Tractor Supply Co /De/ Q2 FY2021 Earnings Call

Good morning, ladies and gentlemen, and welcome to Tractor Supply Company's Conference Call to discuss Second Quarter 2021 Results. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. We ask that all participants limit themselves to one question and one related follow-up. 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, please go ahead with your conference.

Thank you, operator. Good morning, everyone. Thanks for taking the time to join us today, and I do hope you all are staying safe and well. On the call today are Hal Lawton, our CEO, and Kurt Barton, our CFO. After our prepared remarks, we will open the call for your questions. Seth Estep, our EVP and Chief Merchandising Officer, will join us for the Q&A 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 certain risks 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 this call. Given the time constraints and the number of people who want to participate, we ask that you please limit your questions to one with a quick related follow-up. I appreciate your cooperation. We will be available after the call for follow-up. Thank you for your time and attention this morning. And now, it's my pleasure to turn the call over to Hal.

Thank you, Mary Winn, and thank you to everyone for joining us this morning. Our thanks go out to the more than 45,000 Tractor Supply team members for their ongoing commitment to each other, our customers, and the Out Here lifestyle. The team has been through a lot together over the last 15 months as an essential needs-based retailer, including necessary but cumbersome health and safety measures, surging volumes, the rollout of our Life Out Here strategy, supply chain disruptions, numerous digital investments, and more. The team has risen to each challenge to be there as the dependable supplier to our customers and the communities we call home. Thank you to the team for another great quarter. I would also like to say thank you to our vendor and supply chain partners as we work together to overcome the challenges in the global supply chain network. Together, we were able to support our customers as the dependable supplier for their Out Here lifestyle. Over the first 12 months of the pandemic, through the first quarter of 2021, our sales grew approximately 35%, or $3 billion. In the second quarter of 2021, as we are now comping the comp, we are pleased this momentum and all of the underlying trends have remained and continue to sustain. Looking at the second quarter, the Tractor Supply team delivered a very strong performance that exceeded our expectations as we achieved a 10.5% comparable store sales growth for the quarter and a 41% two-year stack. Our results prove yet again Tractor Supply's unique competitive advantages. Our relentless focus on being the dependable supplier for the Out Here lifestyle is embedded in our purpose as a company. Our Life Out Here strategy is still in the early days. We are seeing positive trends from our initiatives. We are excited by the momentum. We remain committed to investing in our team members as we believe they are a key competitive differentiator with our customers. Just last month, we increased pay for nearly 27,000 of our tenured hourly store team members and also raised our minimum wage to $11.25 per hour. Our team members continue to make Tractor Supply a special place that it is. Investing in our team members is not only the right thing to do, it is also a way to recognize their role in driving our business forward. Now, turning to our results for the second quarter of 2021. Our net sales grew approximately 13.4%. Comparable store sales grew 10.5%, driven by a comparable average ticket increase of 6% and transaction count increase of 4.5%. Diluted earnings per share increased 10% to $3.19. Importantly, the underlying foundation of our business is robust. For the quarter, every week had positive comps. Our growth was broad-based across regions and product categories. We continue to gain share across all categories, online and in stores. For instance, in Q2, we experienced comparable store growth in our consumable, usable, and edible categories