Tractor Supply Company

Thank you, operator. Good morning, everyone. Thanks for taking the time to join us today, and we do hope everyone is staying safe and well. On the call today are Hal Lawton, our CEO, Kurt Barton, our CFO. After our prayer of remarks, we will open the call up for your questions. Seth Eastep, 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 uncertainty, 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. This morning, we shortened the prepared remarks to allow more time for Q&A. Given the number of people who want to participate, we respectfully ask that you limit yourself to one question. If you have additional questions, please feel free to get back in the queue. I appreciate your cooperation on this. We will be available after the call for follow-up. Thank you for your time and attention this morning. Now it's my pleasure to turn the call over to Hal.

Thank you, Mary Wynn, and thank you to everyone for joining us this morning. The Tractor Supply Team delivered strong results for the third quarter, with net sales of 15.8%, comparable store sales increase of 13.1%, and diluted earnings per share of 20.4%. The team is doing an outstanding job navigating a very dynamic and challenging operating environment. We continue to benefit from many market trends that we see as very structurally sound. We have strength in our customer base. We're gaining market share across our categories. We continue to advance our life out here strategy. Our business has never been stronger, and we see tremendous opportunities for growth ahead of us. As we've consistently shared with you over the last 18 months, our strong results are a testament to our 45,000 plus team members. And I'd like to thank them for all their efforts in the quarter. They kept each other safe as we went through another COVID-19 wave and navigated through broad-based supply chain disruptions and cost of goods increases and navigated and managed through a tight labor market. Through it all, they've been resilient and persevere to deliver strong customer satisfaction scores, including all-time high Gura scores. Our team members are our greatest strategic asset and a key competitive differentiator with our customers. Our loyal and highly engaged team members have helped us fare better than most as far as staffing across our stores and VCs. Back in June, we raised our minimum opening wage to $11.25 per hour. Our recent wage actions bring our average hourly wage rate at our stores to nearly $15 per hour as we exit the year, with our DC at a higher rate. The investments we have made in store labor are being recognized by our customers by the overall customer satisfaction scores that I just mentioned. I'd also like to say thank you to our vendors and supply chain partners, as we've worked together to overcome challenges in the global supply chain network. And together, we've been very focused on controlling what we can control to deliver these results. Across our network, we've been nimble and been able to navigate the unprecedented supply chain environment and macro issues, including inflationary pressures. And the team has done a great job addressing issues ranging from import container shortages and port delays, driver shortages, higher freight rates, and a multitude of other supply chain constraints. To mitigate these challenges, the team has leveraged dedicated container ships, pop-up DCs, expansion of mixing centers, and direct-to-store shipment. Despite these challenges, our inventory is in good shape, and our in-stock rates finished above last year at the end of the quarter. Our diversified vendor base with only about 12% direct import is a strong point of differentiation for us during these supply chain times. Given our scale and sophistication, We believe that our network is a competitive advantage to being the dependable supplier for the out here lifestyle. Categories in which we participate and the out here lifestyle that we serve continue to have elevated consumer spending levels well above pre-COVID levels. We fully anticipate that the environment we're in is going to continue for the foreseeable future. And consequently, we think that the sales growth that we've seen is structurally sound given the changes in consumer behavior and the lifestyle investments that are now much more ingrained in the consumer psyche. These structural trends that continue to work in our favor include things like rural revitalization, trip consolidation, omni-channel adoption, and a self-reliant lifestyle movement, including DIY trends and investments in hobbies like gardening, backyard poultry, and, of course, pet ownership. For many workers, the return to office has been pushed out until next year, and even then will very likely be in a hybrid environment at most employers. And at this point, our customers will have been ingrained for over two years. As such, we anticipate that their behaviors are much more sustainable and structural. To provide some color on our results, let me share a few other highlights of the third quarter. Like the second quarter, every week had positive comps. Also, like the second quarter, our growth was broad-based across regions and product categories. Our e-commerce business continues to experience strong momentum with double-digit sales increases of over 40%. And in just under a year, our mobile app already has more than 2 million downloads and now represents over 10% of our e-commerce sales. We continue to gain share across all categories. This has been a consistent trend for multiple quarters now. And this share gain has been both online and in stores. The share gain has been aided by the increase in our unaided brand awareness, which has improved by 21 percentage points since November of 2019. This improvement combined with positive trends in our overall customer satisfaction are significant contributor to the share gains we are experiencing. Also consistent from previous quarters, all customer segments were strong with notable strength in our core farm and ranch, which is the largest and most important of our customer base. At the same time, our digital ad campaign to target millennials is supporting the significant growth we are seeing in this important demographic. We think the relevancy of traction supply to the millennial customers has staying power, given the structural changes in the markets and our customer behaviors, and we're certainly seeing that consistently quarter after quarter in our data as our average age of customer trends down. For the year, more customers than ever have shopped at Tractor Supply. These customers are making more trips and are spending more money per trip, and our new customer retention remains very strong. Our Neighbors Club loyalty program continues to exceed our expectations. with year-over-year sales growth of these members north of 20%. We exited the quarter with more than 22 million Neighbors Club members. These members are spending more than about three times the rate of non-members, with Neighbors Club members now accounting for nearly 70% of our sales. This continues to be a step up from where we've been running prior to the relaunch of the program and sequential improvement over the second quarter of this year. The number of high value per customers in the program grew almost 30% for the quarter. And we continue to experience retention rate in excess of 95% for our high value customers. These strong results demonstrate that the changes to neighbors club continue to gain traction with our customers. Given our robust performance through the third quarter, along with our outlook for the fourth quarter, we are again, raising our sales and earning guidance for 2021. and Kurt will share more details on our improved outlook later in the call. Regarding our pending acquisition of Orsola Farm and Home, we continue to work cooperatively with the FTC as it continues to review the proposed transaction. We look forward to the benefits this transaction will offer customers with improved product offering and competitive pricing. As has been the case over the last 18 months, I'm incredibly proud of the way our entire tractor supply team has managed to stay focused on taking care of each other and our customers. our long-term opportunities remain very exciting. Our goal has been to emerge from the pandemic stronger. Over the course of the last year, since rolling out our Life Out Here strategy, we have gotten stronger through this pandemic. And we believe that we're going to emerge from it even stronger and better positioned as we execute our strategy. And with that, I'll now turn the call over to Kurt.

