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The Kroger Co. (NYSE:KR)

F1Q07 Earnings Call

June 26, 2007 10:00 am ET

Executives

Carin Fike - IR

David Dillon - Chairman & CEO

Rodney McMullen - Vice Chairman

Don McGeorge - President & COO

Mike Schlotman - CFO & SVP

Analysts

Chuck Cerankosky - FTN Midwest

Scott Mushkin - Banc of America Securities

Steve Chick - J.P. Morgan

Deborah Weinswig - Citigroup

Perry Caicco - CIBC World Markets

Ed Kelly - Credit Suisse

Meredith Adler - Lehman Brothers

Bob Summers - Bear Stearns

Mark Wiltamuth - Morgan Stanley

Todd Duvick - Banc of America Securities

Presentation

Operator

Good day, ladies and gentlemen, and welcome to The Kroger Company Conference Call. My name is Candace and I'll be your coordinator for today. At this time, all participants are in a listen-only mode. We will conduct a Q&A session towards the end of this conference (Operator Instructions).

I would now like to turn the presentation over to your host, 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 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 first 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.

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David Dillon

Thank you, Carin, and good morning, everyone. We're pleased you could join us to review Kroger's first quarter 2007 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'll begin with a recap of Kroger's first quarter sales results and discuss some of our plans moving forward. Then I'll discuss sales and earnings guidance for 2007. Rodney will discuss Kroger's first quarter results and share additional detail on guidance. After that we'll be happy to take your questions.

We're off to a solid start in fiscal 2007. Total sales for the first quarter increased 6.7% to $20.7 billion and identical supermarket sales increased 6% with fuel and 5.2% without fuel. Growth was broad based across all geographic regions and most departments.

In addition, our convenience stores turned in another strong quarter of identical sales growth, both in fuel gallons and non-fuel merchandise. The strong identical sales growth in the first quarter demonstrates that our associates are focused on our customers, building customer loyalty, and generating strong identical sales growth. This is the key driver of our objective to increase earnings and create value for shareholders.

Excluding fuel, this marks the 15th consecutive quarter Kroger has reported positive identical supermarket sales and the eighth consecutive quarter Kroger has reported identical supermarket sales in excess of 3%. This track record demonstrates that Kroger's Customer 1st strategy and the business model have the power to drive strong sustainable identical sales growth.

As we stated back in March, strong identical sales growth is one driver of our earnings per share growth in fiscal 2007. Today we raised the lower end of our expected range for identical supermarket sales growth excluding fuel to 3.5% from our previous expectations of 3.0%. The higher end remains at 5.0%.

We are confirming our guidance for fiscal 2007 earnings, which did not contemplate the first quarter charge incurred due to labor unrest at one of our distribution centers. That expense reduced first quarter earnings by an estimated $0.02 per diluted share.

Kroger's earnings guidance for fiscal 2007 remains at $1.60 to $1.65 per diluted share, including the $0.02 charge. This range equates to 9% to 12% growth from adjusted fiscal 2006 earnings of $1.47 per diluted share.

Excluding the $0.02 charge related to the labor in the first quarter, the growth rate would be 10% to 14%. In addition to strong identical sales, Kroger's earnings per share growth will be driven by fewer shares outstanding and slightly improving operating margins, excluding fuel sales.

Looking beyond 2007, we believe our Customer 1st strategy will allow us to grow identical supermarket sales in the 3% to 5% range, with a slightly improving operating margin excluding fuel sales. Kroger's Customer 1st strategy is creating a unique competitive advantage that positions us well for multiple-year growth and ongoing value creation for our shareholders.

The strategy has four basic components, our people, our products, the shopping experience, and our prices. We are fortunate to have a team of talented professionals who are focused on listening and responding to our customers. Their daily actions in these important areas gives us confidence that we can continue to grow our business in a competitive and consolidating industry.

Another key advantage for us is our line of corporate brands. Our three-tier program, private selections, store banner brands, and value brands enables us to serve our broad and diverse customer base. We now have more than 10,000 private label products available only in Kroger's family of stores and have plans to continue to expand this successful area of our business.

We know shoppers today have many choices, and that's why Kroger remains focused on improving our customers' overall shopping experience. We continue to invest operating cost savings and productivity gains into improving the value, service, product quality, and selection we offer our customers.

We also have the financial resources necessary to maintain and grow our store base. Our capital investment program is contributing to Kroger's success and is building shareholder value. One great example is our marketplace store format.

Kroger's merger with Fred Meyer in 1999 gave us a competitive advantage in the area of general merchandise, an advantage we are leveraging in our marketplace stores. We have 31 marketplace stores open in four major markets, Phoenix, Salt Lake City, Columbus, and Cincinnati. Customers are responding positively to this format and we are currently working on expanding the format to six additional markets.

Now I would like to turn the call over to Rodney for some additional detail on our first quarter results, financial strategy update, and 2007 guidance. Rodney?

Rodney McMullen

Thank you, Dave, and good morning, everyone. Net earnings in the first quarter totaled $336.6 million or $0.47 per diluted share. During the quarter, the company incurred charges related to labor unrest at one of its distribution centers, which reduced earnings by an estimated $0.02 per diluted share. Net earnings in the same period last year were $306.4 million or $0.42 per diluted share.

First quarter 2006 results included non-recurring legal expenses of $0.03 per diluted share. Excluding non-recurring expenses in both years, Kroger's fiscal 2007 first quarter earnings per diluted share were nearly 9% higher than the same period of the previous year.

As a reminder, when we gave fiscal 2007 guidance back in March, we anticipated that our earnings per share growth rates in the first and fourth quarters would be lower than the second and third quarters. Kroger's first quarter results were in line with our expectations, excluding the labor unrest costs.

As Dave mentioned earlier, we remain focused on our strategy of investing in our customers' overall shopping experience. The financial impact of this strategy is visible in our first quarter gross margin, OG&A, and operating margin.

