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The Kroger Co. (NYSE:KR)

F2Q09 Earnings Call

September 15, 2009 10:00 am ET

Executives

Carin Fike - Investor Relations

David B. Dillon - Chairman of the Board, Chief Executive Officer

W. Rodney McMullen - Vice Chairman of the Board

Don W. McGeorge - President, Chief Operating Officer, Director

J. Michael Schlotman - Chief Financial Officer, Senior Vice President

Analysts

Deborah Weinswig - Citigroup

Simeon Gutman - Canaccord Adams

John Heinbockel - Goldman Sachs

Mark Wiltamuth - Morgan Stanley

Edward Kelly - Credit Suisse

Scott Muschkin - Jefferies & Company

Neil Currie - UBS

Charles Cerankosky - Northcoast Research

Karen Short - BMO Capital Markets

Meredith Adler - Barclays Capital

Operator

Good day, ladies and gentlemen, and welcome to the second quarter 2009 Kroger Company earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today’s call, Ms. Carin Fike, Director of Investor Relations. Please proceed.

Carin Fike

Good morning and thank you for joining us. 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 second quarter press release and our prepared remarks from this conference call will be available on our website at www.kroger.com.

After our prepared remarks, we look forward to taking your questions. In order to cover a broad range of topics from as many of you as we can, we ask that you please limit yourselves to one topic with one question, and a follow-up question if necessary. Thank you.

I will now turn the call over to David Dillon, Chairman and Chief Executive Officer of Kroger.

David B. Dillon

Thanks, Carin and good morning, everyone. Thank you for joining us today. With me today to review Kroger's second quarter 2009 financial results are Rodney McMullen, Don McGeorge, and Mike Schlotman.

As many of you know, Don announced his decision to retire earlier this year and will remain with us in an advisory capacity for the next few months. Rodney was named President and Chief Operating Officer effective August 1st. In a few minutes, Rodney will offer details on certain aspects of our performance during the quarter and then Mike will provide details on the financial elements we report.

First I will start with an overview of the current environment. We are pleased with our performance this quarter as it aligns with our long-term strategy of winning households for life, making Kroger a stronger retailer now and in the future. Our customers are increasingly turning to Kroger's family of stores to meet even more of their everyday household needs. As a result, our customer focus strategy is generating and will continue to generate solid long-term value for Kroger's shareholders.

Identical supermarket sales increased 2.6% in the second quarter without fuel. This is a solid increase, particularly considering changes in customer behavior and significant deflation in produce and dairy. In fact, our product cost inflation estimate excluding fuel dropped to a negative 0.2% from the positive 3.6% we estimated in the first quarter. The increase in identical supermarket sales also signals that more customers are turning to Kroger to consolidate purchases, driving the exceptional unit growth we saw in the quarter. In fact, this quarter -- this is a quarter where we believe our identical sales results do not fully reflect the strength of our business. Our comments today should give you some additional perspective. Growth in the number of loyal households we serve is just one example. Loyal households represents our very best customers and during the second quarter, our data shows a strong increase in the number of loyal households that shop our stores. Our data also indicates that these customers are making more trips to our stores and buying fewer items per trip, yet in the course of a month, these households are buying more total items from Kroger than they were a year ago, which indicates that they are consolidating more of their total spend with us.

In addition to deflation and changes in customer behavior, two other factors influenced Kroger's results in the quarter -- planned investments and competition. As a result of all of these factors, gross margin declined more than expected. Rodney will share details on each of these factors with you shortly but first I want to update you on Kroger's exceptional tonnage growth and discuss guidance for the remainder of the year.

Our overall tonnage growth in grocery increased at almost double the rate we experienced in the first quarter. Strong corporate brand sales drove overall tonnage growth in grocery, just as it has for the past two quarters. We also saw tonnage growth in national brand products. This is a trend change from the past three quarters where we’d seen declines in national brand unit sales.

We experienced very strong tonnage growth, particularly in dairy, meat, and produce as customers responded positively to lower costs and better pricing. I want to thank our associates in our plants, warehouses, and stores for doing an outstanding job keeping up with the tremendous volume growth we’re generating. Keep up the great work.

Looking forward to the rest of the year, we have confirmed our full-year identical supermarket sales guidance of 3% to 4% without fuel for fiscal 2009. This guidance assumes product costs for the remainder of fiscal 2009 are consistent with or slightly lower than they were in the second half of fiscal 2008. We have revised our 2009 earnings per share guidance to reflect continued changes in customer behavior and an uncertain operating environment. We now expect full year fiscal 2009 earnings of $1.90 to $2.00 per diluted share. This is a wider range than our previous guidance of $2.00 to $2.05 per diluted share because of the uncertain economic environment and the subsequent caution on the part of customers.

In the short term, there are several factors influencing our business that caused us to change our original projections. These factors may continue to influence Kroger's financial results for the remainder of the year and will help determine where in the earnings guidance range we end the year. Scenarios that would lead to earnings per share at the high end of the range include improvement in customer sentiment that leads to a sales mix change which could enhance Kroger's gross margin; moderating inflation in produce and dairy; a lessening of competitive or promotional activity in key markets; and stronger margins in our retail fuel business than we had -- than we currently anticipate.

The reverse of these scenarios could lead to a result at the lower end of the guidance range. Despite the challenging operating environment, we remain on our plan and we are confident our approach and the investments we are making will continue to make -- and we will continue to make Kroger a stronger retailer now and in the future.

Now I will turn to Rodney who will discuss other aspects of our performance during the quarter. Rodney.

W. Rodney McMullen

Thanks, Dave. Good morning, everyone. The Kroger team produced solid results in the second quarter. As Dave said, four primary factors influenced our results this quarter -- one, deflation; two, changes in customer behavior; three, planned investments that were part of our original plan; and four, competition. I want to take a few moments to discuss each of these factors with you, beginning with deflation.

In general, we can grow our business in an inflationary or deflationary environment but sudden deflation in a highly competitive market can lead to retail prices and product costs that drop quickly, creating lower margins. This was the case in the second quarter in categories like milk and produce, where we experienced significant deflation, we certainly sold more units. But lower retail prices and profit per unit pressured our second quarter results. And for the first time in several quarters, we began to see deflation in most grocery categories.

