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TRACTOR SUPPLY CO /DE/ - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 4, 2014

General

The following discussion and analysis should be read in conjunction with our Annual Report on Form 10-K for the fiscal year ended December 28, 2013. This Form 10-Q also contains forward-looking information. The forward-looking statements included herein are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 (the "Act"). All statements, other than statements of historical facts, which address activities, events or developments that we expect or anticipate will or may occur in the future, including such things as sales and earnings growth, estimated results of operations in future periods, the declaration and payment of dividends, future capital expenditures (including their amount and nature), business strategy, expansion and growth of our business operations and other such matters are forward-looking statements. These forward-looking statements may be affected by certain risks and uncertainties, any one, or a combination of which, could materially affect the results of our operations. To take advantage of the safe harbor provided by the Act, we are identifying certain factors that could cause actual results to differ materially from those expressed in any forward-looking statements, whether oral or written. As with any business, many aspects of our operations are subject to influences outside our control. These factors include, without limitation, general economic conditions affecting consumer spending, the timing and acceptance of new products in the stores, the timing and mix of goods sold, purchase price volatility (including inflationary and deflationary pressures), the ability to increase sales at existing stores, the ability to manage growth and identify suitable locations, failure of an acquisition to produce anticipated results, the ability to successfully manage expenses and execute our key gross margin enhancing initiatives, the availability of favorable credit sources, capital market conditions in general, the ability to open new stores in the manner and number currently contemplated, the impact of new stores on our business, competition, weather conditions, the seasonal nature of our business, effective merchandising initiatives and marketing emphasis, the ability to retain vendors, reliance on foreign suppliers, the ability to attract, train and retain qualified employees, product liability and other claims, changes in federal, state or local regulations, potential judgments, fines, legal fees and other costs, breach of information systems or theft of customer data, ongoing and potential future legal or regulatory proceedings, management of our information systems, failure to secure or develop and implement new technologies, the failure of customer-facing technology systems, business disruption including from the implementation of supply chain technologies, effective tax rate changes and results of examination by taxing authorities, the ability to maintain an effective system of internal control over financial reporting, changes in accounting standards, assumptions and estimates. We discuss in greater detail risk factors relating to our business in Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 28, 2013. Forward-looking statements are based on our knowledge of our business and the environment in which we operate, but because of the factors listed above or other factors, actual results could differ materially from those reflected by any forward-looking statements. Consequently, all of the forward-looking statements made are qualified by these cautionary statements and there can be no assurance that the actual results or developments anticipated will be realized or, even if substantially realized, that they will have the expected consequences to or effects on our business and operations. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. We undertake no obligation to release publicly any revisions to these forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.



Seasonality and Weather

Our business is seasonal. Historically, our sales and profits are the highest in the second and fourth fiscal quarters due to the sale of seasonal products. In past years, weather conditions, including unseasonably warm weather in winter months, and extreme weather conditions, including snow and ice storms, flood and wind damage, hurricanes, tornadoes, extreme rain and droughts, have affected our sales and results of operations both positively and negatively. Our strategy is to remain flexible and react to extreme weather conditions by adjusting our merchandise assortments and redirecting inventories to stores affected by the weather conditions. We experience our highest inventory and accounts payable balances during our first fiscal quarter for purchases of seasonal products to support the higher sales volume of the spring selling season and again during our third fiscal quarter to support the higher sales volume of the cold-weather selling season. Results of Operations Fiscal Three Months (Second Quarter) Ended June 28, 2014 and June 29, 2013 Net sales increased 8.8% to $1.58 billion for the second quarter of fiscal 2014 from $1.46 billion for the second quarter of fiscal 2013. Comparable store sales for the second quarter of fiscal 2014 were $1.49 billion, a 1.9% increase over the second quarter of fiscal 2013. This compares to a 7.2% comparable store sales increase for the second quarter of fiscal 2013. Comparable store sales are calculated on an annual basis using sales generated from all stores open at least one year and all online sales and exclude certain adjustments to net sales. Stores closed or relocated during either of the years being compared are not removed from our Page 11



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comparable store sales metrics calculations. If the effect of closed and/or relocated stores on our comparable store sales metrics calculations becomes material, we would remove closed and/or relocated stores from the calculations.

