The Kroger Co. Q3 2007 Earnings Call Transcript

Dec.11.07 | About: Kroger Co. (KR)

The Kroger Co.(NYSE:KR)

Q32007 Earnings Call

December11, 2007, 10:00 a.m. ET

Executives

DavidB. Dillon – Chairman andChief Executive Officer

DonW. McGeorge – President, Chief Operating Officer

W.Rodney McMullen – Vice Chairman

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

CarinFike – Investor Relations

Analysts

JohnHeinbockel – Goldman Sachs

MarkHusson – HSBC

MeredithAdler – Lehman Brothers

ToddDuvick – Banc of America

ChuckCerankosky – FTN Midwest Securities

EdKelly – Credit Suisse

JasonWhitmer – Cleveland Research Company

NeilCurry – UBS

BobSummers – Bear Stearns

MarkWiltamuth – Morgan Stanley

Operator

Thank you foryour patience, ladies and gentlemen. The Q3 2007 The Kroger Co.earnings conference call will begin shortly. Again, thank you for stopping by.

Good day,ladies and gentlemen, and welcome to the Q3 2007 The Kroger Co.earnings conference call. My name is Lisa and I will be yourcoordinator for today. At this time all participantsare in a listen-onlymode. We will be conducting a question andanswer session towards the end of thisconference. (Operator Instructions).

I would nowlike to turn the call over toMs. Carin Fike. Please proceed, Ma’am.

Carin Fike

Good morningand thank you for joining us. Before we begin I want to remind you that today’sdiscussion will include forward-looking statements. We want to caution you thatsuch statements are predictionsand actual events or results can differ materially. A detaileddiscussion of the many factorsthat we believe may have a materialeffect on our business on an ongoingbasis is contained in our SECfilings, but Kroger assumes no obligation to update that information.

Our thirdquarter press release and our prepared remarks from this conference call will be available onour website at www.kroger.com.

Now I wouldlike to introduce Mr. David Dillon, Chairman andChief Executive Officer of Kroger.

David B. Dillon

Thank you,Carin, and good morning, everyone. We’re pleased you could join us to reviewKroger’s third quarter 2007 results. With me today are RodneyMcMullen, Kroger’s Vice Chairman, DonMcGeorge, Kroger’s President and Chief Operating Officer, and Mike Schlotman,Senior Vice President and Chief Financial Officer.

Let me begin bysaying we were very pleased with our results this quarter. Our business isrobust and our strategy is working. Our performance this quarter is consistentwith our customer first approach and is yet another example of Kroger’s abilityto continue to deliver financial results in the near termwhile maintaining our focus on investing for the future.

I’ll beginwith a recap of the thirdquarter, year-to-date results and guidance. Rodney will then provide additionaldetails on the thirdquarter results. And after that we’ll be happy totake your questions.

Krogerdelivered another quarter of strong sales performance. Total sales for the third quarterincreased 9.8% to $16.1 billion. And identical supermarket sales increased 7.7%with fuel and 5.7% without fuel. This is the tenthconsecutive quarter Kroger has reportedidentical supermarket sales increases, excluding fuel, in excess of3%.

Our strongidentical sales growth continues to be broad basedacross the company’sgeographic regions and merchandise departments. All of oursupermarket divisions and departments experienced positive identical sales and,in addition,our communit (sic) stores turned in anotherstrong quarter of identical sales growth.

Net earnings in the thirdquarter totalled $253.8 million or $0.37 per dilutedshare. These results include a benefit ofapproximately $40 million from the resolutionof certain tax issues during the quarter.Most of this benefit was offset by lower margins from retail fuel operationsand the company’sdecision to accelerate certain initiatives that are part ofKroger’s Customer First Strategy. Net earnings in the same periodlast year were $214.7 million or $0.30 per dilutedshare.

Our earningsperformance this quarter was solid. Our strategy continues to deliver earningsgrowth in a variety ofeconomic and competitive conditions which underscores the core strength ofKroger’s business model. Kroger’s strong sales performance in the thirdquarter is the directresult of our associates’ efforts to focus on our customers. Our business modelpositions us well to serve the diverseneeds of our customers.

While fuelmargins in the thirdquarter were weaker when compared to the prior year,on theyear-to-year, year-to-date basis they were more normalized. As we have saidbefore, in the fuelbusiness it is notuncommon to see variationsfrom quarter to quarter. It is importantto consider a longer viewwhen analyzing fuel margins to account for these fluctuations because, overtime, our return on assets in the fuelbusiness is well above our cost of capital.

Turning toyear-to-date results, total sales increased 7.6% to $53 billion during the first threequarters of fiscal 2007. For the same period,identical supermarket sales excluding fuel increased 5.3%.

Net earningsfor the first threequarters of fiscal 2007 were $857.6 million or $1.22 per dilutedshare. Net earnings for the same periodlast year were $730.1 million or $1.01 per dilutedshare.

Based onyear-to-date financial results and current trends, Kroger now expects identicalsupermarket sales growth of approximately 5% for the full yearexcluding fuel sales. The companyexpects earnings per share to slightlyexceed the rangepreviously given of $1.64 to $1.67 per dilutedshare. This earnings guidance includes the lower tax rate due to the resolutionof certain tax issues this quarter and a higherestimated LIFO charge of $130 million, which is $80 million more than the companyoriginally anticipated for fiscal 2007. In addition,Kroger’s dividend currently adds slightly over 1% to shareholder return.

As a reminder, the fourthquarter of fiscal 2006 included an extra weekthat we estimate benefitted our earnings per share by$0.07 per dilutedshare.

Ouryear-to-date performance positions us to deliver a slightlyexpanding operating margin, low double-digitearnings per sharegrowth, and strong identical sales growth in fiscal 2007.Our associates’ focus on building customer loyalty through service, product,and value initiatives remains key to Kroger’sfuture earnings growth.

Lookingbeyond 2007, we expect identical supermarket growth in the 3% to 5%range with a slightlyimproving operating margin, excluding the effect ofretail fuel operations.