The second was changes in customer behavior. We continue to experience changes in customer behavior during the quarter. Consistent with the past two quarters, customers are buying more of what they need and less of what they want. The most prevalent trend this quarter was the willingness of customers to switch within a product category. For some customers, it meant switching from one national brand to another lower priced national brand. For other customers, it meant trying a Kroger brand or switching to our value brand. Our corporate brands continued to enjoy exceptional growth -- in fact, this continued to have double-digit growth in units this quarter versus last year.

Corporate brands now represents 26% of our grocery sales dollars and 35% of our grocery units sold. This is almost 200 basis points higher than their unit share in the same quarter of last year.

Another trend we are seeing is in food stamps and other benefits. Government data indicates an increase in these benefits due to the economy. At Kroger, we are seeing an even sharper increase in our sales from customers using food stamps. While all of these changes in customer behavior can adversely affect Kroger's sales and profitability in the short-term, they do benefit us in the long-term because it keeps customers in that category and in our stores.

As part of our overall strategy, we plan our price investments strategically and make decisions based on our deep insight into customer behavior through our partnership with dunnhumby. This is a competitive advantage for Kroger. As a result of our insight, we have moved some planned investments up and delay others based on the competitive market and customer behavior as we did during the quarter.

The competitive landscape also changed during the quarter. While our industry has always been competitive, we did see heightened activity in more markets than we typically do. This is not surprising because customers are spending less and retailers are aggressively competing for their dollars.

We continue to enhance Kroger's strong competitive position in this environment. Our positive identical supermarket sales results and strong tonnage growth demonstrate our ability to continue to gain market share in all economic environments.

As part of our customer focused culture, we deliver value in a number of ways through our people, products, prices, and the overall shopping experience in our family of stores. Additionally, our fuel rewards program continues to reward our most loyal shoppers through discounts on fuel earned through their purchases inside our supermarkets. No other U.S. grocery retailer can currently replicate the value proposition we offer. Customers’ response to our programs and initiatives continues to be overwhelmingly positive. Through these types of investments, our customers have saved $1.5 billion in the past year.

Now let’s turn to labor relations. Last month our associates in Dayton, Ohio ratified a new agreement. Negotiations continue in Atlanta, Arizona, and Portland and we have contract extensions in all three markets. In Colorado, our efforts at the bargaining table have not produced an agreement. We have made a balanced strong offer for a new contract there and we expect it will be in the hands of our associates to vote soon. We are hopeful that our associates will approve the offer without a work stoppage.

In Dallas, the contract for our store associates expire later this year. In addition to the normal pressures on our business, rising healthcare costs and under-funded pension plans will have to play out at the bargaining table. Still, we continue to be a destination employer that is hiring and promoting associates in this tough economic climate and offering high quality affordable healthcare for associates and their families.

Now Mike will offer additional color on the quarter. Mike.

J. Michael Schlotman

Thanks, Rodney. Good morning, everyone. I will review several aspects of Kroger's second quarter performance, beginning with net earnings. Kroger's second quarter net earnings were $254.4 million, or $0.39 per diluted share. This compares with net earnings of $276.5 million, or $0.42 per diluted share in the same period last year. We estimate that our retail fuel operations added a penny less to second quarter earnings per share this year compared to the prior year. I will cover retail fuel operations in a few minutes but first let’s review key financial metrics of our core supermarket business. Let’s start with gross margin.

As many of you know, we use a term internally to measure the difference between the retail price that a customer pays for a product in one of our stores and the cost we pay to procure that product from the supplier. This term is supermarket selling gross margin and it declined 88 basis points during the second quarter excluding our retail fuel operations. This declined significantly larger than our average investment over the past several quarters. It reflects the planned investments that Rodney described for you. It also reflects the unplanned factors he described, including the impact of sales mix changes, some heightened competitive activity, plus produce and dairy deflation that has been deeper and more sustained than we anticipated. These are temporary factors. As they normalize, we would expect Kroger's selling gross margin investment to normalize as well.

Kroger's FIFO gross margin excluding our retail fuel operations decreased 60 basis points on a year-over-year basis. The difference between Kroger's FIFO gross margin and supermarket selling gross margin is primarily the operating costs that are embedded in our FIFO gross margin. These operating costs include shrink, warehousing, transportation, and advertising expenses. During the quarter, we achieved meaningful improvement as the rate of sales in all these areas. We were particularly gratified to see improvement in logistic costs given the significant tonnage increase handled by associates in our distribution system to service the additional customer demand in our stores.

Turning now to LIFO, we recorded a $14.7 million LIFO charge during the quarter, a decrease of $31.5 million from the prior year. We now anticipate a full-year LIFO charge of $70 million for fiscal 2009. This estimate is based on our forecast of 1% to 2% inflation for the year. This particular inflation forecast is based on cost changes for products in our inventory and is used for our LIFO calculation. The LIFO calculation does not consider the velocity at which a product moves -- only how many units of an item are in inventory and the year-over-year change in the items’ cost. When Dave referenced 20 basis points of product cost deflation relative to sales, that calculation does consider the velocity of product movement.

Turning now to operating, general, and administrative expenses, Kroger's OG&A rate excluding retail fuel operations decreased 7 basis points compared with the same period last year. This decline reflects strong cost controls, lower incentive compensation, and our ongoing efforts to control utility costs through several of our efficiency initiatives. We also enjoyed some relief in expenses tied to petroleum costs. For example, the plastic shopping bags provided in our stores.

We are very pleased by this OG&A performance. Achieving OG&A leverage is particularly challenging in an environment of declining retail prices and higher unit sales and we appreciate the progress our team made in this important area. We continue to see opportunities for additional operating cost savings, which will be important as we face ongoing cost pressures in pension, healthcare, and credit card fees.

