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Executives

Carin Fike - Investor Relations

David B. Dillon - Chief Executive Officer

W. Rodney McMullen - Vice Chairman

Don W. McGeorge – President and Chief Operating Officer

J. Michael Schlotman - Chief Financial Officer

Analysts

Karen Short - Friedman, Billings, Ramsey & Co.

Neil Currie - UBS

Analyst for Scott Mushkin - Jefferies & Co.

Charles Cerankosky - FTN Midwest Securities Corp.

Edward Kelly - Credit Suisse

Meredith Adler - Barclays Capital

Mark Wiltamuth - Morgan Stanley

Deborah Weinswig - Citigroup

The Kroger Co. (KR) F3Q08 Earnings Call December 9, 2008 10:00 AM ET

Operator

Welcome to the third quarter 2008 Kroger Co. earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today's call, Carin Fike, Director of Investor Relations.

Carin Fike

Before we begin I want to remind you that today's discussion will include forward-looking statements. We want to caution you that such statements are predictions and actual events or results can differ materially. A detailed discussion of the many factors that we believe may have a material effect on our business on an ongoing basis is contained in our SEC filings, but Kroger assumes no obligation to update that information.

Both our third quarter press release and our prepared remarks from this conference call will be available on our website at www.Kroger.com.

Now I will turn it over to David Dillon, Chairman and Chief Executive Officer of Kroger.

David B. Dillon

With me today to review Kroger's third quarter 2008 financial results are Rodney McMullen, Kroger's Vice Chairman, Don McGeorge, Kroger's President and Chief Operating Officer, and Mike Schlotman, Senior Vice President and Chief Financial Officer. In a few minutes, Rodney will discuss details of our quarterly performance. First, I'll discuss what drove our sales during the quarter, and our outlook in this economy. Then we'll be happy to take your questions.

Kroger's third quarter sales continued to be strong in a tough economy. Identical supermarket sales rose 5.6%, without fuel, reflecting the strength of our customer-focused strategy that we developed six years and continue to sharpen today.

Identical sales growth was positive across all departments and all supermarket divisions. We are still seeing slowness in sales of discretionary general merchandise and jewelry, a trend we have discussed with you since the fourth quarter of 2007. This slowness continues to get worse.

Overall we are pleased with our strong sales trend, particularly in this environment. We realized higher product cost inflation continues to play a role, but our business model is designed to deliver consistent results, whether the market conditions are favorable or less than ideal.

Sales in regions affected by Hurricane Ike thanks to the outstanding efforts of our associates. Our teams worked tirelessly to get stores back in business quickly to serve families as they recovered and restocked their households. And we appreciate the dedication of associates throughout our organization who supported customers and colleagues in the aftermath of the hurricane.

Kroger's focus on low prices, quality products, and providing a convenient one-stop solution for their daily needs continues to resonate with customers and drive sales.

Several trends we have discussed in the past few quarters continue throughout the third quarter, namely a growing interest in private-label products and prepared foods as consumers choose to prepare and eat more meals at home and a sharper focus on price from all customers and all segments.

Customer interest in our corporate brands continues to accelerate in the third quarter for two reasons. First, the current environment is prompting customers to try more of our private-label products, and second, the overall strength and breadth of Kroger's private-label program appeals to shoppers on any budget.

For the second quarter in a row we saw accelerated growth in our corporate-brand penetration, both in terms of grocery sales dollars and units. During the quarter corporate brands represented almost 27% of Kroger's grocery sales and 34% of grocery units.

And our proprietary loyalty card data indicates approximately 14% of our customers are trading over in the purest sense by simply buying the same for less by switching to one of our corporate brands in any of the three tiers we offer.

Our robust corporate brands program is a fundamental part of our Customer 1st Strategy. Our quality products are strengthening our connection with our customers as we work to earn their life-long loyalty.

Kroger's corporate brand products are produced and sold in three tiers, private selection, store banner brand like Kroger's or Fry’s or King Sooper or Ralph’s, and our value brand. We continue to expand our private label offering across all three tiers.

While our entire private label portfolio is winning over customers, we are seeing particularly strong growth in both our private selections and value tiers. In fact, as we outlined earlier this year, our premium tier, private selections, which includes organic lines and gourmet meats, cheeses and deserts, to name just a few, is enjoying significant growth and is on track to reach $1.0 billion in sales in 2008.

We expect to continue to see solid growth in this important area, even after the economy recovers and we will continue to invest in Kroger's private label program.

One other advantage of our strong corporate brands program that it offers is as leverage when we have a supplier who approaches us with product a cost increase. This advantage has become even more important in an inflationary economy and Rodney will discuss this in more detail in a few moments.

I mentioned earlier that we continued to see growth in prepared foods as consumers choose to dine out less often and eat at home instead. This is a continuation of a trend that we have seen for some time. We did see strong sales in our deli/bakery and prepared foods departments again in the third quarter and are pleased that customers are increasingly looking to us to fulfill their needs for convenient, ready-to-eat meals.

Our sushi bars, hot soup, sandwich counters, and refrigerated soups and entrees are all doing well as a result of this shift in consumer behavior. In fact, the third quarter marked the 11th consecutive quarter of identical supermarket sales above 6% in our deli departments. This is nearly three years of consistently strong growth. We will continue to invest in developing prepared food options that are meaningful to our customers.

As we have discussed with you a number of times, Kroger's has been investing in lower prices for our customers for the past six years. Our pricing strategy plays particularly well in this environment as shoppers are increasingly focused on prices of staples they buy week after week and we are seeing signs that prices of staple items are increasingly becoming a deciding factor for customers in determining where they should spend their grocery dollars.

We are pleased that millions of households are choosing Kroger's family of stores because of the value, convenience, and quality that we provide and we remain focused on investing in lower prices for our customers, especially when they need it most.