that were well above our overall comparable store sales. E-commerce recorded its largest-ever quarter of sales. The work we have done over the last year to improve our e-commerce capabilities has certainly resonated with our customers. And just under a year, our mobile app already has more than 1.6 million downloads and now represents over 10% of our e-commerce sales. Given our strong performance year-to-date, coupled with our outlook for the balance of the year, we are raising our sales and earnings guidance for the year. Kurt will share more details on our revised outlook later in the call. Regarding our pending acquisition of Orscheln Farm and Home that we announced in February, we are working cooperatively with the FTC on their second request. We look forward to the benefit this transaction will offer customers with improved product and competitive pricing. We have previously shared key observations of our customer behaviors based on our market data and research, and I would like to update you on that today. Overall, our customer metrics remain very healthy, with both traffic and spending increasing at a balanced rate. First, we are seeing broad, continued strength across our customer base. More customers than ever are shopping Tractor Supply, and these customers are making more trips than ever and spending more money per trip than ever. We are seeing strong retention of customers that have shopped us over the last 12 months. Our retention rates continue to run above historical trends. The conversion of our Neighbor's Club loyalty program to a points-based rewards is resonating with our customers. Year-over-year, we've added nearly 5 million new members to the program. In our Neighbor's Club members, they are spending about 3 times the rate of non-members and they are comping at a rate well above the chain average. Neighbor's Club members accounted for about 65% of our sales, and that's a step-up from where we've been running prior to the relaunch of the program. We've grown our high-value customer base in the program by about 15% year-to-date, with customers migrating upward in spending, significantly outpacing any downward spending. The retention rate of our most valuable customers is running north of 95%. New customers are joining the Neighbor's Club program at a rate of nearly 30%, significantly above the rate from last year. And the new customers we are acquiring as compared to our core customers are continuing to skew younger. We're seeing significant growth in our millennial shoppers. Our trends this quarter for the customer age cohorts of 18 years to 45 years old were in line with the first quarter. We continue to believe that the growth in this customer segment has staying power. Much like last quarter, the types of trends we're seeing can simply be described as once in a generation. We believe key aspects to our customer service such as a convenient place to shop, product assortment, legendary customer service, and in-stock levels are important to keeping these existing and new customers engaged with our brand. On the macro front, the economy remained strong, and key trends continue to work in our favor, such as rural revitalization, trip consolidation, omnichannel adoption, and a self-reliant lifestyle movement, including DIY trends and hobbies like gardening, backyard poultry, and pet adoption. While the cost environment remains elevated across import, domestic freight, commodities, and labor wages, the merchant team has been aggressively advocating for our customers. Where necessary, we are taking price increases to pass through some of the cost pressures that we cannot offset. We are closely monitoring the price elasticity to ensure that we are focused on product unit trends. The team is doing an excellent job navigating this environment. Over the past few months, we have navigated unprecedented conditions. As the country opens back up, the Out Here lifestyle remains incredibly relevant. And with that, I'll now turn the call over to Kurt to review the quarter in more depth and our outlook before I come back to give insight on our Life Out Here strategy and other drivers of the second half of 2021.