Kroger's long-term objective is to balance cost savings with investments. While we did not meet that objective this quarter, we believe the period was a short-term anomaly. Total operating costs did decline and we were pleased with the direction, especially considering the deflation on the top line and strong unit growth. Through the first two quarters of fiscal 2009, Kroger's operating margin excluding our retail fuel operations and the benefit of a lower LIFO charge decreased 17 basis points. On this basis, we now expect a slight decline in Kroger's operating margin for the year.

Let’s now turn to Kroger's retail fuel operations. Kroger now operates more than 800 supermarket fuel centers and about 700 of our convenience stores sell fuel. Gasoline is an important part of Kroger's one-stop shopping strategy, allowing us to offer a convenient service at a great value to our loyal customers. Customers continue to respond well to our fuel offering. During the quarter, we sold more fuel gallons, both on an absolute and identical basis.

In the second quarter, the cents per gallon fuel margin for our convenience stores and supermarket fuel centers was $0.136 compared to $0.179 for the same period last year. Because of the margin volatility inherent in selling large volumes of fuel, we always encourage investors to take a longer view of this part of our business.

On a rolling four quarters basis, the cents per gallon fuel margin was $0.133 this year compared to $0.12 for the same period a year ago. Please keep in mind that the fuel margins we realized in fiscal 2008, particularly in the second and third quarters, were exceptionally strong. Our expectations for the current fiscal year are based on a more normalized fuel margin of $0.11 per gallon.

Now I would like to update you on Kroger's financial strategy, beginning with capital investment. We continue to view the current environment as an opportunity to improve Kroger's store base and overall operations. We believe capital investment is important for the continued growth of our business as it positions Kroger as an even stronger retailer in the future and we continue to see returns above our hurdle rate. For the second quarter, capital investment excluding acquisitions and purchases of leased facilities totaled $518 million compared to $461.1 million in the prior year. On this basis through the first two quarters of fiscal 2009, we have invested $1.1 billion. We continue to project 2009 capital spending of $1.9 billion to $2.1 billion, excluding acquisitions and purchases of leased facilities.

During the first two quarters of the year, we spent $115.3 million to purchase some of our leased properties at very attractive rates. This included several retail stores and one distribution center.

We expect additional real estate opportunities to come our way and we have the financial strength to be able to take advantage of them.

Net total debt was $7.3 billion, a decrease of $198.5 million from a year ago. On a rolling four quarters basis, Kroger's net total debt to EBITDA ratio was 1.78 compared with 1.90 during the same period last year. We expect to continue to improve Kroger's debt coverages on a year-over-year basis.

While Kroger's bias towards debt reduction remains in the current environment, we have continued to make some share repurchases. During the quarter, Kroger repurchased 2.8 million shares of stock at an average price of $21.58 per share for a total investment of $60.1 million. At the end of the quarter, $425 million remained under our current stock repurchase authorization.

Also during the quarter, Kroger returned $59 million to shareholders in the form of cash dividend payments. We believe Kroger's quarterly cash dividend, which currently yields over 1%, is one way that our customer first strategy rewards shareholders.

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

David B. Dillon

Thanks, Mike. As you can hear from our comments today, we remain on our plan. Our approach and the investments we are making continue to strengthen Kroger today and position us well for future growth.

It may seem counter-intuitive to hear me so optimistic in such an uncertain environment but based on what I am seeing first hand in our stores, I am enthusiastic about the can-do selling passion our associates have embraced and our customers tell us that they see it too. That’s why customers are choosing to spend more time and more money in Kroger's family of stores. If you haven’t visited one of our stores in a while, I encourage you to do so. There is an excitement and an energy among our associates that is inviting and is really fun to see. They are doing an outstanding job and that’s why Kroger's future is so promising.

And with that, we’d now be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Deborah Weinswig from Citigroup.

Deborah Weinswig - Citigroup

Great. Thanks so much and thanks for all the color on the call today. You talked about some of the change in consumer behavior in your loyal households. Can you also talk about what you are seeing from the rest of your customer base as well?

David B. Dillon

Well, we’re seeing a couple of things that might be of interest to you. The consumers throughout the U.S. obviously are going through a lot of trauma and so we are seeing a change in the customer behavior in our store a little bit. For instance, the end of the month selling is noticeably at lower levels than what it used to be so it’s more impacted. We saw that through this last quarter and we actually saw earlier signs of it before but I think it’s even more clear now.

I think it also tells you a little bit about consumer behavior when we indicated that among our very best customers that while we’re getting -- that we’re growing the number of households that are counted as our best customers and those folks are shopping with us more often, that’s a little counter intuitive too and they are buying fewer items when they shop more often. That’s also a little counter-intuitive. But the picture as we see it is people are spending money when they need to -- that is for meals for the day or for the week, but they are only spending what they need to and then they are having to come back a little bit more often. By coming back a little more often and because they’ve consolidated purchases with us, we are seeing a higher unit purchase per household over the course of a month.

So I think that’s -- it’s good news for us but it’s a pretty clear picture that the consumers around the U.S. and the customers at Kroger are experiencing some trauma in this environment.

Deborah Weinswig - Citigroup

Okay, and then in terms of a follow-up question, obviously you are gaining market share. Are there certain categories where you are gaining more share or is it pretty widespread throughout the store?

David B. Dillon

Well, it’s really widespread. Let me just give you a little more color on the departments in our ID sales. Our strongest departments were in meat, deli, bakery, grocery and nutrition. All of those were clearly above the average. General merchandise continued to be a little soft, mostly the discretionary areas but it is slightly improving in the trend from where it was before. And produce of course is negative but that is all driven by the deflation experienced in the category. So on the whole, we feel like we are growing share pretty broad-based.

And actually, it’s pretty broad-based across our divisions too. We did have in the quarter we had two divisions that had negative ID sales. Those divisions though were negative less than 1% negative, so just barely negative. We had two that were flat and the rest were positive so that’s pretty widespread as well, so hopefully that will help you a little.

Deborah Weinswig - Citigroup

Great. Thanks so much and best of luck.

Operator

Your next question comes from the line of Simeon Gutman of Canaccord Adams.

