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The Kroger Co. (KR)

F3Q06 Earnings Call

December 5, 2006 10:00 am ET

Executives

Carin Fike - IR

David Dillon - Chairman, CEO

Rodney McMullen - Vice Chairman

Don McGeorge - President and COO

Michael Schlotman - CFO

Analysts

Simeon Gutman - Goldman Sachs

Mark Husson - HSBC

Perry Caicco - CIBC World Markets

Meredith Adler - Lehman Brothers

Chuck Cerankosky - FTN Midwest

Jason Whitmer - Cleveland Research

Bob Summers - Bear Stearns

Ed Kelly - Credit Suisse

Scott Mushkin - Banc of America

Todd Duvick - Banc of America

Presentation

Operator

Good day, ladies and gentlemen and welcome to the Kroger Co. third quarter 2006 earnings conference call. (Operator Instructions) I would now like the turn the presentation over to your host for today's call, Ms. Carin Fike. Please proceed, ma'am.

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 affect on our business, on an ongoing basis. is contained in our SEC filings. Kroger assumes no obligation to update that information. Both our third quarter press release and our prepared remarks from this conference call will be available on our website at www.kroger.com.

Now I would like to introduce Mr. David Dillon, Chairman and Chief Executive Officer of Kroger.

David Dillon

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

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

Total sales for the third quarter increased 4.8% to $14.7 billion. Identical supermarket sales increased 4.9% with fuel, and 5.3% without fuel. Supermarket retail fuel prices were about 10% lower this year versus last year. Across the company, growth continues to be broad based. We experienced particularly strong growth in produce, natural foods, deli/bakery, pharmacy and seafood. Our convenience stores had another strong quarter both in fuel and non-fuel merchandise.

Net earnings in the third quarter totaled $214.7 million, or $0.30 per diluted share. These results include $0.01 per diluted share related to stock option expense, and for comparison purposes, net earnings in the same period last year were $185.4 million, or $0.25 per diluted share.

Our fuel business had a strong quarter in sales, gallons and in margin. While fuel margins for the quarter were strong, on a year-to-date basis they were more normalized. We're pleased with our third quarter results and want to thank our associates for their role in delivering them. In this intensely competitive industry, our associates continue to focus on putting customers first.

These results once again demonstrate Kroger's ability to consistently deliver strong, sustainable growth over time. In fact, this marks the 13th consecutive quarter Kroger has reported positive identical supermarket sales, excluding fuel.

Next I would like to comment on Kroger's year-to-date performance. During the first three quarters of fiscal 2006, total sales increased 7.5% to $49.3 billion. For the same period, identical supermarket sales increased 6.7% with fuel, and 5.6% without fuel.

Net earnings for the first three quarters of fiscal 2006 were $730.1 million or $1.01 per diluted share. During the same period last year, net earnings were $676 million or $0.92 per diluted share. The fiscal 2006 year-to-date results include $0.04 per diluted share for stock option expense and $0.03 of expense per diluted share for the legal reserves recorded in the first quarter.

Based on Kroger's year-to-date financial performance and sustained sales momentum leading into the holiday season, we now anticipate identical supermarket sales growth will exceed 5% for the fourth quarter, excluding fuel. We are also raising our guidance for earnings per share growth in fiscal 2006 to 8% to 10% from 6% to 8%. Based on current results, we are striving for the upper end of that range. We're confirming our guidance for earnings per share growth in fiscal 2007 of 6% to 8% after adjusting for the benefit of the 53rd week in 2006 and the increase in the legal reserve recorded in 2006. Based on current business trends, we are targeting the high-end of this range next year.

Now I would like to turn to Rodney who will share additional details on our guidance as well as our third quarter results.

Rodney McMullen

Thank you, Dave and good morning, everyone. As Dave mentioned, we believe our third quarter performance is the result of our associates' continuing focus on our customers. Our disciplined approach is working. We continue to balance operating cost reductions with investments aimed at improving our customer's overall shopping experience.

I would like to provide some detail on the components of Kroger's operating margin during the quarter. Let's begin with gross margin. FIFO gross margin as a percent of sales was 24.48% this quarter, unchanged from the prior period last year. Excluding the effect of retail fuel operations, FIFO gross margin declined 12 basis points from the prior year. We continue to invest in lower prices for our customers, as demonstrated by the 17 basis point decline in supermarket selling gross margin.

During recent calls, we've discussed this metric we use internally to help us evaluate the pricing dimension of our Customer First strategy. We define selling gross margin as the company's gross margin before incurring expenses directly related to distributing and merchandising products on the store shelves. Examples include advertising, warehousing, transportation and shrink. During the quarter, we invested operating cost savings in lower prices for our customers. This remains an important part of Kroger's strategy.

Operating, general and administrative costs or OG&A are also an important component of operating margin. Kroger's third quarter OG&A costs as a percent of sales increased 4 basis points to 18.27%. Excluding the effect of retail fuel operations and stock option expense, OG&A declined 17 basis points. This decline was driven by leveraging identical sales and progress we've made in controlling our health care costs, offset by continued pressure in pension expense and credit card fees. This marks the eighth consecutive quarter that Kroger's OG&A rate on this basis has declined, and yet we still see additional opportunities to continue this downward trend in the future in the right way. We also see additional opportunities to reduce operating costs embedded in our gross margin, for example shrink, advertising, warehousing, and transportation costs.