During the quarter, FIFO gross margin declined 85 basis points to 23.7% of sales. Excluding the effect of retail fuel operations and expenses related to labor unrest at one of our distribution centers, FIFO gross margin declined 49 basis points from the prior year. Most of this decline was due to continued investments in selling gross margin.

Selling gross margin is a term we use internally to describe the company's gross margin before incurring expenses directly related to distributing and merchandising products on our store shelves. We believe this measure is one way for investors to observe our price investment strategy.

Our first quarter supermarket selling gross margin on non-fuel cells declined 48 basis points. While this decline was more than we planned, it reflects Kroger's strategy of delivering value to our customers through strategic price investments. Price investments can take the form of lower everyday pricing, promotional pricing, or by choosing not to pass all product cost increases along to our customers. Our pricing investments during the quarter took all three forms.

We did experience inflationary pressures across several categories, particularly in dairy and produce. We also saw modest inflation in certain core grocery areas at a level that we have not seen for several years. Typically, such inflation will eventually be passed along to customers, but in some cases we chose not to do so immediately due to competitive situations.

We estimate that our product cost inflation, excluding fuel, was 2% for the quarter. We are working hard to balance the current product cost environment with our strategy to provide everyday value to our customers. On an individual quarter basis, this can affect our gross margin.

While our selling gross margin investment was more than planned, it was mostly offset by our progress in OG&A savings, which was ahead of plan. Operating, general, and administrative costs, or OG&A, declined 76 basis points to 17.41% of sales. Excluding the effect of retail fuel operations and the non-recurring legal expense in 2006, OG&A declined 36 basis points versus last year.

This decline was driven by strong identical sales leverage, increased productivity, and progress we have made in controlling our utility and health care expenses. These gains were muted by higher credit card fees and investments made in associate training.

In the quarter, rent expense without fuel declined 9 basis points versus last year and depreciation expense without fuel declined 1 basis point. Kroger's operating margin on a GAAP basis increased 1 basis point to 3.33% of sales. Excluding the effect of fuel sales and non-recurring items in both years, operating margin declined 8 basis points. This result is consistent with our plan.

For the full year in fiscal 2007, we continue to anticipate a slight expansion in operating margin excluding fuel cells. This reflects Kroger's strategy of investing operating cost savings and productivity gains into improving the customers' shopping experience and pricing in order to drive strong, sustainable identical sales growth. While our Customer 1st strategy and focus remain the same, the financial strategy that supports our business has evolved to reflect our progress in reducing Kroger's leverage over the past few years.

Since January 2000, Kroger has lowered its net total debt to EBITDA ratio from 2.8 to 1.8, a reduction of 1 times EBITDA. This is the result of reducing debt by $2.2 billion and increasing EBITDA by $522 million. This is nearly a 40% improvement in our coverage ratios. Based on this progress, Kroger now plans to dedicate free cash flow to repurchasing shares and pay dividends.

Kroger's investment grade rating remains important as the Company executes its strategy. We believe that maintaining a solid investment-grade rating provides us with the best cost of capital and the flexibility to execute our growth strategy in a competitive and consolidating industry.

Earlier today, we announced that Kroger's Board authorized a new $1 billion stock repurchase program reflecting its confidence in Kroger's Customer 1st strategic plan and management's belief that Kroger's shares represent an attractive investment opportunity. As you know, since January 2000, we have repurchased $3.7 billion of stock and over the past year, over $600 million.

Our share repurchase and dividend programs are delivering value to shareholders. Over the past five quarters, Kroger has returned nearly $1 billion to shareholders in the form of share repurchases and dividends.

Earlier, I referred to the competitive and consolidating industry in which Kroger operates. Recently, we announced two separate acquisitions that reflect this industry environment. In April, Kroger announced plans to acquire 18 Scott's Food & Pharmacy stores in northwest, in northeast Indiana. And just last week, we announced our agreement to purchase 20 Farmer Jack stores in the Detroit metropolitan area. Both transactions are in line with our overall acquisition strategy of primarily seeking smaller, end market opportunities.

We have found that these types of acquisitions generally produce higher incremental returns and lower risk. In all cases, Kroger carefully evaluates acquisition opportunities for their potential to enhance shareholder value. We expect both transactions to be completed by mid-July.

During the first quarter, Kroger invested $555.8 million in capital projects compared to $449.9 million in the prior year. These capital projects included 19 new, expanded, relocated, or acquired stores and 71 remodels. We closed 24 locations, including 19 operational closings.

Total supermarket square footage grew 1.6% year-over-year, excluding acquisitions and operational closings. Our return on assets improved 88 basis points on a pretax basis. This is using the method that Kroger has consistently used to calculate our return on assets.

Our capital investments expectations for the year remain unchanged. We plan to invest $1.9 billion to $2.1 billion in capital projects, excluding acquisitions. We anticipate total supermarket square footage growth of 2%, excluding acquisitions and operational closings, with an emphasis on large, fast-growing markets.

I would like to touch upon a couple of other first quarter items before Dave concludes our remarks and we take your questions. Our first quarter LIFO charge was $20.3 million, an increase of $10.1 million over the same period last year. The increase is related to my earlier comments about inflationary pressures and the cost of many products that we sell.

The year-over-year increase reduced Kroger's earnings by approximately $0.01 per diluted share. Based on today's environment, our current forecast for Kroger's annual LIFO charge is higher than our original expectations for fiscal 2007. However, we still anticipate achieving our fiscal 2007 earnings guidance of $1.60 to $1.65 per diluted share as Dave mentioned earlier.

Turning to labor relations, we recently reached agreements with Unions representing our associates in Detroit, Dallas, and Houston, and we are engaged in negotiations in Toledo, Seattle, and Southern California. In the recent settlements, we have found ways to improve wages and health care benefits for our associates while maintaining a competitive cost structure.

We accomplished this by reaching agreements that include cost-reducing measures, such as relaxed work rules, wage progression extensions, and other changes in health care plans, including employee contributions toward their plans. Fair and balanced contract settlements continue to be our objective in all negotiations.