Now I’d liketo turn the call over toRodney for some additional detail on our third quarter results. Rodney?

W. Rodney McMullen

Thank you,Dave, and good morning, everyone. As Dave mentioned, we are very pleasedwith Kroger’s results this quarter and they are in line withour business plan. Our associates continue to do a great job at executingour Customer First Strategy and we appreciate their efforts in helping usdeliver another good quarter.

I will now discusssome of the incomestatement components that produced our earnings per share growthin the quarter. On a GAAP basis,Kroger’s third quarter FIFO gross margin decreased 110 basis points to 23.38%of sales, primarily due to the lowermargins associated with fuel sales. Fuel margins fluctuate from quarter toquarter and that is why we take a longer viewto evaluate fuel.

In keeping withour strategy, we continue to focus on reducing operating expenses andreinvesting those savings back into customer service, product selection, andpricing. Investments in pricing are reflected in Kroger’ssupermarket selling gross margin on non-fuel sales, which declined 45 basispoints during the quarter.Reductions in warehousing,advertising, and shrink expenses funded a portion ofthese pricing investments as our FIFO gross margin on non-fuel sales declined34 basis points from the prior year.

During recentquarters we have discussed product cost inflationand the impact it has had on ourbusiness. We estimate that our product cost inflationduring the quarter was3%. This figure excludes fuel and utilizes CPI to estimate inflation forproducts in our pharmacydepartment. We continue to experience inflation across many core grocery andperishable categories at a level notseen in severalyears.

Product cost inflation has promptedquestions in recentquarters regarding our position on passing inflation costs on to customers.Generally we do pass alongproduct cost inflationover the long term, butthere could be short-termlags created by competitive situations. During the quarter wedid pass along product costs increases. In our view,periods of modest inflation is a positive forour business because inflation tends to improve sales, increase margin dollars,and create greater leverage of fixed costs.

Inflationalso creates the LIFO chargethat we recognize quarterly. The currentinflationary environment has caused us toincrease the projectedLIFO charge for the secondquarter in a row. Kroger has 98% of ourproduct inventory on the LIFO methodevaluation. This is a higherpercent than many of our competitors.

Whencompanies elect to use the LIFO methodfor taxes they are required touse it forfinancial reporting as well. While a LIFO chargeis a non-cashexpense it creates cashtax savings. Kroger’s estimated fiscal 2007 LIFO charge will reduce our cashtaxes by approximately $50 million.

Now turningto OG&A. Operating, general, and administrative costs declined 78 basispoints to 17.49% of sales. Excluding the effects ofretail fuel operations, OG&A declined 49 basis points. This decline wasdriven by strong identical sales leverage, increased productivity, and progresswe have made in controllingour utility, health care, and pension expenses. These improvements were reducedby higher credit card fees. Rent and depreciation expenses as a percent ofsales without fuel were comparable to last year.

Kroger’soperating margin on a year-to-datebasis increased three basis points. It increase sevenbasis points excluding fuel, charges for labour unrest in the firstquarter of 2007, and certain legal expenses in 2006. As wehave said before, we do not believethat a singlequarter’s operating margin is the best gaugeof the success ofour business strategy. This is due to the timing ofoperating costs savings and investments in ourbusiness.

For the full year in fiscal 2007we continue to anticipate a slightincrease in Kroger’snon-fuel operating margin, which will enable us to deliver low double-digitearnings per share growth.This is a littlebetter than the objectiveswe outlined at the start of the year.

Kroger’searnings per share growththis year is also driven by fewer shares outstanding. We continued ouraggressive stock buy-back program during the quarter,reflecting our judgement that Kroger’s shares represent a compellinginvestment. Kroger repurchased 16.5 million shares of stock in the thirdquarter at an averageprice of $26.77 for a totalinvestment of $442.1 million. At the end of the quarter,201.6 million remained under the $1 billionstock repurchase program we announced in June 2007.

Our sharerepurchase and dividend programs deliver substantial value to shareholders.Over the past fourquarters Kroger has returned$1.5 billion to shareholders in the form of sharerepurchases and dividends.

Moving now todebt. Kroger’s net total debt to EBIDTA ratio was 1.97 compared to 2.03 during the same periodlast year. Net total debt was $7.5 billion, an increase of$502 million from a year ago.Total debt was also $7.5 billion, an increase of$528 million from a year ago.

Our strongEBIDTA on a rollingfour-quarter basis enabled us to improve our leverage ratio while investing$2.2 billion in capitalprojects and $1.3 billion to repurchase 47 million shares of stock and pay $197 millionin dividends.This is in line withour long-term financial strategy of maintaining a leverageratio to support a solidinvestment grade rating.

During the thirdquarter, Kroger invested $555.3 million in capitalprojects compared to $414 million a year ago.Total capital projects during the quarterincluded 13 new or expanded stores and 54 remodels. During the thirdquarter we closed seven locations; five of these were operational closures.

Totalsupermarket square footage grew 1.8% year over year, excluding acquisitions andoperational closures. We continue to anticipate supermarket square footage growthof 2% in fiscal 2007and we still expect to invest $1.9 billing to $2.1 billion in capitalprojects this year. This estimate excludes spending on acquisitions.

In terms ofcapital allocation, our emphasis remains on store remodels and we are verysatisfied with their performance. Our customers tell us they appreciate them aswell, both in terms oftheir comments and the salesperformance.

We havecompleted 155 remodels year to date through the end of the third quarter.That compares to 112 remodels during the same periodlast year.

As you know,improving our return on assets is important to us. On a rollingfour-quarter basis our return on assets improved 74 basis points pre-tax,excluding the effect of the 53rdweek in fiscal 2006.This is on the same basisthat Kroger has consistentlyused to calculate return on assets.

Turning tolabour relations, we’ve reached agreements during the quarter withunions representing our associates in Cincinnati,West Virginia, and in southernCalifornia with Food-For-Less. We also reached an agreementwith the unionrepresenting our associates who work in a warehouse in centralOhio. In Memphis wehave agreed to a contractextension with the union thatrepresents our store associates as negotiations continue there.