The strength of our loyalty card program helps us deepen the connection we have with our customers. The scope and depth of our shopper card program is unmatched in the industry. These cards link our customers to savings on groceries, fuel, pharmacy needs, general merchandise, and corporate brands.

We use data derived from our loyalty card program to tailor unique coupon offerings for specific households. A recent mailing went out to more than 9.0 million households. Of those, 95% of those offers were unique to each household because we understand and appreciate that no two customers are alike. Some may live in the same city, some in the same neighborhood, and even on the street, but we know that they don’t have the same shopping habits. This level of personalization is a direct link to our customers no other U.S. grocery retailer can replicate.

These are just some of the competitive advantages fueling our sales performance. In today’s environment Kroger's team stands out. We continue to post positive identical sales growth consistently because of the unwavering commitment of our associates to our Customer 1st Strategy. And as Rodney will describe, we have the financial wherewithal to leverage our powerful strategy even in a difficult environment.

We are on track to deliver another year of solid results. We have confirmed our identical supermarket sales guidance for the year and raised our earnings guidance for fiscal 2008. We are also looking forward to another year of earnings per share growth in 2009 driven by continued strong trends in identical sales, even with the current forecast of the less inflationary environment.

Now I would like to turn the call over to Rodney for some additional detail on our third quarter results and 2008 guidance.

W. Rodney McMullen

We are pleased with Kroger's third quarter results, particularly against the backdrop of this tough economic environment and believe they illustrate the strength and flexibility of Kroger's business model in varying economic conditions.

Today I will offer some perspectives on certain elements of our results, including the effect of Hurricane Ike, LIFO expense, and strong fuel margins. I will also discuss Kroger's financial strategy, pension issues of today’s environment, and share additional color on guidance.

I will begin with Hurricane Ike and its effect on our third quarter earnings. Our results included a pre-tax charge of $25.0 million, or approximately $0.03 per diluted share, related to property damage and the disruption of our business caused by Hurricane Ike this past September.

The $25.0 million figure represents Kroger's retention under its property insurance and business interruption coverage. Our total losses exceeded that amount. The effect of the hurricane on our business was far-reaching. Ike and its remnants disrupted our operations in Texas and several inland states, including parts of Indiana, Kentucky, and Ohio, causing property damage, extended power outages, and fuel supply issues in several additional markets.

While we did incur some expenses we also realized some benefits as customers restocked their households after the hurricane. We believe these two outcomes likely offset each other. Further, we are preparing a claim under our insurance coverage and in compliance with GAAP accounting rules, will record a receivable once an agreement on the reimbursement amount is determined.

As Dave said, our associates did a terrific job to serve customers in the areas affected by Ike. To give you just one example of how quickly our teams moved, our Kroger's store in Galveston, which sits on the Galveston Bay, was the first major supermarket to reopen after Ike. The island was devastated, but our associates partnered with co-workers in other areas to get the right resources to Galveston quickly to get our store there in shape to serve that community when it needed it most.

We want to thank our associates again for a superb job. Without efforts like this, the effect of Ike would have been much worse.

Another unanticipated item during the quarter was the magnitude of our LIFO charge. We certainly expected a LIFO charge but the detailed analysis we conduct at the end of each quarter to update our estimate produced a result significantly different than our previous expectations.

Recall that when we reported our second quarter results in September we were estimating a full-year expense of approximately $160.0 million for 2008. We now anticipate the figure will be closer to $200.0 million. The incremental $40.0 million applies to the entire year and disproportionately burdens our third quarter results.

It is important to remember that the LIFO charge is an estimate for the first three quarters because we calculate our actual LIFO expense in the fourth quarter. Of all the estimates required for our quarterly financial statements, LIFO expense may involve the most mirrorability, particularly during periods of product cost changes, as we have seen over the past year or so.

The LIFO calculation is complex and depends on a variety of factors but the two primary drivers are year-end inventory level and product cost inflation at a particular point in time during the year. For Kroger's that snapshot is the 48th year of a 52 week fiscal year.

For the past two years, determination of the LIFO charge has added significant volatility to our quarterly results. We don’t enjoy the volatility any more than you do. When product cost inflation was non-existent to moderate, the impact on our financial results was not a significant. Now with grocery inflation at levels we have not seen in almost 20 years, the effect of the volatility is magnified.

During the third quarter our estimated product inflation was roughly 6% with levels of over 7% in many center of the store grocery categories. To give you just one example, canned vegetables is one category where we saw high product cost inflation in the second quarter and even a higher percentage increase in the third quarter. The dollar amount on that inventory is also high.

Even with the added earnings volatility our objective in using the LIFO method of accounting for our product inventories remains the same and that is to reduce Kroger's cash tax obligation. So while the non-cash LIFO charge hurts earnings and can increase the variability of our projections, it ultimately helps cash flow and we believe that is a wise trade-off.

In order to maximize this benefit, Kroger's carries over 95% of its inventory balance on LIFO. This is higher than nearly all our supermarket peers. Kroger's has been using the LIFO method for a longer period of time than many of our industry peers and this also affects the magnitude of our expense.

As you consider the effect of LIFO accounting on other food retailers, keep in mind that some of our discount competitors carry a significant amount of general merchandise inventory in addition to grocery inventory. For those retailers, deflation in certain general merchandise categories can mask inflation they may experience in their grocery inventories.

We understand that raising our full-year LIFO estimate for 2008 may seem counter-intuitive to many of you at the this, but certain commodity prices have declined from historical highs and while in general prices of some commodities have leveled or dropped, we continue to receive cost increases from several of our product suppliers during the quarter.