Now I'll turn it back to Dave for some closing remarks. Dave?

David Dillon

Thanks, Rodney. This quarter gives us a solid start towards achieving our objectives for fiscal 2007. We are positioned well to continue to grow our business and increase our market share by focusing on the key components of our strategy. Our people, our products, our prices, and improving the overall shopping experience for our customers.

Now we'll be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question will come from the line of Chuck Cerankosky of FTN Midwest. Please proceed.

Chuck Cerankosky - FTN Midwest

If we're looking at the tax rate increase, Mike, anything you could comment on that?

Mike Schlotman

Nothing in particular. As you know, with the way you do taxes these days, you'll see a lot of fluctuations, not just with us, but with every company as settlements of prior tax issues get made between quarters. I would expect to have continued volatility in our tax rate from quarter to quarter, but our estimate for the year remains the same as it was at the beginning of the year we gave our guidance in March. It was really driven by settlements in last year's number.

Chuck Cerankosky - FTN Midwest

Okay. How about LIFO? Do you treat that the same way? Are we going to see some volatility in LIFO, and can you give any guidance on what you think the number might be for the full year?

Mike Schlotman

We basically treat LIFO the same way. We do our calculation, we estimate what we think inflation is going to be at the end of the year when we actually do it, or LIFO is going to be. As people may or may not know, LIFO is a point estimate based on inventories taken late in the year and it's this year's invoice minus last year's invoice drives the number.

As far as guidance for the year, I don't think we've given specific guidance, but we're, you can take the first quarter number and annualize it and get to a range that would be real close to what we're looking at for the full year as we sit here today. As every quarter goes by, we get more clarity to that number. It's in the mid-60s ranges when you do that math.

David Dillon

If you just take the first quarter estimate, annualize it that will get you pretty close to what our estimate would be for the year. As Mike mentioned, it's just a point in time, so whatever happens on that point in time will affect the final number, but it is our best estimate so far.

Chuck Cerankosky - FTN Midwest

Last question. Can you discuss how the distribution center labor unrest was resolved?

David Dillon

Through a settlement of the agreement and that operation was third partied as part of that process.

Chuck Cerankosky - FTN Midwest

Is this Louisville?

David Dillon

Yes.

Mike Schlotman

Yes.

Chuck Cerankosky - FTN Midwest

Thank you.

Operator

Our next question will come from the line of Scott Mushkin of Banc of America. Please proceed.

Scott Mushkin - Banc of America Securities

Thanks, guys. Just a little -- thanks for all the color, by the way, on the selling gross margin, but have you noticed consumers changing their behavior? It sounds like it was hard to pass everything along as prices and did it change during the quarter, those trends?

David Dillon

Scott, I don't think we've seen any particular behavior change that would be pronounced enough to identify. You always have a little bit of noise and hard to read that, but I don't think we've seen any clear trends that would be a result there. The issues that Rodney were describing I think had more to do with our choices on competitive pricing and the competitiveness of pricing in markets of what we chose to do on certain prices rather than pass along increased costs at the moment. We chose to pass them along a little later.

Rodney McMullen

And slower. Because if you look at dairy, the rate of inflation was pretty fast.

David Dillon

Yes, so our pass-through has been little lower than the cost increase that actually came through to us.

Scott Mushkin - Banc of America Securities

So it's not necessarily customers trading down? I know in '03 and '04, one of the things when we had some inflation, was the consumer was in a much different position. So you haven't really noticed a lot of behavior changes, it's mostly your business just catching up to what's happening on the inflation front?

David Dillon

I would say that's correct. I don't think that supermarkets as an industry are very good at measuring behavior change in these times of inflation or no inflation or other economic activities. You can sometimes see it, but more often than not you won't really see big trend changes. The trend changes you'll see are more societal changes. Some of the things we've noted about people eating at home more often, I think that still seems to be true, but other than that, I don't think we have anything we would identify.

Rodney McMullen

Scott, on Dave's comment on the trend changes, how much of that is driven by the economy and how much of it is just driven because people eat together as a family, they stay together as a family, how much of it is what piece we don't know, but we do know that it is something that is of benefit to us in helping us and we certainly believe the trend is longer term.

David Dillon

We certainly think both of those factors are at work right now in the world around us.

Scott Mushkin - Banc of America Securities

A follow-up question vis-à-vis Wal-Mart, Dave. They've been dropping pricing in consumables, which we confirm with the CPT companies. They tried it in October, it didn't work. It looks tough in our survey and the gap is widening out again with the supermarket companies. Have you guys detected any of this activity and how do you respond?

David Dillon

Well, I'm not going to speak about Wal-Mart's pricing strategy, but I will tell you, of course, we watch all of our competitors closely on what they do on pricing. What we see generally, and this would apply to Wal-Mart too, is that they move some items down, but they also move some items up and that they offset it with one item is changed and the other item goes the other way.

That sometimes is driven by deals they had promotional deals, they had vendors put in the market. Sometimes it's driven by a particular decision that they or we might make. I don't think I would characterize the competitive market today, other than the addition of inflation, which makes it a little bit problematic at times when, for instance, when book price is going up and cost is going up, when do you move your retail. Other than that problematic issue, I wouldn't describe it as more or less competitive than it was last year.

Scott Mushkin - Banc of America

Would you ever take the marketplace to an adjacent market? And then I'm done -- that you're not in?

David Dillon

Oh, a market we're currently not in?

Scott Mushkin - Banc of America Securities

Yes. Adjacent, but not in.

David Dillon

Well, ever's a long time, I don't think I would answer that specifically. We would never say no to that, but we don't have any current plans to do that and the markets we are evaluating now would be existing markets.

Rodney McMullen

And part of that is obviously just driven by the risk. We have plenty of opportunities in our current markets, so there's really no reason to take the additional risk on going into a new market. And we continue to learn the format in terms of each one we're making it better than what the last one we built.

David Dillon

There's still so much opportunity in existing markets, like Rodney said, we would have to ask ourselves, why would we want to do that, at least not now.