Kroger's operating margin on a GAAP basis increased 9 basis points to 3.05% of sales. Excluding the effect of retail fuel sales and stock option expense, operating margin increased 21 basis points. A sizable portion of this increase came from sales leverage over rent and depreciation expense. 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 real estate plus leverage from our strong identical sales growth. Similarly, we anticipate continued leverage over depreciation expense resulting from the strong identical sales growth and improved efficiency in capital investment.

Kroger's operating margin can fluctuate on a quarterly basis, depending on the timing of our cost savings and our re-investment of those savings. That's why we continue to encourage investors to evaluate our operating margin over a longer timeframe to gauge the success of our business strategy.

On a year-to-date GAAP basis, Kroger's operating margin decreased 7 basis points to 3.13% of sales. However, the important measure is to exclude the effect of retail fuel sales, stock option expense and the increase in legal reserves. On this basis, operating margins increased 17 basis points. We still forecast slightly improving operating margins for fiscal 2006, resulting from the leverage of strong identical sales growth over expenses including rent and depreciation.

During the quarter, Kroger's strong free cash flow enabled us to invest in our store base, reduce debt, repurchase shares, and pay cash dividends. Capital investments totaled $415 million for the quarter compared to $336.9 million a year ago. For fiscal 2006, we plan to invest approximately $1.7 billion to $1.9 billion in capital projects. Based on our current run rate, we expect to close the year near the low end of this estimate.

We anticipate total supermarket square footage growth of 1.5% to 2% before acquisitions and operational closings. For the third quarter, total supermarket square footage grew 1.4% year over year, excluding acquisitions and operational closings. Our return on asset measure improved almost 94 basis points on a pretax basis. This is using the method Kroger has consistently used to calculate return on assets.

Total debt was $7 billion, a reduction of $299.1 million from a year ago. Our investment grade rating continues to be very important to us. We have focused on improving our coverage ratios since merging with Fred Meyer in 1999. Our net debt to EBITDA ratio in the third quarter was 2.0, an improvement of 22 basis points from the same period last year.

During the third quarter, Kroger repurchased 10.2 million shares of stock at an average price of $22.79 for a total investment of $232 million. At the end of the third quarter, $322.8 million remained under the $500 million stock buyback announced in May of 2006.

Since January 2000 Kroger has invested $5.3 billion to repurchase shares and to reduce net total debt. Of this total, $3.5 billion was used to repurchase 180.2 million shares of stock at an average price of $19.46 per share. This equates to approximately 20% of the company. Kroger expects to continue to buy back stock in 2006 in accordance with the company's strategy of using one-third of free cash flow for debt reduction and two-thirds for stock repurchase and cash dividend payments.

Our third quarter tax rate was 37.2% compared to 38.4% for the prior year. We continue to expect our tax rate for fiscal 2006 will be 37.8%. As Dave mentioned, on a GAAP basis, we have raised our guidance on earnings per share growth this year to 8% to 10%. Based on current results, we are striving for the upper end of this range.

As we look to fiscal 2007, we continue to anticipate earnings per share growth of 6% to 8%. As a reminder, the 6% to 8% growth rate for 2007 should be applied after reducing fiscal 2006 GAAP earnings by a net of $0.02 per share. This net adjustment to 2006 earnings reflects the $0.05 benefit from the 53rd week, offset by $0.03 of additional legal expense. As Dave said earlier, based on Kroger's current business trends, we are targeting the high-end of this range. This is the same range we provided for 2007 earnings per share growth when we released our year end 2005 results in March. But this will start with a higher base as 2006 earnings are trending higher than originally anticipated. We will provide more details for the 2007 targets in March when we release year end results for 2006.

Before I turn it back to Dave, I would like to comment briefly on labor as we head into 2007. It will be a heavy year as negotiations open, covering store associates in Southern California, Cincinnati, Detroit, Houston, Memphis, Toledo, Seattle, and West Virginia. Many of these contracts may be challenging as we seek competitive cost structures in each market. In every contract negotiation, we work to reach a balanced agreement that meets the cost efficiency objectives while fulfilling our commitment to provide our associates with solid wages and benefits. Maintaining this balance allows Kroger to invest in our business to provide new job opportunities for existing associates and create new jobs for more people. We look forward to constructive negotiations in the new year.

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

David Dillon

Thanks, Rodney. Kroger's performance this quarter shows consistent improvement as we steadily execute our business strategy. This allows us to be competitive in every aspect of our business and generate value for our shareholders. In fact, this week, shareholders will receive another quarterly dividend check, the third one the Kroger Board has declared since March. The dividend is a vote of confidence by our Board that our Customer First strategy is on target. These results clearly show what we can achieve by focusing on improving the service, product selection, quality and pricing that we offer customers throughout the year.

Now we'll be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Simeon Gutman - Goldman Sachs.

Simeon Gutman - Goldman Sachs

First, given that your selling gross margin was relatively stable this quarter and that your IDs did not appear to suffer are you starting to feel greater comfort with the level of price investments you made? I know the process is never truly complete, but as you budget next year, how does it impact the way you approach it?

Rodney McMullen

We're actually feeling more comfortable with the overall balance of the plan. Think about the strategy as we described it: price certainly is important and the investment in price is important, and we have indicated that in the long run, we would anticipate additional price investment. We're comfortable enough with our price position that we think that putting additional emphasis on the shopping experience, on the people in our stores and the products we sell and balancing the focus on those, investing in those areas can produce the sales that we need.

I think I would come to a similar conclusion you did, but a little bit for different reasons because I think that our results are being achieved by a balanced approach and are being impacted by more than just the price.

