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The Kroger Co. (NYSE:KR)

F2Q06 Earnings Conference Call

September 12, 2006 10:00 am ET

Executives

Carin Fike - IR

David Dillon - Chairman, CEO

Rodney McMullen - Vice Chairman

Donnie McGeorge - President and COO

Mike Schlotman - SVP, CFO

Analysts

Perry Caicco - CIBC World Markets

John Heinbockel - Goldman Sachs

Meredith Adler - Lehman Brothers

Chuck Cerankosky - FTN Midwest

Scott Mushkin - Banc of America Securities

Mark Husson - HSBC

Jason Whitmer - Cleveland Research

Ed Kelly - Credit Suisse

Mark Wiltamuth - Morgan Stanley

Todd Duvick - Banc of America Securities

Presentation

Operator

Good day, ladies and gentlemen, and welcome to the second quarter 2006 Kroger company earnings conference call. (Operator Instructions) I would now like the turn the presentation over to your host for today's conference, Carin Fike. 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.

Before I turn the call over to Mr. Dillon, I want to take a moment to remind you about our upcoming investor conference here in Cincinnati on October 10th and 11th. We look forward to seeing many of you at the conference.

Now I would like the introduce Mr. Dillon.

David Dillon

Thanks, Carin and good morning, everyone. We're pleased you could join us to review Kroger's second quarter financial results. With me today are Rodney McMullen, Kroger's Vice Chairman; Donnie McGeorge, Kroger's President and Chief Operating Officer; and Mike Schlotman, Senior Vice President and Chief Financial Officer.

I would like to begin by briefly reviewing Kroger's second quarter financial performance and then I'll provide an update on Kroger's outlook for 2006. Rodney will share additional details about our second quarter results, and then we'll be happy to take your questions.

Total sales for the second quarter increased 9.2% to $15.1 billion. Identical supermarket sales increased 7.9% with fuel, and 6.0% without fuel. This is the 12th consecutive quarter of positive identical supermarket sales excluding fuel. As we have said, our business model is driven by identical sales growth, and we are pleased to achieved by identical sales growth, and we are pleased to achieved another strong quarter.

Growth continues to be broad based across all divisions and all store departments. It was particularly strong in grocery, produce, natural foods, deli, bakery and pharmacy. Our convenience stores had another strong quarter in fuel and in non-fuel merchandise. Net earnings were $209 million, or $0.29 per diluted share for the second quarter. These results included $0.01 per diluted share related to stock option expense. Net earnings in the same period last year were $196.5 million or $0.27 per diluted share. We're pleased by this improved performance and believe it reflects our unique approach to serving our customers.

Our results this quarter indicate we are realizing the benefits of our strategy which includes listening to our customers and associates. Where investing our resources in what they tell us is most important, an approach that builds loyalty to Kroger. These results also illustrate the balance our strategic plan requires: sales, earnings, focus on our customers, and cost control. These results show our strategy is building sustainable sales and earnings growth and value for our shareholders.

In looking at Kroger's performance during the first two quarters of fiscal 2006, total sales increased 8.6% to $34.6 billion. For the same period identical supermarket sales, excluding fuel, increased 5.8%. Net earnings for the first two quarters of fiscal 2006 were $515.4 million or $0.71 per diluted share. These results included $0.03 per diluted share for stock option expense. They also included $0.03 per diluted share for legal reserves recorded in the first quarter. For the same period in fiscal 2005 net earnings were $490.7 million or $0.67 per diluted share.

Kroger's results through the first half of 2006 indicate we are on track to exceed our original identical sales guidance and meet our earnings guidance for the year. We are affirming our guidance for earnings per share growth in 2006 of 6% to 8% including the increase in legal reserves recorded during the first quarter which essentially raised our guidance. Without this increase, Kroger's projected earnings per share growth would be 9% to 11% for fiscal 2006.

As we often mentioned, strong identical sales are a key driver of our earnings per share growth. We originally forecasted identical supermarket sales growth excluding fuel sales in excess of 3.5% for fiscal 2006. When we reported our first quarter results, we raised that guidance to approximately 4.5% for the year.

Today, thanks to dedicated efforts of our associates and their emphasis on placing the customer first, we are raising our identical sales guidance once again. We now anticipate identical supermarket sales of at least 4.0% for the balance of the year, or approximately 4.9% for the full year, excluding fuel.

I want to remind investors that in 2005 several markets experienced unexpected sales increases as a result of Hurricanes Katrina and Rita. As a result, it is difficult to forecast this year's identical sales for the same period. Our entire organization remains focused on driving sustainable, identical sales growth.

Now I will ask Rodney to share some additional details on Kroger's second quarter results.

Rodney McMullen

Thank you, Dave, and good morning, everyone.

As Dave mentioned earlier, we believe our second quarter performance is a direct result of our strategy and reflects the consistent approach we have taken to managing our business; balancing investments aimed at improving our customer's shopping experience with operating cost reductions. I would like to discuss how this strategy affected several indicators during the second quarter, starting with gross margin.

FIFO gross margin was 23.47% of sales, a decrease of 112 basis points compared to the second quarter of 2005. Excluding the effect of retail fuel operations, FIFO gross margin decreased 65 basis points from the prior year.

In the past two quarters we have introduced you to a metric we call selling gross margin. This is the term we use internally at Kroger to describe the Company's gross margins before incurring expenses directly related to distributing and merchandising products on our store shelves such as advertising, warehousing, transportation, and shrink. Kroger's second quarter selling gross margin on non-fuel sales declined 65 basis points. During the quarter we made additional targeted investments in select markets to take advantage of market share opportunities. These investments account for a portion of the decline in our second quarter selling gross margin.

Operating general and administrative costs declined 73 basis points to 17.5% of sales. Excluding the effect of retail fuel operations and stock option expense, OG&A declined 47 basis points.