The 2014 comparable store sales increase was driven by continued strength of consumable, usable and edible products (C.U.E.) and an increase in traffic counts. C.U.E. products represent certain high-velocity, consumable items from several of our major product categories. The favorable drivers of the comparable store sales increase were partially offset by deflation, continued softness in our safe category and weaker than expected sales of certain seasonal products primarily in the Northern regions. We estimate that comparable store sales were unfavorably impacted by approximately 100 basis points due to deflation, principally in livestock feed and bird feeding products. In addition to comparable store sales growth in the second quarter of fiscal 2014, sales from new stores, which are stores opened for less than one year, were $100.3 million for the second quarter of fiscal 2014, which represented 6.9 percentage points of the 8.8% increase over total second quarter fiscal 2013 net sales. For the second quarter of fiscal 2013, sales from new stores were $72.3 million, which represented 5.6 percentage points of the 12.7% increase over total second quarter fiscal 2012 net sales.



The following chart summarizes our store growth for the fiscal three months ended June 28, 2014 and June 29, 2013:

Fiscal three months ended June 28, 2014June 29,



2013

Store Count, Beginning of Period 1,308 1,197 New Stores Opened 23 26 Stores Closed - - Store Count, End of Period 1,331 1,223 Stores Relocated 1 - The following chart indicates the percentage of sales represented by each of our major product categories for the fiscal three months ended June 28, 2014 and June 29, 2013: Fiscal three months ended June 28, 2014 June 29, 2013 Product Category: Livestock and Pet 41 % 40 % Seasonal, Gift and Toy Products 24 25 Hardware, Tools and Truck 22 22 Agriculture 7 8 Clothing and Footwear 6 5 Total 100 % 100 % Gross profit increased 8.8% to $550.5 million for the second quarter of fiscal 2014 from $506.1 million in the second quarter of fiscal 2013. As a percent of sales, gross margin was flat to prior year quarter at 34.8% as increased transportation costs and the unfavorable impact from the change in mix of products and slightly more sales-driving promotions offset the favorable impact of our key gross margin enhancing initiatives and the favorable impact of deflation. Our key gross margin enhancing initiatives include inventory management, strategic sourcing, exclusive branding and price optimization. As a percent of sales, selling, general and administrative ("SG&A") expenses, including depreciation and amortization, increased 30 basis points to 21.5% in the second quarter of fiscal 2014 from 21.2% in the second quarter of fiscal 2013. The increase as a percent of sales was primarily attributable to lower comparable store sales and higher employee benefit expenses, partially offset by lower incentive compensation expense. Total SG&A expenses increased 10.2% to $339.5 million from $308.2 million in the second quarter of fiscal 2013. This change is due primarily to new store growth and variable costs associated with our same-store sales growth. Page 12



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The effective income tax rate decreased to 36.7% in the second quarter of fiscal 2014 compared to 37.4% for the second quarter of fiscal 2013 due principally to the timing of the recognition of certain state and federal tax credits. The Company expects the full year 2014 effective tax rate will be approximately 36.9%.



As a result of the foregoing factors, net income for the second quarter of fiscal 2014 increased 8.0% to $133.4 million or $0.95 per diluted share, as compared to net income of $123.6 million, or $0.87 per diluted share, for the second quarter of fiscal 2013.