Simeon Gutman - Goldman Sachs

Can you discuss as it relates to gross margin the vendor allowances going into next year? How does the process work with timing in light of the top line momentum being good for quite some time? Is it fair to assume next year should be made more favorable and is this done all ahead of the year or in lumps across the year?

Rodney McMullen

I am not sure I fully understood your question. If I understand your question, it is how do promotional allowances from vendors come to us through the year? Actually it is randomly distributed, is the best way to think of it. It is not like we sit down in December and negotiate all the promotional allowances for next year. Now, some of that happens; but as the year goes on, there are promotional strategies that get developed by the CPG companies and by the grocery companies, and those happen throughout the whole year. It is pretty evenly distributed.

David Dillon

One other note on allowances, all of our allowances we put in cost of goods, so we actually reduce the price that we pay for the product from the vendor, and we do not recognize that allowance until we actually sell the item to the customer.

Simeon Gutman - Goldman Sachs

Lastly, can you just shed some more light on your comment about the pharmacy business? You mentioned it was doing well. What's driving it? Because I think reports regarding Medicare Part D suggest the supermarket channel didn't fare as well from Medicare Part D. Separately, discuss how the Wal-Mart $4 generic program has been affecting your pharmacy business.

David Dillon

Well, I think about the best I can say is that our pharmacy business is good. We singled it out among several departments to make sure that we commented on it because it is doing well. The results are because customers find what we provide to be relevant to what they want in the way of pharmacy services. I realize that is sort of begging the question because the reason our identical sales are up there and our scripts are doing well there is because more customers come in.

I think that that is in essence the answer to everything from the Part D to the impact of Wal-Mart's generic prescription program. We obviously are not going to comment from a competitive point of view on Wal-Mart's prescription program. I think you probably read that we do have three smaller markets in which we have put in similar programs, and our purpose there, as we said, is simply to be familiar with the relative impact of those prices and the mix change and all of the other elements that go with a program like that, but we're not announcing or deciding actually any additional steps at this point. We think it is too early to do so.

Rodney McMullen

One other comment on our pharmacy business, our pharmacists are really focused on making sure they provide the right service to our customers. When we do our customer research we find time and time again this is a more important element in terms of where you pick your pharmacy as some of the other things that Dave talked about in terms of price. We know from the research that we score very well, and we know our pharmacists are really focused on even taking it to a higher level and providing what the customer needs, so we feel pretty good about where that business is.

Operator

Our next question comes from the line of Mark Husson - HSBC.

Mark Husson - HSBC

Good morning. I wonder if you could hold my hand a bit on the sales line. You have a comparable store sales number of 5.2%, and you've got actual sales growth of 4.9%. You also have square footage growth of 1.5%. Can you reconcile that for us?

Rodney McMullen

The 1.4% square footage growth is before acquisitions and operational closings. If you look at operational closings, we would have closed over 1% square footage, so if you look at the net change in square footage, it is down 0.2%, if you look at the square footage that we've actually closed. As you know, operationally, some of that would be northern California where we closed more stores than typical there.

In terms of the other pieces of it, a big piece of it would be our convenience store business because obviously over half of that business is gas. As Dave mentioned we had a meaningful deflation in selling retail gas per gallon, so that also pulled the C-store volume down; but not in terms of gallons. It was nicely up, but in terms of dollars it was down. Really those two components would be the two biggest parts, Mark.

Mark Husson - HSBC

So the C-store comp store sales that you report in your aggregate group comp is only in the bulk sales.

Rodney McMullen

We do not include convenience store comps at all in our supermarket identicals.

Mark Husson - HSBC

Nothing in there? Okay. That's useful. Then just --

Rodney McMullen

I am sorry, Mark. As Dave mentioned, our gallons and our inside sales at the C-stores were up very nicely. We are very pleased with that result.

David Dillon

The only thing driving the percentages that looked a little odd was because the retail price was down. All of the other metrics were good.

Mark Husson - HSBC

Just in terms again on the sales line which obviously is a very good one, you've seen some competitive activity. You talked in your conference about seeing competitive closures in the marketplace. You talk about capacity coming out. You did have some specific store closures in this period. Did that meaningfully affect the sales line or not?

Rodney McMullen

No.

David Dillon

I don't believe it did.

Rodney McMullen

And as Dave mentioned, it was broad-based in terms of the sales strength. That's one of the things that we obviously always track is how is our identical sales track versus specific competitors and across markets, and it was very broad-based.

Mark Husson - HSBC

One final small question. Just on the private branded manufacturing business, can you comment on whether the velocity in private brand is as good as it is for your overall business?

Rodney McMullen

In terms of units, it is good. It is growing.

Mark Husson - HSBC

Manufacturing performing well, poorly?

Rodney McMullen

Oh, yeah, we're quite happy with the manufacturing team. They've done a nice job.

Operator

Our next question comes from the line of Perry Caicco - CIBC World Markets.

Perry Caicco - CIBC World Markets

The rent charge in the quarter seems very low compared to where it's been in previous quarters and last year. I know you alluded to it a little bit, but perhaps you can explain why it is as low as it is?

Rodney McMullen

It is really if you look at the number of stores that we closed in the third quarter itself, where we had to take the present value and the future expected rent was lower this year than last year, and we did not have very much of that expense in the quarter.

Perry Caicco - CIBC World Markets

So going forward this rent number as a percent of sales is a reasonably good guidance for forecasting?

Rodney McMullen

Well, I would say yes, but I would put one caveat on that. Obviously depending on the timing of closing stores and the amount of remaining lease liability on those it could affect the number.