Scott Mushkin - Banc of America Securities

Great. Thank you very much.

David Dillon

Thank you, Scott.

Operator

Our next question will come from the line of Steve Chick of J.P. Morgan. Please proceed.

Steve Chick - J.P. Morgan

Hi, thanks. I guess first off, related to the inflation pressures that you saw, was that -- did that pick up as the quarter progressed, and did it get -- did it accelerate now that you've seen a month following the quarter end?

David Dillon

It did pick up a little bit from Midway through the quarter to the end. It wasn't a straight line from the first period to the fourth that each one was rising, but if you looked at the latter part of the quarter compared to the very early part of the quarter, we did see it increase.

Steve Chick - J.P. Morgan

Okay. And if you had to kind of assign, I don't know, this may be difficult, but if you had to assign what percentage of the price increases you're able to pass through, are we talking about -- you can pass 80% of it through and maybe you're eating 20%? Can you get that simplistic?

David Dillon

I think our intent is to pass them all through. It's only a question of timing. And I've looked at, actually pretty closely at a lot of the data and we've been very successful in passing along most cost increases, especially that's especially true in CPG kinds of products, in the grocery kind of products.

It becomes a little bit more problematic in some of the commodity areas, because you are fighting what happens to movement and you're also fighting what else is going on in the market. Produce is the best illustration of that or meat. Dairy prices were a good example of that, because you have some competitive reasons that you may not want to move milk prices up as rapidly as the costs went up.

But generally speaking, we feel confident and do not, I don't see anything in even the latter part of the quarter in the inflation numbers, I don't see anything in those numbers that suggests we won't or couldn't or shouldn't pass those things along. It really comes down to a question of timing, whether you do it immediately, or whether you do it slowly, and we've chosen different strategies on different items for competitive reasons.

Rodney McMullen

The other thing, Steve, I would add to that, and you've heard us talk about it before, but it's one of the advantages of having such a strong corporate brands program. Anytime that we have a CPG company that's passing cost increases beyond what's in the marketplace, we're filling time and time again our private label gained share when the CPG company does that. And you've heard us say that before, but at any point in time, there's inflation more than what's going on in the marketplace, private label always gains share over time in those categories.

Steve Chick - J.P. Morgan

Okay, all right. Second question, if I could, congratulations on the progress you guys have made with your balance sheet. Kind of sounds like you're moving the a third, a third, a third capital allocation and focusing on repurchases and dividends.

With the stock up here, and your leverage down here, it seems like if you could buy assets in size at seven times EBITDA or south, it would be a much more maybe efficient use of capital and pretty accretive.

So what are you seeing out there in terms of acquisition opportunities and maybe even something more sizable than the small ones that you're going to complete in July?

David Dillon

The answer on acquisitions -- the general answer I'll give, and Rodney may have some more specifics or Mike might that they want to add, but we continue to see lots of acquisition opportunities. We evaluate most things that come across our desks, but very few of them hit the kind of criteria that we're after.

We see of course less risk and better results from the end market acquisitions that we can extend our store count in a market or our Kroger name even sometimes to an existing market or pick up something even in immediate adjacent markets. Those things seem to work real well for us.

We aren't saying we wouldn't do a large or even a midsize acquisition. We're saying instead that we would look at that very carefully and we would want to evaluate whether or not it was a good move for our shareholders in the long run, and that's what would make that decision. Rodney, do you want to add?

Rodney McMullen

Steve, I agree with your math completely. On Dave's point, it really is making sure we're getting the right one. We're not opposed to doing something at all, but then really you have to find the right opportunity at the right price.

Steve Chick - J.P. Morgan

Okay. That's helpful. Thanks.

David Dillon

Thank you, Steve.

Operator

Our next question comes from the line of Deborah Weinswig of Citigroup. Please proceed.

Deborah Weinswig - Citigroup

Good morning, Rodney, you spoke about in your prepared remarks about on the OG&A side that you had made progress in utility and health care expenses. Can you provide a little bit more color on that?

Rodney McMullen

Well, one of the things that we've talked about publicly, if you look in utilities, we've reduced our usage per square foot over the last five or six years by over 20%. We've continued that progress in the quarter. That obviously allows us -- if you look at utility expense as a percent of sales we've made meaningful progress on reducing that during the quarter.

On health care, it would really tie back to some of the labor comments that I made in terms of some of the design in health care plans, but it also would tie to the company plans and changes that have been from a design perspective there.

And if you look at like adding an HSA and a lot of usage of an HSA, those items, it's primarily plan design changes that have facilitated that. That doesn't mean our costs aren't going up, it's just our costs are going up, it's slower than what our sales increases are.

Deborah Weinswig - Citigroup

Okay.

David Dillon

Some of those changes in health care, Deborah, include the influence of consumer driven health care choices. HSA is the example that Rodney gave and this may be worth noting that a lot of times the popular press talks about health care as a shift from company costs to an individual cost. And there's certainly occasions when that happens.

But in programs like HSAs and other market related programs, actually what we've seen is the tendency to actually drive the total use of health care down, that by working on remaining healthy, looking at preventative steps, that sometimes you can actually reduce the overall cost, regardless of who picks up the tab. And we think that's better for our employees and we think it's overall better for the health of the company and that's the direction we seem to be moving more in.

Deborah Weinswig - Citigroup

Great. And then, Dave, you had also talked about people eating at home more often. Can you talk about specific initiatives that Kroger has in place to address those needs of the consumer?

David Dillon

Well, the consumer in addition to wanting to eat at home more often is looking for simpler meals, easy meals, fast meals, convenient meals. Sometimes they want to have something they can prepare quickly, but do want to prepare it, and other times they want something basically ready to eat right away.

We have increased over the last several years -- actually, this has been a gradual change for many years -- but we've increased our offerings in our stores in our deli's, our bakeries, and meat departments, particularly those areas, and in produce too to a certain extent, a range of products that makes it easy to prepare a meal quickly, or makes it easy to have a meal ready to eat without much preparation. Those two trends are certainly important and ones that we've seen some growth in sales.