Thank you, Hal. And hello to everyone on the call. Once again, Our third quarter results demonstrate the strength and resilience of our business and our strategic initiatives. As Hal shared, we continue to believe the underlying health of our business is very strong. Third quarter comp store sales of 13.1%, representing a 39.9% two-year stack, were driven by a comparable average ticket increase of 9.5% and transaction count increase of 3.6%. An example of the structural advantage we have is the ongoing strength in our consumable, usable, and edible products. Our Q products represent the strength of our core business and what drives trips to the store. Once again, Q outperformed the chain average comp sales, and for the sixth consecutive quarter in a row, Q had comp sales growth at or above 15%. Key subcategories such as poultry, livestock feed, and dry dog food were among the strongest categories with broad base strength. Continued to have solid comp store sales performance in line with the chain average.

Turn mowers. 700 basis points to comparable store sales. As you've heard from the retail sector and others,

the cost environment remains elevated across imports, domestic freight, commodities, and labor wages. Our 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. Our merchant and supply chain teams are currently navigating this challenging and disruptive environment extremely well. As we closely monitor our customers' purchasing behaviors, we are focused on product unit trends and are committed to being priced right every day. Our third quarter gross margin rate was 36%, a decrease of 41 basis points versus last year.

For comparison, our gross margin rate this quarter was still about 100 basis points

above our Q3 2019 rate of 35%. Year over year, the gross margin drivers were principally three items.

Second, elevated freight costs, inclusive of domestic and import costs.

And third, a more normalized product mix shift in Q. All of retail is working through the drivers of inflation and freight costs.

The tractor supply team effectively offset a significant portion through our price management program.

Additionally, we continue to see favorability in the frequency and depth of promotions. This is due to our commitment to our everyday low pricing strategy and a continued strong demand for our product category. For the field activity support teams, our FAST initiative, which was launched in the second half of last year, was consistent with our guidance. Our third quarter SG&A expense ratio, including depreciation and amortization, is primarily attributable to good leverage and occupancy and other fixed costs from the increase in our comparable store sales, along with low expense costs and decreased incentive compensation.

Partially offsetting this leverage were higher wage rates, incremental store labor hours to ensure we are providing great customer service,

and investments in our Life Out Here strategic initiatives.

Given the elevated volumes and current operating environment, we also encourage select discrete costs, such as incremental team member benefits, pop-up DCs, and the timing of our annual sales meeting, which normally occurs in the first quarter.

The offset to our fast initiative benefit and gross margin was approximately 20 basis points of incremental SG&A expense for the labor cost for the team, as we are now cycling the initial investment to launch the program last year, 2023-2019. We've had about 70 basis point favorable expense ratio since then, 10% in the quarter.

Dilute EPS was $1.95, an an increase of 20.4% from the third quarter of last year.