Those higher costs are the primary driver of the higher LIFO estimate. As you would imagine, we are discussing pricing issues with many of our vendors to make sure that the price that they charge Kroger's reflects the appropriate input costs.

As we have described for you several times, Kroger's manufacturing business and strong corporate brands portfolio gives us additional leverage in these discussions. As product costs do come down, keep in mind that we plan to pass along that benefit to our customers. We do not view lower product costs as a margin expansion opportunity. This mind set and approach is in line with our overall customer focus strategy.

Now I would like to comment briefly on our retail fuel operations. We did see exceptionally strong margins in our fuel business reflecting our typical margin experience when wholesale fuel costs declined, as they did throughout the quarter. Considering the following year-on-year comparison, the cents per gallon fuel margin for our convenience stores and supermarket fuel centers was $0.239 compared to $0.087 in the prior year.

While the effect on Kroger's earnings were quite favorable, we have been in the fuel business long enough to know that the fuel margins do tend to normalize over a longer period of time. On a rolling four-quarter basis, the cents per gallon fuel margin was $0.156 this year compared to $0.109 last year. But even that rolling four-quarter figure is skewed by two quarters of very strong fuel margins this year. We expect a more normalized fuel margin would be approximately $0.11 plus or minus a little.

Next, I would like to update you on our financial strategy. Our company’s financial strength has long been a competitive advantage and is even more so in the current environment. Kroger's balance sheet is strong and our financial position gives us the flexibility to continue investments in our successful Customer 1st Strategy and store base that will create value for our shareholders in the future while delivering near-term financial results.

We have aligned Kroger's cash flow priorities to leverage our financial strength and support an appropriate level of liquidity necessary under current economic conditions. We are now allocating cash flows primarily to capital investments, debt reduction, and dividend payments.

Given our current bias toward debt management, we were less aggressive in buying back shares during the quarter. Under current market conditions, this continues to be our position regarding share buybacks. As market conditions change, we will adjust our buyback activity accordingly.

We are on track to invest $2.0 billion to $2.2 billion in capital projects for fiscal 2008. For fiscal 2009 we expect capital investments similar to 2008. Our emphasis on store remodel activity and infrastructure investments will continue.

Our debt leverage matrix are improving. On a rolling four-quarter basis, Kroger's net total debt to EBITDA ratio was 1.96 compared with 2.02 during the same period last year. At the end of the quarter total debt was $8.0 billion, an increase of $553.0 million from a year ago.

As a reminder, the third quarter is typically our seasonal peak for debt levels as we build inventories to prepare for the holiday season to make sure we have inventory for Thanksgiving and Christmas.

While the credit markets remain under stress, Kroger's has ample sources of funding available to meet both short- and long-term financing needs. The company’s $2.5 billion committed 5-year credit facility maturing November 2011 continues to be available. Even on peak borrowing days, we expect to have more than $1.2 billion of this facility remaining available.

We also maintain uncommitted money market lines totaling $75.0 million. Furthermore, our access to the commercial paper markets has improved and we continue to obtain short-term funding as needed.

Our long-term funding sources are also well managed. In 2009, our only significant debt maturity is $350.0 million in senior notes due on June 1. Under normal conditions we would typically refinance that debt within a few days of maturity.

Current market conditions are anything but normal so when we saw an opportunity this past November to issue debt we did so. We were pleased to place $600.0 million in long-term bonds with a coupon rate of 7.5%, particularly in this environment. There was significant demand for this offering. This illustrates bond investors’ assessment of the strength of Kroger's balance sheet and business.

I wanted to spend just a few minutes talking about pensions. Many investors are wondering how the current market conditions are affecting both the company-sponsored and multi-employer pension plans.

For the company sponsored defined benefit plans we expect 2009 expense to be comparable to 2008. We expect to contribute between $150.0 million and $200.0 million to those plans in 2009. This is more than the 2007 and 2008 but comparable to 2006.

For the company’s 401(k) plan we expect a slight increase in our cash contributions and expense. This is a result of higher enrollment by our associates as they respond to our efforts to encourage employees to save for their retirement.

For multi-employer plans, we do not expect a significant increase in contributions, and therefore expense, in 2009.

Should current market conditions persist into 2010 we would expect contributions for the company sponsored defined benefit plans and multi-employer plans to increase during 2010.

Regarding labor relations, we are currently negotiating agreements that cover our store associates in Las Vegas, Phoenix, and Portland. Looking to next year, we will enter negotiations covering store associates in Albuquerque, Atlanta, Dallas, Dayton, Denver, and Roanoke.

Our objective in every negotiation is to achieve competitive cost structures in each market while meeting our associates’ needs for good wages and affordable health care. The likely increase in pension costs and how they align with other labor priorities will need to be addressed in bargaining.

Our ability to balance competitive costs with associate benefits allows Kroger's to invest in our business and create new job opportunities for existing and future associates.

Now turning to guidance, as Dave said, we are confirming our identical sales and raising our earnings per share guidance for fiscal 2008. We expect identical supermarket sales growth of 4.5% to 5.5%, excluding fuel, for the full year.

Excluding the $0.03 for diluted share charge related to Hurricane Ike, full-year earnings are expected in the range of $1.88 to $1.91 per diluted share. This equates to an annual growth rate of 11% to 13% over fiscal 2007 earnings of $1.69 per diluted share and implies a fourth quarter earnings range of $0.49 to $0.52 per diluted share. Kroger's dividend yield of more than 1% further enhances shareholder return. This guidance range considers the cautious mind set of many consumers this holiday season.

Looking to 2009, we are currently projecting identical supermarket sales growth, excluding fuel, of 3% to 5%. We do think inflation will be lower next year than in 2008. Our current expectation for product cost inflation would be in the range of 2% to 3%. This identical sales growth will enable Kroger's to generate earnings per share growth that combined with our dividend, will create a solid return for shareholders.