Simeon Gutman - Canaccord Adams

I think the numbers make a pretty clear statement that Kroger is going to maintain its pricing advantage in the marketplace and given your scale, probably best positioned to handle it. But your competition has to be feeling more pain than you are and I know you might not have lived through a past cycle like this one but how -- in your best guess, how long do you think this could last for and are different channels important in the equation this time?

David B. Dillon

Well, I don’t think there’s been a cycle like this one before, at least not that I would have experienced. It’s hard to predict, obviously, how long this will last and you can follow the economists and get their sense but my sense is a while longer. I realize that doesn’t help you very much but we are actually, as you can tell, pretty optimistic. We saw signs last quarter in the tonnage growth, and you’ve never heard me before, I don’t think, say that our sales were better than the identical sales that we actually reported but they were.

To give you a little perspective on that just for a second is if you look at the tonnage and look at our produce and dairy sales and try to adjust -- in other words, take the movement we experienced but take the deflation that we experienced out of it, you’d see almost an increase of roughly 200 basis points in our ID sales. I mean, that’s remarkable.

And so actually you’d say I think in those numbers that Kroger saw some recovery in sales last quarter but it doesn’t really show in the numbers because of so much deflation. So I’d watch for when the commodities begin to change, when the deflation subsides a little, and I would think a couple of quarters but it’s still out there.

Simeon Gutman - Canaccord Adams

And the --

David B. Dillon

-- might want to add to that.

Unidentified Participant

Well, I was just going to say -- you know, from an economy standpoint, we’re doing our planning with the assumption that it will be slow for a while but it will continue to get slightly improved from where we are today. As Dave talked about deflation, we certainly think deflation is possible for the next couple of quarters but not as bad as what we saw in the second quarter and then once we cycle, we would certainly expect to see next year or typical grocery inflation.

Simeon Gutman - Canaccord Adams

Okay, and then my follow-up, maybe you can just reconcile what you just said about deflation being persistent because I think in the guidance it says the costs for the remainder of this year consistent with or slightly lower than they were in the second half of last year. I think the second half of last year, maybe I’m misinterpreting, I think you were still looking at costs in the 5% to 6% range. Am I missing something there?

J. Michael Schlotman

What that was attempting to say was that while it went up last year in the fourth quarter, third and fourth quarter, we would expect no inflation to slight deflation in the back half of this year compared to those high cost increases last year.

Simeon Gutman - Canaccord Adams

Okay, thanks.

J. Michael Schlotman

It’s not saying we are going to have the same inflation as last year’s second half. We feel it’s going to be flat to slightly down.

Simeon Gutman - Canaccord Adams

Okay.

Operator

Your next question comes from the line of John Heinbockel from Goldman Sachs.

John Heinbockel - Goldman Sachs

A couple of things -- Dave, I guess from the guidance with regard to the back half of the year on comp, you have seen no further slippage in your comp number here early in the third quarter but that number has held. And then you would expect to get a bump in the fourth quarter on maybe less deflation and general merchandise, with Fred Meyer coming back. Is that fair?

David B. Dillon

Well, actually it’s not quite accurate. If you look at the third quarter so far and we only have four weeks I think into the quarter, our identical sales actually are down a little from what we experienced in the second quarter. However, and it’s a big however, the comparisons are actually difficult, beginning I think roughly last week, for us to draw many conclusions because last year you may recall we had several storms, hurricanes, one of which actually just this last weekend a year ago came up through the Midwest and did quite a bit of damage, so the comparisons are kind of tricky right at the moment but I did want to make sure you knew that our sales so far in this quarter are down just a little bit from where they were last quarter. That obviously suggests that later in the third quarter and certainly in the fourth quarter that we expect to see some modest pick-up in our sales in order to get within the guidance and that would be accurate.

John Heinbockel - Goldman Sachs

The follow-up to that, first quarter didn’t you say what the tonnage growth was? I thought it might have been 4% or something like that. Is that not right?

David B. Dillon

I don’t know if we did or not.

J. Michael Schlotman

The only thing that we talked about in the first quarter going off of memory would be on corporate brands had double-digit tonnage growth and that national brands actually had slightly negative tonnage growth.

John Heinbockel - Goldman Sachs

Okay. All right and then finally, if you look at the ROI of your price investments and obviously you are doing this, you are picking up some traffic, you expect to keep those customers as the economy gets better -- how do you look at the ROI and do we know yet if the returns you are getting are comparable to what you’ve gotten in the past?

David B. Dillon

Well, we obviously believe the ROI on the price investments is worth the investment. We believed it at the time we took the position or we wouldn’t have taken it and we continue to believe it or we wouldn’t have maintained that price position.

The good part about it at Kroger is we get a look at the customer through our customer insights and that allows us to adjust as we go, so as if we see something that we don’t think is going to pay off in the short or long run, depending on what our expectations of the particular investment was, then we change it. And that’s been true through the quarter and it’s been through actually in the past as well.

J. Michael Schlotman

And if you go back at the price investments that we would have made two or three years ago, we are very, very happy with the results that we’ve got from those and it’s one of those things where you continue to measure over an extended period of time, and as Dave mentioned, if something is not working, you adjust accordingly.

John Heinbockel - Goldman Sachs

All right. Thanks, guys.

Operator

Your next question comes from the line of Mark Wiltamuth with Morgan Stanley.

Mark Wiltamuth - Morgan Stanley

Good morning. Just to dig in a little bit on private label gains, are your gains slowing a little bit now that the brands have begun to grow again? If you could speak to that a little bit.

David B. Dillon

Well, we had two -- three quarters now in a row where our percent of units sold in grocery in corporate brands was 35%. Fourth quarter, first quarter and second quarter, all three were 35%. Now, the growth in the fourth and first quarter was roughly a 300 basis point increase and the growth this last quarter was roughly 200 basis point increase and so I suppose the rate of growth is different but that’s only because last year the rate was different. But we’re still running 35%, which is strong.

Now, we see this as a continuing trend. We do not see it subsiding. We are very happy with that.

Mark Wiltamuth - Morgan Stanley

And what do you think is behind the trend change on the branded side of the house?