Michael Schlotman

Perry, keep in mind the day we close a store we have to book the net present value of the future lease, and quarter to quarter this year we simply had fewer of that activity this year versus last year.

Perry Caicco - CIBC World Markets

Okay. That's fine. A question for Dave, then, on the pricing outlook going forward. I guess you segment your stores among value, mainstream and upscale, I am wondering if that's beginning to have an impact on the necessary price investments? Presumably if you have a more accurate offering of quality, variety and service or whatever in each store, I would think it would allow to you rely a little less on price. Are we beginning to see that and beginning to forecast next year, would that have an impact on your necessary price investments?

David Dillon

I think we're seeing that, Perry, actually not just because of segmentation as you describe, but for all of the reasons that are embedded in our strategy. Price is but an element of why customers choose where they go, and we took of course some strong hair cuts initially in this plan, which helped get the momentum going and which helped set the tone. While there is still some more work to be done, I think you're absolutely correct to say that some of these other elements can offset the need to go much deeper on price in some elements of some areas.

We seek here to have a sustainable strategy, one that we can balance over time and that comes out in a good equation for the shareholders, for the customers, and for our associates, and I think that what you're saying is absolutely correct.

It is the reason, though, that we even said a year or so ago, maybe two years ago now where we said that essentially we're going to invest in price only to the extent that we can find a way to pay for it through lower costs and that it is our overall long-term strategy. We reached that conclusion because we think we had gotten to the point where some of these other pieces of our strategy could carry some weight. I think you're correct in your statement.

Perry Caicco - CIBC World Markets

Just one last slightly related question. Your new store productivity system, I am presuming is rolled out or close to being rolled out by now. I am wondering if you saw any of these benefits in this quarter or is that still to come? Where you'll see the benefits and again is that part of the savings that should offset the price declines?

David Dillon

We have a number of things in play that are working on productivity in our stores, and several of those had an impact, really through the whole year, and several of those had an impact just in the quarter; but there is more to come. It is kind of early in the process of our most recent steps, but it did have some impact in the quarter, yes.

Perry Caicco - CIBC World Markets

That's good for now. Thanks.

Operator

Our next question comes from the line of Meredith Adler - Lehman Brothers.

Meredith Adler - Lehman Brothers

Good morning, everybody.

Rodney McMullen

Good morning.

Meredith Adler - Lehman Brothers

A couple of questions for you. In the past, you guys have talked about making price investments and it seems like you sometimes go too far in one quarter and then pull back a little bit in the next quarter. I hear everything you're saying that you're getting what you want out of your price investments, but was there any of that in second quarter and third quarter or was the level of investment reasonably steady?

David Dillon

Meredith, I prefer to think of it a little bit differently. In the second quarter we made an intentional choice to invest a little bit more in advance of our original plans, the plans that we made at the beginning of the year, because we saw an opportunity to do so and thought it was timely to do so, and so we took that step. We described that on the last call.

In this quarter we didn't have anything like that where we did some advanced investments. The investments that we had intended for the quarter had started actually earlier, so I don't really think of it quite as the seesaw that you described, although I certainly can understand why you would draw that conclusion.

I wanted to put a little different perspective on it at least in the near term. A couple of years ago I remember where that would be a more correct description.

Meredith Adler - Lehman Brothers

Okay. I wasn't sure it happened; I just wanted to make sure it hadn't happened. Another question for you would be a little bit more big picture. In the last six months there was a lot of discussion amongst retailers about the fact that higher gas prices were getting people to maybe shop closer to home and to aggregate their trips. As gas prices have come down, have you seen any real changes in behavior? I know it is very hard to know what consumers are doing, but is there anything in your data that points to a change?

David Dillon

I would say no, that there isn't anything in our data that points to a change, but some of the description that we have given -- and I will maybe go back through those in a second -- but some of the descriptions we've given aren't really provable by data. They're what you read about, what you hear from customers, what you think may be happening, and those include essentially the same descriptions we gave last quarter where we said look at the restaurant sales trend. Well, that's actual data. You can see what's happening in restaurant sales, so you can presume that if they're not eating in restaurants as often, that they are more likely buying something in our stores, taking it home and preparing it. We believe that is happening.

Whether that's driven because of cost consciousness because it is clear that a customer who buys the meal from us and prepares it at home does so less expensively than if they go to a restaurant to do it; or whether it is driven by focus on their family, wanting to have family time as we talked a little last quarter that there are significant social implications of having dinner at home with your kids that is getting some attention, and we suspect that and just the general social trend maybe is having some impact. And then you get to the question of gas which you described, which is given the cost of gas, customers may be traveling less, wanting to combine trips in a nearby location, we're more convenient. We have gas, all of those combinations work together so they shop with us. I suspect that's also true.

Where gasoline is 10% lower in our supermarkets this year than last year, that's meaningful, but it is still a fairly high number. Customers still have that as a budget issue they need to worry about. In my judgment at least, we're still getting some benefit from high cost of fuel in the minds of the customers and I think it is showing up in our sales.

I think probably and I have answered this I think earlier on some of the earlier questions. I think the biggest contribution to our sales really has to do with our strategy. The steps that we've taken, the alignment we have with our customer, the commitment our associates have made to that. If you go out to our stores, our associates are on fire. They are remarkable in the way in which they are thinking about customers and trying to meet the needs of those customers, and I couldn't be any more happy about that.

Meredith Adler - Lehman Brothers

Wonderful.