Now I will turn it back to Dave for some closing remarks.

David B. Dillon

Before we take your questions I would like to offer some additional thoughts on Kroger's third quarter performance.

On the whole we are pleased with our strong sales in the quarter, particularly considering the difficult economic environment. Our identical supermarket sales are among the best in the industry and we achieved those even with the considerable challenges Hurricane Ike presented.

Our sales show our Customer 1st Strategy is working. We are increasing customer traffic in our stores and selling more to customers who already shop with us. Our industry-leading corporate brands are gaining momentum and our pricing strategy is resonating with shoppers. We are making our customers lives easier by offering them a one-stop solution for their daily household needs.

During the quarter, we are in a good position to take advantage of the opportunities afforded by strong margins in our fuel business. But as Rodney mentioned, fuel margins do vacillate from quarter to quarter and tend to normalize over a longer time frame. We do not run our business based on margins.

Still, we could have done a better job in managing expenses during the quarter. Our OG&A performance was disappointing and we will improve. We must be relentless in our efforts to reduce expenses so that we can continue to drive cost savings back into lower prices and a better overall shopping experience for our customers.

We are keenly aware that the economy will continue to put pressure on our customers and our organization. Our Customer 1st Strategy is designed to give us the flexibility to perform well in good times and in bad. We are focused on maintaining our strong financial position so that we can continue to invest in our successful Customer 1st Strategy and produce a solid return for our shareholders.

Now, we would like to take a few minutes to answer your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Karen Short - Friedman, Billings, Ramsey & Co.

Karen Short - Friedman, Billings, Ramsey & Co.

I would just like clarification on your sales guidance for the full year. On the identical sales range of 4.5% to 5.5%, that implies a pretty wide range for the fourth quarter, so I am wondering if you could comment where sales are trending right now and what would make you think they decelerate enough to get you to the low end of the range for the full year.

And to follow up on that note, talk a little bit about the potential for a deflationary environment and what you think that would mean for retail prices.

David B. Dillon

It is a wide range, of course. But now times are such that it is a little less predictable than you might want, but to just give you a feel, we have four weeks under our belts in the quarter. The calendar is a little bit different this year in that Thanksgiving was at the very end of the month, and we had a two-day shift in the first of the month, back from February all the way until now and each month has produced some unusual results.

But even with all of that in the first four weeks of the quarter we are just a tick below 5% IDs without fuel; it’s where we are right now. So that gives you a sense of the picture today. We described that some of the discretionary products have been an issue all year long. In fact, we started describing it, I think, fourth quarter last year and it has gotten a little worse.

Fourth quarter is an important time for that. That would be one of the reasons for leaving a little breathing room on those numbers. But generally, you can see we are bullish in what we have achieved and our connection with the customer has been strong so I am actually feeling pretty good about things, given the environment that we are operating in.

One other piece that might be helpful to you that, generally speaking, it would be a little different in the holiday moments, but generally speaking the discretionary items we are talking about are roughly 10% of our sales. It wouldn’t be just some general merchandise items but it would be general merchandise and some other items in the store, but roughly in that range. So it’s not 50% of our business, and it’s also not 1% or 2%. It would be a bigger part of the business for Fred Meyer. That would give you a feel for that, too.

And then thinking about the inflationary environment going forward, we do recognize with commodity prices there is some likelihood that the retail prices will begin to plateau, maybe even decline. And in fact, in some categories and some items we have even seen that happen already. And certainly our efforts, as you know, because of the pricing position we take we are going to push the price out of things if we can, to make sure that we come out on the side of our customer in times like this.

And as we look at inflation as it does subside, it of course takes a little bit out of our sales lift that may be due to inflation, but that’s not the only thing happening in our sales lift. A lot of it is the more relevant connection we have with our customer.

Don W. McGeorge

To me, in a deflationary environment, I feel very comfortable we will perform very well relative to our competitors and better than many. And we think manufacturing always gives us a competitive advantage because we will be able to take those lower costs and give them to the customer sooner than some of our competitors will be able to, which should allow us to further gain some share.

So that doesn’t mean that it’s going to be easy but I don’t think any environment is easy in retail and I feel very good about our ability to react and adopt to whatever the environment is and utilize some of the strengths that we have.

Karen Short - Friedman, Billings, Ramsey & Co.

And on gas prices coming down, one, is are you seeing any change in consumer behavior? Higher traffic, with the lower gas prices, or shift in traffic versus basket.

And then could you give us what the fourth quarter gas margin was year?

David B. Dillon

On customer traffic, we saw customer traffic as we have seen, really, all year long. Customer traffic, as measured by transactions, has increased, both on a total and an identical basis. Our transaction size has increased, but you should recognize that there is quite a little bit of inflation in that number and so I would have to say once you take the inflation out we have had actually stronger increase in the number of transactions than we have actually even in the average sale.

But the average sale is strong, too, but in part because of the inflation.

J. Michael Schlotman

Gas margins, the fourth quarter last year would be a little over $0.12, about $0.125 and that was a little bit higher than the rolling four-quarter number.

Operator

Your next question comes from Neil Currie – UBS.

Neil Currie - UBS

The sales performance you are achieving right now is outstanding and I hear your sort of cautious tones for next year and I note that at the beginning of this year you also forecasted 3% to 5%. To what extent is the current economic environment actually a benefit to you right now? You have clearly driven a good price image amongst your consumers who see you as potentially a place to save money. Is the current environment actually driving more people to your stores, helping you to gain market share?

David B. Dillon

That is a great question and is you look the way we have described that throughout the whole year, there are certainly parts of the current economy that have helped us. In particular the parts related to customers when they decide it is less expensive to either get prepared meals at Kroger's or to buy ingredients and make meals at home. We are a great way to save.