Our balance sheet remains incredibly strong. At the end of the quarter, our merchandise inventories were $2.2 billion, representing an 11.7% increase year-over-year in average inventory per store. The increase principally reflects growth to support the robust sales trends, along with the impact of inflation. Moving now to our updated guidance for fiscal 2021. we continue to operate in a time of heightened uncertainty regarding the pandemic. Despite this uncertainty, including product cost inflation and supply chain constraints, we are raising our full year outlook. Our updated guidance reflects the strong results for the first three quarters of the year and the positive and structural momentum we see in our business continuing into the fourth quarter. Against the backdrop of what we know today, we are forecasting fiscal 2021 net sales centered around $12.6 billion with comparable store sales growth of about 16%. For the year, we forecast an operating margin of 10.2% to 10.3%, a step up from our prior guidance. Diluted EPS is now forecast in a range of $8.40 to $8.50. This compares to our previous earnings range of $7.70 to $8 per diluted share. Within this updated guidance, we are forecasting comparable store sales growth for the fourth quarter of 8% to 10%. Two modeling points to keep in mind. The prospective acquisition of Orsland Farm and Home is not included in our guidance. And as you start to roll forward your models for 2022, please keep in mind that next year we'll have a 53rd week for us. This week is typically a low-volume week of sales given that it follows the Christmas holidays. We have a unique opportunity with the positive customer trends and momentum in the business. And with that, we are committed to investing in store and supply chain labor as we look to provide a legendary customer experience across all channels. The strength of our balance sheet and the consistency of our free cash flow continue to be a position of strength for Tractor Supply. We remain committed to returning cash to shareholders through the combination of a growing dividend and share repurchases. For 2021, we remain on track for anticipated share repurchases in a range of $750 to $800 million. This year will mark a milestone with approximately $1 billion returned to shareholders through the combination of share repurchases and dividends. In summary, 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. With that, I'll turn the call back over to your key parts of our life out-here strategy.

At a time of urgency and action on climate change and social justice, we just announced new goals in the commitment to sustainability,

By 2040, we are committing to achieve net zero carbon emissions across all our operations.

As part of our rising and accelerating our initiatives and actions for diversity, equity, and inclusion. At Tractor Supply, we are focused on cultivating an environment of inclusion where diversity of all kinds is appreciated and valued.

I invite you to learn more on our dedicated ESG website. Starting next to our Life Out Here strategy. As a reminder, we've been executing against five key strategic initiatives this year as part of our overall strategy. Those initiatives are Neighbors Club, Digital, Fast, Fusion, and Sidelight. The strategy and its initiatives are designed to capitalize on the attractive opportunity that we see in our nearly $110 billion total addressable markets. Our Project Fusion and side lot model transformations represent significant investments in our stores. These store-level investments are designed to grow our market share and drive the productivity of both existing and new stores as part of our Life Out Here strategy. So let's start with our Project Fusion store remodel program. As a quick reminder, Project Fusion is our state-of-the-art space productivity program designed to enhance the customer experience in our mature store base and give customers that may not have shopped with us in the past more reasons to shop. We anticipate having about 15% of our total store base in the new Fusion layout by year end. We've reduced the time to complete Fusion remodels by 50% since the beginning of the year, and in turn allowing us to minimize the disruption to the store operations and our customers' shopping experience. Our customers are taking note of the improved layout, the ease of shopping, and our new product offerings. Specifically, in our customer intercept surveys, they call out better organization, improved merchandise selection, cleaner and brighter aisles, and easier to navigate layout. Categories seeing the strongest lift in sales include areas like apparel, campaign and animal, and power tools. Given the size of our store base, this is a multi-year opportunity to continually refresh our store base and further drive comp sales through productivity. Another significant component of our space productivity efforts is the transformation of our side lot. Again, as a reminder, typically there's as much space outside of our stores in the side lot as we have on the inside of our store. And the productivity of this space is substantially below the chain average. We're 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 space is leveraged to offer a wider product offering in the lawn and garden categories, enter new categories with a garden center, and offer greater convenience through the expansion of our buy online pickup and store capabilities for drive-through pickup. In select locations that meet sales volume thresholds, we're also adding a feed room to help deliver the bagged feed demand. And as a reminder, we're the... We also continue to see a positive halo effect from the garden center to the existing store and vice versa. The addition of product categories, increased ease of shopping, and new services provides us with even more ways to continue to keep our existing customers engaged with tractor supply and attract new customers also to the brand. Our ability to drive higher sales per square foot through the transformation of our side lot space remains a significant opportunity.

We anticipate having about 150 side lots complete across the chain as we exit 2021.

In these early remodels, we're learning a great deal about our customers' appetite for an expanded lawn and garden assortment. and we're even more excited than we were when we embarked on the initial test pilot late last year. As with our fusion remodels, we continue to reduce the project timeline, also customers and store teams, as we implement our findings from our test and learn process. While still early on, we are very positive about the continued refinement and learning.

While implementation is very challenging in the current macro environment, we're making progress in our ability to significantly reduce construction costs, the construction time, and the corresponding disruption at the store site.

While the majority of the remodels have been completed more recently, we are very pleased with the early read on sales list. Post the disruption period, we're seeing lifts of low single digits for fusion remodels and mid single digits for combo stores, which have both fusion and side lot remodels.

We expect continued improvements in these results as we began these projects.

Over the course of the last year, the team has done a great job operating the business at elevated levels, navigating our transformational initiatives to support our life out here strategy. And to wrap up, our results are working, that the team is navigating the challenges effectively, and that we're emerging from the pandemic stronger than before. We're extremely optimistic about our future. As we enter one of the busiest periods in retail, my thanks and sincere appreciation go out to each of the more than 45,000 Tractor Supply team members for their dedication and commitment

And with that, operator, we would like to open the lines for questions.