We've made good progress as an organization in controlling costs in an inflationary environment. I would like to highlight three areas in particular: bag costs, transportation management, and our collective efforts in controlling utility costs. We saw a decrease in bag usage, thanks to the efforts of our front line associates. With regard to transportation costs, we achieved higher sales with lower mileage by better utilizing our truck fleet. In terms of kilowatt hours, our team was successful in significantly reducing usage by installing energy efficient lighting and introducing other energy savings improvements in our stores to offset increasing utility costs. These three examples reduced costs and benefit the environment.

In fact, since 2000, Kroger has reduced our overall energy consumption per square foot by more than 19%. This is the kind of cost control that allows us to invest in improving the shopping experience and lowering prices for our customers. We can give you several other examples but wanted to highlight a few to help you understand some of the changes going on within our business.

Rent expense in the second quarter was $153.4 million, an increase of $8.9 million over the prior year. Excluding closed store activity, we continue to expect rent expense as a percent of total sales to decrease due to the emphasis our current strategy places on owning the real estate. Kroger's operating margin on a GAAP basis declined 17 basis points to 2.96% of sales. Excluding the effects of retail fuel sales and stock option expense, operating margins declined 5 basis points.

On this same basis, recall that our first quarter operating margin grew 32 basis points. This illustrates what we have told you to expect concerning our operating margin on a quarter by quarter basis. That is, it may fluctuate depending on the timing of our operating cost savings and our reinvestment of those savings in the customer's shopping experience.

On a year-to-date basis, Kroger's operating margin declined 15 basis points to 3.16% of sales. Excluding the effects of retail fuel sales, the first quarter increase in legal reserves and stock option expense, operating margins increased 16 basis points. On this basis, for fiscal 2006 we still forecast slightly improving operating margins resulting primarily from continued improvements in California.

During the quarter, Kroger's strong cash flow enabled us to invest in our store base, reduce debt, repurchase shares, and pay a cash dividend. In the second quarter, capital investments totaled $361.2 million compared to $271.9 million a year ago. We are on track to invest approximately $1.7 billion to $1.9 billion in capital projects during our fiscal year 2006. We still anticipate total supermarket square footage growth of 1.5% to 2% before acquisitions and operational closings. For the second quarter total supermarket square footage grew 1.4% year-over-year excluding acquisitions and operational closings.

Our return on asset measure improved almost 80 basis points on a pre-tax basis. This is using the method Kroger has consistently used to calculate return on assets.

Net total debt was $6.3 billion, a reduction of $679.1 million from a year ago and a reduction of $2.5 billion since January 2000. Net total debt includes a reduction of $666.1 million to reflect temporary cash investments. Total debt was $7 billion, a reduction of $263 million from a year ago.

As we've mentioned before, our investment grade rating is very important to us. We have focused on improving our coverage ratios since merging with Fred Meyer in 1999. Our net total debt to EBITDA ratio in the second quarter was 1.87. This is our best performance on this measure since our merger with Fred Meyer in 1999, and in fact our best since Kroger's leveraged recapitalization in 1988.

During the second quarter Kroger repurchased 7.6 million shares of stock at an average price of $21.40 for a total investment of $161.6 million. At the end of the second quarter, $389.3 million remained under our $500 million stock buyback announced in May of 2006.

Since January 2000, Kroger invested $3.3 billion to repurchase 170 million shares at an average price of $19.26 per share. This equates to approximately 19% of the Company. Kroger expects to continue to buy back stock in 2006 in accordance with the Company's financial strategy of using one-third of free cash flow for debt reduction and two-thirds for share repurchase and a cash dividend payment.

As Dave mentioned, we expect earnings per share growth of 6% to 8% in 2006. This range includes the first quarter charge of $0.03 per diluted share to increase our legal reserves. Even though that additional legal reserve was not expected when we gave our original guidance.

Fiscal 2006 is also a 53-week year. As we look to fiscal 2007, we continue to anticipate earnings per share growth of 6% to 8% on top of the 2006 base that I just described. In other words, the 6% to 8% growth for 2007 should be applied after reducing fiscal 2006 earnings by a net of $0.02 per diluted share. This net adjustment to 2006 earnings reflects the $0.05 benefit from the 53rd-week offset by the $0.03 of additional legal expense.

This is the same guidance we communicated for 2007 earnings per share growth when we released year end 2005 results in March. We wanted to clarify it to ensure consistency in the treatment of two unique items in our fiscal 2006 results. The additional legal accrual that occurred in the first quarter and the 53rd week that will occur in the fourth quarter.

Our second quarter tax rate was 38.2% compared to 37.4% for the prior year. We expect that our tax rate for fiscal 2006 will be 37.8%, slightly higher than our original guidance at the beginning of the year. The year-to-date tax rate is slightly higher than the expected annual rate. This is because the work opportunity tax credit has not been approved but we anticipate it will be retroactively reinstated by year end. This tax credit will not be reflected in our effective tax rate until it is approved.

Before I turn it back over to Dave, I would like to comment briefly on labor. As I mentioned last quarter, we do not face the magnitude of contract negotiations this year that we did last year. Still, labor negotiations continue to be a challenge in the face of competitive pressures, rising pension and healthcare costs. In each contract negotiation we will work to reach a balanced agreement that meets the needs of our cost reduction and containment objectives while fulfilling our commitment to provide our associates with solid wages and benefits. This balance will allow Kroger to invest in our business to create new job opportunities for existing associates and hire some more people.

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

David Dillon

Rodney, thank you. Our second quarter results show we are on track to achieve our financial objectives for the year. In keeping with our strategic plan, our results this quarter demonstrate our ability to invest cost savings to enhance our customers' overall shopping experience. We thank our associates for maintaining their focus on our customers. We will now be happy to take your questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Your first question will come from the line of Perry Caicco - CIBC World Markets.