David B. Dillon

I actually think it’s two things -- I think it’s using our investments in brands effectively. Our customer insights helps us think about how we spend our money on promotions and on pricing and on promotional pricing, everyday pricing and so forth. And I think that helps us target the customer where the customer wants to be targeted. And second is I think some of the national brand vendors are really trying to regain some tonnage movement and see us as a natural place to do it since we are effective at using money wisely in that regard.

It does not seem to affect really the growth though of our corporate brands and so we see that as really good news, that it broadens the customer appeal and we see that all as positive news.

Mark Wiltamuth - Morgan Stanley

Okay. And then on the deflation discussion, is there any insight you can give us on what’s going on on the supply side in any of those categories? Have farmers backed off on production? Is there anything that could point to that could end some of the deflation just from supplies tightening up?

David B. Dillon

Well, if you look at -- like on dairy, as an example, there’s been a reduction in the number of milk cows but this summer has been so mild there’s actually been an increase in the production of milk. So if you look at net net, there’s actually an increase in production of milk. At some point, that will -- you will have a normal cycle and that will affect the amount of milk that’s out in the market and it will affect cheese also.

Mike mentioned to me corn is the same thing, where there’s fewer acreage this year but so far it’s been a very good growing season when you look at the country overall, so there’s plenty of supply there.

Mark Wiltamuth - Morgan Stanley

And produce is another area where you’ve had some double-digit deflation -- what’s going on there?

J. Michael Schlotman

As you know, that will change for each season. The summer season was incredibly strong, both from a quality standpoint -- I mean, the product was eating outstanding and there was a lot of it. That won't always happen but we just had an incredibly good summer from a produce standpoint.

Mark Wiltamuth - Morgan Stanley

Okay. And just maybe a little more color on the increased competitive activity. It sounds like you probably invest a little more gross margin than you would have liked because of what others were doing. If you could talk about that a little bit.

David B. Dillon

Well, we don’t talk about specific markets on competitive activity but it’s pretty clear that there was more of it this quarter than in the past. We’ve always described quarters as being highly competitive and I think that certainly continues but we just saw more markets that had retailers trying to regain some lost position in the -- during the quarter and that caused us to make sure that we were responding appropriately.

We look at market share as a very important strength for Kroger and plan to keep it that way.

Mark Wiltamuth - Morgan Stanley

Okay. Thank you very much.

Operator

Your next question comes from the line of Edward Kelly from Credit Suisse.

Edward Kelly - Credit Suisse

Good morning. Dave, I just want to make sure I heard you correctly in terms of your IDs and where you are running now and what you expect for the rest of the year. I mean, it seems like you need IDs to pick up from here to hit the guidance that you provided. Is that how we should think about that or are there other moving parts to that?

David B. Dillon

Our year-to-date through the second quarter IDs without fuel are 2.9%, so to be within the guidance, we obviously have to be better than we’ve been running to get it back up to 3 or higher. And we indicated that in the first four weeks -- it’s just four weeks but the first four weeks of the third quarter were a little bit less than what we experienced in the second quarter. That’s also correct but then identified that the storms and stuff from last year made at least last week and even this week, and maybe even the week after, a little hard to compare. So it will take us another three or four weeks before we see the picture more clearly but that what we are expecting is some pick-up in our IDs through the remainder of the year, particularly later in the year, especially as we think and believe and expect and hope that produce deflation moderates a little and dairy deflation moderates a little. Those two by themselves, I gave that number earlier where if you take just those two areas, produce and dairy and try as we can, although there’s no real sure way to do this, try as we can to adjust and say if we had not had the deflation but did have the tonnage growth, what would our ID sales have been? And it was roughly a 200 basis point impact. So it’s a big deal. If we saw some change in that area, even if the tonnage didn’t quite maintain, I think we would see some pick-up in ID sales.

So that’s the base of our assumption and how you should think about it.

Edward Kelly - Credit Suisse

Okay, great. And clearly what you have discussed in terms of tonnage, you know, to me seems extremely encouraging and it seems like you are continuing to take share. I mean, should we infer from all that that your acceleration in your price investments are performing at least as well as you would expect relative to plan in your peers?

David B. Dillon

Yes.

Edward Kelly - Credit Suisse

Okay. And one last quick question for you -- you did buy back a little bit of stock this quarter. You had indicated previously that you probably wouldn’t be doing that. Why not buy back more at this stance with your stock sitting here at $20 and the credit markets getting much better?

J. Michael Schlotman

Well, we continue to balance our need to make sure we have the right liquidity through this time and while I agree the capital markets are getting better, we do have a bank credit facility that matures in 2011 and somewhere around this time next year we’ll be in the throes of renewing that and once we can see clearly where that’s going to shake out, we’ll take another look at our liquidity. We also think it’s important to get the increase in our credit rating from S&P to triple B flat so that when we redo that credit agreement, we can also issue A2P2 commercial paper, which will be a huge help from the standpoint of how we access the capital markets.

Edward Kelly - Credit Suisse

Great, thanks. Good luck the rest of the year, guys.

Operator

Your next question comes from the line of Scott Muschkin from Jefferies & Company.

Scott Muschkin - Jefferies & Company

Hey guys, thanks for taking my question. So beating a dead horse a little bit here but I wanted to get your insights -- you know, we’ve gone now I guess starting in 2001, you guys started to do a lot of price investing but we have actually walked a lot of your stores, Dave, and we would actually concur with what you said about your execution. It seems over the last three years, execution merchandising stocking pricing and all the end caps really is probably as good as some of the private companies out there. When do we not have to invest 88 basis points in gross margin to keep customers loyal? That’s a lot. I’m not saying you guys don’t have to invest still but that’s a lot and it seems like with what we are seeing at the stores, there should be more loyalty or am I missing something? Maybe there’s not an answer here but I would love to have you respond to that.

David B. Dillon

Scott, I appreciate your vote of confidence and your observations and I think that’s reasonably accurate with what we feel about our own business. We would agree with you that the 88 basis points of selling gross that we invested in the quarter is strong, is deeper than we’ve had in recent quarters and I really see it as a bit opportunistic. In this current environment, based on what our customers clearly want, we felt we needed to take some pretty strong positions.