Rodney McMullen

Some specific examples, I know the stores that we've had a chance to show everybody, but if you look at, like sushi, we continue to aggressively add sushi in our stores. If you look at, like chicken, we continue to add flavor of chicken. If you go back two or three years ago, you would have had fried chicken and basically that's it. We continue to expand the variety that we offer for our customers, would just be a couple of specifics.

Deborah Weinswig - Citigroup

And Dave, when we attended FMI this year, again this kind of idea eating at home more, it sounded like there had been a real, I would say, increase in the past 12 or 18 months. Are you seeing that show up in sales as well?

David Dillon

Well, yes, I think -- it's hard to measure that for sure, but we see on one hand a societal trend, and on the other hand an improvement in our sales and some general improvement in supermarket industry sales. Although, not as much as ours. And as a result, I would absolutely attribute some of it to that change.

Deborah Weinswig - Citigroup

Great. Thanks so much for the color. I really appreciate it.

David Dillon

Thank you, Deborah.

Rodney McMullen

Thanks, Deb.

Operator

Our next question will come from the line of Perry Caicco of CIBC World Markets. Please proceed.

Perry Caicco - CIBC World Markets

It's Perry Caicco. Good morning.

David Dillon

Hi, Perry.

Rodney McMullen

Hi, Perry.

Perry Caicco - CIBC World Markets

The general merchandise side of your business has been growing quickly, I guess in concert with the growth of the marketplace stores. There's been some indication I think from some other retailers that those kinds of goods are slowing down a little bit in terms of sales. So just wondering if you're experiencing that and if they had any impact at all on your ID sales number?

David Dillon

Well, it may have had some impact on the average, but I think we certainly see a positive rate of sales growth in our general merchandise area. It hasn't declined.

Rodney McMullen

They were extremely close to the overall company number on identicals.

Perry Caicco - CIBC World Markets

Okay.

David Dillon

Does that help, Perry?

Perry Caicco - CIBC World Markets

Yes, yes, thanks. Just on to the perishable side. I guess in 2007, I guess this is a year when you're planning on putting I think a very big push on improving your perishable's offering. Can you tell us where that stands by department and any statistical indicators of improvement in either sales of margins since you embarked on the project?

David Dillon

We actually see perishables in total and several departments in particular as real important to our overall future. When you've described it as a project, yes, there are several projects we have worked on, but it almost -- it makes it sound too much like a point in time where we decided we were going to change it and push that.

But we actually tried and worked on a number of things in the last several years and have seen some traction on several of them. One in particular, I won't describe the details of, I think we're pleased with what it has produced both in sales, and I think it's improving both our quality image and picture among our customers and overall we've moved it out to quite a few number of stores. So we're pleased with that.

But there are plenty of other smaller examples too of things that we're doing, but I think for competitive reasons, we're not going to try to describe what those are. You in particular get into a lot of our stores.

You probably see that as much as anyone and you can describe what those are yourself and we're particularly happy for you to do that, particularly if you buy something while you're there. But I think I'm not going to describe many of those programs.

Perry Caicco - CIBC World Markets

Okay. And just lastly, if I could, I wanted to get an update on the store segmentation. I guess I'll call that a project. I know it's in an early stage, but just some kind of an update on to perhaps how many stores or perhaps how many categories may have been touched by that particular effort?

David Dillon

I don't think we'll give out that information, but to give you just a general sense, we're interested in segmenting on two levels, as I've described it before, at least. First, is on the obviously areas of, for instance, an upscale store being different than a mainstream store.

But we even see within mainstream stores pretty high variations in what they need. Some of them are more value driven and some of them may be more upscale driven. And so they will have some characteristics of those kinds of customers in those stores if that seems to be true of the customer count.

And so we make even subtle changes by category or by store based on how we read that particular store rather than even though we've described the three big segmentations that we've had as the value and the mainstream and the upscale, I think it's just as important to think about the variations within those themes too.

We continue to make progress in this area. I'd say, frankly, I think we've made more progress in the mainstream than we have on the other two, and that's actually an advantage, because we have more mainstream stores than we have the other two, but I see progress in all of those fronts.

Rodney McMullen

I would agree with everything Dave said. I would also add, if you go back and look at how we would define segmentation a year or two ago, we've done that in all our stores. But what that process has taught us, is we can get better at segmentation and the changes that Dave described is really the getting better, because we're really learning how to take it to the next step for our customers.

Perry Caicco - CIBC World Markets

Okay. Just one last question, if I could, and this might be, may be a difficult one to answer. When we look at the gross margin decline in the quarter, outside of the labor unrest and the fuel operations, how much of that decline could we attribute to pricing investments specifically, and how much of that could we attribute to the timing between the inflation on your costs and the ability to pass that through?

David Dillon

I'm not sure I want to quantify the number, but I'll just give you maybe a little bit more color on gross margin. The gross margin reduction in the quarter, I think there were several factors. One was there certainly was some additional flow-through from last year, programs that we put in place during the year that not yet rounded a full year. That's played a role.

The second is the description of the areas that Rodney talked about where we had inflated costs and did not pass them through as quickly as the costs actually increased to us.

Now, I want to emphasize overtime it is our intent to pass those through and we don't see any issue really in being able to do that. But as we see items in their competitive flavor, we choose sometimes to be a little slower.

We were not particularly satisfied with where we were in the quarter on this point. We would have preferred to be able to pass it through all instantly, but unfortunately, in a competitive environment, you can't always have that choice. And so we did deliberately slow some things down.

A third area, though, which you alluded to, in addition is there was some promotional costs in the quarter and to the extent that varies, of course, from quarter-to-quarter, but that's a decision we make based on opportunity to invest in price in a meaningful way.

We've talked about sustainable identical sales. And one of the things that we think makes our sales sustainable, particularly when we think about the element of price, is that not all of our investment is in promotional pricing. When you invest in promotional pricing, you get instant results, but then next year you come around to that point in time and you have to face what do I do now to increase our sales.