Perry Caicco - CIBC World Markets

Good morning. You mentioned on the topic of gross margins that a portion of the gross margin decline was pricing investment. What was the rest?

Rodney McMullen

The overall decline would have been pricing investments through every day pricing and promotional pricing. However, the comment that I mentioned in some markets we accelerated our price reductions because of some opportunities for market share in some selected markets, and that's the part that we accelerated.

Perry Caicco - CIBC World Markets

Okay. I wonder if you could explain the rent situation. Rent was up, but in Q1 rent was down. Can you just go over that?

Rodney McMullen

The majority of the rent increase was because of the present value from closing a few stores, and it is just the present value of the lease obligation. That shows up all in rent expense in the quarter that you present value the rent. It is the net of what we expect to collect from the rent versus what we're paying in rent.

Perry Caicco - CIBC World Markets

Just one last question for David. If you hold to the thesis, David, that the U.S. consumers is tightening the belt a bit, what have you been doing to prepare your company for that?

David Dillon

I think the actually there are several trends that we're seeing or at least have read about and since may be going on, and tightening the belt relates to a couple of those trends. Let me maybe identify those and talk briefly about them because it ties very closely to the strategy we have at Kroger.

The three trends that we've seen, the first is that at a supermarket is costs a lot less to prepare a meal for a family than to go to a restaurant, either to go to a restaurant or go and pick up food and bring it home, which has been a trend that has increased for a number of years. We think that that may be if not reversing, certainly changing a bit, because it is quite true that a family can be fed much more economically at the supermarket.

That being said, I suspect that that is what's happening in the environment where fuel costs are higher and people are feeling the pinch, and we certainly read a lot about that. Now, there is not a good way to empirically prove it, but that is one friend.

The second trend is with high fuel costs a lot has been said about people driving fewer miles, and if that is true, the convenience of Kroger as a nearby store is perfect, fits naturally into our sweet spot. We believe that is also occurring.

A third trend that you probably haven't read as much about but we've read some things recently about is the trend towards families looking at the value of family meals together at home. In fact, if you're not familiar with it, you all ought to check this out because at the Columbia University there is a center there called the National Center For Addiction and Substance Abuse. They have done some significant research to identify that meals at home with family can go a long ways, that family time can go a long ways to reducing lots of issues for kids and families: drug usage, alcohol usage, performance in school as examples.

One-way that CASA, which is what that center is called at Columbia University can help emphasize this -- and they started this a year or two ago I believe – is by emphasizing a Family Day which this year is going to be Monday, September 25th of '06. You will probably see a lot more stories even than you've seen already about their research, about their findings, and I actually think in a number of places around the U.S. that has begun to resonate among our customers.

So those three trends that we see all play to the natural strength not only of supermarkets but in particular of Kroger because at Kroger our strategy as you clearly know, I think, is that we're trying to grow sales; by growing sales it helps lower our costs. By lowering our costs, we reinvest in the shopping experience through a variety of things, not just the pricing that you mentioned, not just the promotions you mentioned, but also in other experiential things like faster checkout, things like lower out of stock, those kinds of elements.

That strategy we believe fits perfectly with these kinds of trends going on with the consumer today. Our pricing in particular positions us well given that the customer is a little more pinched both for money and also not wanting to spend the gasoline to drive a long way to get it. We think it is a natural for us, Perry.

Perry Caicco - CIBC World Markets

All right. Thanks, Dave.

David Dillon

Thank you.

Operator

Your next question will come from the line of John Heinbockel - Goldman Sachs.

John Heinbockel - Goldman Sachs

A couple of things, I wanted to drill down on gross a little bit more. If you take out the accelerated investments, was gross essentially in line with your budget or what you expected?

David Dillon

Very close. I would say in line overall.

John Heinbockel - Goldman Sachs

You said a portion. Would I be right in assuming the accelerated investments would be less than half of the decline in gross year-over-year?

Rodney McMullen

We wouldn't really want to get in that much specific detail, John.

John Heinbockel - Goldman Sachs

Was the accelerated investments more shelf price or promotional activity?

David Dillon

It would be a mixture of both, and it really depends on the opportunity within a market.

John Heinbockel - Goldman Sachs

Okay. Was it more proactive or reactive?

David Dillon

Proactive.

John Heinbockel - Goldman Sachs

Okay. So I guess it would be your view that what we saw in the first half is more like what you ought to see on a regular basis, the first quarter may be a little under investment, second quarter over, and the combination of the two is more where you see things longer term?

David Dillon

I think, John, it is important to think about this in the longer term context. It is one of the reasons that we don't try to give guidance for each quarter because we're going to call each quarter as it goes through as we need to do. It is the year and the two years and that sort of long-term horizon that we're trying to balance out rather than look at any one individual quarter, and I think those two quarters together help illustrate that point.

John Heinbockel - Goldman Sachs

If you calculated ROI on the investments this quarter, is it too early to do that and are you satisfied with the ROI?

David Dillon

I am satisfied with the ROI first. But second is, to run a proper ROI in our business you need a longer time horizon than a quarter, and as a result, I don't think it is something we can actually do, but I am satisfied that we will be happy with that return when we can run the numbers.

Rodney McMullen

And Dave's point about looking at it longer term to me is absolutely correct. If you look at our longer term strategy in terms of where we're trying to go, this fits in perfectly with where we're trying to go, and it really, given the strong sales growth, we had the opportunity to make some investments a little earlier, and the cost reductions that we've achieved in the business, and we just took advantage of those opportunities because of the strength of the business.

John Heinbockel - Goldman Sachs

Are you also investing in labor such that the decline of 47 basis points, it is actually better than that ex investments or, no, you're not making investment there?