To ask a question, please press star followed by one on your touchtone keypad. If you have a question, please press star followed by two. Again, to ask a question, press star. In today's call, please dial in and enter star one.

As a reminder, if you are using a speakerphone, please remember to Pick up your handset before asking your question. your question to one question and return to the queue for any additional questions. We will pause here briefly to allow questions to generate in queue. The first question is from the line of Oliver Wintermantle with Evercore ISI. Thank you. You may proceed.

Yeah, good morning, guys. Hal, you mentioned a lot about structural changes within the business. And my question is regarding gross margins. And I think you said it's 100 basis points higher than before the pandemic in 2019. So I was wondering if you have early indications of what you think is in gross margins, structural, maybe give back when promotions start. come back on and maybe the comp decelerates from the very strong 40% to your comps. Thank you.

Hey, Oliver, and good morning. Thanks for joining our call. Yeah, on gross margins, we're very pleased both with our short-term results, you know, kind of this past quarter on gross margin, and also very optimistic about the long-term nature of our gross margins. On the short term, We've had a significant amount of cost coming through our business, whether that's in cost of goods as it relates to raw materials and commodity-based goods, also vendors passing along costs related to labor and freight. We've also seen freight costs increase as well, as well as the costs related to imports. You know, the team's done an excellent job navigating those costs, funding offsets, productivity measures, really being the advocate for the customer to keep prices as low as possible. That said, as Kurt mentioned, we did have inflations of two to seven percent in the quarter, which helped us offset a lot of those costs and deliver the gross margin results that we did in the quarter, which sequentially from a gap to last year improved from Q2. You know, long term, as we talked about on several of our calls, the questions really around the promotional intensity and the clearance intensity, the clearance intensity in the business. And those two remain at the same levels that they have over the last six quarters. Very low. We remain very focused on everyday low price. We remain very focused on delivering value every single day to our customers and And we see it playing out that way for the foreseeable future.

We have no plans for significant promotional intensity in Q4. And we think that we'll remain in a very supply-constrained environment as we move into the first half of next year.

and that, too, will continue to limit any sort of promotional intensity in the market. And, you know, a couple years in now with minimal promotional intensity, I think that bodes well for being able to maintain kind of the structural nature of our long-term gross margin.

Thanks very much. Good luck.

Thank you. The next question is from the left. Hi, thanks very much.

So, based on all those comments that you just provided, Hal, the question would be on, obviously, the longer-term algorithm, and, you know, we haven't had an update on that for a little bit, but you're clearly trending well above the dollar in how you think about

long-term operating margin algorithm more broadly versus the prior nine to nine and a half because and good morning and thanks for joining the call um we see significant growth opportunities ahead in our business as we've talked about several times you know 110 billion billion dollar total addressable market

Super excited about our Life Out Here strategy and the runway ahead there.

And we're investing, you know, in that strategy to acknowledge that the write-down on PetSense that we did a 10.1% op profit in 2020 and our guidance for 2021 here at 10.2 to 10.3, that both of those exceed our long-term targets. You know, we certainly don't want to get ahead ahead of ourselves here in the third quarter.

What we commented on is that we're in the midst of our annual planning for 2022. At the same time, we're also just always looking at our long-term targets, and it's very natural for us to be reviewing that over the next period where there's a significant amount of opportunity ahead. And we're very pleased with the results we put up this quarter, the outlook we have for the balance of the year, and also excited about the long-term opportunity that we still see out there in our $110 billion market as we're gaining significant share in it and the team's just executing on all cylinders right now.

Great. Thanks very much.

The next question is from the line of Brian Nagel with Oppenheimer. You may proceed. Brian Nagel Hi.

Good morning. Another great quarter. So, you know, I think my question may be a bit repetitive here prior to, but the question I have is, you know, and Hal, you mentioned the structure a lot and you prepared comments. From a demand, from the demand side, you know, clearly demanded, uh, tractor now lost several quarters has been outstanding. There's still this very odd, you know, you pretend unique dynamic within the overall consumer environment. I mean, what I guess the question I have is what are, what are you seeing in your business, how your consumers are, are performing that gives you greater confidence that there is a structural shift in demand trend that will persist, you know, once the COVID crisis is completely behind us.