Thank you, Hal, and hello to everyone on the call today. As Hal shared many details on the second quarter, in my time on the call today, I would like to go into some of the specifics around our financial performance and our increased outlook for the full year. We are very pleased with our performance. These results demonstrate the strength and resilience of our business and our strategic initiatives. For the quarterly cadence, April and June were the strongest months of the comp store sales performance. All geographic regions and all major merchandising categories had comp store sales growth. We believe the underlying health of our business is structurally advantaged. A great example of this is the strength in our consumable, usable, and edible products. Our C.U.E. products represent the strength of our core business and what drives trips to the store. For the fifth consecutive quarter in a row, C.U.E. had comp store sales growth above 15%. Key subcategories such as poultry, livestock feed, and dry dog food were among the strongest categories with comp sales all greater than 25%. Of note, we are seeing strong retention rates of our new customers across every species of livestock and companion animal. For example, poultry, a hallmark homesteading category for Tractor Supply has the highest retention rate of the animal species for new customers and new to the category. Our big ticket categories, which were going against significant growth in the prior year, continue to have strong comp sales performance above the chain average. This was driven by strength in zero-turn mowers, safes, utility vehicles, and trailers. Lastly, inflation contributed about 350 to 400 basis points to comparable store sales in the quarter. Our second quarter gross margin rate was 35.8%, a decrease of 67 basis points. Year-over-year, the gross margin drivers were principally three items. First, higher freight costs that all of retail are experiencing. Second, an initial impact from the relaunch of our Neighbor's Club loyalty program. And third, a more normalized C.U.E. product mix. Our price management program partially offset these factors as we look to mitigate the impact of inflation and other cost pressures. Consistent with our guidance, we received approximately 40 basis points benefit from vendor funding for the field activity support teams or FAST initiative, which was launched in the second half last year. Of note, we continue to see favorability in the frequency and depth of promotions as we are committed to being true to our everyday low pricing strategy and continue to see strong demand for our product categories. For comparison, our gross margin rate this quarter was still about 90 basis points above our Q2 2019 rate of 34.9%. Our second quarter SG&A expense ratio, including depreciation and amortization, improved by 6 basis points to 22.3%. This improvement was primarily attributable to lower COVID-19 pandemic response costs and decreased incentive compensation, as well as good leverage in occupancy and other fixed costs from the increase in our comparable store sales. Partially offsetting this leverage were higher wage rates, additional store labor hours to ensure we are providing great customer service, and investments in our Life Out Here strategic initiatives. The offset to our FAST initiative benefiting gross margin was approximately 40 basis points of incremental SG&A expense with the labor costs for the team. Much like our gross margin rate, our SG&A performance compares favorably to Q2 2019 when our SG&A expense ratio was 22.7%. Operating profit increased 8.5%, with an operating profit margin of 13.5% on the quarter. Net income was $370 million, an increase of 9.3%. Diluted EPS was $3.19, an increase of 10%. Turning now to our balance sheet, which remains strong, merchandise inventories were $1.99 billion at the end of the second quarter, representing a 14% increase in average inventory per store. The increase principally reflects growth to support the robust sales trends along with the impact of inflation. Our supply chain and our vendors are executing at a very high level to meet customers' current demands. We finished the quarter with $1.41 billion of cash and cash equivalents and no borrowings on our $500 million revolver. Moving now to our updated guidance for fiscal 2021, looking ahead, while the trends in our business provide additional confidence in the structural nature of the tailwind, we remain aware that the COVID-19 pandemic and the vaccine rollout can have further impact on the broader economy, the consumer and our fiscal 2021 results. There is still some measure of uncertainty we continue to plan for fiscal 2021 based on a range of potential outcomes and we will remain nimble and adjust as necessary. Our updated guidance reflects the strong result in the first half of the year and the positive momentum we see in our businesses continuing into the second half of 2021. Please note that the prospective acquisition of Orscheln Farm and Home is not included in our guidance. So against the backdrop of what we know today, we are updating our guidance to a net sales range of $12.1 billion to $12.3 billion with comparable store sales growth in the range of 11% to 13%. For the year, we forecast an operating margin of 9.7% to 9.9% of sales, a step up from our prior guidance. Diluted EPS is now forecast in a range of $7.70 to $8. This compares to our previous earnings range of $7.05 to $7.40 per diluted share. We have a unique opportunity with the positive customer trends and momentum in the business. We are committed to investing in store and supply chain labor as we look to provide legendary customer service to meet our customers' expectations. While we continue to lap challenging sales and earnings comps, we expect positive sales comp in both the third and fourth quarter with the third quarter a few points higher than the fourth quarter. Please keep in mind that we will continue to cycle strong gross margin performance of the prior year where we benefited from minimal promotional or clearance activity as well as favorable product mix where C.U.E. products represented a smaller portion of sales. Much like the results in the second quarter, we are expecting gross margin decline in the back half of the year due to higher transportation costs and continued strength in the C.U.E. products. Our guidance assumes promotional activity comparable to last year in Q3, with Q4 seeing some shift back to normalizing promotions during the holiday season. While we are dealing with significantly higher transportation costs, a mix shift to C.U.E. and cost of goods increases, we continue to see benefit from a pullback in promotions and are seeing less price elasticity from consumers as we adjust prices. We believe we are effectively navigating impacts to our gross margin. The strength of our balance sheet and the consistency of our free cash flow continue to be a hallmark of Tractor Supply. We have raised our outlook for capital spending to now be in the range of $500 million to $600 million to reflect higher construction and raw material costs for store projects and increased technology investments for the customer experience. We remain committed to returning cash to shareholders through the combination of a growing dividend and share repurchase. For 2021, we remain on track for anticipated share repurchases in a range of $700 million to $800 million. This year will mark a milestone with approximately $1 billion returned to shareholders through the combination of share repurchases and dividends. To wrap up, we are very pleased with our performance in the first half of the year and see positive momentum carrying into the second half of 2021. We continue to build relevance and market share both today and over time. We are excited about the investments ahead of us to better serve our customers from new stores, Project Fusion remodels, and our side lot transformation. We are strengthening our supply chain and growing our digital commerce, all in support of our commitment to driving strong shareholder returns for the long term. With that, I'll turn the call back over to Hal.