Fiscal Six Months Ended June 28, 2014 and June 29, 2013 Net sales increased 8.9% to $2.77 billion for the first six months of fiscal 2014 from $2.54 billion for the first six months of fiscal 2013. Comparable store sales for the first six months of fiscal 2014 were $2.60 billion, a 2.0% increase over the first six months of fiscal 2013. This compares to a 4.2% comparable store sales increase for the first six months of fiscal 2013. The 2014 comparable store sales increase was driven primarily by continued strong results in key C.U.E. products, principally animal- and pet-related merchandise and an increase in traffic counts. We estimate that comparable store sales were unfavorably impacted by approximately 90 basis points due to deflation, principally in livestock feed and bird feeding products. In addition to comparable store sales growth in the first six months of fiscal 2014, sales from stores opened less than one year were $173.7 million for the first six months of fiscal 2014, which represented 6.8 percentage points of the 8.9% increase over total first six months fiscal 2013 net sales. Sales from stores opened less than one year were $134.5 million for the first six months of fiscal 2013, which represented 5.8 percentage points of the 9.9% increase over total first six months fiscal 2012 net sales.



The following chart summarizes our store growth for the fiscal six months ended June 28, 2014 and June 29, 2013:

Fiscal six months ended June 28, 2014 June 29, 2013 Store Count, Beginning of Period 1,276 1,176 New Stores Opened 55 48 Stores Closed - (1 ) Store Count, End of Period 1,331 1,223 Stores Relocated 1 - The following chart indicates the percentage of sales represented by each of our major product categories for the fiscal six months ended June 28, 2014 and June 29, 2013: Fiscal six months ended June 28, June 29, 2014 2013 Product Category: Livestock and Pet 45 % 44 % Hardware, Tools and Truck 22 22 Seasonal, Gift and Toy Products 21 21 Clothing and Footwear 7 7 Agriculture 5 6 Total 100 % 100 % Gross profit increased 10.3% to $946.8 million for the first six months of fiscal 2014 from $858.2 million in the first six months of fiscal 2013. As a percent of sales, gross margin increased 40 basis points to 34.2% for the first six months of fiscal 2014 compared to 33.8% for the comparable period in fiscal 2013. The increase in gross margin as a percent of sales resulted from the favorable impact from key gross margin enhancing initiatives which include inventory management, strategic sourcing, exclusive branding and price optimization, as well as deflation, offset by the unfavorable impact of product mix and increased transportation costs. As a percent of sales, SG&A expenses, including depreciation and amortization, increased 30 basis points to 23.7% in the first six months of fiscal 2014 from 23.4% in the first six months of fiscal 2013. The SG&A increase as a percent of sales for the first six months of 2014 was primarily attributable to lower comparable store sales and higher employee benefit expenses, partially Page 13



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offset by lower incentive compensation expense. Total SG&A expenses increased 10.9% to $657.0 million from $592.3 million in the first six months of fiscal 2013. This change is due primarily to new store growth and variable costs associated with our comparable store sales growth as well as higher operating costs related to the extreme cold weather and increased distribution center costs. For the first six months of fiscal 2014, the effective income tax rate increased slightly to 36.9% compared to 36.8% for the first six months of fiscal 2013. The increase in the effective tax rate was due to a reduction in tax credits, principally the federal WOTC which has not been reinstated for 2014. The Company expects the full year 2014 effective tax rate will by approximately 36.9%. As a result of the foregoing factors, net income for the first six months of fiscal 2014 increased 8.7% to $182.2 million compared to $167.6 million in the first six months of fiscal 2013. Net income per diluted share for the first six months of fiscal 2014 increased to $1.30 from $1.18 in the first six months of fiscal 2013.



Liquidity and Capital Resources

In addition to normal operating expenses, our primary ongoing cash requirements are for new store expansion, remodeling and relocation programs, distribution center and store support center capacity and improvements, information technology, inventory purchases, share repurchases and cash dividends. Our primary ongoing sources of liquidity are existing cash balances, funds provided from operations, borrowings available under our Senior Credit Facility, capital and operating leases and normal trade credit. Our inventory and accounts payable levels typically build in the first and third fiscal quarters to support the higher sales volume of the spring and cold-weather selling seasons, respectively.