And the investments that we have made in our retail pricing for the last six years continue to resonate well with customers, they recognize it, they see that, and they have responded. So in an economic environment like this, that certainly helps.

It also helps that when the gas prices were high, now at the moment they are lower, but when they were high, certainly customers saw us as a ready access for gasoline, one-stop shopping. They like that combination and it seemed to work well. The convenience of our store to a neighborhood also worked well in the high fuel price moments, but we still see traffic strong even despite the fact that gasoline has dropped a bit.

What we described earlier in the year, though, was that if conditions did not worsen. And clearly, as an economy, things have gotten a little worse across the country and I think you can see that in some elements of our business, too, in the things that we have released today. And on the whole, as a result, there are some things that are negatively tugging at our business in the economy but there are plenty of things that are working for the positive.

The bottom line for us is that when an economy is bad, people are still going to eat and somebody, some retailer, is going to do well and we are really committed to it being us.

Don W. McGeorge

The other thing, as we look at 2009 expectations and what we have outlined, is really trying to make sure we position the company for sustainable growth, and not just for 2010 but 2010 and beyond. And we want to make sure that we position it appropriately so that we have a long runway in front of us and not just a one-year runway, too.

Neil Currie - UBS

Just to touch on some of those comments, also in regards to people eating out less, could you give us some color on how your convenience are doing, or prepared foods? I know you have had some new ranges introduced via Green Core, but maybe on some of the other prepared-type meals and deli items that you have, are you seeing strong sales there?

David B. Dillon

We are. We have a wide variety of products that would fit that category and I wouldn’t single any of them out, but one of the comments I had in our prepared comments was that for 11 quarters now, almost three years, our delis have run in excess of 6% identical sales and that is a long time.

That is important to note because that means that we have responding to that trend for a long time and that we keep getting better and our customers keep recognizing that and it has now been year after year, after year.

Operator

Your next question comes from Analyst for Scott Mushkin - Jefferies & Co.

Analyst for Scott Mushkin - Jefferies & Co.

I just wanted to ask about share gains. Implied with your comp results, your ID results, you are picking up share. Where do you think you are getting it from? Is it from super centers, from conventional competition, from all the above?

David B. Dillon

First of all, we don’t give any public share changes until once a year and we will do that in March, when we come back and look at that data. But clearly, the business that we are getting though, is from lots of different places. As we have pointed out, in most of our markets, that even if you take us and others of large scale in our business, there is still roughly half the market that is up for grabs. And in addition to that, the most important I think, is to recognize how much restaurants are a piece of the eating action anymore.

In the last 20 years that is probably the single biggest trend that occurred in the U.S. communities as the people started eating at restaurants a lot more frequently. Well, that doesn’t have to change very much for it to be a very healthy thing for supermarkets, and I think we continue clearly to see that working to our advantage.

And that is partly driven by the economy, it is partly driven by the kind of products that we are offering now and the experience customers have is partly driven by the price structure and pricing practices we have and it is partly driven by people’s desire to have more meals at home with families. So all of those work, really, to our advantage.

Analyst for Scott Mushkin - Jefferies & Co.

And I wanted to ask about in an environment where gas prices are actually coming down, or have come down, how do you view the $0.05 discounts or have you strategized what you are going to do with gas in a $2.00 per gallon environment or below?

David B. Dillon

Our gas strategy is a lot more than just discounts like that. The real value is the convenience of having gas at a location where you can do most of your shopping, most of the household needs that we have, and at a retail price, our street price, is very competitive.

In fact, I have had customers actually thank me for when we opened gas stations in their neighborhood because we tended to bring the prices down in that area, that were posted at the pump, not only us but other would then match our price.

So on the whole I think customers see us as both convenient and a good price place to get gas. And then the gas promotions that you are describing are helpful, too, in that they do reward people who shop with us more regularly.

Operator

Your next question comes from Charles Cerankosky - FTN Midwest Securities Corp.

Charles Cerankosky - FTN Midwest Securities Corp.

Could you briefly talk about the convenience stores? How they did in the quarter.

W. Rodney McMullen

The c-stores had a great quarter. They had both strong identical inside sales and strong gallon growth and we are very pleased. And obviously the strong gas margins were on top of that.

So one of the things we always do internally is look at our relative performance to the other public companies and we felt we had an unusually good quarter relative to the other public companies, this quarter.

Charles Cerankosky - FTN Midwest Securities Corp.

Does the gas margin information you provided earlier include the convenience store element?

W. Rodney McMullen

Yes, it is c-stores and supermarkets added together.

Charles Cerankosky - FTN Midwest Securities Corp.

Looking at gasoline and the customers’ response to the promotion aspect of it, how has that changed with gasoline coming down?

David B. Dillon

I don’t think it has changed very much. It is an ongoing program that we have had for a long time.

Charles Cerankosky - FTN Midwest Securities Corp.

So people still want it.

David B. Dillon

Yes, they still want it. I think the biggest difference is that when gas got up over $4.00 a gallon people were pinched but as they filled up their tank they had less cash and I think it was noticeable to people’s budgets. Now that the gas is back down, at the moment, under $2.00, I don’t know how long that will last but at the moment that is where it is, customers have a little bit more spending cash.

But how they will spend that is anybody’s guess. Whether they will go back to restaurants a little bit more, that’s one of the values of us having given you an indication of where we are three to four weeks in the quarter, just to give you a sense that things really haven’t changed much. And that was our objective so that you could see that, even since gas has been low in this current quarter.

Charles Cerankosky - FTN Midwest Securities Corp.

You bought 3.0 million shares of stock in the quarter. Was that early in the quarter and what is your philosophy on stock buybacks here? Do you stop it all together or are you going to be in and out of the market, but just be overall less aggressive?