And there will always be some investment in promotional pricing for us, but we don't think that that's the long-term future for us to keep ramping that up. We think giving our customers meaningful price positions can help them choose to shop with us in the long run. I realize that doesn't answer your question how to proportion that out, but I would say those are the three biggest factors really in how we looked at the quarter.

Perry Caicco - CIBC World Markets

Okay. That's helpful. Thanks very much.

Operator

Our next question will come from the line of Ed Kelly of Credit Suisse. Please proceed.

Ed Kelly - Credit Suisse

Yeah. Hi, Dave. Just to follow-up on Perry's question. If you look at your selling gross margin over, say, the last four quarters or so, it's been down an average of, let's call it 35 basis points or so, which is clearly less than what it was this quarter. As we think about that going forward over the next couple of years, should we look at selling gross margin to be down at a similar rate, maybe moderate a bit? I'm just trying to -- how do we really think about how that should look going forward?

David Dillon

We think about it not exactly in annual terms. But think about it this way. We look at it in annual terms or longer periods of time than a quarter. And we tend to look at the operating profit margin and in our guidance, if we expect 2007 to be consistent with the guidance we've given, which is slight expansion of our operating margins for the year and to do that, in order to have that true, we need our gross profit changes and our OG&A changes to be roughly equivalent through the course of the year.

There are some other comments on rent and depreciation we could add to that too, but overall we see those two as moving in sync over the longer periods of time, over the course of this year, for instance. So our objective is to make sure that our operating margin increases slightly for the year, and we cannot do that if we have very many quarters where we invest more in gross margin than what we saved in OG&A or rent or depreciation.

So just this last year where we had, I think there was one quarter last year where we had a slight decline in operating margin, this year I would expect that we could have a slight decline in a margin like we did this quarter and fully still expect to have a year where the margins expand, just as we've described in our guidance.

And so, as we've said before, our investment in price is predicated on how we're able to afford to do that and that's how we make our judgments through the course of the year.

Ed Kelly - Credit Suisse

Okay. And then Just in terms of inflation, one last question on this topic, your overall view of inflation, not just for this quarter, but longer-term, is it good for you guys, is it bad, is it neutral? Do you just ultimately intend to keep gross profit dollars flat? How do we think about that?

David Dillon

Generally, I see it as slightly positive, but I see us actually as being successful in any market, whether it's inflation, no inflation, or whichever direction it goes. Rodney, do you want to add some color to that?

Rodney McMullen

Yes. There is always -- overtime, a little bit of inflation as a general rule always makes the business a little easier, but people have to get used to first seeing cost increases on a regular basis. And once people become less sensitive to cost increases, that's when inflation becomes a positive. And that usually takes a period of time before you get to there.

Ed Kelly - Credit Suisse

And could we get into a situation though where the cost increases get larger maybe than what they would be historically and there is a little bit of sticker shock with the customer?

David Dillon

You could get in -- I usually differentiate between commodity price changes and say grocery cost changes. In commodities, you have a lot of change in volume, as you have change in cost and change in retail. And there you would have a full change of mix. And milk would be one of those areas, by the way, but produce and meat are the best examples.

Typically, in commodity areas, you don't have sustained inflation over long periods of time, either. You usually have swings and cycles, but there the driving element is sticker shock can cause change and that's one of the reasons, for instance, in milk, in the first quarter that we did not pass it along as quickly as it came through. Because some of the increases then and in the next couple of months, actually, could be high enough that you'd need to be careful not to give that sticker shock or you end up hurting yourself.

You may pass through, so it doesn't help as much if we pass through the whole cost increase if our sales decline on that item, because we have dollars to spend and dollars are generated by the pennies of margin times the volume. So that's real important to us. And in fact, in the whole area of cost increases, the whole issue for us is making sure we're competitive, making sure our sales grow, and to keep pushing on the metrics of what do our customers want.

So your point of some high sticker shock kinds of items. Well, our intent there would be we need to make money as a business and we're interested in our bottom-line for operating margin for the whole company. We don't try to make a margin on any one item and we remain to be -- intend to remain very competitive and focused on what our customers want in the way of pricing and in the way of the other three keys.

Rodney McMullen

One other thing just in terms of our business on Dave's point on commodity cost increases, as a general rule, people substitute what they purchase. So if you look at like produce, when you have inflation of a particular area in produce, usually quality is declined. Usually when prices are the highest, quality is the worst.

And people will usually substitute and buy something else. So they'll go from oranges to grapefruit or grapefruit to apples or whatever the substitution may be. If you look at meat, customers will often substitute from buying beef to buying chicken or buying pork and as a general rule, you don't haven inflation, significant inflation on all three at the same time. So you have a lot of substitution.

David Dillon

That's a good point. I completely agree with that.

Ed Kelly - Credit Suisse

Okay, great. And just one last question for you here. Could you talk a little bit about your organics pricing strategy? How do you view your pricing versus the specialty players, like a Whole Foods? And what's the real strategy there?

David Dillon

I think I'm going to choose not to comment on specific pricing strategies, especially as it might relate to another specific competitor, but I will tell you that we continue to grow our sales in the natural food and organics areas.

We see that as an opportunity, we see the Kroger Company as well positioned with both our buying power and our knowledge of the products to be able to offer those products to our customers at prices that our customers love. So we're quite pleased with that business.

Ed Kelly - Credit Suisse

Okay. Thank you.

David Dillon

Thank you.

Operator

Our next question will come from the line of Meredith Adler of Lehman Brothers. Please proceed.

Meredith Adler - Lehman Brothers

Hey, guys. A couple of questions. If we could talk a little bit about the investments you've made in pricing and promotion over the last few years, very generally you've talked about gaining market share in many markets, but are you able to tie specific investments to gains in market share?

David Dillon

I think the answer to that is yes, but I don't have metrics in front of me to prove that. So you're hearing an answer from my intuition.