David Dillon

We would be making investments in the shopping experience for the customer that would cause OG&A to be higher or that caused OG&A to be higher.

John Heinbockel - Goldman Sachs

Finally, your contract or relationship with Dunnhumby, will Tesco have the ability given they're an owner here when they come into the U.S. to use Dunnhumby as well as or do you have a geographic exclusive?

David Dillon

It would have to be the Dunnhumby from the U.K. It could not be the Dunnhumby from the U.S. The learnings they would have here they would have to learn again.

John Heinbockel - Goldman Sachs

You're not at a disadvantage because of that, they're going to have to learn the U.S. consumer from scratch?

David Dillon

Correct.

John Heinbockel - Goldman Sachs

Thanks.

David Dillon

Thank you, John.

Operator

Your next question will come from the lane of Meredith Adler of Lehman Brothers.

Meredith Adler - Lehman Brothers

Good morning, guys.

David Dillon

Good morning.

Meredith Adler - Lehman Brothers

I would like to start with question about whether you changed some of your promotions to emphasize fuel a little bit more and does that have some impact on reported sales for non-fuel? If you're putting promotions on the food side into fuel, does that mathematically make sales look stronger on the food side?

David Dillon

Meredith, we have a variety of promotions that tie inside the store to what you pay for fuel at the fuel pump. The cost of those promotions are charged against the sales inside the store. While you may receive a discount on what you spend per gallon of fuel, we charge that discount against the 6% ID we reported because what we're really trying to do with the promotion is drive inside store sales not necessarily fuel sales. The 6% sales ID sales that we reported would reflect the cost of those kinds of promotions, and the reduction of sales.

Meredith Adler - Lehman Brothers

Got it. Okay. And they be I was just wondering if you could talk a little bit about the what's happening in the acquisition environment? Are you still seeing lots of opportunities, and has your appetite changed in any way?

David Dillon

We continue to see plenty of opportunities. It really hasn't changed, and our approach to it really hasn't changed, that we've talked about probably for the last ten years or so. We look at pretty much everything. We bid on a small percentage of what we look at, and we usually end up buying about half of what we bid on. Still an awful lot of folks out there think their assets are worth more than we do, and time will tell who is right or wrong on that.

Meredith Adler - Lehman Brothers

My final question is about Wal-Mart. They have said publicly they will slow down their fill-in growth in markets where they've operated for awhile, and we also have some information that says their food pricing may be going up. I think they still have the lowest prices in town, but maybe not as low, and I was just wondering if you have actually seen either of those things in the markets where you overlap with Wal-Mart?

David Dillon

I would say that's too early to tell on those points. Those would be recent developments, plus we're not likely to comment on specific trends that we see at a competitor anyway.

Meredith Adler - Lehman Brothers

Okay. Thank you.

David Dillon

Thanks, Meredith.

Operator

Your next question will come from the line of Chuck Cerankosky of FTN Midwest.

Chuck Cerankosky - FTN Midwest

Good morning, everyone. As you're showing these strong comps, 6% in the most recent quarter, it generates leverages as you go through the quarter. How do you allocate, Dave, the price promotion investments into the various markets? What drives the process?

David Dillon

It is really based on an individual assessment of those markets by the people in the markets and the merchants both in the divisions and here at our general office. As Rodney pointed out as we went through the quarter, we saw additional opportunities. Those were identified in some cases from the individual divisions, sometimes it was here, and we addressed it. So it is really trying to read the business day-to-day and week to week and trying to read it both at the local level and at the general office level.

Chuck Cerankosky - FTN Midwest

So a strong division, it is getting more leverage than it can reinvest may see some of the cash flow directed towards market share growth opportunity in another division?

Rodney McMullen

It could be, or could be if the opportunity is there we'll push harder there, either way.

David Dillon

The other thing is not all the investments are growth. Some of it is in service. The service side really is driven by what our customers have told us is most important to them, and where we stand versus what they want, and what the cost of bridging that gap, so on a service side it is really driven by feedback from the customers in addition to what Dave talked about.

Rodney McMullen

We have a lot of metrics that help a local market understand how well they're coming across to the customer, and each market is trying to improve on those metrics, and so that's exactly right. In those markets, those decisions on investing end up typically being a local choice and a local decision.

Chuck Cerankosky - FTN Midwest

Does the closure of the Albertsons breakup, did that affect some of the timing of promotion and investments in the second quarter?

Rodney McMullen

Not particularly.

Chuck Cerankosky - FTN Midwest

Okay. Switching a little bit to gas promotion, are you doing any specific promotions at the convenience stores, looking at them on a standalone basis?

Rodney McMullen

Well, we would in markets where we overlap with the supermarket, the supermarket would tie together with the promotional strategy on offering gas at C stores also. That would be the primary promotion. The other thing that their business is growing nicely is that it is really doing all the basics in terms of customer service and keeping the stores updated and adding variety and some of the other things. It is really both those pieces that's driving that business.

Chuck Cerankosky - FTN Midwest

All right. Now, is there anything you mentioned earlier that gas promotions do influence the sales because of the discounts. Any other metrics we should be aware of on that when you're using gasoline to promote in-store, and then further now we have some sharp fall off in gas prices. Are you seeing any trends that have developed since then or are you reducing gasoline promotions at all?

David Dillon

I can't think of any other metrics that we ought to comment on. None come to mind, anyway. I am not sure exactly what you're driving at. I don't think we're seeing any difference in what we're trying to do in gasoline given the cost change. It has dropped dramatically in the last week or two. In terms of actual data, I don't think we would report anything to shed on that anyway.

The one thing that's really worth noting is you will now clearly see, I think, certainly next quarter you will see the reasons that we have from the very beginning taken gasoline out of our numbers to show you what the numbers look like because if you leave them in there, you will get some very erratic results, and it will not be a meaningful picture of what's happening inside the business.