Don W. McGeorge

In this market we will be cautionary on the amount of stock we buy back. We still have a buyback plan in place that puts us in the market at certain prices, but just given the backdrop of the liquidity of the debt markets today, we feel it is prudent to maintain as much flexibility from the liquidity standpoint as possible and not be out buying shares when there is uncertain access to debt markets.

Now that said, we have had no problem accessing the debt markets and the commercial paper markets have opened back up for us to some extent. It is not always the best rate but we do issue some commercial paper from time to time, to keep our name out there.

Overall it has gotten a little better but until we see marked improvement we are likely to remain cautionary and devote our cash to debt pay-downs, dividends, and keeping a strong capital program.

Charles Cerankosky - FTN Midwest Securities Corp.

Any thoughts on improving the dividend yield at current stock price?

David B. Dillon

Obviously that is a choice that the Board makes and we have that choice and the market has another choice. If the stock price drops that of course increases our yield but that is not our objective.

Charles Cerankosky - FTN Midwest Securities Corp.

That’s not the way I was asking it.

Don W. McGeorge

Obviously, we haven’t had a dividend for that long and there are two things when you reinstitute a dividend you want to make sure of. One, that you can continue to maintain the dividend and we do think it is appropriate, over time, to continue to increase the dividend in terms of the dividend per share. And that would be our long-term goal, without getting specific about what we would do in any one fiscal year.

David B. Dillon

And I think in an environment like this you would have to consider all of the current factors, too, as we would always do. And I won’t speculate now on what the Board would want to do on that.

Charles Cerankosky - FTN Midwest Securities Corp.

Can you give us any insight into how gift card sales are tracking?

J. Michael Schlotman

So far so good, but it’s still very early, and as Dave mentioned before, the calendar has shifted so much that you really don’t know for sure until where the holiday ends, but so far so good. But we won’t be able to really give you a definite answer until after the holidays.

Operator

Your next question comes from Edward Kelly - Credit Suisse.

Edward Kelly - Credit Suisse

One of the biggest surprises to me this quarter, I think even more so than the LIFO charge, was the OG&A rate. You mentioned it a little bit, but it was up about 7.6%. That growth rate is higher than what we have seen historically. I think, ex the Ike impact, the ratio was up 23 basis points. Can you talk a little bit about what happened there this quarter?

David B. Dillon

In my mind, too, that is the soft spot in our quarter and I agree with the comments that you made. Let’s get the perspective just for a moment. The number we indicated was a 40 basis point increase but if you adjust that for the deductible in Ike, it was a 23 basis point increase, without the fuel.

We described health care as being at 13 basis points of that and we described energy-related and oil-related kinds of products, like utilities and bag expense, supplies, that sort of things as being 5 basis points of that.

All that is helpful to explain where we are but our bottom line is that we could have done a better job of managing expenses, that our OG&A performance was, even to us, disappointing and that we will improve.

Edward Kelly - Credit Suisse

If you look at some of your competitors, specifically Safeway, who now is really growing SG&A, or really not growing SG&A, it’s kind of flattish, and I get the company is focused more on SG&A, when the top line is maybe not going as well, and clearly that is not what is happening with you. But what is the opportunity for you, going forward, to control SG&A a lot more aggressively? Safeway will talk about how they can do it and not impact their IDs. Is that something that you think is an opportunity going forward?

David B. Dillon

Yes, we do agree that it is an opportunity going forward. And if you look at our history, 2006 and 2007 and 2008, I think in that whole time other than last quarter, only one quarter, did our OG&A actually go up. All the rest it was declining numbers. And that is our objective. That is our future objective. We believe the opportunity is there.

The caution for us internally is to say that we want to make sure that we don’t mess up our offering to the customer. That is real important. We could slash OG&A expense pretty easily just simply by cutting costs. That is not our objective.

We are trying to changes processes, we are trying to change some of our conventional mind sets on how to serve customers and we are trying to it in a way that the customer will actually see things as improved, not as worse.

So with all that in mind, I guess that is a long-winded way of saying I agree with you. All of everything you said is right. We should have done better, we can do better, we expect to do better in the future. We are committing to ourselves and by saying what we have done, we are committing to you that we are going to work on that hard in the future quarters.

Edward Kelly - Credit Suisse

Safeway is now slowing down its lifestyle remodel strategy. I assume that it has had at least some impact on you in the past. Do you see a benefit now going forward to your IDs, just from that program itself, rolling off?

David B. Dillon

I wouldn’t think that we would see anything specific as to that and plus I am not going to comment on any one competitor’s specific strategies and what they try to do or not do. I have said in the past that I admire what Safeway does and has done. I think they have done a good job with that program and I suspect they are slowing it because they have covered most of the stores they plan to cover. But that still means we are competing with a lot of the stores that have been converted, so it’s not those stores go away. They are a great competitor and we think we have fared as well in those markets as well as other markets.

Don W. McGeorge

This is a comment that is broader than just this quarter, but if you look, as Dave mentioned, for the quarter we had strong identical across the whole company and all divisions were positive. And you should assume that in order to get there that that means the identical were pretty consistent against competitors, too. So it’s very consistent across the whole company and across all types of competitors.

Operator

Your next question comes from Meredith Adler - Barclays Capital.

Meredith Adler - Barclays Capital

I have a couple of questions, maybe following a little bit on some of the recent questions. First, in talking about expenses, you did particularly call out health care and I don’t remember you mentioning it so much recently. Could you talk a little about whether the increases were particularly at the corporate level or for your unionized plants and what are you going to do to manage that? Is it manageable?

David B. Dillon

It was disproportionately more in the company plan than in the plans covered by union agreements, that are jointly managed stress funds. It was a combination of things. It was in some parts a bad experience on some individual claims and some increase in claims generally.