Yeah. Hey Brian. Um, I'd point to three things in our business. First off, I'd talk about just kind of broad macro trends. Second thing I'll talk about is the consistency of our business. And the third I'll talk about is share gains. In the broad macro trends, all the trends that we saw in Q2 of last year really have all sustained themselves. And I think tailors and other businesses that saw the benefit as it relates to kind of COVID behavior, and that waned. And I think, you know, that's not been the case for us, whether it's things like rural revitalization, which is a bit more of a permanence in, you know, as people move, and whether it's things like pet ownership and adoption, it whether it's homesteading and just kind of this self-reliance mentality, we're seeing those as more permanent behaviors. And really no matter what data set you look at, whether it's home purchases, whether it's mobility, whether it's pet ownership, any sort of qualitative data on where people are spending their money, they all reinforce the structural nature of those trends. The second thing I'd point to is the consistency, as I mentioned. Our business has been remarkably consistent month to month, week to week, by category and by region. And that's been regardless of whether or not we've been in COVID surges or whether or not certain states have been more in lockdown or less in lockdown. And that, I think, just, again, speaks to the structural orientation. share really in almost every category in our business and we're seeing that share gain in our core customers who have long shopped us and as they come to us now with the confidence that we're in stock with the right level of customer service and at the right price and then also new customers who are finding the lifestyle that we serve to be kind of what they're seeking in this time and You know, we're gaining share really across the board on all of our categories in that context. So, you know, I'd point to those three things that give us real confidence in the structural orientation of our business. And as I said, I think it's, you know, there's a set of COVID winners that were early on that have seen some of that wane. And then there's another set that are seeing it much more structural and top of that second camp.

That's very helpful. I appreciate it. Congrats again. Thank you.

The next question is from the line of Peter Keith with Piper Sandler & Co. You may proceed. Hi.

Thanks. Good morning. Great results, everyone.

You know, looking forward to the next couple of months with the winter here, looks like we're going to be seeing kind of record energy prices, home heating costs, And I'm just thinking back to 10, 12 years ago, with some of the heating exposure you guys have, there sometimes can be a nice benefit for tractors. So I guess the question is, on a net basis, how do you feel about this elevated heat?

A net positive or conversely, maybe elevating cost for your core consumer?

Hey, Peter, this is Seth. Thanks for joining the call. Hey, when we look ahead over the next, couple months just a little bit more broadly. I did call the energy cost as well. You know, we're really excited about the opportunity that lies ahead, you know, based off a lot of the macro benefits that Hal just discussed. And, you know, I'd love to just highlight a couple of things that we look to see to drive our business, you know, over this holiday season and to maximize and capitalize on that opportunity. You know, when we think about that, you know, we are really excited about executing our portfolio strategy, leveraging the FAF team.

We are doing a record number of resets as we go through the quarter. And for holidays specifically over the next couple, we're really excited about the momentum we're seeing. Core customers that are coming to us for categories more broadly than maybe they have. have in the past, things like apparel and footwear. And we're seeing expansions like in key brands like Ridgecut, where we're expanding into the women's lineup.

We weren't in the past where we can continue to drive market share in those categories. We're also seeing that with that rural revitalization, consumers come to us for outdoor activities, even here in the

So things like patio heaters, you know, grills, even like wildlife and UTVs driving that demand.

We're still seeing strength across the board there. And then we're going to continue to focus on our queue activity where customers are coming to us for footsteps. So, you know, with a record number of pet adoptions over the last few years, we continue to be extremely excited about the momentum that we have in our pet business holistically, as well as the Q business. And we're going to be looking to drive that throughout the whole holiday season. So I know it's a little bit broader than just kind of the energy market question there as well, but also, you know, where we see it as we come through, like we're seeing activity across our consumer base, be very consistent with what we've seen over the last few quarters, and they're really resonating with the new items, the new categories, as well as the new partnerships that we're continuing to establish.

Okay. Thank you very much, Seth.

The next question is from Kate McShane with Goldman Sachs. You may proceed.

Hi, good morning. Thanks for taking our question. I just wanted to go back to inflation for one minute. I wondered if you could talk to us about how much inflation you are expecting for the fourth quarter. And when it comes to the pricing actions that you took, was it across most of the store or in certain categories? And when do you expect or what has been the reaction from an elasticity standpoint?

Hey, hey, this is Kirk. Good morning and good morning to everybody. Yeah, on the inflation side of it, as Hal mentioned, on the top side, there was 700 basis points of inflation benefit on the business. We saw at that are slightly higher cost pressures in Q3. As we look ahead to Q4, we exited Q3 and into Q4 with continued levels of inflation, moderating at the levels compared to what we saw coming out of Q2 into Q3. But there continues to be some levels of inflation that's factored into our guidance. In regards to how we handle that, it really is more of a portfolio approach. We take a look at where those costs are contributing, both in transportation and product costs, and we look at our portfolio. Seth and the merchant team manages the shopping patterns from the customers as well as making sure that in key traffic driving areas we've got great everyday low pricing. So we leverage our pricing tools really well and make sure that from the portfolio standpoint that we can balance from a retail side as well as what we can do to leverage the strength of our mature supply chain to keep costs as low as possible. And again, our team has just managed through this great and we Our forecast and our guidance for Q4 expects that they're able to manage that in a similar pattern.

Thank you.

The next question is from the line of Michael Lasser with UBS. You may proceed.