In 2008 we willnegotiate contracts covering store associates in Columbus,Indianapolis, Las Vegas, Louisville, Nashville, Phoenix, and Portland. Fair andbalanced contract settlements continue to be ourobjective in allnegotiations. We work to reach balanced agreements that meet our cost efficiencyobjectives and fulfill our commitment to providing our associates with solidwages and benefits. Maintaining this balance allows Kroger to invest in our businessto provide new job opportunities for existing associates and create new jobs for morepeople.

Now I’ll turnit back to Davefor some closing remarks.

David B. Dillon

Thanks, Rodney. Our quarterly and year-to-dateperformance is a great example of the strategywe have been discussing with you for some time: a sustainable,sales-driven plan that allows us to invest cost savingsinto initiatives that are meaningful to our customers. We continue to execute our strategywell in every area of our business to create value for our shareholders, asevidenced by the results we shared with you today.

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

Question-and-AnswerSession

Operator

(Operator Instructions). Our first question comes fromJohn Heinbockel from Goldman Sachs. Please proceed.

John Heinbockel –Goldman Sachs

Dave, a couple ofquestions that will tie into your accelerated investment in pricing.Obviously, can you talk to the degree that that tied into the taxbenefit? I assume that was fairly planned. Was that more shelf pricingadjustments or promotional activity? And then how do you measureor have you been able to measure the return onthat investment during the quarter in terms of comp lift, etcetera?

David B. Dillon

Some of theacceleration of our strategies included some pricing plans, for instance, thatwe have been using in some markets, but not all markets.We have elected to extend those to some additional markets that we had beenplanning to do, but we actually planned to do it just a little bitlater. We decided to do it when we did because, as we’ve said before, we’re going to look at theaffordability of the choices we make in some ofthese strategies.

I think it’s important to recognize it wasn’t justsome promotional strategy that we did sort of on a whim becausewe had money available to spend, but rather it was part ofa plan where we actually had these strategies worked out in our mindsand over time and we’re trying to pick the best timeand best circumstance and best competitive situation in which tointroduce them. So that’s really all it was and that’s how we tried to approach it this lastquarter and that’s actually how we’ve been approaching it for sometime.

Both of the two or threestrategies I’m thinking about mostly relate to shelf pricing or pricingstrategies as opposed to a short promotion.

W. Rodney McMullen

The other thing, Dave, that I would add on top of that, in somemarkets there were some non-price initiatives, too. If you look at one examplewould be products where it’s ready-to-heat type products. Certainly wecontinue to accelerate the roll-out of that in differentmarkets, but when you look at when you first put that product in placeobviously you have a very high shrink on that product until the customers get accustomedto buying it. So there’s initiatives such as that and some service initiatives thatwere also part of the acceleration.

John Heinbockel –Goldman Sachs

Was it driven more by timing, anyway, by the fact thatyou had the tax benefit or you saw something in terms of the macro or thecompetitive environment that caused you to move themforward?

David B. Dillon

Well, it’s really all of the things youdescribed and a whole lot more. At the beginningof the year we had a specific plan in mind and we have a number of strategies, some service strategies, some productstrategies, some pricing strategies, and we had animplementation schedule. But in the lastseveral years we have varied that implementation schedule a little bitby how much we could afford in terms of the situation.But we’ve also varied it by the opportunity that we saw. In somemarkets if the competitive situation we think could benefit from theintroduction of something we may have moved it ahead of the scheduleand vice-versa. So competitive openings could have an effect onthat. But it really is all of those factors.

Now, the tax amount, of course, at the beginningof the year we didn’t know what the tax amountwould be. It’s not uncommon to have adjustments, but this is a littlelarger than – I don’t know if it’s larger than normal, but larger than a usual taxadjustment. As a result, when we saw what that was and when we saw how the gas marginswere faring in the quarter, the two we thought would balance out sufficiently well that we could move ahead onsome of these other initiatives. So we choseto.

John Heinbockel –Goldman Sachs

All right. And then just finally, if you take out theinvestments would it be fair to say that food gross margin, your selling gross margin would have beendown modestly or no? You try to separate this out. Because obviously theseinvestments are not necessarily, they’re not one time, but they’re not necessarilygoing to get this every quarter either.

David B. Dillon

Some of the investmentin the quarter was the ongoing investment from the last threequarters. In other words, you get somerolling effect there. So our margin would have been down irrespective of these additionalinvestments that we chose to make. However, we also are, as we’ve said all along,trying to match up at least on an annual basis – and even to a certainextent on a quarterly basis – what our savings our in OG&A orour savings in shrink or logistics or advertising, and take those savings and see what wethen have available to reinvest in appropriateways and ways that we think would benefit the customers grow the sales andthen therefore produce an improved result for theshareholders. So it would have been down anyway.

This was not a case of weinvested all of the down gross margin. The sellinggrowth we identified was 45 basis points. That decline was not all driven. In fact, it was only a small partdriven by these new initiatives. It would be more drivenby the overall plan and our overall picture on OG&A.

John Heinbockel –Goldman Sachs

Okay. Thanks.

David B. Dillon

Does that help, John?

John Heinbockel –Goldman Sachs

Yeah, yeah. That’s great. Thank you.

Operator

Our next question comes from Jason Whitmer from ClevelandResearch Company. Please proceed.

Jason Whitmer –Cleveland Research Company

Hi, good morning. Dave, could you talk a little bitabout the price promotional landscape that you might seestructurally changing, whether at Kroger or in the channel at large, such as an evolving high-low or an EDLP blendor even using fuel, for that matter, as a pricevehicle. Maybe some pricing software. What’s the overallimpact of a lot of these changing landscapes on thecompetitive market and really overall in the marginoutlook.