I don’t think most of us in our working career, maybe none of us, have seen an environment, a selling environment quite like what we are experiencing right now. And we are intent on making sure that it turns into a good opportunity for us and for the company, for our shareholders and for our associates and for our customers.

And so we’ve looked for ways in which we can effectively spend money that we think will give a return to the shareholders in the long run but will certainly attract the customers in the short run. We think it’s a current advantage we have. It takes advantage of the customer insight we have, it takes advantage of the financial strength that we have, it takes advantage of the market share that we have. So we see this as really a -- I won't say a one-time opportunity but there are not many times like this and we wanted to make sure we used it to a reasonable extent. We realize the gross investment was deeper than most of you expected and it was deeper than what we had planned for originally for the quarter. But we made -- through the quarter, we made several intentional choices to go down this path because we believe it was the best long-term path for you as shareholders, for our associates, and as I’ve said, for our customers.

Scott Muschkin - Jefferies & Company

Okay, I appreciate that. And just I guess two follow-ups, one on what you are saying -- when you look at the demand curve and what people respond to, you know, you walk into let’s just say a Ralph’s in Southern California, fully stocked produce area, competitors including Walmart not seeing that. Do customers want to pay for that? You know, that type of execution? In other words, if your prices are just as good or better, doesn’t that help you or were you basically saying hey, come to my stores and see what we -- and try to gain actually new customers?

David B. Dillon

That is a trickier call than most of the things -- trickier decision than most of the things that you’ve described up until now because that really is the acid test. There are costs associated with that produce presentation you just described and the question really is do the customers want to pay for that? And we are regularly reevaluating that question, not necessarily, although certainly includes the topic of produce stocking but it includes lots of other things.

You’ve seen some differences in our shelf conditioning, as an example, because we specifically concluded that customers didn’t want to pay for that. And we saved the money and with the savings, we reinvested that into things that the customers did want, which was lower prices, shorter lines in the stores, and a few other things, better in-stock conditions, that kind of thing. So we are constantly trying to reevaluate that.

I think that balance in what services we offer in the stores will probably change over the long haul. It won't change quarter to quarter and week to week. We would just confuse customers with our brand if we were to do that but I think you will see gradual changes over time as we continue to assess what the customers really want in our stores.

But you picked a rather -- I won't call it an extreme example but a really good example because Ralph’s does such a great job in their produce presentation and you do have to ask that question.

Now I’ll also offer that the Ralph’s produce department is a very effective group too. They work real hard and I would give them high credit for getting that done at a minimal amount of cost that it would take to do that. Other parts of the country might not be as successful to deliver on that at the same lower costs that they can achieve.

W. Rodney McMullen

Certainly if you look at the research that we do with our customers every quarter, this past quarter on our four keys the customers gave us higher ratings than they had before so certainly we are connecting even better with the customers than what we have before.

You know, as you look at over time, and Dave and Mike both mentioned, we would certainly expect more balance in terms of between selling gross reductions and reductions in total operating costs over time.

Scott Muschkin - Jefferies & Company

Actually, we’d love to keep talking about this but I’ll open it up. I may follow up with you guys later today if that’s okay.

David B. Dillon

Feel free.

Operator

Your next question comes from the line of Neil Currie from UBS.

Neil Currie - UBS

Good morning and thank you for taking my questions. I guess margin is the topic of the day and I just wanted to drill down a little bit more, if I could. It seems to be that there are three main areas of -- or three main reasons why your margin went down. One was planned investments, one was reactive investments, and the other behavioral changes by consumer, with some positive like private label and some negative like trading down.

I just wondered if you could give us a level of magnitude as to which contributed most to the overall 88 basis point decline in the supermarket selling margin?

J. Michael Schlotman

If you look at the four areas that I talked about on deflation, changes in customer behavior, planned investments, and competition, that order would be in terms of how we felt affected the numbers the most. So we felt like deflation affected the gross margin, selling gross the most. Changes in customer behavior was second, planned investments was third and competitive changes was fourth.

Neil Currie - UBS

Doesn’t competition actually feed into deflation one as well, because I think it was a quarter ago that we talked about milk margins. In fact, obviously the costs are down as well as the selling price and I think a quarter ago, you were saying that units were up and the gross profit dollars were slightly richer in milk, yet that’s changed. And is that to do with more competition?

J. Michael Schlotman

To me, that’s the $6 million question -- how much of it is being driven by the market and how much of it is driven by competition? I think each one of us in the room here would have probably a different answer and I am not sure you can prove what is the right answer but we certainly think the deflation and changes in customer behavior will cause more competitive reactions.

Neil Currie - UBS

That seems to be the biggest change quarter on quarter, is that last quarter, gross margin seemed to be, and we’ve seen this [inaudible] with the company is that the lower cost of goods sold is not necessarily a bad thing but it seems to now be a bad thing. Would it be right to say that’s been the biggest change quarter to quarter?

J. Michael Schlotman

I think if you only look at the quarter, when you look at longer term, we do not believe it will be a bad thing.

Neil Currie - UBS

And if I may, I just wanted to ask the same question everybody else has asked but in a slightly different way, which is if you look at the one area that’s -- that you can control better, which is the planned investment, do you feel that you could -- obviously things change through the quarter. Do you feel you could still achieve the sort of tonnage growth that you are achieving whilst moderating that planned investment? How sticky is it?

David B. Dillon

We actually made changes to our original plan before the quarter started and during the quarter. We accelerated a couple of items and we decelerated and postponed a couple of items based on how we read the market at that time. And I believe, personally believe that what we chose to do was a good contributor to the increased tonnage that we experienced and the connection with our households that we experienced. I suppose you could argue on any one of the points of what we did or whether it produced the value but the proof really comes with a little bit of time. And as Rodney correctly pointed out earlier that it’s our past experience with some of these approaches that have helped us interpret what we ought to do today and in today’s environment. And it was a judgment call and that’s what we ended up making.