Good morning. Thanks a lot for taking my question. Kirk, can you just clarify what you intended to say with response to that last question in terms of the inflation contribution moderated relative to the 700 basis points, or in the inflation contribution that you're expecting, 4Q moderated relative to the 350 to 400 basis points. And hopefully that wasn't my question, but it was just a little confusing how that was answered. My question really is, moving forward, you still need a 3% comp or so to lever your expenses. In your prepared remarks, you noted that SG&A has levered 70 basis points relative to 2019. And given the sheer magnitude of the volume increase your stores have had, there would be some opportunity to right-size or manage your cost structure such that you might be able to lever on a more moderate comp moving forward. Thank you.

Yeah, Michael, I'll hit the two questions. In response to clarification on Kate's question, for Q4, the inflation pressures in the business will be fairly similar to what we described and saw in Q3, flattish to potentially slightly up in regards to Q4. In regards to our leverage point, where we're at right now with the business, the elevated levels of revenue growth as well as Our focus on our investments really makes the whole algorithm different than just saying, is it a 3% comp that you leverage on? And to your point, right now we're seeing really strong momentum in the business. And that does elevate our ability to leverage on the cost. But we're also using that to the point that Hal made and that I made in our prepared remarks that we definitely see this as a tremendous opportunity. We're investing from a position of strength. So our continued outlook about managing SG&A to Flattish over time will still be our outlook in the way we're managing this business. Great opportunity to just continue to gain market share and drive traffic into the stores. Thank you very much.

The next question is from the line of Chris Horvath with JPMorgan. You may proceed.

I'm afraid we can just move on to the next question if Chris is in on.

Hello? Hey, there you are. Thank you, Mary Lynn. So, Seth, with your commentary around 4Q, you know, obviously soft lines, a lot of Asian sourcing, I'm guessing the heating business and OPE. So it sounds like you're feeling good from an in-stock level there. Is that accurate? And then How are you thinking about, you know, next spring?

At this point, you're probably making orders for that. So will you be ordering up for next spring?

Hey, Chris. Yeah, so, you know, we're – We always say we're not, you know, we're not, we always want more, but we're satisfied with where we are right now. You know, as we've managed through the supply chain with both our supplier partners and our supply chain team and merchants to get the products where we are, we feel really good where we are heading to the holiday season as products flowing in. As we've managed through this throughout the course of the whole year, you're spot on. You know, we've looked at every piece of our process. We're giving earlier forecasts to our key supplier partners. You know, we're, you know, working with our overseas factories to give commitments, you know, in an earlier lead time than we have historically so that we can properly plan within, plan through the supply chain. look for alternative ways to source product where need be to make sure that we can have product hit shelf. And we're taking it when, you know, we'll be able to take it when we can get it even earlier than we have in the past as well so that we can be locked and loaded and ready for the spring business. So really feel good about the planning that's going on across the team and across with our supplier base to make sure that we can continue to navigate this supply, you know, global supply chain challenge that's been out there.

Got it. Thank you.

The next question is from the line of Peter Benedict with Baird. Thank you. You may proceed.

guys um thanks for taking the question um i get back under the expense stuff um you know the investments you guys are making obviously the capex has been up so i'm curious just on dna um and how we're thinking about that um kurt for this year uh and then next year it would seem this year is probably up 25 year year maybe it's 270 million dollars of dna how do we think about that as you kind of pencil through um 2022 should we see a similar growth rate um or how should we think about that that's my question thank you yeah sure peter so for this year the depreciation growth year over year um throughout the quarters mid to high 20 growth rate is very much in line with um our expectations the investments we've made this year The incremental ones principally with the new distribution center build, as well as the fusion and side lot remodel has us right where we expected to be on depreciation. And for 2022, at this point with our plan, we would expect very much similar in the low 20% growth rate likely. And that's very much what we framed out when we launched the life out of your strategy.

Okay, got you. Thanks so much, Kurt.

The next question is from the line of Simon Gutmann with Morgan Stanley. You may proceed.

Hey, everyone. Good morning. Can I – Hal and Kurt, maybe I'll take another stab at the longer-term margin question. I think the math would suggest that your business could be running above that level. The question is, you know, philosophically, do you let it run above that level? And Hal, in that regard, are there things, you know, along the out here strategy that you can accelerate? Are there price investments that you would think about? Are there any other reinvestments that, you know, the second or third layers of the plan where you could, you know, lean in? and just say, hey, we don't want to run the business at a higher margin so that we can keep building on the growth. Curious how you think about that.