David B. Dillon

Well, I don’t actually see it muchdifferent than I have for the last several quarters. I don’t, I do not see it gettingmore competitive, but I also don’t see it gettingless competitive. I assume the pricing software you’re talking about are some of the priceoptimization software packages out there and the number ofpeople who use those and use them effectively, I think they help you thinkabout your pricing strategy. But overall pricing strategies are chosen bywhat gross margins they produce and the grossmargin that you require as a company is predicated on the returnyou’re trying to achieve and your coststructure.

As you know here, we have tried to drive our sales, we’vetried to improve on our cost structure, therefore allowing us room to invest on other thingsthat were meaningful. Some of it’s been priced, but much of it has been onadditional service, which of course then goes back into OG&A costs,training, and other product areas, which often will end up in the gross,sometimes affects this rank, as Rodney described earlier.

So I don’t think the current environment is much different than what we’ve seen for the lastseveral quarters. There is a change, of course, going on in the overalleconomy. Inflation has picked up a bit. Mike will probably talk a little bitmore about inflation if you have questions, but inflation was the highest in the thirdquarter than we’d seen in a long time. And I say highest, but I say that carefully because it’s still pretty darn moderate. Andmoderate inflation, as Rodney points out, we view as generally helpful to us.And so I think that’s the environment we see in the economy as a result I don’t think that’s changinganybody’s behaviour. At least not that I’ve seen.

J. MichaelSchlotman

The other thing is, you know, we would work with dunnhumby a lot, ourmerchandising teams, in terms of how to approach pricing – both every-day pricing,promotional, and special offers, too. That is one of the thingsthat dunnhumby has been especially helpful for us.

Jason Whitmer –Cleveland Research Company

I guess that leads right into my follow up then. Is it fair tosay, and I don’t know how you’d characterize this, but how much more effectiveor profitable have your programs and deals been, either on the impact todrive – you know, drive the business is very evident, but the overall flow throughof that in a vacuum, has that improved substantially over the lastcouple of years?

David B. Dillon

I think we have improved theeffectiveness of our spend. And we have improved that through theintersection of several things, one of which is dunnhumby looking at data. Butalso I think it’s just within Kroger the desire to be more datadriven. That is, what are the results of the choices we made? And then be willing tore-evaluate choices we made and modify them as we think appropriate given the facts. AndI think those elements have created a moreeffective approach to spending. More effective in what wespend our pricing on, more effective in every-daypricing, more effective in what we spend our promotional money on, and frankly more effectiveon our investments in product and in the shopping experience in the stores andin the service metrics. All of those Ithink have been improved by our focus on what are the factsshowing us, what does the data show us?

Jason Whitmer –Cleveland Research Company

And is there anything to garner from the data as it relates tofuel this quarter? Is it all just kind of the delta from what you pay and whatyou buy it for relative to what you’re giving it away for at the pump ondiscounts? I don’t know how you take a look at that, butcertainly it’s one of the bigger pinches you’ve had in a long time ifnot ever on fuel margins.

David B. Dillon

Well, it’s one of the biggerswings we’ve had from last year to this year in the quarterand from second quarter to third quarter this year. Those were bigger swingsthan I think we typically would have seen, so it sort offocuses or magnifies the effect. Fuel margins typically end up being what they are. In otherwords, we don’t control those very much. We can control them a little bit,but the costs of the commodity is what it is and the retailprice is reflective of exactly the retailbusiness in each community that we serve. It’s a little bitlike we’ve discussed on milk, for instance, that you can’t just simply set a retail at whateveryou want it to be because in gasoline when you do your volumedrops off substantially.

So for fuel for us, we look at the resultsover a longer period of time. We look at, well, the threequarters, for instance, is a reasonable period of time, but I even like a full year orlonger to understand what the margins are doing. And on a three-quarter-to-date basis our fuel margins are a little belowwhere they were last year, but more normalized, we think. Much more normalized.And so we had a benefit in the second quarter of which we identified as higher than normal and wehad an impact this quarter which was clearly lower than normal.

W. Rodney McMullen

Jason, I do want toremind you of one thing. In your question I thought I heard you reference the effect ofpromotions on lower fuel margins. I do want toremind you that our fuel rewards program that discounts fuel for purchasesinside the grocery store is charged against grocery store idents so that the 5.7%identicals we announced excluding fuel are reducedfor the cost of that program there, not charged against fuel operations.

Jason Whitmer –Cleveland Research Company

That’s helpful. Thank you very much.

David B. Dillon

That’s a good point becauseas you look at our gross profit investment in the quarter tothe extent that we spent more money on fuel promotions, it would showup in the non-fuel gross profit investment.

Jason Whitmer –Cleveland Research Company

Great. Thank you.

David B. Dillon

Thank you.

Operator

Our next question comes from Meredith Adler from LehmanBrothers. Please proceed.

Meredith Adler –Lehman Brothers

As long as we’re talking about fuel I want to go back, Dave, to yourquestion about, your comment about the return onassets being higher than your cost ofcapital for fuel. It’s also clearly a veryvolatile business, and I don’t know if you perceive that volatility as risk,but if you were to see it as risk and make a riskadjustment would you still say that the return is acceptable? Because I think that’s what we see now asmore volatility.

David B. Dillon

Yeah, Meredith, I absolutely would. Volatility in this sense,you can take an individual quarter and make a case to say,well, fuel wasn’t a good deal. But if you take, in a year thatI’ve looked at it or longer periods than a year, too, Ithink you would always come to the sameconclusion. I don’t remember any single year of where I thought it was not a goodinvestment. And as a result the volatility is really simply the volatilityof the commodities and represents, when you see highvolatility, sometimes we can actually make more margin when the cost is morevolatile. But just because, for instance, the cost of fuelis going up, it’s going up steadily and predictably, we don’t make more money in thatsituation. Or if it’s going down predictably and settling may be the samething. But when there’s some volatility there that tends to improve the marginsbecause we don’t have quite as much volatility in our retailas we do in our costs. I don’t know if you want to add.

W. Rodney McMullen

Well, I was just going to say, if you look at it over an annualbasis the volatility isn’t all that high.

