for closing remarks. Thank you.

Thank you, Flora, and thank you for everybody for joining our call. Marianne and I will be around today if you have any remaining questions, please feel free to reach out. And the team looks forward to speaking to you at Q4 in January. So thank you for your interest in Tractor Supply.

This concludes today's conference call. Thank you for your participation. You may now disconnect your lines.