Rodney McMullen

One other comment on your question to Dave, if you look at our identical sales growth usually almost every quarter somewhere along the line we end up talking about how much of that is driven by count and how much of it is driven by average basket, and we continue to see it very balanced between growth between counts, so with new people shopping in our stores and the average basket size, and it was slightly more on the count side than the basket side, but it is pretty close to 50/50 and has been for the last two or three quarters.

Meredith Adler - Lehman Brothers

My final question is about general merchandise. Clearly you guys have put much more emphasis on general merchandise and we're coming into the holiday period. Could you just talk about what kind of trends you've seen recently? Is general merchandise getting traction in your grocery stores and how are you feeling about what's going on happen in your business that are more focused on general merchandise.

Rodney McMullen

We are quite bullish on our general merchandise for a whole lot of reasons. We are seeing some traction. We're seeing improved quality of the products we're buying which comes from the hard work here, those in general merchandise here at our general office and the help of those out at Fred Meyer. The combination of that has really worked magic on both the selection of what we get, the quality of the assortment, the pricing on it, the costs, all of that is working to our advantage, and we're quite pleased with what we've seen there. I would have to say we're bullish.

You mentioned and I don't want to miss this opportunity. You mentioned the Fred Meyer Jewelers, and even though that doesn't go into our supermarket GM sales, I should point out this is their season to shine, and I just happen to have their website handy for you. It is www.fredmeyerjewelers.com. If you go there, there is still time to order jewelry for this holiday season.

Meredith Adler - Lehman Brothers

Thank you very much.

Operator

Our next question comes from the line of Chuck Cerankosky - FTN Midwest.

Chuck Cerankosky - FTN Midwest

Good morning, everyone.

Rodney McMullen

Hi, Chuck.

Chuck Cerankosky - FTN Midwest

Did you say you expect to come in at the low end of your CapEx spending range for this year?

Rodney McMullen

Yes, Chuck.

Chuck Cerankosky - FTN Midwest

What's that range again?

Rodney McMullen

$1.7 billion to $1.9 billion.

Chuck Cerankosky - FTN Midwest

In looking at some of the specific things that you've reported so far, if we start with fuel margins, you suggested that they were a little better than normal. Can you quantify that for us?

David Dillon

Well, let's see. They were a little bit better than last year in dollars. Last year was good, though, was quite strong in the third quarter, but as we pointed out, while it was strong in the quarter, year-to-date was more normalized. That's important to recognize with fuel because our customers need fuel, and we have lots of short-term fluctuation around the margins and even around the pricing and around the sales, but long-term we think it is a good investment. It was important in the quarter. Do you want to add anything more?

Rodney McMullen

You said it a little bit, Dave, but if you look at margin per gallon in the third quarter it was actually a little bit lower than the third quarter of last year, but because of our gallons were so strong, the margin dollars more than made up for that.

David Dillon

That's a good point. I am glad you made that.

Chuck Cerankosky - FTN Midwest

So penny profit per gallon down a bit but gallons drove the thing.

Rodney McMullen

Yes. With that said, as Dave said, if you look at the quarter relative to long-term trend, margins were certainly higher than a long-term trend but you have to look at gas margins over a longer period of time.

Chuck Cerankosky - FTN Midwest

Okay. You mentioned when you're discussing selling gross margin that shrink, advertising, distribution, were all areas of cost that could be improved. Is that going to be improved through programs or are you talking about levering it because of the sales momentum or both?

David Dillon

It is really both of that. Shrink, we were challenged a little in the quarter but we're certainly improved if you look year-to-date. We still see lots of opportunity remaining and not just the leverage of higher sales. We keep trying to balance that, with making sure with don't put out our sales trend by trying to reduce shrink. You can get shrink to zero, but you wouldn't like the results.

Rodney McMullen

If you look at actually some departments we had increase in shrink, and it was part of the planned program of adding variety, so you really do have to break it down category by category in terms of looking at where we are and where we're trying to go.

David Dillon

I would say in every one of those categories you listed, though, we see opportunities in addition to what the leverage of sales does.

Chuck Cerankosky - FTN Midwest

In looking at acquisitions, how would you describe the environment right now, and is it perhaps a better time to be looking at more than just buying small store groups? Do you see any economics looking more attractive for buying a whole other division to get you into a new market perhaps?

David Dillon

The market on acquisitions isn’t different than the last couple of quarters we commented on.

Rodney McMullen

Not at all. As you know, we look at it a lot. We don't bid on too much, but we look at a lot. Any merger that we would do it would have to be something that's a quality asset with good management and good market share and a good economic model that's sustainable.

Chuck Cerankosky - FTN Midwest

No fixer uppers.

Rodney McMullen

The only fixer uppers, if it is an end market where we are looking at a specific site, and just we want that corner and we already have a good reputation in the market.

Chuck Cerankosky - FTN Midwest

Last question, if we look out a couple years, do you see Fred Meyer spreading outside of its current area?

David Dillon

Well, I don't know that I am going to comment on Fred Meyer, but I will comment on the resulting Marketplace store that has a direct outcome of our merger with Fred Meyer and the work we've done with Fred Meyer and our general merchandise folks here. We've put together this store which many of you have seen, and we have a number of them now around the country. We've now opened two in this market, in the Cincinnati market, and they are actually remarkable stores. They are much like a Fred Meyers store except that they aren't as big a store, and they don't have quite the same assortment in some of the other departments that Fred Meyer would have, and so for us that is a really good first step of taking the Fred Meyer advantage and expanding that elsewhere.