David B. Dillon

Maybe that’s the best wayto –

W. Rodney McMullen

If you look at it over a two-yearbasis, rolling basis, it’s almost non-existent. Now, the shorterperiod of time you get the more volatility there is. And if you look at fuelmargins for the year in terms of where we budgeted them for the year andwhere we are and where we think we’ll be, we think we’re going to be pretty darnclose to what the estimates were. But when you look at it in the quarter,as you know, in the second quarter, as Dave mentioned, and we did on the call, the secondquarter was a little higher than normal, third quarter’s a little lowerthan normal. But when you look at itcumulatively it looks like it’s going to be pretty darnclose to where we thought it would be.

Meredith Adler –Lehman Brothers

Of course, it’s a bit of a strain for the market tothink of in a two-year time frame. Another question about fuel –

---Interjection

Another question about fuel. You haven’t – Pardon me?

David B. Dillon

Meredith?

Meredith Adler –Lehman Brothers

Yeah?

David B. Dillon

Let’s go back to what you just said.

Meredith Adler –Lehman Brothers

Pardon me?

David B. Dillon

Let’s come back to what you just said because you don’thave to look at two years to get a clear picture.

J. MichaelSchlotman

Keep in mind what Rodney just said, and that is we expect to be very closeto what we expected fuel to deliver for this year.

Meredith Adler –Lehman Brothers

Yeah.

J. MichaelSchlotman

It’s not a two-yearlook we’re saying and all Rodney was trying to do was the longertime frame you look at the less volatile it is, but typically within one of our fiscal years we’ve been fairlyclose to what we expect fuel to deliver to the bottomline on an annual basis. There’s obviously some variations on yourexpectations, but what we see today we’re going to wind up prettyclose for this fiscal year.

Meredith Adler –Lehman Brothers

I might be a cynic and say the market has troublelooking at even a whole year time frame.

Just talking about sales, the benefit,fuel clearly is something that helps you drive food sales. You didn’t talkabout it so much this time, but you are veryeffective in using your pricing on fuel as a way to drivefood sales. Do you have any numbers where you can sort of quantify that?

David B. Dillon

Actually we don’t. We have internally some sense of the numbers,but nothing that we would want to share. Suffice it to say,though, is that we do believe that there is some benefit to our grocery store business byhaving fuel stations out front. Theconvenience of those, the tie-in with fuel promotions, all of thathelps.

Meredith Adler –Lehman Brothers

Okay.

W. Rodney McMullen

The other thing, Meredith, and we’ve talked about it on previouscalls, overall we believe that higher fuel costs is a positive forour type of business overall, our industry. And it’s one less trip thatsomebody has to make in our stores and our typical customer only has to drive a mile or twoto get to one of our stores. We think all thosethings tied together is really what drives our identical sales.

Meredith Adler –Lehman Brothers

Okay. And then I just want to kind of go back to, I thinkthis is the question John Heinbockel was giving you, I think the market has a tendency to see tax asbeing something completely independent of operations. But it sounds likeyou don’t think about it that way, that you think about tax as an expensethat’s being managed and look at how thatimpacts the bottom line and then you manage your business to some extent aroundthat. Is that fair to say?

David B. Dillon

It’s fair to say that welook at it actually from lots of different vantage points, but first vantagepoint is that it is part of our cash flow. And so, if you look at our overallresults as we look at them, we look at our overall cash flow and all of the thingsthat affect it. We do tend to separate tax swings like this, but also gasoline swingslike this from our day-to-day operations for us to get a sense of howour business model is working. When you take those two elements out of ourquarter our quarter looks just peachy. And as a result Ithink you could look at it from either of those vantage points and come out feeling asoptimistic as I do about where the quarter was.

Meredith Adler –Lehman Brothers

Would it be fair to say that youearned $0.37 or that you beat, if you took out both the fuel and the taxbenefit? That you were better in thisquarter?

David B. Dillon

Hm. I’m not sure how to answer that. Mike, do you want totry to piece together the math? Or Rodney, do you have a picture?

J. MichaelSchlotman

We would have been, if you take out, if you were to takeout the tax end of fuel we would have been very happy with the growth weposted this quarter.

Meredith Adler –Lehman Brothers

Okay. Great.

David B. Dillon

That’s a fair way tocharacterize it, yes.

Meredith Adler –Lehman Brothers

Okay. Thank you very much.

Operator

Our next question comes from Chuck Cerankosky from FTNMidwest. Please proceed.

Chuck Cerankosky –FTN Midwest Securities

Hello. Good morning, everyone.

David B. Dillon

Good morning, Chuck.

Chuck Cerankosky –FTN Midwest Securities

What do you specify the tax benefit amount was?

David B. Dillon

It’s $40 million.

Chuck Cerankosky –FTN Midwest Securities

Four-zero?

David B. Dillon

Yeah, four-zero. That’s correct.

Chuck Cerankosky –FTN Midwest Securities

All right. And what would you say the gas amount wasthat Meredith was just referencing as being an unusual pointof pressure on the gross margin?

David B. Dillon

We didn’t give the specificnumber other than saying that when you look at the fuelmargin and the other initiatives that we invested in used up,covered most of that $40 million.

W. Rodney McMullen

And obviously some of it did follow the bottomline because we did post $0.37.

Chuck Cerankosky –FTN Midwest Securities

Gotcha. All right. Andwhat about your (inaudible) guidance for the full yearof 5%, that’s a little less than year to date. Are we simplylooking at the effect of the extra week last year?

David B. Dillon

No, we actually left a tiny bit of an element ofconservatism in case the economy in some way impacts us that we can’t see it. It’snot trying to signal anything other than we were happy with our sales lastquarter and we expect to be happy with our quarter sales this quarter.

Chuck Cerankosky –FTN Midwest Securities

All right. Do you anticipate a second half of this year, Dave, similar to the first halfwhere there’s a little bit more inflation catch up as the half wentby? Inflation catch up in terms of shelf pricing.