Hey, C-Man, good to talk to you this morning. Thanks for joining us. I'd say, first off, we see sizable opportunity ahead in our market. For those who followed us for a long period of time, it's a very attractive market. It's one that's very fragmented. One, where we're very well positioned with our scale and size and relationships that we have and investments we've made historically. We think that there's significant further opportunity as we look out to continue to grow in an outsized way and take share. And we're committed to going after that share and continuing to grow. That said, I would acknowledge two straight years, the performance above 10% op margin. It's above our long-term guidance. And as we go through our 2022 annual planning process, you know, that will help us really think through our long-term guidance and the relevance of that as we look forward. But right now it is our long-term guidance. What I would say is as it relates to investments, you know, we're very bullish on our investments. We're very focused on excellent capital allocation. We're seeing the results of our investments in the business. As we shared today, the fusion stores and the side lot stores are performing very well. As they mature and begin to normalize, we're seeing the results right in line with what our business model and business plan for them were. That said, also, our business continues to grow at an outsized rate, and that gives us an opportunity to leverage and scale on our business in a way that we didn't fully anticipate last year at this time. And, you know, I think as we see how that continues to evolve into early next year, you can expect to hear more from us on that. But again, we remain very bullish on our opportunity, very pleased with our business. It's never been stronger. And we're excited about both the short-term and long-term potential inside of it.

Thank you.

The next question is from Zach Fathom with Wells Fargo. You may proceed.

Hey, good morning. So, Kurt, another expense question. As you're lapping a year of elevated COVID costs, incentive comp, and strategic spend, so first of all, can you talk through the lingering impact of some of these items? And then as we look to 22, you mentioned an uptick in strategic spend. Is there any detail you can provide there? And then separately on the 20% DNA growth. Is that with or without Orchalyn?

Yeah, Zach, this is Kurt and a number of things in there. Let me just try to package that in this one. I'll hit the last one first. Orchalyn is not considered in any of the numbers of the guidance that we've given in regards to the depreciation, the expense structure. So COVID expenses, uh have been elevated from the level that we entered the year into just because the pandemic with the delta variant others have lingered they're at lower levels than we saw in comparable quarters last year but we continue to emphasize having a a safe and clean environment for our customers and our team members the incentive comp with the outperformance this year while at lower levels than last year continue to be above target And so as you think about going forward, those are items for us as in future years, those are leverage points. And if, like in this year, while there's incentive comp above target, the performance gives leverage above and beyond the level that we're paying in incentive comp, so it's net and overall leverage this year. And next year, those will be favorable items to compare against. The depreciation expense, as I mentioned earlier, the growth rate that I quoted and referring to is very much in line with what we expected in our long-range plan when we launched the Life Out Here strategy and talked about a three- to five-year plan. And so with the elevated sales, I mean, we feel very comfortable with, you know, a 20% growth rate and depreciation because that's where those investments are at. It does not include Orsland. And, again, we're very comfortable with the management we've got and what we have visibility on our expenses for the fourth quarter and even the near term beyond that.

Got it. Thanks, Kurt. What about the strategic side?

The strategic initiative that we've had, we haven't really specifically mentioned anything. you know, increased spend on strategic initiatives outside of what we had planned in the Life Out Here strategy on technology, digital that we had this year, and we'll continue to execute the plan. So maybe just clarify, you know, what you're referring there.

Well, you mentioned you were going to continue to invest in 2022. So I was just curious if there was an uptick in strategic spend that we should anticipate.

Gotcha, Zach. No, it's very much in line with what we said, that our capital expenditures over the next few years, we anticipate those still to be in that $450 to $550. Some years could be higher because of launching of distribution centers, but the level of investment in the business is consistent with what we expected.

Got it. Appreciate the time today.

The next question is from the line of Seth Basham with Redbush. You may proceed.

Thanks a lot and good morning. My question is just a clarification around the trends you're seeing in terms of the comp lift following the fusion and side lot rollout. I think you said you're seeing low single digit for fusion and mid single digit for combo stores in the stores that have been completed. But your plan is for a full first year lift of mid single digit for fusion and high single digit for combos. Is that correct?

Hey, good morning. And, yes, that is what we said in our prepared remarks, and it is accurate. You know, the ad that I'd make to that is just as is typical with a store remodel. There's a little bit of disruption. There's disruption that happens during the remodel. Particularly with the current supply chain environment, there's a little disruption that's occurring still even after the remodel with some kind of fixtures and other types of things come in sometimes a little late. And then we start to see the lift happen as customers get used to shopping, the new layout, and find the new categories and the new brands and kind of the new remodel. And so what we're seeing is kind of what we would expect, which is kind of every week, every month it goes by, post kind of the re-grand opening of the remodel, that the performance of the store continues to improve. And that's the case with both combo stores and the fusion remodels. The adder that I would make to that is as it relates to the side lot with the garden center, we have a couple of stores that went through kind of year two of spring. We saw kind of outsized gains in those, which is in line, again, with our expectation of that we would see more of a maturity curve with the garden center than we would with the inside of the store fusion remodel. We expect and what we're seeing in the fusion remodel is more of an immediate impact with, you know, kind of the maturity curve being more of a three-, four-, five-, six-month maturity curve. Whereas with the garden center, we're seeing a nice, strong, immediate impact. But then we're also seeing kind of 12-, 18-month kind of continuation of that maturity curve. But, yeah, the results are very much in line. Nice positive lift already, even a few months into each of the remodels. And then we see even continued lift as we complete kind of year one of those remodels, whether it's fusion or the combo.