Chuck Cerankosky - FTN Midwest

Thank you very much. Great quarter.

David Dillon

Thank you, Chuck.

Operator

Our next question comes from the line of Jason Whitmer - Cleveland Research.

Jason Whitmer - Cleveland Research

Thanks. Good morning. Dave, I wanted to ask the acquisition question in a different perspective. I am not curious if you're actually pursuing anything but in your preference would you rather do one of three things: would you like to push competitors out of the market with your aggressive positioning in price, service, et cetera; or would you like to wait patiently for rationalization; or third, use that acquisition strategy in selectively end market to fill up your pipeline and build up greater density?

David Dillon

My lawyer is shaking his head saying we're not going to answer that question. Actually think about it this way, and I think this is accurate for us. The single biggest difference we've made in the last several years is to work on our plan, and to figure out what we wanted to have happen in our stores and how we wanted to connect with our customers. We have to be conscious of what happens with competition. We have to be conscious of what the playing ground looks like and who goes outs of business, who doesn’t, who is weak, who is connecting with our customers, who is doing better than us and those sorts of things.

But really, it has to be our game plan. Once you go down that path, you can have a natural thought process of what happens with acquisitions, for instance, and whether somebody falls out because they can't compete, whether they get purchased by somebody, all of those are the normal things that happen in any market that is in change. Our objective isn't so much causing one or another of those alternatives to happen, it's to play out our strategy the best way we can, and I believe all of those things will happen in different ways and at different times.

Jason Whitmer - Cleveland Research

That's fair. When you look at the whole bucket of your price and non-price investments, going forward is the balance of the actual dollar investments going to be fairly constant or are price investments actually more costly if you try to spread that out over service products and shopping experience and be more balanced as you said? Are there some of those investments still fairly constant or is that something where you can make more progress with your investments with fewer dollars?

David Dillon

When we were originally starting down this path, nearly 100% of what we were investing was in price. We gradually added other elements. First it had more to do with service and so forth, and now it is adding some other dimensions and it actually has capital investment dimensions today. We are intending to have it more balanced although the price will probably always be on people's minds because it is so easily calculated where some of the other things like training budgets and capital budgets and the way we do remodels and things like that aren't always as easily calculated.

I think you will continue to see us continue to invest more, proportionately more, in the other non-price areas than the price areas, but I doubt that we'll ever get to where it is no additional investment in price. I just don't imagine that at any time in the near term anyway.

Jason Whitmer - Cleveland Research

Are those other areas equally as costly on a dollar basis when you add it all up at the end of the day?

David Dillon

For the benefit achieved?

Jason Whitmer - Cleveland Research

Exactly.

David Dillon

Actually that's hard to answer. They're harder to achieve, price is certainly easier to address because you simply make a decision to price something different. Helping your organization engage itself to figure out how you address customers and having our associates aligned in such a way they are seeing the customer strategy as their own rather than something that's handed out from some corporate office some place, that's a lot harder to do and takes a lot more organizational energy. How you put a cost around that, I am not sure. We see it as an opportunity as opposed to a cost, and so I don't know that we've really done the metrics the way you're thinking about it.

Jason Whitmer - Cleveland Research

How far along are we within the segmentation of the store base? Is there an X percent of the base that's been SKU value, upscale, mainstream, any metrics you're tracking on that?

Rodney McMullen

To me it is a great question, and to answer it you need to separate it into two parts. If you look at the initial part on segmentation, we're probably 80% or 90% of the initial process done. However, with that said, as we went through the process we identified a lot of additional opportunities, and when you look at the additional opportunities, we're probably only 20% or 30% along the way done on that, and hopefully as we learn more and more on segmentation with the help of Dunnhumby and Don's merchandising team, what we'll find is that continues to happen.

If you look at the initial project list, it is pretty well done, but out of that project list identified a lot of additional opportunities and that's what they're focused on getting done now. Pleased with a lot of additional opportunities there.

Jason Whitmer - Cleveland Research

Great. Thanks. Good work.

Rodney McMullen

Jason, one other comment on your first question of today. I know we have pointed this out before, but if you look at our major markets, we still have almost 50% share in our market held by people out without our economies of scale, and how they ultimately fall out, time will tell, but clearly there is still a lot of market share held by people without our economies of scale and without our big competitors’ economies of scale.

Operator

Our next question comes from the line of Bob Summers - Bear Stearns.

Bob Summers - Bear Stearns

With the comps you've been putting up it is fairly obvious you're gaining share. What I would be curious to know is, is there a specific type of competitor or retailer that you're gaining share from?

The second question is, in the markets where you're testing a generic initiative, could you talk about what you learned or observed so far and maybe frame the answer a little bit around the impact in margins, traffic levels, and service levels?

David Dillon

Let me take the second first and the answer is no. I actually can, but I am not going to. I don't think it would be useful, and it is a bit premature to do that anyway.

Let me go back to your first question about share and from whom we're getting it. A few years back, actually many years ago, we changed how we looked at market share, and we started looking at it from any place that customers could buy the goods that we sell, which then started including lots of things we previously had not measured.

I think the way in which I would answer the question where are we getting our sales? I think we're actually getting it from a variety of places. It isn't a single competitor. It isn't in a single market. It isn't in a single department. It isn't from any one single strategy of ours or any one single strategy of our competitors. It is a variety of all of those working together to achieve that.

I do suspect that we are picking up share. I think that's probably an accurate statement, but I do think we're bringing it in from all of the places that customers would buy products and not just any single source.