David B. Dillon

In the quarter, we recovered the cost,product cost increases that we experienced. And we would expect that that would be truebarring some unusual situation. We would expect that would be true in the fourthquarter, too. The rate of inflation in the third quarter we’ve already described as being the highestreally this year and for some time, but still moderate. We expect, based onwhat we’ve seen so far, that the fourth quarter will be verysimilar to what the third quarter was on inflation. So I wouldexpect whatever benefits were derived in the thirdquarter I would think you’d see the same kindof picture in the fourth quarter.

Chuck Cerankosky –FTN Midwest Securities

All right. And all that $40 million tax benefit is hard cash?

J. MichaelSchlotman

What it is, Chuck, is it’s a reduction ofexpected payments. We would have expected to be paying $40million than we ultimately are going to pay. It wouldn’t necessarily be cash thisquarter. The payment may or may not have been due this quarter, but ultimately it will be a reduction of$40 million in cash taxes. Exactly what month I would have had to write thatcheque, I couldn’t really zero in on that.

Chuck Cerankosky –FTN Midwest Securities

But pretty much in fiscal ’07of that?

David B. Dillon

Yes.

Chuck Cerankosky –FTN Midwest Securities

Gotcha. Thank you.

Operator

Our next question comes from Neil Curry from UBS. Pleaseproceed.

Neil Curry – UBS

Thank you. Good morning, everybody. I don’t think it’s a surprisethat you’re investing cost savings into price and other initiatives to drive sales becausethat’s what you’ve been doing for the lastnumber of years. I think just the timing wassomewhat of a little bit of a shock to the street after what happened in the secondquarter and I think you indicated the thirdquarter might have similar characteristics.

You indicated that it wasn’t dueto any sort of increase or decrease in specificenvironment, but you did talk about looking for the bestcompetitive situation to re-invest. So what is the bestcompetitive situation? Is it when customers aren’t expecting it and you cansurprise them with lower prices and that’s when you get the bestreturn on the investment? Or is it purely thatyou felt that with the economy weakening that you just wanted to support your valuemessage?

David B. Dillon

The answer is actually yes on both of those. For me, as an operator, Ilike to see both extremes as places you would invest, places where you feel youneed to, because of defensive moves, but also places you invest because youwant to because you sense that it willimprove your sales. The time you don’t want to invest is when you think putting additionalmoney won’t produce additional sales and won’t have a desiredeffect with the customer. And there are times whenthat happens. If the customers are behaving in a sense that says they don’t want to spend money you can sense thatoften where your sales are and that’s not a particularly good time to spend money. But we’re not sensing thatsituation right now.

W. Rodney McMullen

Neil, the otherthing, and I’m confirming my numbers here quickly, but you talked about the secondquarter, but if you remember year-to-date at the secondquarter our operating margin had increased five basis points and that increase in ouroperating margin now, and that excludes fuel, is up to seven basis points. So I think on a year-to-datebasis we are executing what we’ve told the world thatwe’re going to execute.

Neil Curry – UBS

Sure, I think it was just the grossmargins in the second quarter. And maybe we misinterpreted the commentson inflation continuing into third quarter meaning that the grossmargin growth ex-fuel would continue in the thirdquarter. But that’s our problem, not yours.

J. MichaelSchlotman

But as we’ve tried to tell everybody for the last twoor three years, we are clearly focused on our operating margin because when we do havesavings we do expect to invest them while early in ouroperating margin slightly on a year-on-yearbasis.

Neil Curry – UBS

Well, that’s a greatstrategy and no problem with that.

Just another question. I just wondered if you had anyearly comments on Tesco’s fresh and easy format? It looks as ifthey’re going to quickly saturate at least the Phoenixand Vegas markets over the next year or so with sort of stores every couple of miles and obviously clearly low prices. Iwonder what your early take was on what impact the prices,not necessarily market share, but the pricescould have on your offer in those markets.

David B. Dillon

Well, I won’t specifically address their pricing, but Iwill comment. I’ve been to several of the Tescostores in a couple of different markets. As we’ve said before, we have alwaysassumed that Tesco would come to the U.S. We’rethe biggest market around the world andthey would need to come here for their growth. And we’re quite comfortable in ourstrategy. In fact, our strategy was designed knowing that someone like Tescowould be here. As I’ve looked at theirstores I see a lot of positive things about their stores. Actually, more positivethings than even have been written about. I think they’ve done a nice job.But one thing though that is clear, and that’s more clear about Kroger, isfirst we take Tesco and other competitors like that very seriously and secondis that at Kroger we will improve as a result ofthis new competition. Those are the importantmessages from our vantage point. What individual effect they may have in individualmarkets, what the pricing strategy may affect I don’t want to speculate at this point.

Neil Curry – UBS

Okay. And just finally on the communit(sic) consumer, how do you think your consumers feel right now? Do you see anyevidence of trading down to private label products or that sort of thing?

David B. Dillon

We do not see any big swings in customer behaviour. Now, obviously smaller, more subtle changes maynot be as evident. We have said before, and I still think it’s true, twothings about this, one is that as customers feel pinched one of the reactionsthat often occurs is going to restaurants less often and instead going tosupermarkets where it’s less expensive to prepare a meal for a family oreven for an individual person. And we do think we’vebeen seeing some of that for some time now. Not just in the lastquarter, but for a long time.

And second is that we don’t refer, especially now in the lastquarter or so, we don’t refer to buying our Kroger brand as trading down. Weactually see that as trading up because the customers are learningthat the product quality in our Krogerbrand is not only as good as but often better than the leadingnational brands and it costs less money. So what’s notto like about that?

But we’re not seeing a change in behaviour,is the bottom line of your question. We’re not seeing a change in behaviour,certainly not in the third quarter or anything that we saw in the datathere.

Neil Curry – UBS

No, I didn’t mean to bedisrespectful about your product brand.

David B. Dillon

I didn’t take it that way.I’m using this as an opportunity for a commercial.

Neil Curry – UBS

And would that be consistenton the non-food size of the businessas well in some of the larger stores?