Rodney McMullen

One thing that I would say that we do have specifically or whatever is if you look, every quarter, as you know, we survey customers to get feedback on how we're doing on all the four keys that Dave talked about.

And on price, as we talked about at the investor meeting last year, our customers are giving us a disproportionate amount of credit relative to the other three on the pricing progress that we have made. And certainly, if you look at individual markets, we're beginning to see a correlation between changes in what customers tell us and our identical sales.

Meredith Adler - Lehman Brothers

Okay. And then I would like to just go back to the inflation topic. This is really a beating a dead horse, perhaps, but I think you did just comment that you anticipate that prices will continue to increase for milk. But when you look at what the likely outlook is for cost increases, do you believe that you're closer to having passed on those costs than you were, the closer to the end than to the beginning of passing on those costs? Because I guess I see this as maybe not completely temporary or one time, but when you think about the run rate of the business, at some point you'll have passed along those increases?

David Dillon

If you look at the source of inflation in the quarter, it was primarily the three areas Rodney described. The corn-based effect driven through some of the grocery categories and other areas, produce, and then dairy.

Produce, I think, will be cyclical based on fairly typical produce markets. Milk will be cyclical too, although these increases have been driven a little higher and I suspect I don't know enough about dairy costs to know how the government goes about setting those prices. But I suspect corn has been a reasonable factor in that regard.

And so that maybe depends upon and grocery depends upon what happens with corn and other related products. So, when corn gets high, then people look for substitutes of that too, and then some of those items get in higher demand and those end up going a little higher, which sort of pushes the inflation needle a bit.

I mean 2% is, while it's a bigger number than we've seen recently its not all that high of a number. I mean we've certainly in our work experience, in my our work experience, have seen numbers much greater than that. And so I would say it still is pretty moderate. But it is a clear change from what we had been experiencing before.

And so I don't think we'll be able to pronounce an end to this particularly, but I think what we're seeing is a steady process over time, except in the produce and dairy areas, which are commodity more, and they will tend to be more sharp changes, more abrupt changes.

Meredith Adler - Lehman Brothers

Okay. And then you haven't commented on shrink at all this quarter, but that's clearly been something that you were very successful in improving. Any update for us?

David Dillon

We were not as pleased this quarter, as we would have like to have been. And that is an area we are focusing some more attention on as we said though before, it is a regular tug-of-war. On one hand, we are applying some improved thinking, some better systems to what we do on shrink. And I think that has driven some improvements, particularly in some perishable areas recently in the quarter.

But at the same time, we want to make sure that we don't hurt our sales trend by getting too focused just on shrink. What we're interested in is the final outcome, is the total sales on one end and the operating profit on the other. And so on balance, we were satisfied with how it balanced out, but we considered in the quarter a challenge of what happened with shrink for us in grocery and drug GM in particular.

Meredith Adler - Lehman Brothers

Okay. And then my final question would be about a kind of store pruning process that you clearly have been doing. And obviously, it's always ongoing to close stores for operational reasons, but do you kind of feel like you're at the far end of that process?

David Dillon

You answered the question how I would answer it, which is there's always ongoing pruning that needs to occur in a growing, vibrant business like our. Rodney or Mike may want to add a little more color to that.

Rodney McMullen

Other than I would say that we're over halfway done, I don't know that I would say we're at the end of the process, but I would say that we're certainly over halfway done. And part of the reason why I would make that comment is if you look at last year when we left Northern California, we wouldn't anticipate anything to that degree anywhere else.

David Dillon

That's a good addition, yeah.

Meredith Adler - Lehman Brothers

Okay. Well, I thought you had a great quarter, so congratulations.

David Dillon

Thank you, Meredith.

Operator

Our next question will come from the line of Bob Summers of Bear Stearns. Please proceed.

Bob Summers - Bear Stearns

Good morning. Just some thoughts on how you're specifically preparing for Tessco's entering into the market and whether you've contemplated testing a smaller box yourself, particularly given that you're already in the convenience store business.

David Dillon

The word in your question of specific is one that will cause me not to answer the question. I can tell you generally, as with any new competitor, anyplace, really, we try to size up what that will mean for us and what steps we need to take in order to be better positioned to compete in that market under those circumstances and we've done that.

We admire Tessco as a company they're a terrific operator. We've seen lots of their operations and are very familiar with them. As they come to the United States, it will be an interesting dynamic that will occur and I think we'll be ready to compete vigorously.

Bob Summers - Bear Stearns

And then any thoughts on looking at a smaller prototype yourself?

David Dillon

I don't think we'd comment on that or actually any variations on that.

Bob Summers - Bear Stearns

Okay. And then any thoughts on how the FTC is looking at the Whole Foods Oats transaction and does it impact in any way at how you're looking at the acquisition landscape?

David Dillon

No. No comment and no effect.

Bob Summers - Bear Stearns

Okay. Thank you.

Operator

Our next question will come from the line of Mark Wiltamuth of Morgan Stanley. Please proceed.

Mark Wiltamuth - Morgan Stanley

Hi, good morning. I wanted to follow-up a little bit on Wal-Mart's slowdown of its supercenter expansion. One hundred fewer supercenters entering the market certainly should be a positive for all the grocers. Is there any way you could quantify how much of a operating income drag you have from one supercenter entering your market and then I guess we can place our bets on how many supercenter removals end up in your markets?

David Dillon

Well, I'm trying to remember the data, but we compete against about 1,000. I think its Wal-Mart supercenters roughly. And the story that we've described to you on this journey for the last several years is a pretty clear picture and that's the extent to which we would describe this.

And that is, any supercenter that opens is like another competitor that opens. It is impactful, but it is impactful only in that sense. It's not like it's some remarkable concept that obliterates the supermarket that's in the vicinity.

Generally speaking, there is life after a Wal-Mart supercenter opens. We've given some specific statistics each year that shows in the Wal-Mart markets what's happened. And last year, for instance, while I don't have the statistics right in front of me, the gist of it is, is that our market share grew in the markets where Wal-Mart has a reasonable market position where we have as one of our key markets. And it grew because of us aggressively pursuing our strategy and recognizing that we have to please our customers as opposed to trying to focus on just competing with Wal-Mart. So that's the overall picture.