The way we manage that, and expect to manage it going forward and have managed it in the past, is working hard at plan design, which we have made lots of design changes over time, and not simply trying to shift costs to employees. That’s not the objective of a plan design. The plan design changes our design, really, to cause an associated to have some skin in the game, where they actually have some of their money they’re spending and so they have to let the market make some choices for them about what they want to do in their own health care and do they want to be healthier in their own personal lifestyle and so forth, to reduce their costs.

We have put a lot of emphasis, for instance, on health savings accounts and those programs do that very well. But we plan to continue some of the same strategies that we have had in the past and I do think it is manageable over time. Individual quarters, even individual years occasionally, may perk up a bit. You are right, we have not called it out in this particular way for some time, but we are paying close attention to it and it is an area that we think we can do a lot with.

Meredith Adler - Barclays Capital

A question I have been getting a lot from investors about inflation, I remember 18 months ago, Dave, you said that food inflation was probably a neutral on the perishable side and a modest tailwind on the packaged good side. We still do have packaged good food inflation, but can you talk about, you were forward-looking at the time. Did you believe that on the packaged good side it was a modest positive to profit and what happens when you get deflation?

David B. Dillon

My personal opinion, based on the observations I have seen over the last several quarters, is that inflation is a moderate plus, just like we hypothesized at the time, but that when inflation either becomes erratic, that is occurs quickly, or is a much higher number, both of which occurred in the last quarter or so, then it starts to chip away at that net-net positive and makes it harder.

And I think what has made this harder in the last quarter or two is lay that on top of an economy that went south in a very fast hurry, I think this year has been, for all of us, one for the record books. I don’t think anyone has expected many of the radical changes that occurred at the pace they occurred with the high variability. I think all that degree of uncertainty and so forth layered an additional element on top of just inflation at work.

Had it been just inflation at work, it may have even continued to be still a net-net positive. Now I see it as a little bit more neutral than I did. I don’t see it as a harshly negative thing, though.

Now you asked about deflation, deflation is another animal. I think it is going to depend on how it comes. We have seen commodity prices plateau, subside a little, and in some cases even decline from last year. How that gets translated into lower costs, and how quickly it does, and then how that gets played out in the markets and what happens in the consumer behavior in terms of the economy and their spending patterns, I think will all determine whether or not the less the moderate rate of inflation, the lower rate of inflation, will create a positive or just be neutral.

W. Rodney McMullen

I was just going to add one other comment. On the inflation, when you go back and look at as we put together our Customer 1st plan overall, and what we assumed would happen, and as you remember, one of the things we had always assumed was like Tesco would come to the US.

Well, one other major assumption we had made long term was that inflation would be somewhere between zero and 1% a year. So our fundamental belief, on a longer-term basis, is that inflation will be very modest. Obviously, the last year or so it has been higher than that but longer term we don’t think it will be and we have always tried to build our business model around that assumption that it wouldn’t be.

Meredith Adler - Barclays Capital

So you are not looking at it and saying you benefited so much from inflation and now that we have deflation it’s going to hurt?

David B. Dillon

No, we’re not saying that. But we are cautious saying we are in unchartered territory, what’s occurred the last six months, and it makes it a little hard to forecast. And it makes the future a little hard to forecast because what we are going to experience is different than maybe has been experienced before.

W. Rodney McMullen

I feel very comfortable if you look at it over a year or a year and a half, the business will be able to adjust accordingly. But if inflation went from 6% positive to 6% negative in one quarter, I think it is going to take a little while to adjust for that. But longer term, and when I say longer term on that comment I mean a year to a year and a half, I think the business will readjust and things will be fine.

David B. Dillon

It further illustrates why we look at this business on an annual basis instead of just a quarter-to-quarter basis. And it also illustrates why we try not to manage it simply by margins. We are trying to look at our connection to the customer over time and the business we have with them over time.

Meredith Adler - Barclays Capital

When you think about, I believe the branded manufacturers are still raising prices on packaged goods, partially because the locked in higher commodity costs, do you have a philosophy about the gap in pricing between your corporate brands and the national brands? Will you be widening that or is it category by category?

David B. Dillon

Well, it is item by item actually. It depends on what works well for the customers. When you look at what happened in the quarter, our tonnage on Kroger brand and corporate brand products increased. But as you can see from our sales and also the rate of inflation, our tonnage on the whole really grew a little but not a lot, as a company.

And that you can just do the math and know what happened with national brands. National brands plateaued, or even declined, in many cases. And that will, on their parts, require some rethinking of how they want to approach that business.

But our view is that it is the customers we are interested in. We are not trying to beat the national brands with corporate brand necessarily. We think it is a great offering but many of our customers want the national brands and we see that as actually our friend. So our interest is in getting our customers what they need, which is lower prices, and if it is our Kroger's brand products and the national brands don’t follow suit, well that’s fine. We will just pick up even more market share than we are already picking up in the corporate brands and that will put further pressure on the national brands to get right on their pricing.

Meredith Adler - Barclays Capital

You said that the higher LIFO had a particularly bad impact on the third quarter, but you are anticipating that it will be higher than your original plan in the fourth quarter, too, is that right? And did that contribute to the fact that the growth rate in the fourth quarter, which originally you thought would be faster than the rate for the whole year, will not be, based on your current guidance?

J. Michael Schlotman

If you look at it relative to expectations, LIFO in the fourth quarter will be higher than what we were thinking before. Not necessarily higher than last year, but certainly higher than prior expectation.

Meredith Adler - Barclays Capital

And that impacts the guidance?