Rodney McMullen

On your question, Dave's last point really is in terms of your question is there anything else you should look at, that is the reason why we've been giving the numbers with and without fuel for the last five or six years is the very point that Dave just made.

David Dillon

It was our experience at the convenience stores which we've had for years -- actually decades -- that you have to be careful about fuel dollar sales in particular because they are so erratic, and that's the reason we started doing that in the very beginning because of the experience we had there, so we've learned a good lesson. I think that is probably the best advice I could give you is to look at the numbers without fuel to get a real sense of how things are going at Kroger.

Chuck Cerankosky - FTN Midwest

All right. Thank you.

Operator

Your next question will come from the line of Scott Mushkin of Banc of America Securities.

Scott Mushkin - Banc of America Securities

Thanks very much. I was just wondering, do you guys have a number like promotional spending, how much of that is being tied to gas this stage?

Rodney McMullen

I don't think we would have anything like that that we would release publicly, no.

Scott Mushkin - Banc of America Securities

Great. Then just a couple more here. How much of the O&A improvement is being driven by labor savings?

David Dillon

That's a hard one. I am not sure I can dissect it that finely. We certainly know that some of the labor contracts have contributed to our ability to successfully reinvest for the experiences with our customers, but I think I would look at it as part of this overall strategy as we've been able to contain or reduce costs in labor or in healthcare or even reduce the rise of pension, even though it continues to go up, those areas as examples we see that as money that gets reinvested either back in additional training or back in the experience in the store or even in pricing in some way to improve on our overall sales which of course then drives additional labor hours. So the metric changes once again because then your labor usage goes up, but the dollars are being contained a little bit better. I don't know if there is a better way to look at it.

Rodney McMullen

One thing I would add is if you look at some of the improvement in OG&A is driven by lower total employee costs, but that reduction really is driven by productivity improvements from the sales leverage and just changing work processes. If you look at it on an average hourly rate basis, you would not see that. It really is productivity improvements from the higher identical sales growth and actually changing work process.

Scott Mushkin - Banc of America Securities

Rod, that's a great point. Is it fair to say that with a lot of the new contracts, renegotiated contracts you guys have signed we will actually start the cycle, I guess when it goes to California that the growth rate of that average hourly wage or total compensation has been held in check by the activity that you guys engaged in to renegotiate those contracts?

David Dillon

That would vary by each market. Some markets that would clearly be true. Other markets were not particularly high cost, and they might not quite be the same way you just described.

Scott Mushkin - Banc of America Securities

Dave's point really is it is a market by market basis, and it is what type of cost structures in the market currently, what kind of cost structure do we anticipate in the market because of competitive changes, and what's the wage rate that's competitive and fair for associates and how can we run our economic model? How can we manage those costs appropriately?

David Dillon

The balance that Rodney referred to in his earlier comments are not just words that we use to describe this. It is really genuinely what we mean. We are trying to balance what our associates need and deserve, with what we need in the business in order to be able to grow and build the business and give people good job assurance for the future and to hire more people and add more hours.

Overall it is a balance, and the challenges have typically been wages somewhat, healthcare definitely, pension definitely. Those areas have been the challenges in each negotiation. We have tried to address it for those particular locales when we have, under each contract. We've done it this year, in past years and expect to do it in future years too.

Scott Mushkin - Banc of America Securities

Thanks very much. One more quick one. As far as the gross margin goes, this is more as we look out, when I look back at my model we've seen some steady erosion in the gross margins that brought pricing down. I know it has been part of your strategy. Is there any end to this, or is this just something we should come to expect, gross margin is just going to deteriorate on an ongoing basis to be offset by some of the savings? Or do we at some point get through the majority of the investment and maybe not stabilize but we don't see it drift sharply lower?

David Dillon

If you don't mind, I will refer to it as an investment rather than erosion, but with either word, I think what we said I guess a couple years ago, we did invest without having the cost to support that, and that was initially. We said at that point we reached a point where we think we've made strong enough investment in price that we can grow these other elements of our business and as we grow them and as we reduce our costs, we will reinvest that money in either shopping experience kinds of items -- which we've mentioned things like training and improved out of stocks and faster checkout and that sort of thing -- or we'll invest it in pricing.

I think at least for the foreseeable future as we identify that just in the next year or so, we've said that our intent is to reinvest that in order to improve our sales, and that our sales strategy is essentially how we're going to grow our earnings. I think you can now see clearly our sales can grow higher than what I think many people may have thought, and we think the opportunity out there is enormous for us to grow those sales and we want to keep trying to do that.

We are trying to be very mindful, though, of paying the bill as we go. We're not trying to invest in price or in other things without be able to have the lower cost structure to provide for that so that we don't end up eroding our operating margins.

That's important to our strategy, and that important change we made -- as I said, I think a couple years ago if I remember right -- and as we made that change, that was a significant statement on our part. In terms of the long term, I don't know. I am sure there will be an end. There obviously is some end. I don't know what that will be exactly. I know we drew the line by saying we're not going to let our operating margin drop further on the whole on the long run.

Rodney McMullen

Without fuel.

David Dillon

Without fuel, and that was an intentional statement.

Rodney McMullen

The other thing, Scott, is the plan that Dave has outlined talks about we are confident that that will generate solid shareholder return through that process and actually will create a competitor -- that Kroger will be even a stronger company than where we are today from our associates and customer's standpoint both.

Mike Schlotman

That's a good point. I sort of took that for granted and maybe shouldn't, and make sure we point that out. When we did the math on this model, and as we've developed it, we're sure it will lead to a good return for shareholders. That's essential. We can't embark on a model that does not produce that result.