Now as to the decrease that they are going to open in terms of supercenters, of course we noted that and don't have any comment from the point of view of Wal-Mart. I will remind you; though, that it does leave quite a few stores that will open. It's not like they're not going to open new stores against us, it's just not the same pace that they had originally planned.

But we've had anywhere from 50 to 100 Wal-Mart’s opening, new supercenters opening against us each year for several years now and we've shown that we're quite able to compete in that environment.

Any other particulars, Rodney or Mike, you may want to offer?

Rodney McMullen

Well, I was just going to point out, and we've mentioned this before, but if you look at it over a three to five year period of time, as a general rule, our return on assets will be higher after three to five years than before the supercenters entered our market and what happened, is it usually takes three to five years for the competitive changes to take place.

Now obviously, initially, you do have a decline in earnings and a decline in return on assets, but once the market shakes out, time and time again, we find that our return an assets are fine, assuming that you have the right cost structure on dealing with business in that market. And we have numerous examples of that.

Mark Wiltamuth - Morgan Stanley

Okay. And just to switch gears a little bit, on your buyback, you certainly discussed using free cash flow to fund the increased buyback. You were carrying as much as a full turn of EBITDA in terms of higher leverage levels in the past.

I'm sure you've seen all the leverage recap activity going on in the marketplace. Have you ever given any thought to levering up a little bit and buying back more stock?

Mike Schlotman

Obviously, we have to, we're going to use our free cash flow to buy in stock and our intent is to remain an investment-grade rated company. Obviously, at 1.8 times, there is room to have slightly more leverage and still maintain coverage ratios that would give us a solid investment-grade rating.

Mark Wiltamuth - Morgan Stanley

And where do you think the thresholds are for you in the rating agencies? Where would they be concerned and would drop you down to below investment grade?

Mike Schlotman

I wouldn't comment on that.

Mark Wiltamuth - Morgan Stanley

Okay, thank you.

David Dillon

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

Operator

Our final question will come from the line of Todd Duvick of Banc of America Securities. Please proceed.

Todd Duvick - Banc of America Securities

Yes, good morning. Thanks for taking my call.

David Dillon

Good morning Todd.

Todd Duvick - Banc of America Securities

Just a couple of related questions, and obviously, with respect to the financial policy, part of what I was going to ask was already answered in your press release, but just thinking about your share price and how well it's done over the last year, can you kind of frame for us how you would consider approaching when to buy back shares, because it seems like obviously the stock is near the highs for the last several years.

So how are you approaching that and absent any share repurchases, would you just kind of plan to accumulate cash on the balance sheet?

David Dillon

I'll let Mike and Rodney answer this in a second, but the whole idea of buying back stock, even with today's price, is a positive thing for us because we see it as a good investment opportunity.

We obviously are optimistic and confident about our future and what our business plan, our strategy, our business model will produce and we think it's a good investment for us to make. But with that background, Mike or Rodney, do you want to add to that?

Mike Schlotman

Todd, the shares we've bought back since January of 2000 are just right around $20 per share, but we've continued to buy shares in this quarter at $28.17 a share on average as we said in our earnings release.

At current prices, we still think it remains an attractive investment, which is why the Board authorized us to implement the new $1 billion stock buyback plan. Whether or not we would put cash on our balance sheet or not, today our balance sheet's a little bit better than it's been over the last few years.

Last year at this time I actually did have quite a bit of cash invested on the balance sheet. One of the reasons for that was I had no borrowings under my working capital revolvers. Today I do have borrowings under those revolving lines of credit with the banks.

So, I have the ability in the short run now to reduce my debt and then effectively borrow it back as I make those open market purchases. I don't necessarily expect that we would put hordes of cash on to our balance sheet.

We plan to stay consistent with our approach and use the authorizations that are granted. Because that's why we go to the Board and ask for it and they grant the authority, as we have shown over time that we do use our authorizations, and we've pretty well finished up every one that's been granted to us.

Todd Duvick - Banc of America Securities

Okay. I know there's very little that you can say with respect to the Southern California labor situation, but can you tell us if you have any types of provisions for the event of a strike in terms of excess cash or any reserves related to that situation?

David Dillon

First, on Southern California, we always have operating plans in the event of a strike and we always take into account the financial implications in the event of a strike. But I would just point you to the recent settlements. We just settled, in Texas, settled just recently in Michigan, up in Detroit. Those contracts both provided improved wages and health care and at the same time gave us a competitive cost structure.

We fully expect that to be the outcome in a market like Southern California and are pursuing the negotiation strategy and believe that that will have a positive outcome in that regard. But you always have to plan for all of the possible outcomes.

And Mike, you may want to comment on the financial side. I don't know that you can add anything more.

Mike Schlotman

We've changed our policy to use all free cash flow to buy stock or pay a dividend. If there were to be a work stoppage somewhere, obviously, we would have less free cash flow, so that would affect how many dollars we could spend on buying in stock.

Todd Duvick - Banc of America Securities

Okay. Thank you very much. I appreciate it.

David Dillon

Todd, thank you very much. Thank you to all of you. And before we sign off, though, I would like to offer some additional comments to our associates who are listening in today.

First, let me welcome the teams from Scott’s and Farmer Jack to Kroger. We look forward to working with you as we continue the great tradition of community involvement and customer service that you have established in each of your markets.

To all of our associates, we thank you for your efforts this quarter. You are the reason our customers choose us instead of one of our competitors, and we appreciate the hard work you do in every area of our business. We continue to face competitive pressures and know that there is much more we need to accomplish this year. We know you are up to the challenge and we look forward to growing our company together with you.

On a final note, we hope you and your families enjoy a safe and happy summer. With that, we thank you all for joining us today. Good-bye.

Operator

Thank you for your participation. Ladies and gentlemen, you may now disconnect. Have a great day.

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