Thanks, Kurt. Tractor Supply has thrived over the last 15 months. We continue to operate from a position of strength and are committed to investing in the business. Our Life Out Here strategy is designed to capitalize on the attractive opportunity that we see in our nearly $110 billion total addressable market. We are transforming our stores through our Project Fusion remodel and side lot transformation, optimizing our technology in-store and online, and investing in how we operate our stores. I am incredibly proud of the progress the team has made in advancing our strategic priorities, especially amid a global pandemic and running the business at an elevated rate. So, let me share with you an update on how a few of our comp initiatives are progressing. I'll start with the field activity support team. The 1,200-plus person organization is designed to improve store labor productivity. Example tasks of the FAST team include execution of merchandising programs like center court, end-caps, clip strips, planogram resets, seasonal programs, and our sales driving initiatives. Rolled out in the third quarter of last year, this team has made great progress in improving execution of our merchandising activity, which represents the second largest body of work for our store team members. Year-to-date, the execution of tasks by the FAST team is running at 97% or nearly 33 points higher than our base year of 2019. The FAST team is allowing the store teams to spend more time on customer service and improve their in-store execution. We believe the FAST team will continue to contribute to comparable store sales well into the future. Turning next to our Project Fusion store remodel program, recall, our Project Fusion is our state-of-the-art space productivity program designed to enhance the customer experience in our mature store base and give new customers that may not have shopped with us in the past more reasons to visit. We now have more than 160 stores in the new layout, and the customer feedback has been overwhelmingly positive. Our customers are taking note of things like the improved shopping experience in our remodels, and specifically in our customer intercept surveys, they are calling out better organization, improved merchandise selection, cleaner, brighter, and easier to navigate factors. While the majority of the remodels have been completed more recently, we are very pleased with the early read of our customer response and the comp lift of the remodel is running in line with our expectations. Given the size of our store base, this is a multiyear opportunity to continually refresh our store base and further drive comp sales. Another component of our space productivity program is the transformation of our side lot. Typically, there is as much space outside of our stores in the side lot as we had inside the store. The productivity of this space is substantially below the chain average. We are in the midst of a multi-year project to transform our side lot with an expanded product offering and an enhanced shopping experience. With this investment, the side lot spaces leverage to offer a wider product offering in the lawn and garden categories, enter new categories, and offer greater convenience through the expansion of our buy online, pickup at store capabilities for drive-thru pickup. We also continue to see a positive halo effect from the garden center to the existing store and vice versa. Addition of product categories, increased usage shopping, and new services provides us with even more ways to continue to keep our existing customers engaged at Tractor Supply and attract new customers to the brand. Our ability to drive higher sales per square foot through the transformation of our side lot remains a significant opportunity. We currently have about 60 side lot transformations completed, and we anticipate having greater than 150 complete as we exit 2021. In these early remodels, we are learning a great deal about our customers' appetite for our expanded lawn and garden assortment and we are even more excited than when we embarked on the initial test pilot. The team has done a great job laying the foundation of our Life Out Here strategy as we scale our transformational initiatives. Beyond our multi-year strategic initiative, at Tractor Supply, we are always focused on having the seasonally appropriate offerings to support our customers. Wrapping up the summer season, we're exiting the quarter with clean inventory with a seasonal changeover. We continue to focus on enhancing our product offerings for the transition to the important fall and winter season. Across all areas of the store and online, we have fall-centric merchandising and marketing plans in place to keep our customers engaged. Whether it's the launch of our Pet Appreciation Week in September to the rollout of our Deer Hunting planograms set, or our focus on heating products for the change in temperature, our customers know that they can count on Tractor Supply for the relevant products that they need to live Life Out Here. We are leveraging new items and innovation across grilling, safes, and home and decor. In addition, Ridgecut, our exclusive brand of performance workwear will be expanded across new categories and into women's workwear. These product expansions are relevant to both new and existing customers and will help retain our growing customer base. Across all parts of the store, we have exciting products for the fall and winter as we shift gears to ramp up for our customers' need to care for their land, home, animals, and pets as colder weather comes. On the marketing front, we are making continued investments to drive our brand awareness. As part of our plans, we are excited to announce a new multi-year partnership to be the official Life Out Here partner for the Professional Bull Riders effective this season. The partnership includes the flagship presence on the PBR tour that hosts over 200 events per year, a Tractor Supply branded broadcast boost during the pre-show on CBS, and in-arena broadcast activation and local customer activation. PBR will also produce and distribute custom content for our social media channels. We are very excited to support our customers' passion for this dynamic and rapidly growing sport. Again, on marketing, given the strong millennial trends we've been experiencing, we're investing in marketing to continue to attract and nurture this important demographic. Given that the millennial customer cohort may not be as familiar with our brand, we are executing marketing plans to introduce Tractor Supply to this next generation of customers. Just last month, we launched a new campaign targeting millennials' immediate channels like Pandora, YouTube, and other streaming services. That campaign is called Welcome to Life Out Here and introduces this new audience to what lies ahead in our stores and the lifestyle we help support. The focus is on key categories such as pet, backyard poultry, gardening, and self-reliance. With the primary goal to drive awareness, the millennial campaign has delivered significant impressions since the launch. Early results show best-in-class performance in ad recall and awareness relative to traditional benchmarks. We believe this indicates that we are resonating with this audience, and it is driving consideration for Tractor Supply. To summarize, we've delivered strong results year-to-date and made significant progress with our strategic initiatives. We have confidence that our strategy and execution will allow us to continue to build a stronger Tractor Supply. With our purposeful actions, we will emerge from the pandemic a stronger company. It's an exciting time at Tractor Supply. My appreciation goes out to each and every one of our more than 45,000 Tractor Supply team members for their dedication to our mission and value. And with that, operator, we would now like to open the line for questions.