Scott Mushkin - Banc of America Securities

Thanks. They were phenomenal sales results. Appreciate your time.

David Dillon

Thank you, Scott.

Operator

Your next question will come from the line of Mark Husson of HSBC.

Mark Husson - HSBC

Good morning. I just wanted to be devil's advocate here and just say gas goes back to $2.30. You talked about some of the behavioral changes and notwithstanding the joys of cooking for my delightful children and cleaning up after them and maybe people do eat out a bit more and drive a few more miles and your gas promotion becomes a bit less of a [inaudible] if gas does go back to $2.30, what are you seeing in terms of attitude stuff to make you comfortable that you have created an unbeatable set of consumer advantages no matter what gas prices do?

David Dillon

The first thing I will tell you is the advice I have for you is teach your kids to clean up after themselves -- that's what we try to do in our household. I think you really raised a really good point is what happens now with gas dropping back down and does that change the overall attitude of the customer and the behavior? It is amazing. You watch people shopping today for gas, and they actually think that fuel costs are low, and their memory is remarkable. We were comparing notes the other day. I can actually remember paying $0.199 a gallon and filled up my Volkswagen for a $1.50 years ago. There was a price war in my hometown at that time.

Our perspective on fuel, I remember the $1 mark and how hard it was to get over that hurdle, and now the $2 mark and now we look at $2 at being cheap gas. I do think the human mind does tend to adjust rather quickly.

However, having said that, the amount of money that a family has, even at $2 a gallon is less money than they had a couple years ago just because they have to spend that much on fuel. That fact, that's not something that's an attitudinal thing. That’s an actual fact. They either have the money or they don't. I think that's what has driven some of the behavior. It may moderate a little bit at $2 rather than $3 a gallon, but I don't think it is going to change radically.

Even if it does, our overall strategy while I think we got an extra boost, perhaps a small boost anyway on what's happened with fuel prices, that is not the basis of our strategy. Our strategy really comes down to understanding what the customer wants and balancing price investment and shopping experience investment to be the place that customers actually prefer to buy their groceries. As a result, yes, we could lose a little bit of the steam that came from the gas, I suppose it is possible. It is certainly possible because it was possible that we got it. On the other hand, it is not the sole reason for the sales growth we're getting. Our strategy, I think, is paying off and it is a measurable part of what we're doing.

Rodney McMullen

I was going to say the other thing is our associates have really done a good job on improving what's within the store, and when you come out for the investor conference you will see some of those improvements, that it really is our merchandising team, our division operations team working together with our store associates and improving that experience. Hopefully a lot of customers have come into our stores because of fuel costs will decide to stay because you can save two-thirds versus going out to a restaurant for a meal that's just as good or better.

Mark Husson - HSBC

Just on the gas margin side it seems to me probably this last quarter given the shape of the pricing drop, the gas margins probably weren't all that great. Can you remind us what happened in the post-Katrina period last year on gas margins?

Rodney McMullen

Last year in the third quarter our gas margins were noticeably strong. In the second quarter we just finished, also our gross margins were noticeably strong.

Mark Husson - HSBC

Okay. And then finally just a question for Mike. With interest rates falling, what have you done with your discount rates for your PBO and what effect has that had on the P&L account?

Mike Schlotman

We changed that annually, and last year end we actually reduced the interest rate for the discounts of both future obligations and of the investment. The annual amounts that we're charging to the income and expense this year isn't dramatically different between the two years, year-on-year and the Company sponsored plan. Some of that is because we've funded the plan to a higher stake than it's been in the past. We put the incremental dollars in and the way FASB 87 works, even though I have higher liability amount, the year I put the cash in, for every year I am assuming I am earning 8.5% on the return, and that reduces my book pension expense.

Mark Husson - HSBC

So the dollars are not actually meaningfully different?

Mike Schlotman

Not meaningfully.

Mark Husson - HSBC

That's all. Thank you.

David Dillon

Thanks, Mark.

Operator

Your next question will come from the line of Jason Whitmer of Cleveland Research.

Jason Whitmer - Cleveland Research

Good morning. You spent a lot of time talking about proactive investments, a lot of money that's going out. How about within your cost reduction, some of your internal efforts to save money? Has that alternated? I know you say that can change from quarter to quarter within a given year, but as far as actual dollars and maybe versus your own expectations, how do you think you're tracking in the whole sum of the bucket?

David Dillon

I think we're tracking well. We described the cost efforts before this way, and it is still exactly the same. Every time we think we reached the pinnacle of a mountain, we look out in the distance and we see the next mountain. We continue to see new opportunity after new opportunity after new opportunity, and they are many of them, now some are big, but many are actually small, just a lot of them, and we're working on many of those as we go through the organization.

We're trying to pick the one that is make the most sense, work through those and work to the next, and that's actually one of reasons we don't try to quantify an absolute dollar amount is that I don't think we're ever going to be satisfied on that metric. I think we're always going to believe that there are additional savings out there that can be reinvested in some way that would be of benefit to our shareholders and our to customers, and we're going to try to do that. I don't know if that answers your question.

Jason Whitmer - Cleveland Research

Within something like shrink, which has been a big dollar category and you made a lot of progress on it, do you still see a lot of opportunity out there? How are you tracking on things like that versus your expectations on a quarter-to-date, year-to-date or last 18 months?

David Dillon

Let's take as an example Rodney pointed out that the decline in FIFO gross margin was 65 basis points, and that our decline in selling gross margin was 65 basis points. Those two being the same numbers suggest that we were pretty neutral on the expenses within gross margin.

Now, those are not in OG&A, but we look at them and deal with them just like they're in OG&A, and those expenses include things like advertising and shrink and warehouse and transportation. As an example, we did not make as much progress in shrink this second quarter as what we had hoped we would make, and in part that was our own doing because we made some decisions on merchandising that we knew would increase our shrink and as a result it did. So we had to be careful about setting goals that would hurt ourselves.