Working Capital

At June 28, 2014, the Company had working capital of $655.2 million, which decreased $21.9 million from December 28, 2013 and increased $29.0 million from June 29, 2013. The shifts in working capital were attributable to changes in the following components of current assets and current liabilities (in millions): June 28, December 28, June 29, 2014 2013 Variance 2013 Variance Current assets: Cash and cash equivalents $ 56.0$ 142.7$ (86.7 )$ 55.7$ 0.3 Inventories 1,154.6 979.3 175.3 1,082.9 71.7 Prepaid expenses and other current assets 48.1 57.4 (9.3 ) 52.7 (4.6 ) Deferred income taxes 25.5 29.8 (4.3 ) 14.4 11.1 1,284.2 1,209.2 75.0 1,205.7 78.5 Current liabilities: Accounts payable 390.2 316.5 73.7 360.8 29.4 Accrued employee compensation 21.1 50.6 (29.5 ) 26.8 (5.7 ) Other accrued expenses 144.4 155.6 (11.2 ) 138.4 6.0 Current portion of capital lease obligation 0.1 - 0.1 - 0.1 Income taxes payable 73.2 9.4 63.8 53.5 19.7 629.0 532.1 96.9 579.5 49.5 Working capital $ 655.2$ 677.1$ (21.9 )$ 626.2$ 29.0



In comparison to December 28, 2013, working capital as of June 28, 2014 was impacted most significantly by changes in our cash, inventories, accounts payable, accrued employee compensation and income taxes payable. The decrease in cash is primarily attributable to inventory purchases,

common stock repurchases and capital expenditures, offset in part by

earnings from operations. Capital expenditures are principally related to

new store construction and construction of the new store support center in

Brentwood, TN.

The increase in inventories and accounts payable resulted primarily from the

purchase of additional inventory to support new store growth as well as an

increase of average inventory per store of 10.9% due to normal seasonal

patterns. The decrease in accrued employee compensation is primarily due to the payment of annual incentive compensation. The increase in income taxes payable is primarily due to timing of tax payments. Page 14



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In comparison to June 29, 2013, working capital as of June 28, 2014 was impacted most significantly by changes in our inventories, accounts payable and income taxes payable.



The increase in inventories and accounts payable is primarily a result of

new store growth partially offset by a decrease in average inventory per

store of 3.4%. The decrease in average inventory on a per store basis is due

to deflation in the current year and a prior year inventory per store that

was slightly elevated due to strategic early third quarter inventory

purchases in key categories and additional inventory build to support the

relocation of the southeast distribution center in the third quarter of

fiscal 2013.

The increase in income taxes payable is primarily due to timing of tax

payments. Operating Activities Operating activities provided net cash of $166.5 million and $62.8 million in the first six months of fiscal 2014 and fiscal 2013, respectively. The $103.7 million increase in net cash provided by operating activities in the first six months of fiscal 2014 compared to the first six months of fiscal 2013 is due to changes in the following operating activities (in millions): Fiscal six months ended June 28, June 29, 2014 2013 Variance Net income $ 182.2$ 167.6$ 14.6 Depreciation and amortization 55.1 46.9 8.2 Stock compensation expense 8.1 6.9 1.2



Excess tax benefit of stock options exercised (4.2 ) (24.8 ) 20.6 Deferred income taxes

(13.0 ) 4.5 (17.5 ) Inventories and accounts payable (101.6 ) (134.3 )



32.7

Prepaid expenses and other current assets 9.2 (0.9 ) 10.1 Accrued expenses (40.1 ) (41.3 ) 1.2 Income taxes payable 67.9 34.9 33.0 Other, net 2.9 3.3



(0.4 ) Net cash provided by operating activities $ 166.5$ 62.8$ 103.7

The $103.7 million increase in net cash provided by operating activities in the first six months of fiscal 2014 compared with the first six months of fiscal 2013 primarily relates to the timing of estimated income tax payments. Also, inventory, net of accounts payable, required less use of operating funds in the first six months of fiscal 2014 than in the same period last year due to timing of receipts and payments. Investing Activities Investing activities used cash of $81.9 million and $90.0 million in the first six months of fiscal 2014 and fiscal 2013, respectively. The decrease in cash used for investing activities primarily reflects a decrease in capital expenditures. Capital expenditures for the first six months of fiscal 2014 and fiscal 2013 were as follows (in millions): Fiscal six months ended June 28, June 29, 2014 2013 New and relocated stores and stores not yet opened $ 39.6$ 29.9 Corporate and other 20.8 12.1 Information technology 12.1 14.7 Existing stores 8.7 5.5 Distribution center capacity and improvements 0.9