Rodney McMullen

I think some of it is really driven by trend changes that Dave talked about earlier. To be able to put a specific number on it is hard to say but clearly we get the feeling people are eating at home more, how much of that is driven by gas, how much of it is driven because people want to eat together as a family; that we don't know, but when you look at our deli business and some of the prepared meal areas, that business is doing very well. Certainly when you look at produce and nutrition that, as Dave mentioned on his remarks, that business is growing nicely and certainly that is a trend change where more and more customers are buying those types of products.

Operator

Our next question comes from the line of Ed Kelly - Credit Suisse.

Ed Kelly - Credit Suisse

Good morning. Congratulations on a good quarter. There seems to be some saber rattling out of the USCW in Southern California. Can you give us an update on where we stand in the process right now and what we can expect as negotiations commence early next year?

David Dillon

The first thing I will tell you is that around any negotiations, Southern California or anywhere else, there is always a lot of public noise and I would encourage you, as I typically do, to disregard that because it doesn't necessarily tell you what's happening in that market. Southern California in particular, the contract expires the first part of March, and obviously I think it would come as no surprise that we see the contract in that market as a challenging market.

We are committed, though, to reach a fair and balanced solution, and I think what Rodney said in his prepared remarks is important for us to remember; is that in every contract negotiation we work to reach a balanced agreement that meets our cost efficiency objectives while fulfilling our commitment to provide our associates with solid wages and benefits. It does require that kind of balancing, and we fully expect that that will be the approach, and we expect that will be the outcome in Southern California.

The actual bargaining in that process will likely start soon. My guess is next month, but those things, you never quite know for sure when it actually starts getting some traction, but it is a big market. There are seven locals, and it is an important market to us and it is an important market to other grocers, too. It is one we'll be paying quite a bit of attention to.

Ed Kelly - Credit Suisse

Tesco recently stated they're look to go spend about $2 billion in the U.S. over a five-year period which certainly seems like a lot of stores now. At your analyst meeting you stated that you always assumed Tesco would be in the U.S. and built your business model around this. Can you elaborate on that a bit?

Rodney McMullen

It is really in terms of what we believe Tesco is really good at and what we assumed from a pricing and service standpoint they would build in, and what type of things as we understand the customers in the U.S. that they want, making sure that we build our economic model around providing our customers what their wants and needs are with the understanding and belief that we would have to compete against Tesco. It really is as simple as that, and it is trying to make sure that we think we understand their economic model and how to compete against that and making sure that we listen and talk to our customers to deliver what they want.

Operator

Our next question comes from the line of Scott Mushkin - Banc of America.

Scott Mushkin - Banc of America

Thanks. I wanted to revisit the rent expense issue because really it was partly due to the big surprise on the EPS, and so I know what you said, but you said there were also a lot of closures in the quarter. I was wondering how the present value of the lease could have been down? Were there credits in the quarter that could have pushed that number down or maybe just a little more clarity there would be great.

Rodney McMullen

It would have been closures that were in the third quarter of last year that drove that number up a little higher than the trend line, and this year we did not have very many in the third quarter of '06.

David Dillon

A good part of the improvement, Scott, compared to last year was last year was particularly high.

Scott Mushkin - Banc of America

Okay. As we go forward and look at this -- because expense was down like 16% in the quarter -- would you consider it very abnormal? How do we model this line going out forward? I look back over a three or four-year period and we never saw action like this.

Rodney McMullen

That delta is unusual, obviously. The change is unusual.

David Dillon

As you model it, I would look at it more in terms of a year-to-date number rather than just a quarter number. Obviously in each quarter you're going to have some swings just because of seasonality from the business from a revenue standpoint, but as you model forward I would look at a rolling four-quarter basis in terms of what you're modeling, and as I said, we continue to expect it to create some of the operating margin going forward.

Scott Mushkin - Banc of America

Right. And then following up on some of the questions asked, I asked a question in the last quarter about the investments, when are they going to stop and the answer was given that it is kind of hard to say. Looks like we're going to invest in price on an ongoing basis, so it seems like that changed a little bit. What in the quarter made you guys feel like you could change your strategy, at least to a degree, and back away from the price investing? It does seem like it did change from your last answer.

David Dillon

I don't think we backed away from price investment. I mean the way you described it implies that we're rolling back the other way. I don't think I actually see an end to the investments, maybe forever. I think we'll always be asking ourselves how do we want to invest on behalf of our customers to continue to be relevant in their minds. Sometimes it will be in price. Sometimes it will be in the other three keys, but generally the long-term will be in all of those areas, and yes the price investment in this particular quarter was a little bit less than what we had experienced in some other quarters, but in the last two years, for instance, if you just look at gross margin, we've had three other quarters where the investment in gross margin was a little bit less than it was in this last quarter, as I look at that. Now, we tend to look at selling gross, and I don't have that at the tip of my tongue so I can't answer it from that perspective, but I didn't see it as rolling back our price investment.

Scott Mushkin - Banc of America

I didn't mean rolling back, I meant more not as much.

David Dillon

That's correct. It wasn't as much. That was deliberate. We said all along our plan all along was to try to focus on some of the other keys and to get some leverage from those as well. Those are longer term to get benefit from and so having started that several years ago, we believe we're starting to see some benefits from that, particularly from the shopping experience, but those things we think are a little slower burn so we had to let them have a little time before they started to give us benefit.