So as we're tracking on that item, I would say I am not particularly satisfied with shrink right now, but in another area, warehouse and transportation, transportation costs obviously the fuel costs are much higher, but because we ran fewer miles to produce the sales, and the way we accomplished that was hard work on the part of our logistics team, and because our warehouses performed particularly strongly, we ended up with better results there. We're targeting and progressing well on our metrics on that item. Those are just a few examples.

Rodney McMullen

Jason, I guess when I look at it overall, we're very pleased with where we are where we thought we would be when you put all the cost reduction efforts together. It really is everybody working together, and you can give examples -- Dave and I and Don and the rest of us could go on forever on giving examples, some small, some big, but it adds up to a meaningful amount. Even with that said, we still see meaningful opportunities to continue to improve from where we are.

David Dillon

I think that's the main point is that I got trapped in the details of some individual examples, but those individual examples illustrate exactly what Rodney said is that this is made up of individual items taken one at a time and collectively they produce a picture. The picture that we see so far collectively is very bright, and we're very optimistic and pleased both with the sales. We're pleased with the leverage they have given us. We're pleased with the reduction in our OG&A costs. We're pleased with the reduction or cost containment of those expenses embedded in gross. We're pleased in the way in which we have reinvested to benefit our customers, and we're pleased that the customers keep coming back and repaying us and that's how re ended up with those identical sales.

Jason Whitmer - Cleveland Research

When you look at bigger picture ideas to further shave off costs wherever in your organization, do you see any major infrastructure changes that are needed to address in meeting your customer needs either at corporate or store level?

David Dillon

We have discussed a number of changes in the organization, one that we actually talked about on this call before and talked about publicly is for example we have shifted more of the buying over the last several years, more of the buying to one central location. It has two benefits. One is it gets the benefit of leveraging the numbers so you don't have to have quite as much resource applied to the issue.

Second it allows you to put significant intellectual pressure on that particular point that you could not afford to do if you tried to do that in 17 divisions, so things like that we have done. We have been doing those now for a number of years. I can't think of anything particular right now that we would want to announce on this call.

Jason Whitmer - Cleveland Research

Sure. Last two small questions, one, maybe is for Mike. What is the actual dollar impact of those closed stores on rent? Any major mix shifts going on that would help gross margin dollars but hurt the percentage?

Mike Schlotman

What was your last question?

Jason Whitmer - Cleveland Research

Any mix shifts within the stores that would be impacting the percentage but not as much on the dollars for gross?

Mike Schlotman

The rent expense that was a little over $6 million of it was the NPV of the closed stores, and I was looking through my papers to say get that answer even though Dave asked for your question twice.

Jason Whitmer - Cleveland Research

Sure. Any major mix shifts within the stores or the regions that is putting a dent on your percentage gross margin but helping on you the gross dollars?

Mike Schlotman

I am not sure I understand. Mix shift?

Jason Whitmer - Cleveland Research

Any drags on your percentage from gross margin from any mix shift in categories or divisions?

Mike Schlotman

Categories, I can't think of any in particular other than the obvious one of fuel, and we take that out for purposes of evaluation.

Jason Whitmer - Cleveland Research

Okay. Thank you.

Operator

Your next question will come from the line of Ed Kelly of Credit Suisse.

Ed Kelly - Credit Suisse

Good morning. Could you give us your thoughts on the acquisition side in terms of end market deals versus something larger on the new market side?

Rodney McMullen

In terms of historically we have been much more focused on end market to improve existing share. As a general rule that would be our focus. Now, as you know when we merged with Fred Meyer in 1999 that was obviously out of market. If something was out of market, it would have to be somebody whose culture was very similar to ours, with very strong store operations and market share before we'd ever consider it, and it would have a different standard than what we looked at in market. It wouldn't be any different from what we merged in Fred Meyer. What we saw was so beneficial to merge with Fred. Those are the characteristics that would have to exist.

Ed Kelly - Credit Suisse

Okay. Great. And that could you just talk a little bit more detail in terms of what's developed in some of your markets that you think has given you the opportunity to get more aggressive on price?

David Dillon

Sometimes it is more aggressive on price. Sometimes it is more aggressive on other things in the store like we mentioned on improving out of stocks or speed of checkout or training as examples. I think what it is is we see the opportunity in a market. If we see the opportunity for better sales, either a competitor who is weak or a competitor who is strong, either one of those situations might call for a little stronger investment. If they're strong, it is a competitor reaction, if they're weak, it is not a competitive reaction so much as it is trying to take advantage of the situation.

We feel our way as we go and markets you can tell that a little by what's happening with the sales. You get a sense of it from your customers. You get just a sense at the ground level from the people locally what they sense is going on in those markets. That's really how we make those choices.

Ed Kelly - Credit Suisse

Given that you are more proactive, then it is more taking advantage of a competitor you think is weak?

David Dillon

In both cases -- we actually have examples of both, I think it is proactive also in the sense that we made the decision rather than for instance a price war starting someplace and we're simply reacting to that. I would even view it as proactive if we had strong competitors if where he decided that we were going to firm up our position or strengthen our position or even reduce the decline if we had a declining situation. That could be proactive as well. When we talk about reactive is when someone else starts a price war or promotional price war or something along those lines.

Ed Kelly - Credit Suisse

In this situation it could be a weak or strong competitor depending on the market.

Rodney McMullen

Yes.

Ed Kelly - Credit Suisse

In terms of this accelerated investment, can we expect this to continue throughout the rest of the year at this pace or does that really change quarter to quarter?

David Dillon

It changes quarter to quarter first. All we're really forecasting for you is where the sales look like they will be and where we think the earnings per share are going to be and the operating margin for the year. Those are the givens, and within that we'll read it as we go through the quarters.