Your first question comes from Steven Forbes with Guggenheim Securities.

Good morning. So, Hal, I wanted to focus on the Neighbor's Club relaunch. So, maybe a two-part question here. If we look at the spending tiers, right, that are sort of defined by the program. Curious if you'd provide some context around how these tiers were determined. And any sort of color, right, that you could provide to help us better understand sort of what percentage of members today would qualify, right, for the preferred for plus tiers? Any color would be appreciated there.

Steve mentioned that we have over 21 million members in our Neighbor's Club. Like other loyalty programs, we established three tiers to distribute rewards reasonably, with diminishing benefits as you move across the levels. These tier levels are designed to promote upward movement and discourage downward movement. Notably, our Neighbor's Club members generate over 65% of our sales, and we have an annual retention rate exceeding 80%. In our highest tier, the Premium Plus, retention rates surpass 95%. This indicates strong upward mobility and reduced downward shifts among members. Additionally, Neighbor's Club members average two more trips per quarter than non-members and spend over $1,000 annually. We have nearly 2.5 million such high-spending members, and this number is growing daily. The program has shown impressive growth, with more than 5 million new members joining in the past year. The retention rates are strong, migration is positively affecting retention, and we’ve received an enthusiastic response to the new program. Since its launch, our Neighbor's Club members are significantly outperforming the overall average of our chain.

Thanks. And just a quick follow-up. If I think about the last few quarters, you provided some context around repeating trends. I think a percentage of customers repeating within 12 months, probably on a rolling basis. I think it was 50% last month. You mentioned sort of it's running at a high. So just any context around repeat trends that we think about the growth from the customer base, the experience over the past 18 months.

Our customer repeat shopping trends remain very strong. New customer retention rates are around 50 percent, similar to previous quarters. New customer counts were only slightly below those from Q2 2020, indicating positive news on the customer front. We had 11 million new customers last year, with almost 3 million in Q1, and we're experiencing retention rates above 50 percent for these new customers. To put this in perspective, of the 11 million new customers last year, 6 million have made additional purchases and 3 million joined the Neighbor's Club program. These metrics highlight excellent retention and strong conversion to the Neighbor's Club program. This quarter, our new customer counts are nearly on par with those from the second quarter of 2020 at the pandemic's onset.

Thank you.

Thanks, Steven.

And your next question comes from the line of Simeon Gutman with Morgan Stanley.

Hey, good morning, everyone. Nice quarter. My first question is the stabilized period that you outlined at the earnings day, it hasn't really happened yet. I guess it has relative to last year, but the business is still growing. Can you talk about the factors that would argue that the business doesn't need to digest and therefore, continue to grow and then vice versa. What suggests that we are going to have a digestion period and we'll have a deeper stabilization period versus the way you expected it?

Yes. Hey, Simeon, how are you? At the highest level, I would say there continues to be a lot of uncertainty in the United States economy and globally, especially concerning COVID, the delta variant, and how that impacts mobility and customer shopping behaviors. Reflecting back on our October enhanced earnings day last year, we suggested there would be a return to normalcy that happened more abruptly than expected. However, as we observe how COVID is developing, that has not been the case. Our business is evolving as well. Previously, we discussed a balance of structural versus transitory trends, but we now lean more towards structural in our assessment. When considering pets, millennials, homesteading, rural revitalization, and categories like poultry, for instance, we sold 11 million birds last year, half of which were to new customers. As Kurt mentioned in his remarks, we have seen exceptional retention from those customers who purchased poultry last year. In fact, our retention rate is higher than any other segment in animal feed or pet products. This indicates that the trends we began to see last year are resonating well and are resilient, highlighting the strong momentum we are experiencing with our customers and the Out Here lifestyle that we promote. In my prepared remarks, I noted that between Q2 of 2020 and Q1 of 2021, we grew by $3 billion with a 34% increase in comparable sales. As we approached Q2, like many companies, we were uncertain about how we would perform against that comp, and we had initially guided towards a flat or even slightly negative outlook at the start of the year. Instead, we finished with a 10.5% increase, surpassing our expectations. It truly comes down to the strong underlying trends, consumer behavior, new customers, and the attractiveness of the Out Here lifestyle. While there is still significant uncertainty in the upcoming quarters and years, we feel more confident in the structural nature of the trends than we did last October.

Thank you for that. In terms of CapEx, I think Kurt had mentioned that it was relatively level in these out years as it steps up from a couple of years ago. Does it peak in 2021? Do you spend further and accelerate into 2022, how should we think about cadence?