33.1

Purchase of previously leased stores - 3.3 $ 82.1$ 98.6 Page 15



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The above table reflects 55 new stores in the first six months of fiscal 2014, compared to 48 new stores during the first six months of fiscal 2013. We expect to open approximately 102 to 106 new stores during fiscal 2014 compared to 102 new stores in fiscal 2013. The decrease in spending on distribution center capacity and improvements in the first six months of fiscal 2014 compared to the first six months of fiscal 2013 is primarily due to the construction of our new Macon, GA distribution center in fiscal 2013, which is the relocation of our former Southeast distribution center in Braselton, GA. This facility became operational in the third quarter of fiscal 2013. The increase in corporate and other in the first six months of fiscal 2014 compared to the first six months of fiscal 2013 is primarily due to the construction of our new store support center in Brentwood, TN, which is expected to be completed in the third quarter of fiscal 2014.



Financing Activities

Financing activities used cash of $171.3 million and $55.8 million in the first six months of fiscal 2014 and fiscal 2013, respectively. This change in net cash used in financing activities is largely due to $77.7 million more in common stock repurchases and $20.6 million less in excess tax benefits related to stock option exercises during the first six months of fiscal 2014 compared to the first six months of fiscal 2013. On May 16, 2014, the Company exercised the option to increase the availability under the Senior Credit Facility by $150 million, which increased the aggregate principal amount available thereunder from $250 million to $400 million. The sublimit for swingline loans was also increased from $20 million to $30 million. This agreement is unsecured and matures in October 2016, with proceeds available to be used for working capital, capital expenditures, dividends, share repurchases and other matters. The Company had no borrowings under the Senior Credit Facility at June 28, 2014 and June 29, 2013. There were $70.9 million and $73.9 million outstanding letters of credit under the Senior Credit Facility as of June 28, 2014 and June 29, 2013, respectively. Borrowings bear interest at either the bank's base rate (3.25% at June 28, 2014) or LIBOR (0.15% at June 28, 2014) plus an additional amount ranging from 0.40% to 1.00% per annum (0.50% at June 28, 2014), adjusted quarterly based on our leverage ratio. The Company is also required to pay, quarterly in arrears, a commitment fee for unused capacity ranging from 0.08% to 0.20% per annum (0.10% at June 28, 2014), adjusted quarterly based on the Company's leverage ratio. The agreement requires quarterly compliance with respect to fixed charge coverage and leverage ratios. As of June 28, 2014, the Company was in compliance with all debt covenants. The Company believes that its existing cash balances, expected cash flow from future operations, borrowings available under the Senior Credit Facility, operating and capital leases and normal trade credit will be sufficient to fund its operations and its capital expenditure needs, including new store openings, store acquisitions, relocations and renovations, new store support center and distribution center capacity, through the end of fiscal 2014.



Share Repurchase Program

On February 24, 2014, the Company's Board of Directors authorized a $1 billion increase to the existing share repurchase program, bringing the total amount authorized to date under the program to an aggregate of $2 billion of common stock, exclusive of any fees, commissions, or other expenses related to such repurchases, through December 2017. The repurchases may be made from time to time on the open market or in privately negotiated transactions. The timing and amount of any shares repurchased under the program will depend on a variety of factors, including price, corporate and regulatory requirements, capital availability, and other market conditions. Repurchased shares are accounted for at cost and will be held in treasury for future issuance. The program may be limited or terminated at any time without prior notice. The Company repurchased 1.0 million and 0.4 million shares of common stock under the share repurchase program for a total cost of $62.5 million and $19.4 million during the second quarters of fiscal 2014 and fiscal 2013, respectively. During the first six months of 2014 and 2013, the Company repurchased 2.2 million and 1.4 million shares under the share repurchase program for a total cost of $147.0 million and $69.3 million, respectively. As of June 28, 2014, the Company had remaining authorization under the share repurchase program of $1.01 billion, exclusive of any fees, commissions, or other expenses. Page 16