Ed Kelly - Credit Suisse

Lastly, would you care to comment just on the markets where you do see this opportunity or are taking the opportunity?

David Dillon

We typically don't talk about individual markets and would not choose to do so today. That's really just for competitive reasons.

Ed Kelly - Credit Suisse

Okay. Thank you.

David Dillon

Thank you.

Operator

Your next question will come from the line of Mark Wiltamuth of Morgan Stanley.

Mark Wiltamuth - Morgan Stanley

Good morning. I wanted to ask with the consumer tightening the belt a little bit here, have you seen the consumer buying more on promotion and are they accepting higher priced package food costs that have been rolling through?

David Dillon

Let's see. With consumer tightening their belt, I don't know that we've seen a particular significant change in promotional buying on the part of the customer, but I will let Don comment on that in just a second and also ask Don to comment on what we're seeing in terms of cost increases and the ability to pass those through.

Donnie McGeorge

On the CPG cost increase front, let me first say in the second quarter as we internally track our grocery commodities, which would be largely where the CPG influence would be, our internal measures suggest that we had less than 1% inflation, and we did have some cost increases and of course we had to buy them as usual as well. We do pass on those increases, and sometimes obviously in market by market you may be more successful in others.

But one of the things that I think is a tremendous benefit that should be understood is as a manufacturer which we are, a significant manufacturer, and we produce our own corporate brands as you know, we've got a very good working knowledge of what the cost components, if you will, of products are.

And if we get what we consider ton unjustified cost increases, then we do certainly take advantage of it with our own corporate brands. Sometimes CPG's will pass on cost increases and then kind of read the market, judge their own volume, and reaction to it and often will either increase allowances later or maybe even rescind increases they previously had done if they're not satisfied with their volume.

In some ways I would not characterize the second quarter as being anything particularly unusual. We didn't see anything that would cause us to suggest that the increases we're seeing are not any more or less different than it has been before.

Mark Wiltamuth - Morgan Stanley

Okay. Can you shed any light on how much of the 6% comp was traffic versus ticket?

Donnie McGeorge

It was some of both.

David Dillon

It was pretty balanced between the two.

Donnie McGeorge

Yes.

Mark Wiltamuth - Morgan Stanley

Okay. Thank you.

David Dillon

Thank you.

Operator

Your next question will come from the line of Todd Duvick of Banc of America Securities.

David Dillon

Todd, hi, and we're going to make you the last question if that's all right.

Todd Duvick - Banc of America Securities

That's great. I appreciate it. Congratulations on a great quarter. I wanted to ask not to sound like a broken record here, but just on the acquisition front again, I think you have been fairly clear in terms of your acquisition appetite looking primarily at in-market acquisitions, but I am wanting to know if the case of a transformational acquisition like a Fred Meyer, how you balance that type of acquisition with your investment grade rating and if you would potentially use equity in that type of situation?

Rodney McMullen

To give complete specifics, you can never do that until you're in that situation. As you know and as we've said over the last several years our investment grade rating is very important to us, and it is important to us just in terms of the financial flexibility it gives you to deal with any situation. That hasn't changed. It has been true and will continue to be true at the investment grade rating is very important.

To say specifically how we would finance some kind of merger until you actually get to that point it is really hard to say how you will do it, because you may be merging with somebody that wants cash, and you have to address it accordingly.

Todd Duvick - Banc of America Securities

Right. Suffice it to say that transformational acquisitions are probably secondary in terms of your appetite at this point?

David Dillon

I would never call it secondary. I can tell you when we merged with Fred Meyer up until a couple of months before that we really hasn't give it a lot of thought, and when we started sitting down and talking, it moved pretty quickly. To say that it is not top of mind today but tomorrow that could change because the world changes.

What you should feel assured of from Kroger's standpoint is to understand one that our investment grade rating is important; and, two, to the extent that we would do any merger it would have to satisfy all the same things that Fred Meyers did in terms of causing us to grow in a way we weren't able to grow before and have the right type of culture to merge with a group of companies. It would have all those same characteristics.

Todd Duvick - Banc of America Securities

Okay, and one other point on this SuperValu prior to buying a large chunk of the Albertsons franchise, also talked about this commitment to the investment grade rating and it seemed to be a once in a lifetime opportunity. I know you can't say for certain, can you respond in terms of would there be a situation, once in a lifetime opportunity, that could present itself that may actually prove to be a higher priority than the investment grade rating?

David Dillon

To give that you specific answer, Todd, I don't think we could. The thing I would suggest is look at our track record over the last ten or fifteen years in terms of the importance of the investment grade rating and the things we've done along the way to be sure we've tried to maintain it and improve our coverage ratios. I would really point to look at our track record rather than answering a specific question going forward.

Todd Duvick - Banc of America Securities

I understand that. Thank you very much.

David Dillon

Todd, thank you and before we sign off today, I would like to make some additional comments to our associates who are listening in today. Rodney mentioned the progress we made this quarter in controlling energy costs in such a challenging environment. He specifically mentioned bag expense, trucking costs and energy usage. He could have also mentioned many others.

Fortunately, we can point to thousands of individual efforts our associates make every day to benefit our customers. From taking a customer's groceries to their car when they need a little extra help to a team of facility engineers who find the right lighting solutions, our people look for opportunities where they can individually make a difference towards placing our customers first.

Efforts like these and thousands of others make our business strategy work, so on behalf of our customers, we deeply appreciate your work. Thank you.

Operator

Thank you for your participation in today's conference. This does conclude the presentation. You may now disconnect your lines. Have a wonderful day.

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Source: Kroger F2Q06 (Qtr End 08/12/06) Earnings Call Transcript (KR)
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