Simeon, this is Kurt. On the cadence over the next few years, as we pointed out back in October when we launched our new long-term targets in the Life Out Here strategy, we said that we've got consistency in our investment, in the existing stores as we drive productivity with Fusion and side lot, but that where there may be some variation would be on the supply chain as we grow our supply chain, particularly new distribution centers. And so, as you've heard us in the last couple of quarters emphasize the importance of our investment in our supply chain, we are looking to accelerate and would see us shifting some of the supply chain investments earlier in the next few years. There may be higher than average in 2021, 2022, even 2023, but over the period of time, it still averages out about the five-year expectation that we gave. The important thing is the recognition of our confidence in the structural nature of this business and therefore the importance of our timing of investments in the supply chain. So I see 2021 and 2022 pretty consistent in potential on capital as we emphasize ensuring the strength of our supply chain.

Thank you very much.

And your next question comes from the line Michael Lasser with UBS.

Good morning. Thank you for taking my question. It's hard to believe that poultry or livestock products are growing as rapidly as you have reported. At some point, do you anticipate facing challenges in scaling, or will you need to focus more on promotions? There haven't been any losses in market share, so when do you foresee this risk becoming significant in the upcoming quarters?

Hello, Michael, it's great to have you on the call this morning. I want to start by saying that we feel very confident. We're gaining market share across all major categories in our business, both in stores and online. Our analysis shows strong growth in sales and transactions from both new and existing customers. As I mentioned earlier, more customers are shopping with us than ever before; they are visiting us more often and spending more during their visits. We operate in a significant market valued at $110 billion, where our current market share, based on our updated guidance, is just over 10%. There is ample opportunity for us to gain more share in this space. Our primary focus remains on enhancing the customer experience through various initiatives, including investing in our team members to ensure exceptional service and maintaining sufficient inventory levels. Regarding the promotional landscape, we have experienced minimal to no promotions in the first two quarters of this year, and we expect this trend to continue throughout the remainder of the year. I don't foresee any changes in the competitive environment, primarily due to ongoing supply and demand challenges. The global supply chain remains disrupted, and businesses are concentrating on maintaining inventory levels in their stores. This mindset will likely overshadow any attempts to gain market share through promotions. Additionally, we don't have direct competition with any major retailer; as a lifestyle retailer, we offer a unique blend of large categories tailored to our customers' needs. Typically, our competition is on a category-by-category basis rather than as a wholesale competitor, and I don't expect an increase in promotional activity in the market or for us in the near or medium term.

My follow-up question is about the acceleration from last quarter. Where do you expect that to go in the next few quarters?

Yes, Michael, this is Kurt. You stated the results accurate on the last quarter. Let me give quick backdrop and that will lead towards the back half, but we entered the year expecting 100 to 200 basis points of retail inflation throughout the year that quickly produced in Q1 closer to 300 basis points, principally from commodities. As we shifted into Q2, at 350 to 450 basis points of retail benefit from inflation. One, it demonstrates the ability, as Hal mentioned, to be able to adjust pricing appropriately. The increase in Q2 over Q1 was principally related to transportation costs and other non-commodity type based cost increases. We see in the back half of the year staying at elevated levels, and we would anticipate that the numbers in Q2 would be at that level and potentially at moderately higher levels throughout the back half. In this inflation environment, I always like to remind that our merchants in our business, we deal with inflation and deflation every year, and they are managing this excellently and we feel we've got the ability right now in the consumer sentiment, the less price elasticity in their behavior to be able to manage the inflation environment very well throughout this year.

Great, thank you so much.

And your next question comes from Chuck Grom with Gordon Haskett.

Thanks and good morning. My question is on Side Lot. Is it possible now with a few quarters under your belt to give us some update on the sales that you've seen this spring and any other learnings that you plan to apply to the balance of the stores you are going to open this year in the side lot format? And then as a follow-up, you talked about 60% to 70% of the fleet potentially holding side lot. I'm curious how quickly you think you're going to accomplish all that cycle?