David B. Dillon

Don-food is a littleharder to read because of seasonal impact and weather impact. So we haveseen a little more softness in the drug GM side of ourbusiness than we’ve seen in the other parts of our business. But as we’ve identified, it’s a positivedepartment. At least I believe I’m correct in mystatement. I’m looking over to be sure the numbers are right.

But I’m not reading anything into that right now aboutconsumer behaviour because we’re not a real largenon-food merchant, you know, like a departmentstore might be or some of the other mass merchants.

W. Rodney McMullen

And we also have one extra day between now and Christmas.Until you get through the complete cycle you don’t know exactly where you are relativeto that.

David B. Dillon

Yeah, that does make it a little bithard to read is the shifting of shopping patterns with Christmas falling as it does.

Neil Curry – UBS

Thank you very much.

David B. Dillon

Sure. Thanks, Neil.

Operator

Our next question comes from Mark Husson with HSBC.Please proceed.

Mark Husson – HSBC

Yeah, I guessthe firstquestion is just a plea givenyou’re a steady-eddykind of company. You’re not doing our forecasting credibility any good at all the way you comeout with quarterly earnings. So perhaps youcould give us a little bitof advance warning on big things liketax charge changes to makethis whole thing seem like you’re not making it up as you goalong. To that end, what is the tax rate going to be for the fourthquarter in the year?

W. Rodney McMullen

If you look at it for the fourthquarter, we expect it to be about 38%,which is what we estimate it for the yearstarting out. For the whole yearestimate.

Mark Husson – HSBC

Okay. Andthen the other thingis, when you’re looking at yourindividual reporting companies, you know, they have to make bonus somehow. Ifyou could just refresh everybody on how the individualreporting companies make bonus and how you make bonus. Is it fair to themto get them to pay or to investback into EBIDTA, if you like, a tax benefitwhich may not have impacted their bonus? How do you get around that?

David B. Dillon

I have tothink about the way thatwould impact. I think first of all the bonus, Idon’t think it would haveany effect. The bonus isbased upon, that portion of the bonus isbased on EBIDTA. For our divisions and for our officer group, for generaloffice here. And I don’t think that would affect EBIDTA in any way thatI can think of.

Mark Husson – HSBC

Oh, no. To the extent thatyou had a tax benefitand you spent the tax benefitback in EBIDTA.

David B. Dillon

Well, if we –

Mark Husson – HSBC

You’ve usedEBIDTA, haven’t you, because you’ve got some tax money?

David B. Dillon

Yeah. If wespent it all and had nothingto show for the spendingthen it would havehurt bonuses. But if you look at our view, myview is that the money wespent on things like we’ve described improves our sales and ultimately improvesour earnings. And our EBIDTA. And develops a more positiveoutlook for our shareholders and certainly more positive for us. I think the way the bonus is setup for individual divisions or for general office or for me, it is prettyclearly in alignmentwith the shareholderbenefits in short runand the shareholderbenefits in the long run becausewe take elements based on identical sales growth, EBIDTA, performance on ouroverall strategy in terms of howwe’re producing on things like our customer first tracker that we’ve describedbefore. Things like that. And then a portion oncapital spending and the effectiveuse of capital spending and hitting our targets on capital spending. Those are the elements andthose are very alignedwith shareholder objectives too.

Mark Husson – HSBC

Sure. Onlonger term, absolutely. I’m just wondering, given what the performance(inaudible) whether you’ve made any changes to the accrualsyou’ve been making for bonuses for this year.

J. Michael Schlotman

No. I mean,other than being consistent, pretty consistent throughout the year.

Mark Husson – HSBC

Okay. Great.And then just one sort of bigger picture question. When you look at Tesco’sformat of 10,000 square feet, about four times the size of youraverage convenience store and about a quarter the size of youraverage supermarket, when you think about formats I know you’ve spent some timeinvestigating in largerformats and discount formats. When you think about capital dollars how do you thinkabout allocating those dollars going forward in formatsense?

W. Rodney McMullen

If you look,as you know, in one of the comments wecontinue to focus quite a bit ofcapital on remodelling existing stores. If you look at in terms ofrelative to formats, what we believe works the best is tohave a complimentof several different formats in a market. So if you look at a market likePhoenix or a market likeWichita, Kansas, might be a betterexample, where you’ll see marketplacestores, regular supermarkets, and also convenience stores tied together. So it’s from a customerstandpoint we really are trying tohave where a customer canengage with us multiple formats and we believe that’s most effective. So we’re reallylooking at all of themtogether rather than each one individually.

Mark Husson – HSBC

Is the marketplaceformat now performing at groupaverages in terms ofreturn on capital?

W. Rodney McMullen

At least.

Mark Husson – HSBC

Okay. Great.Thank you very much.

W. Rodney McMullen

And one otherthing, just FYI for everyone, we did open up a newmarketplace market in Tucson,Arizona, this week. We opened our first marketplace store in Tucson andthat is the first marketthere. We have another one that will open in a couple ofweeks there too.

Operator

Our nextquestion comes from Todd Duvick from Banc of America. Please proceed.

Todd Duvick – Banc of America

Yes. Good morning. Thanks for taking myquestion. This is on the debt side. With respect to the debt that is maturingin March 2008 I believe there are two issues totalling about $950 million.Given that your policy has changed such thatyou’re no longer focusing on debt pay down are we to assume that you will refinancethat in the capital market?

David B. Dillon

I wouldn’tnecessarily be definitiveexactly what I’m going to do as that debtmatures. Do keep in mind that whilewe may not be targeting reducingthe absolutedollar of debt outstanding we do continue toexpect to manage our leverage ratio at a level thatwill keep us triple B, a solidinvestment grade rating. So it’s notthat we’re going to totally ignore what our debt levels are. We do expect tocontinue to manage it on a ratio basis.

Todd Duvick – Banc of America

Okay. And so I guess justdepending on market conditions you’ll decide closer to time what you’re goingto be doing in terms of anyrefinancing?

David B. Dillon

I would look at it the way we didsome refinancings earlier this year. We would probably make sure that the market isripe and receptive to an offeringfrom Kroger on the rightparticular day versus being forced to do it on anyparticular day. We would look for the rightopportunity rather than feeling like we have to do something.