Neil Currie - UBS

Thanks, and if I can just ask one more question, you took guidance down for the year by around $0.05 to $0.10, depending on where the high and low point was. And you missed in this quarter the street’s expectations by around $0.05 or so. That seems to indicate that the second half of the year, your expectations are broadly unchanged, enough despite sort of a tough headwind on fuel profit comparisons. So does that indicate that the second half of the year, you feel just fairly secure about your original expectations and the second quarter was really just an inflection point in terms of competition?

J. Michael Schlotman

Well, if you look at -- and we don’t give quarterly guidance but if you look at where the consensus estimates are for the back half of the year and add it to our first half results, it would be the high-end of our range. So if things were to go right and we were to hit the metrics that Dave spoke about in talking about our guidance, that could put us at the high-end of the range, because we’re $1.05 so far and it’s I think $0.95 for the back half of the year is the current street. So I -- we didn’t take $2 off the table but there is variability out there. We have a big mountain to climb in the third quarter with where our retail fuel operations were last year and just the uncertain customer environment is what caused us to give the broader range that we did give.

Neil Currie - UBS

That’s very helpful. Thanks very much.

Operator

Your next question comes from the line of Charles Cerankosky with Northcoast Research.

Charles Cerankosky - Northcoast Research

Good morning, everyone. Dave, could you discuss sort of the pace of business in the second quarter, to start off with? I mean, was it getting more difficult as the quarter progressed or was it a very sudden thing at some point in the quarter?

David B. Dillon

We actually saw just two things that were notable in the quarter. Mid-summer, which would have been the middle of the quarter, was softer than I would have expected but the most important thing that we saw was the end of the month was noticeably softer than it had been running before and the first of those end of the months came right after we had this conference call after the first quarter, so the end of June. It was true at the end of June, end of July and it’s safe to say the end of August, even though that’s in the next -- in this new quarter. Those were all soft periods and I think it’s something we’re just going to have to get used to because I think it’s a clear picture for what our customers are going through. They just run low on money by the end of the month and that ends up softening even more the discretionary purchases that you get.

W. Rodney McMullen

Certainly from a dollar standpoint and from a unit standpoint, not as much so.

David B. Dillon

That’s true. That’s very true. We still have a lot of physical work in the stores because we have a lot of traffic in the stores end of the month but they are not buying quite as much in the dollar size of what they did before.

W. Rodney McMullen

So a lower price point.

David B. Dillon

So I think it’s just a shift in what we have to get used to as handling the business. It’s not a danger sign or anything like that but that’s really what we saw in the quarter.

Charles Cerankosky - Northcoast Research

Are you seeing the private label national brand split more distinct towards the end of the month?

David B. Dillon

You know, I don’t know that I’ve looked at that, so I don’t know that I have an answer. I’m looking around and I don’t think we have an answer for that, Chuck. That’s an interesting question. I’d suspect that I would -- I mean, I would hypothesize that there are some changes in the end of the month in a number of ways and that could certainly be one of them.

Charles Cerankosky - Northcoast Research

Can you talk about the growth you saw in loyal households in the items? You were happy with the growth in each. Could you describe what is a loyal household and how much stronger things actually are?

David B. Dillon

Well, I’ll give you a sense -- loyal households, we use an internal definition which I won't repeat or share but it basically is a grid that is made up of frequency of visits and amount of purchase in a period of time before we will count somebody as a household that is loyal to Kroger. And loyal doesn’t mean exclusively with us -- in fact, you’ve heard me talk a lot before about we believe that among our loyal households that as much as 50% of their business that they could give us, they are giving to other places, other outlets. So there’s still significant increases available from our loyal households. So you can imagine what the non-loyal households have to offer. But we are seeing a growth in that area. We are also seeing specifically a growth disproportionately high, not huge but still disproportionately high, the new households, new loyal households that we are seeing are disproportionately in the direction of customers who are a little more price sensitive. Now, that could be driven by what is happening in the economy. We certainly think what we are doing helps with that because we are trying to play to that sweet spot and we believe it affects the way people shop and certainly our data would suggest that too.

Charles Cerankosky - Northcoast Research

And included in this definition you mentioned, it would be the tonnage growth -- that’s where that’s coming from? More households, more loyalty?

David B. Dillon

Yeah, we actually track tonnage two different -- at least two different ways. One is to look at what moves through our warehouses and goes to the stores. On that basis, we were very happy with tonnage. With the households, we actually track units that they buy in each visit and then we track units that that household buys over the course of time. And as we pointed out in the households, they are actually buying fewer units each time they come but they are coming enough more often that the average number of units that a household is buying from us is higher than it was. So that’s actually good news.

Charles Cerankosky - Northcoast Research

And deli bakery was one of your stronger categories, I think somebody said? I just want to check on that.

David B. Dillon

Yes, that was one of the departments that was better than our average. We are very happy with that area.

J. Michael Schlotman

It still seems pretty clear that people are switching from going to restaurants and eating at home and either buying things in our stores to prepare at home or buying things in our deli department.

Charles Cerankosky - Northcoast Research

And finally, you had a number in the press release about the purchase of the leased facilities. Is that strictly your own buildings or does that include from other companies, other retailers’ buildings?

J. Michael Schlotman

It’s by and large facilities we operated that were leased that we had the opportunity to buy out that lease. There was one building we acquired with the way you described but it was only one.

Charles Cerankosky - Northcoast Research

How do you feel about the opportunity over the rest of this year and into next year, actually, being able to purchase buildings from other owners, other operators?

J. Michael Schlotman

I would think it would continue. There’s one that came across my desk just today. It was a property we’ve been trying to negotiate with the owner to buy it out. They didn’t like our offer. They actually decided to take it to auction and we are now going to buy it because we have first right of refusal on the property, that we are now going to wind up buying it at what it went for auction for, which was well below our original offer, so we are glad they didn’t take our offer.

Charles Cerankosky - Northcoast Research

All right. Thank you.

Operator

Your next question comes from the line of Karen Short from BMO Capital Markets.