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Dividends

During the first six months of fiscal 2014 and 2013, the Board of Directors declared the following cash dividends:

Dividend Amount Date Declared Per Share Stockholders of Record Date Date Paid February 5, 2014 $ 0.13 February 24, 2014 March 11, 2014 April 30, 2014 $ 0.16 May 19, 2014 June 3, 2014 February 6, 2013 $ 0.10 February 25, 2013 March 12, 2013 May 1, 2013 $ 0.13 May 20, 2013 June 4, 2013 It is the present intention of the Board of Directors to continue to pay a quarterly cash dividend; however, the declaration and payment of future dividends will be determined by the Board of Directors in its sole discretion and will depend upon the earnings, financial condition, and capital needs of the Company, along with other factors which the Board of Directors deems relevant. On July 30, 2014, the Company's Board of Directors declared a quarterly cash dividend of $0.16 per share of the Company's common stock. The dividend will be paid on September 3, 2014 to stockholders of record as of the close of business on August 18, 2014.



Off-Balance Sheet Arrangements

The Company's off-balance sheet arrangements are limited to operating leases and outstanding letters of credit. The Company typically leases buildings for retail stores and offices rather than acquiring these assets which allows the Company to utilize financial capital to operate the business rather than invest in fixed assets. Letters of credit allow the Company to purchase inventory, primarily sourced overseas, in a timely manner and support certain risk management programs.



Significant Contractual Obligations and Commercial Commitments

At June 28, 2014, the Company had contractual commitments related to the construction of its new store support center of approximately $1.8 million.

There have been no other material changes in our contractual obligations and commercial commitments other than in the ordinary course of business since the end of fiscal 2013. At June 28, 2014, there were $70.9 million outstanding letters of credit under the Senior Credit Facility and an $18.3 million outstanding letter of credit at a financial institution outside of the Senior Credit Facility.



Significant Accounting Policies and Estimates

Management's discussion and analysis of the Company's financial position and results of operations are based upon its consolidated financial statements, which have been prepared in accordance with United States generally accepted accounting principles. The preparation of these financial statements requires management to make informed estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. The Company's significant accounting policies, including areas of critical management judgments and estimates, have primary impact on the following financial statement areas:



- Inventory valuation - Income tax contingencies - Self-insurance reserves - Long-lived assets - Sales tax audit reserve

See the Notes to the Consolidated Financial Statements in our Annual Report on Form 10-K for the fiscal year ended December 28, 2013 for a discussion of the Company's critical accounting policies. The Company's financial position and/or results of operations may be materially different when reported under different conditions or when using different assumptions in the application of such policies. In the event estimates or assumptions prove to be different from actual amounts, adjustments are made in subsequent periods to reflect more current information. Page 17



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Recently Adopted Accounting Pronouncements

In May 2014, the FASB issued ASU No. 2014-09, "Revenue from Contracts with Customers (Topic 606)". ASU 2014-09 amends the guidance for revenue recognition to replace numerous, industry-specific requirements and converges areas under this topic with those of the International Financial Reporting Standards. The ASU implements a five-step process for customer contract revenue recognition that focuses on transfer of control, as opposed to transfer of risk and rewards. The amendment also requires enhanced disclosures regarding the nature, amount, timing and uncertainty of revenues and cash flows from contracts with customers. Other major provisions include the capitalization and amortization of certain contract costs, ensuring the time value of money is considered in the transaction price, and allowing estimates of variable consideration to be recognized before contingencies are resolved in certain circumstances. The amendments in this ASU are effective for reporting periods beginning after December 15, 2016, and early adoption is prohibited. Entities can transition to the standard either retrospectively or as a cumulative-effect adjustment as of the date of adoption. Management is currently assessing the impact the adoption of ASU 2014-09 will have on our Condensed Consolidated Financial Statements and related disclosures, including which transition method it will adopt.


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