J. Michael Schlotman

Yes. Three-thirteenths of the extra $40.0 million falls in the fourth quarter and ten-thirteenths is in the third quarter. That’s just how you have to book it. We have to get right year-to-date and it’s $40.0 million more expense for the year so year-to-date we have to get ten-thirteenths of the $40.0 million behind us and that leaves three-thirteenths, or about $9.0 million or $10.0 million for the fourth quarter.

Operator

Your next question comes from Mark Wiltamuth - Morgan Stanley.

Mark Wiltamuth - Morgan Stanley

I wanted to dig in a little more on the gas margins. Our model was predicting a pretty big margin swing and the number you called out was fairly similar to it so that sounds like almost an $0.08 or $0.09 swing in earnings per share versus a year ago. Did you get to reinvest some of that into lower prices or did it come too late in the quarter?

David B. Dillon

As we mentioned in the comments I made is that the higher gas margins afforded the opportunity to some of the things we were otherwise doing, but we fully recognize that that’s not a permanent solution because gas margins were particularly high, we got partly by skill and partly by luck in the quarter but we’re not expecting that benefit out into the future and as a result we can’t permanently lock in spending that. It can only help us with some of our programs at that particular time.

Mark Wiltamuth - Morgan Stanley

And did some of the gains carry into the first four weeks of the fourth?

J. Michael Schlotman

We won’t give that level of guidance because within the quarter it will swing all over the place and it’s way too early to tell you where we think it will be for the fourth quarter.

David B. Dillon

And on the quarter, the higher LIFO also costs almost $0.03.

Mark Wiltamuth - Morgan Stanley

On pensions, on your company operated plan you said that the contribution may not increase. Are you just talking about the cash contribution? I would imagine the expense number would probably be higher because of this year’s shortfall, is that fair?

J. Michael Schlotman

No. On the company plans for 2009 we would expect cash contributions to increase, $150.0 million to $200.0 million. But we believe the expense related to that will be a very modest change.

Mark Wiltamuth - Morgan Stanley

Did you make some changes to the plan, to account for this year’s miss? After this year’s shortfall I would imagine that would increase expenses.

Don W. McGeorge

Keep in mind the way you account for a company sponsored plan is one year’s lost gets amortized over a several-year period of time, from a book standpoint. You don’t take all that one-year loss in one year.

Mark Wiltamuth - Morgan Stanley

And then your discount rate goes higher probably.

Don W. McGeorge

The liabilities are discounted at the AA corporate rate and while the AA corporate rate, the base treasury is at historic lows, the spreads are at historic highs, so as I sit here today I would expect a higher discount rate this year than last year, which would mitigate some of the short fall from our return.

J. Michael Schlotman

And if you look, all recent hires, a few years ago we changed the plan to where it’s more a 401(k) because that’s really what our associates wanted in today’s world. And that change was made a couple of years ago, which also affects the numbers overall.

Operator

Your last question comes from Deborah Weinswig – Citigroup.

Deborah Weinswig - Citigroup

With regard to capex, the guidance was for flat in 2009 versus 2008. Can you provide a little bit more color around that and do you think there are opportunities for taking over locations from other retailers as well.

Don W. McGeorge

The guidance on capex would be organic capex. It would exclude any acquisition opportunity, so there wouldn’t be anything baked into that. If those kinds of opportunities come up, oftentimes it winds up accelerating the capital expenditure program.

For instance, when we bought the stores in Ft. Wayne and Michigan in last year, being able to pick up those sites really fills out those markets quite well and you shift from needing to build new stores to remodels. So if those kinds of things are out there, there could be some trade-off. But we think that kind of a spending level is appropriate, given the remodel activity we have planned as well as some of the infrastructure spend that will use those dollars.

Some of these are really good investments for the very long term that have very good returns and very solid returns, on the infrastructure side.

David B. Dillon

If you look at the dollars overall, as we have done for the last several years, we continue to focus more and more on remodels and expansions and it would have a very similar look in 2009 as what you have seen in 2008 and 2007 because we feel we are getting much better results out of the remodels and expansion projects.

Deborah Weinswig - Citigroup

Just going back to the sales guidance for 2009, IDs up 3% to 5% excluding fuel, when we compare this to the 4.5% to 5.5% for 2008, is the majority of the difference between the tiers, your outlook for product cost inflation, or just a conservative stance, or a combination of the two?

David B. Dillon

At the moment it would be more inflation-driven. You would probably accuse us of being more conservative.

Deborah Weinswig - Citigroup

On the corporate brand penetration, health and beauty aids versus the rest of the store, what kind of opportunity is there in the HBA side?

David B. Dillon

I think there is big opportunity, actually, in HBC and still in grocery, too. But HBC would have a little bit more opportunity than grocery would. But we see them both as still really ripe for development and we continue to invest in the opportunity.

Thank you all for joining us and before we end the call I would like to share with you some additional thoughts for our associates who are listening in today.

For our associates, first, thank you for another quarter of strong sales. Our sales performance is a result of your individual contributions. The economy is pressuring more and more families every day and you have heard us mention low prices as one of the primary reasons customers are choosing our stores over others in this environment.

Kroger's is able to continue to invest in lower prices for our customers because of cost saving that we work to find every day. And your personal commitment to saving costs no matter where you work in the organization, no matter how small the savings, makes our lower prices possible, helping to drive customers into our store.

Every time a customer chooses us we are in a better position to take advantage of opportunities to grow our business. As your family members, friends, and neighbors celebrate this holiday season, please remind them about our low prices and our great products they can find at their neighborhood one-stop Kroger's store.

As we close, I want to thank you for your commitment to our customers and to each other. I hope that you each take time to enjoy this holiday season with those close to you. Thank you for taking time to join us.

Operator

This concludes today’s conference call.

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Source: The Kroger Co. F3Q08 (Qtr End 11/08/08) Earnings Call Transcript
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