That's helpful. Just a point of clarification. When do you start measuring lift post-disruption? How many months after the completion does the disruption period end?

Yeah, we start measuring lift the day of the re-grand opening. So not to get too tactical, but there's a sign-off that the store manager and the project manager and the construction manager do. On the day of that sign-off, that's when the project is complete. The re-grand opening happens reasonably quickly after that, one week, two weeks kind of thing. And then we start measuring the lift from that re-grand opening date. Thank you.

The next question is from the line of Chuck Guam with Gordon Haskett. You may proceed.

Hey. Thank you. Good morning. Great quarter. Hal, let me look at the side lot initiative. I'm curious what's been the biggest areas of upside surprise for you guys or said differently? What did you learn in the class of 21 side lots that you would look to apply to future store efforts? And then any sense for where you think the productivity longer term could be relative to your in-store productivity?

Yeah, hey, Chuck, and thanks for joining the call today. I'll hit kind of three things on sidelight, and then I'll just briefly touch base on fusion productivity. On the sidelight, you know, the three things I'll talk about is the garden center, I'll talk about BOPIS, and then I'll talk about our feed rooms. So first on the garden center, you know, our customers – you know, key data set is that the category that we least address from a destination perspective that they most engage in is live goods and gardens. And so that's really what the garden center strategy is all about, is creating another key destination category in our business. And we're seeing that in our results. I'd say we're more excited now about the prospects for, you know, kind of adding to our fleet to Garden Center than we were even this time last year. And just kind of taxing the behavior, we're seeing our customers exactly what you'd expect. It's a little less around beautification, like what you might see in more of a home improvement store in terms of the core product, and much more about fruits and vegetables and shrubs and trees. all the sorts of things that really speak to life out here, whether it's the gardening you do in your backyard or whether it's the shrubs and the trees you're planting along your fence line and in your land. And we have significant convenience kind of advantages for our customers from a location perspective. So the garden centers are performing very well, and we're just getting started both on the build-out of those, obviously, but also with our relationships with our live goods vendors and the assortment, tailoring it by store. The second thing is on both this drive-through. We are seeing incredibly high levels of drive-through behavior from our customers. And, you know, we're seeing in some of our stores that have been open for, four, five, six, eight months now, we're seeing 50, 60, 75% of the buy online pickup in store being drive-through. And just that extra convenience factor you're seeing with customers, and then that's driving repeat behavior. And so really pleased with how that's evolving and the behavior we're seeing from our customers is consistent with what the feature was when we rolled it out. And then lastly is the feed room. So We are the largest seller of bagged feed in the country. And if you think about our average store volumes and the growth we've seen in those store volumes, combined with the outsized performance in Q, that's put a lot of stress on our stores as it relates to the receipt of bagged goods, getting it out onto the store, staying in stock for our customers, and then being able to You know, kind of get that onto customers' trucks and get them on their way. And the feed rooms have provided valuable capacity and also allowed us to effectively, from a cost perspective, serve that customer because we're not touching the bags two and three, four times. We're able to leverage our mixing thinners in a way that they're designed now. And so all three of those things are really coming together. We're seeing excellent performance across all three exactly as we designed them and built them. And we're continuing to use our tests and learn to tweak it along the way. Our productivity as we move forward, you know, we're still committed to our comps kind of outpacing overall retail and outpacing the life out here market that we define as that $110 billion market. And so, you know, you can expect continued productivity improvements on our same store sales. in an outsized way as we move forward. We even, in spite of six consecutive quarters now with double-digit comps, we still have that expectation moving forward. One other thing I just, while I've got the mic here, so to speak, I'd like to just step back and reference this a bit about kind of our long-term kind of op margin leverage, as Kurt was talking about. What I'd say, if you look at our long-term guidance, because there are several questions on this topic, you know, we, and our long-term guidance, that we announced last year had 6% to 7% sales growth and 8% to 10% earnings per diluted share, which implies continued leverage on the business as we move forward. And we're not in a state of normalcy right now, obviously, with our comps being the six consecutive quarters of double-digit growth. But what I would say, the spirit of the continued leverage you are seeing in our results. And that is the expectation we have of our business, whether we're seeing outsized costs from labor and outsized costs from freight and cost of goods or whether that's in a more normal environment. And so we're holding ourselves accountable to executing in that way regardless of the environment that we're in. And just wanted to clarify that. I think, you know, Kurt's point around 3% comp and whether that's a point of leverage is still accurate in a normal environment. But we still, even in a kind of quote-unquote non-normal environment, still accept that same challenge.

Great. Thanks, Hal. And, Operator, that will conclude our call today. I really appreciate everybody's cooperation that allowed us to get through a lot more questions. So thank you all. Look forward to speaking to you in January on our fourth quarter earnings call. And Mary Ann and I will be around this afternoon for any questions. So thank you all for your cooperation. Have a great day.

That concludes today's conference call. Thank you for your participation and enjoy the rest of your day.