Rodney McMullen

As Dave mentioned before and as we mentioned in the second quarter, some of the investments that we made in the second quarter we originally planned to do those investments in the third and fourth quarter.

David Dillon

That's a good point. If we had done that as we originally planned, it would look a little more balanced for the year.

Rodney McMullen

A little smoother when you look at quarter to quarter. Obviously when you look at the year, it will be consistent with what we've said, is that we would expect to invest in selling growth as we reduce costs and be able to pay for that.

Scott Mushkin - Banc of America

The OG&A line seems to have not improved as much as we've seen. The trend is still improving, but not as much. I wonder if you can elaborate a little bit on what you saw on that line and the difference between the second quarter and third quarter?

David Dillon

First in OG&A I would remind you that some of our reinvestment with our customer goes into categories that would hit OG&A, and we have not attempted to quantify that in any public way. So because it does, don't read too much into it being 17 basis points versus last quarter being 47, just as an example. There are some things that go in quarter to quarter over time and tend to even out a bit, but there are some anomalies in individual quarters that can make it look a little odd.

From an OG&A point of view, some of the things we saw in the quarter we of course saw a significant sales leverage, and that sales leverage on lots of expense lines. We also saw progress in healthcare, as Rodney pointed out. Some of that was due to sales leverage, and some of that was due to progress in some selected plans where we had planned design changes. In that particular area, we must continue to address it to be competitive, though, because it is an area where our costs are noticeably higher than many of our competitors.

Some of the challenges in the quarter included pension and credit card fees are two of the best examples. We talked about both of those pretty regularly, and those did work against us in the quarter, and so we have some of those challenges as well.

Rodney, do you want to add anything?

Rodney McMullen

When you look at the last eight quarters as I mentioned, we had declining OG&A in the last eight quarters when you look at it without stock option expense and some of the miscellaneous unusual items. The 17-basis point decline is better than five of the other quarters out of the last eight, so there were only two quarters in the last eight better than the 17 basis points. When you look at it overall, we feel real good about 17 basis points and what it sets us up to continue to do in the future.

Scott Mushkin - Banc of America

Great. Thanks for taking my question.

David Dillon

Thank you, Scott. We have time for one more question.

Operator

Our final question comes from Todd Duvick - Banc of America.

Todd Duvick - Banc of America

Good morning. Just a couple quick questions here. First of all, on the cash flow statement it looks like there was a pretty big negative variance in the cash flow for the quarter. It looks like most of it was attributable to a build in the working capital. Could you address that, and especially from the standpoint of what we might expect going forward?

David Dillon

When you look at obviously we have a lot of build up of inventory just from a seasonal standpoint, because of the holidays in November and December, so a good chunk of that is just build up for the inventories for the season. The other impact on the year-to-date cash flow statement would be the amount of cash taxes that we paid so far this year is quite a bit higher than last year, so it is really those two parts. There isn't anything on the inventory that causes us to be uncomfortable. Obviously as our identical sales has been very strong, we need to make sure we have product in the store to support that, and we feel good about the holiday season in that regard.

Todd Duvick - Banc of America

Not to beat a dead horse here, but just on the acquisition question again, I guess from a bit of a different angle and I appreciate you saying again how you're committed to your investment grade rating and we can't hear that enough, but just with respect to any large-scale acquisitions, if you were to take a look at that with respect to Fred Meyer, I think when you did the Fred Meyer acquisition, you paid a lot with equity, but that was also at a time when the stock had a little more momentum than it's had the last couple of years. I am just wanting to know if you can give us a sense for were you to bid on a large acquisition how you might be able to finance that and how the investment grade rating factors in there?

Rodney McMullen

The investment grade rating is, as you know, as we said several times is very important to us, and anything that we do we look at it in that regard. To say we won't do something or we will do something without knowing what it is that we're doing would be always obviously hard to answer. Investment grade rating we believe it is very important, and we believe it is very important because we believe it creates the lowest cost of capital, and it creates the financial flexibility to deal with the marketplace whatever happens and whatever opportunities that comes before us. As you know, when we merged with Fred Meyer, we were very willing to use stock to finance part of that merger. What a specific one is in the future, I would not really want to speculate to guess on that at this point.

Todd Duvick - Banc of America

But it is possible that you might be willing to use equity again if it made sense, if the acquisition was large enough so it is not something you wouldn't consider, I guess?

Rodney McMullen

On anything you look at all the pieces of the puzzle, and obviously investment grade is very important. Obviously creating shareholder value is very important and looking at all the pieces, what kind of synergy opportunities are created, and what's the resulting expectation from that.

Todd Duvick - Banc of America

Fair enough. Thank you very much.

David Dillon

Thank you. Before we sign off today, I would like to make some additional comments to our associates listening in today. This quarter's another clear sign that you're making strides in improving our customer's overall shopping experience, and as we head into the new year, we all know that competition will only increase in all aspects of our business. So we must continue to focus on our customers in order to grow our business, but we also know how hard you work throughout the year, and we have a special appreciation for the extra effort that you make during the holiday season. This year is certainly no exception.

Thank you for your commitment to our customers. We hope each of you takes some time to enjoy the holiday spirit with those close to you. Please know that your individual contributions are so important to our overall success. On behalf of our customers, thank you for your hard work. In closing, I would like to thank all of you for joining us today, and remember Kroger for all of your holiday needs. Happy Holidays.

Operator

Ladies and gentlemen, thank you for your participation in today's conference call. This does conclude the presentation.

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Source: Kroger F3Q06 (Qtr End 11/04/06) Earnings Call Transcript
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