Yes, Chuck, I'm doing well, thank you for joining the call today. I'd like to start by discussing both Fusion and side lot. We are very pleased with the results and have made significant progress over the last six to nine months on both initiatives. We have completed over 160 Fusions and more than 60 side lot transformations. In addition to these individual projects, we've brought project management in-house, which has helped us reduce construction times and costs. We see many opportunities to continue improving as we move forward. Specifically for the side lot, we have refined our plans multiple times and are continuously optimizing the format. We are pleased with the results and the progress of both projects. Typically in retail, you begin to get a solid understanding of how the remodel lift is performing about three to four months after a store reopens and the remodel is complete. Most of our remodels haven't been open for that long yet, so we will be monitoring the data closely over the next three to six months. However, for the stores that have been open for that duration, they are performing at the levels we anticipated in our initial business case. We have seen more of this performance in Fusion stores compared to side lots, but we are pleased with both projects. As I mentioned earlier, customer excitement about our transformation into a garden destination has exceeded our expectations, and we are feeling increasingly optimistic about this moving forward. Regarding the penetration of Fusion and side lot, we expect to provide more information over time. In a five-year timeframe, we anticipate that the vast majority of our stores will include Fusion, with side lot around 60% to 70%. We are feeling more optimistic about completing more Fusion stores than we were six months ago, given the positive developments in the project, the costs, and the initial lift we're observing, alongside the ongoing need to remodel our store base.

That's very helpful. And just a quick follow-up I know this is unrelated, I apologize. But given some new over the past few days about this delta variant, I'm curious, if you've seen any choppiness in some of the regions that you operate on vaccinations?

Our business has remained incredibly consistent over the past 15 to 18 months across regions and category trends. All 13 weeks of this past quarter and each of the three months showed positive comparisons. We exited June with strong momentum, and despite the rise of the delta variant, we haven't seen any impact on our trends at either a national or regional level. This is similar to what we observed last year. I believe that the lack of mobility caused by these outbreaks may actually benefit Tractor Supply. When people are spending more time at home with their families, pets, and land, they tend to purchase more from us as we serve as a one-stop shop for their hobbies. While we hope for a quick return to normalcy, we don't view the delta variant as a threat. Instead, it could bring some positive outcomes for our business results.

Thank you, Hal. Good luck.

And your next question comes from the line of Chuck Cerankosky with Northcoast Research.

Good morning, everyone. If we look at sales trends over the past two quarters and, Hal, could you tie it to the TV advertising you've been doing and did that lead into this relationship with the PBR?

We aim to dominate the "Life Out Here" space and believe we have the trust of our customers to achieve this. We conduct a customer awareness survey biannually. In our previous earnings call, I noted that our unaided brand awareness was at 37% in November 2019, and 18 months later, as we were finishing Q1, it had risen to 51%. Therefore, we've experienced a 17-point increase in our unaided brand awareness, moving from 34% to 51%, with much of that growth coming from our core customers, but also significantly from millennials. Last quarter, we saw a 4-point increase in millennial customer penetration compared to the previous year, which continued into Q2. We believe that our marketing efforts are expanding consumers' understanding of Tractor Supply and enhancing both unaided and aided awareness, driving more customers into our stores. We have maintained strong comparable transaction growth overall and are excited about our partnership with PBR. This category resonates well with our customers, offering over 200 activities each year for engagement throughout the regions where our customers reside. It's going to be a fantastic partnership. Additionally, we've launched a comprehensive marketing campaign aimed at millennials. Previously, our main advertising focused on television and Facebook. On TV, we've concentrated on news media, which has proven effective for our core customers, as those are their primary media platforms. However, millennials engage with different media channels like Pandora, Spotify, and YouTube. Consequently, we've developed a distinct creative concept called "Welcome to Life Out Here," which introduces Tractor Supply and highlights initial hobbies that they may pursue, such as backyard poultry, gardening, and pets. These are entry-level categories in the "Life Out Here" lifestyle. We are very enthusiastic about this initiative, and the early feedback from customers has been exceptional. Kudos to the marketing team for their efforts in significantly boosting awareness of our business and increasing foot traffic to our stores.

Thank you, Hal.

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

Hi, good morning everyone. I have the first question. Kurt, your plans for the second half suggest there may be some negative incremental margins. I know you've mentioned some of the investments you're making, but I'm curious about your perspective on this. Could you provide an idea of the extent of the gross margin decline, particularly in relation to the 65% to 70% decline in the second quarter? Additionally, looking ahead, what flexibility do you have in your profit and loss statement if sales were to slow or decrease? What options are available to you in that scenario? Thank you.