Karen Short - BMO Capital Markets

Just a couple of questions, sorry to beat a dead horse also on this one but as it relates to the planned investments, I know you said you accelerated some and then decelerated some but for the full year, it’s fair to say that you will increase your planned investments. Is that right?

David B. Dillon

Let’s see if I can describe it this way -- that’s not right. I think the planned investments will be fewer this year than what we had originally had in mind but I can say that at least one of them is a little more expensive than what we had originally planned, which is entered into our thinking.

Karen Short - BMO Capital Markets

Okay, and then I guess just switching to the environment, a couple of questions within this -- you know, you said you had two divisions that have slightly negative IDs. Can you just give some color around how that might -- I know there was only one division in the fourth quarter and then one division in the first quarter but they weren’t the same division. Can you maybe just give some color on that?

And then wondering if you can just talk about the environment and how you -- I mean, obviously it’s competitive. Would you say it’s become irrational?

David B. Dillon

I actually don’t remember which divisions were negative in the previous two quarters so I don’t know whether it’s the same ones or now. Mike may know that and answer it in a second but I think it’s real important in the deflationary picture that we only had two that were negative and those two that were negative were less than 1% negative -- I mean, I think that’s an astounding picture, personally. So I think that’s important to note. Did you want to answer that question?

J. Michael Schlotman

On the negative divisions, the divisions are different than what the division was in the fourth quarter and what it was in the first quarter.

David B. Dillon

Yeah, so that just illustrates what is happening, is the market is in a bit of a state of flux. It just is. I mean, this is just an unusual market time.

Karen Short - BMO Capital Markets

Okay, and then I guess just the last question -- Mike, can you just elaborate on what you think needs to happen for you to get an S&P upgrade, or a rating change?

J. Michael Schlotman

Well, they came out a couple of weeks back and put us on positive credit watch, which in their language means that a ratings upgrade should be imminent. They described the environment that it would take for that upgrade to occur and in their model, we could have a decline in EBITDA of up to 2% this year and still have the metrics that they think would allow us to be upgraded. And while this quarter was soft, if you look at EBITDA year-to-date, we are up on EBITDA year-to-date. So I think we are hitting the metrics that they want us to hit and we have a lot of conversation with them. Obviously ultimately they have -- they are the decision-maker, not us but we continue to deliver from a credit metric standpoint what it is we promise to deliver.

Karen Short - BMO Capital Markets

Okay, great. Thanks very much.

David B. Dillon

Thanks, Karen. We have time for one more question.

Operator

Your final question comes from the line of Meredith Adler from Barclays Capital.

Meredith Adler - Barclays Capital

Most everything has been answered but I was just wondering if you could comment, when you talk about trading down or changes in consumer behavior, you didn’t mention consumers buying more product on promotion. Other market chains have talked about that. I was wondering if that’s something you were seeing.

David B. Dillon

I think it’s fair to say we are seeing a little bit of that but is that because of the state of mind of the consumer and our customers or is that because the markets are a little bit more promotional with the competitive activity? I’m not sure I know the answer to that question. I’m looking around to see if there’s any other color to that but I’m not sure that we have anything more to add.

Meredith Adler - Barclays Capital

And do you believe that having the frequent shopper data and being able to be more targeted in your promotions allows you to avoid having to do sort of widespread kinds of promotional activity?

David B. Dillon

Sometimes it does but a lot of what we have done in this past quarter would have -- is pretty obvious, either in our ads or in our stores and wouldn’t be targeted individually but the thing about what we are picking and the value of some of our consumer insights is it allows us to understand when we pick an item or a price or the combination, it helps us to understand who is the target audience that that item and that price speaks to, because even though it may be available in the store to everybody, it obviously doesn’t speak to everyone. So that’s really the value of consumer, customer insight for us is it can target the way in which we behave in the store.

W. Rodney McMullen

And we use that data more and more to go to suppliers and suggest things to try together to enhance their volume and enhance the loyalty for our customers with our customers also.

David B. Dillon

Yeah, we talked about the national brand increased tonnage in the quarter and I think one of the contributions there that created that is the vendors we do the best job with are ones we are partnering with, who work with us and thinking about how to use this data effectively, just like Rodney described.

Meredith Adler - Barclays Capital

And is there any change in the level of support that you feel you are getting from vendors, either secularly or because of your ability to partner?

David B. Dillon

Well, I think vendors are generally speaking, and this isn’t just with us, they weren’t happy with their tonnage so I think they are trying to reassess what they do on pricing, both list price and also promotional money. One of the advantages that we have at Kroger is that we partner well with national vendors and the insight that we have allows us to effectively spend the money that we can use to invest with the customer, so it ends up being a good spend and as you can see then, good results.

Meredith Adler - Barclays Capital

Great. Thank you very much.

David B. Dillon

Meredith, thank you and before we sign off though, I do have a few thoughts I want to share for our associates who we encourage to listen in. First, I want to thank you for your hard work during the quarter. We are making a difference in the lives of our customers by offering more and more ways to save money and to take care of their families. You are the direct link to our customers and we appreciate all you do every day.

I want to say a special thanks to the 55 associates who will be featured on products sold in our stores next month as part of our Giving Hope a Hand Breast Cancer awareness campaign. These terrific ladies are encouraging others to take charge of their own health by sharing their personal journeys as breast cancer survivors with their fellow associates and our customers. They are an inspiration to each of us and we are fortunate to have them on our team.

And on a final note, I want to thank Don McGeorge and congratulate Rodney McMullen. Don has devoted 32 year-career to the Kroger Company and he has influenced every aspect of our business over the years. He is a true champion of associates and customers and we are all indebted to Don for his exceptional leadership, balanced with just the right amount of humor.

And Rodney has stepped into the job as President and Chief Operating Officer and many of you already know Rodney but for those of you who haven’t met him yet, you will find him to be a passionate retailer who, like Don and I, started in our stores. We look forward to his insightful leadership in his new role.

That completes the call today. We thank all of you very much for joining us.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Good day.

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Source: The Kroger Co. F2Q09 (Qtr End 8/15/09) Earnings Call Transcript
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