Thank you for your question, Peter. Regarding the operating margin for the second half, we see it primarily influenced by gross margin performance, which contributed significantly during the pandemic. For Q3, we expect gross margin performance to be similar to what we experienced in Q2, as we have better visibility for this quarter. Moving into the latter part of the year, we are adopting a cautious outlook due to increased uncertainty beyond the next quarter. Historically, we have provided more definitive guidance for the nearest quarter. For the second half and particularly the fourth quarter, we acknowledge factors like supply chain disruptions, inflation, and the competitive landscape during the holiday season. These uncertainties are reflected in our fourth-quarter operating margin outlook, which will largely depend on our gross margin performance. As demonstrated in Q2, we have managed well in this challenging environment, and we are confident about our business moving forward. Should the uncertainties resolve favorably, there could be upside to our guidance. We are actively pursuing profit improvement initiatives and have identified areas within the supply chain where we can enhance efficiency, such as reducing transportation distances and leveraging our organization's size. Additionally, we are prepared to adjust variable costs in response to any changes in business momentum, particularly in distribution and store operations. Our solid profit improvement efforts are helping us maintain operating margins well above pre-pandemic levels while we continue making significant investments in the business.

Right. Thanks so much.

Operator, maybe time for one more call.

All right and your last question comes from the line of Zach Fadem with Wells Fargo.

Hey, good morning. Thanks for fitting me in today. So, Kurt, you suggested in the past that the 100 basis points of gross margin expansion in 2020 was largely related to muted promo, low clearance environment. Now that we're halfway through this year and you've seen the environment more or less continue, can you just talk us through the long-term state of the gross margin line and to what extent the current 35% plus margin is the right way to think about this business, or are there reasons to believe that the historical 34% range is more appropriate as promos and clearance inevitably return?

As we've mentioned during this pandemic, we've experienced over 100 basis points of improvement in our operating margin compared to pre-pandemic levels, mainly driven by gross margin. We expect that as we move past the pandemic, some factors like promotions and clearance will normalize. While we are committed to maintaining everyday low pricing for our customers, our long-term guidance reflects some expected normalization. We recognize that our guidance indicates we will retain operating margins above our long-term target range for a second year in 2021. As we proceed through 2021, we will reassess our long-term expectations for gross margin while continuing to prioritize strong everyday low pricing. We aim to increase market share and drive unit growth, making pricing a key focus as we leverage the strengths of our business with an efficient and agile supply chain. As our visibility improves, we will acknowledge trends in gross margin and operating margin in relation to our long-term targets. For now, we will not project beyond the visibility we have in the upcoming quarters.

And a quick follow-up on that. I mean, in 2019, you had a $10 billion sales day. Last year that stepped up to $10.5 billion and this year it's going to step up more to $12 billion. Could you guys talk about the scale advantages you generated and how that should translate at the gross margin and operating expense lines?

Hey, Zack, it's Hal. And again, thanks for joining the call today. I'd say a few things. First off, on the scale advantage, I'd say it dominantly gives us an opportunity in the market. With our 8 distribution centers, moving towards 11, the relationships that we have with our vendors and the meaningfulness of that, with the technology investments we're able to make. As an example, every single one of our team members wears a headset that really creates an optimal customer service experience in the stores. We're in the process of rolling out new handheld devices for every team member inside the stores as well. Those sorts of investments are enabled by our scale, and they are really focused on helping us create, gain, and capture market share and drive top-line sales. As we've talked many times, our main goal is to grow at a rate faster than the market. That's what's implied in our long-term operating trends, and that's how our business is performing now. On the operating profit rate, as you said, we've been able to hold SG&A flat or down, and we've done that over the last six quarters and anticipate continuing to do so. So as we've grown our sales and grown our sales base, we've been reinvesting in the business, but doing it at a point where we're not deleveraging there. Whether it's in the capital line or in our team member line, and we view our team members as a strategic asset. We are a customer service driven retailer. We are not a retailer where you're going to walk in, pick the item you want, go to a self-checkout and never talk to someone, loading your car yourself and drive away. We are going to help you pick the item, we're going to review, we're going to check you out, and we're going to help you load it in your car. That said, that's going to drive sustainable share gain for us. On the gross margin rate side, I think we continue to be very pleased that the promotional environment remains very little to none, and our inventory position where it is, we are just requiring little to no clearance activity as well. Our hope is that the longer that sustains itself, the more structural that becomes. Right now, we are in a high-cost freight and import environment. That's reflected in our guidance. We're very pleased with the low promotional nature. It's allowing us to offset those freight and import pressures to allow us to give the guidance that we've given right now. We fully acknowledge, as Kurt said, that sales remain at the rates that they are in Q2 that there would be upside to the guidance that we've given, but we just thought it was prudent at this point to kind of provide the guidance that we had just given the continued level of uncertainty out there.

Makes sense. Appreciate the context.

Great. Thank you everyone. Dan, that will wrap up our call today. So thank you for joining us. Marianne and I will be around for any questions and will look forward to speaking to you at our call in October.

Ladies and gentlemen, this does conclude today's conference call. Thank you for your participation. You may now disconnect your lines.