Todd Duvick – Banc of America

Okay. That’shelpful. Thank you.

W. Rodney McMullen

And weobviously like the direction ofoverall rates at the moment, too,and where they seem to be going.

David B. Dillon

Even with the higherspreads the couponswould still wind up beingattractive, particularly compared to the debt that ismaturing.

Todd Duvick – Banc of America

Okay. That’sgreat. Thank you.

W. Rodney McMullen

Thanks, Todd.

Operator

Our nextquestion comes from Bob Summers from Bear Stearns. Please proceed.

Bob Summers – Bear Stearns

Good morning.Just in terms ofacquisition market given overall operating conditions and maybe a pullback in privateequity, are you startingto see a loosening upat all in either the availabilityof assets or price points?

W. Rodney McMullen

I wouldn’t say in terms of ifyou look at the flow there’s muchof a change. And so far I thinkpeople still have a prettypricey assumption in terms ofvaluation. And as you know, we kind of have the sameapproach, whether the market isstrong or weak in terms ofwhat’s the value that it adds for us.And in existingmarkets it’s really looking at specificreal estate opportunities. To go into new markets it has to be a good solidasset with good market share before we would look at it seriously.

But reallynot seeing much change. I thinkpeople are stillexpecting that it’s a short termrather than long term andvaluations still need to come down to make a little bitmore sense of it, I think.

Bob Summers – Bear Stearns

Okay. Andthen kind of a pointedquestion. These unusual items that we’ve had, you know, have become a littleprobably too usual over the last six or so quarters. Aswe continue to manage through this customer first approach, I mean, when can westart to see maybe a moreconsistent shareholder friendly approach to managing the business?

W. Rodney McMullen

Actually, I’mnot sure I fully understand what it is you’resaying, but for us unusual items are things thatwe think are importantfor you to know in order foryou to understand what’s happening in ourbusiness. And our management team here tries to call out those things that are good for usand those things that are bad for us. So that youwould have a clearerpicture, the same picturethat we would look at as the businessrolls forward. As a result, Idoubt that you’ll find a time when wedon’t call out some things. I mean, there may be somequarters where nothing happened that’s unusual enough that we ought to point it out to you,but we try to play it right down the middle bycalling out the good and the bad where wesee it and when wethink it is importantto you.

And we thinkwe have been managing the business nowfor several years in what we viewto be a shareholderfriendly environment. If you look at the summation ofthis year, strong identical sales, low double-digitearnings per sharegrowth, a sustainablemodel going forward, all of ourmetrics are lookingbetter, our leverage ratio has improved.

J. Michael Schlotman

Slightlyimproving operating margins.

W. Rodney McMullen

The operatingmargins have slightly improved.

J. Michael Schlotman

And returned a billion and a half dollarsto shareholders.

W. Rodney McMullen

Yeah. I mean,if you look at how we spentthe cash flow that’s all from a shareholderpoint of view is a good thing.We think the way the metricsought to be viewed are positive andwe think calling out these unusual items are helpful toyou, not hurtful to you. We could have left them all alone thisquarter and you wouldn’t have known the difference.Well, you would have known the differencebecause our stock would have been up $3.00.

David B. Dillon

Or the tax rate would havebeen obvious too.

W. Rodney McMullen

Yeah.

David B. Dillon

I mean, Bob,we don’t mind pointedquestions whatsoever, but we actually do think that so far year todate and what we expect to deliver for the year isgoing to wind up being a shareholderfriendly year.

Bob Summers – Bear Stearns

Okay. Andwhen do you address the buy-back?You’ve almost completed the June ’07stub.

W. Rodney McMullen

You know,that was, we still have $200 million left as of the end of the quarter.That will depend on the stock priceand the board’sdesire to give us an additional authorization.

Bob Summers – Bear Stearns

Well,unfortunately you’re getting an attractiveentry point today. Thanks.

Operator

Our nextquestion comes from Mark Wiltamuth from Morgan Stanley. Please proceed.

Mark Wiltamuth – Morgan Stanley

I just wantedto clarify a little biton the acceleratedinitiatives under the CustomerFirst Strategy. You talked about that being a little bitgross margin and OG&A investment. Can you just talk a little bitmore about how much was OG&A and some of the elementsunder that Customer First Strategy you were really emphasizing here?

David B. Dillon

No, I don’tthink we’ll try to quantify it. We were just trying to give you someillustrations. And I don’t want to overplay that additional investment. We didcomment earlier that the decline in our sellinggross was not primarily driven by accelerating investments, but rather by ouroriginal plans and the continuationof our original plans. So I don’tthink you should read too much into our gross margin or OG&A, either one,as a result ofthose accelerated investments. They were meaningful, but they were notmeaningful enough to turn the (inaudible).So I think the bigger issuewas the $40 million in tax benefitswas, much of it was offsetby the margins in fuel and wehad a little leftover for this additional investment and we had a little leftover to drop to the bottom line.

Mark Wiltamuth – Morgan Stanley

So you wouldcharacterize the margin storyas kind of getting back to your normal strategy of reinvesting gross margininto the business.

W. Rodney McMullen

I mean, wedid invest dollars into gross margin and somebody made, I forget who it was, made the same commenta second ago, it might havebeen Neil, relative to you would have expected the secondquarter to continue. When you think about gross margins on a year-to-yearcomparison you have to think about what happened in the prior yearand if you think about the secondquarter of ’06 versus the secondquarter of ’07 one of the things thatcaused gross margin to expand in the secondquarter of ’07 is we made some pretty big investments in the secondquarter of ’06. If you look at the thirdquarter of ’06 as compared to the thirdquarter ’05, that margin difference was very, very minor. And so if you look at our marginson that kind of a basis youhave to understand what happened in the prior yearwhen you say we went upor down as compared to the prior year. The secondquarter was frankly a littleeasier to have expanding margins because we made pretty big investments the prior year. The thirdquarter of this year as compared to the priorquarter of last year, it’s reasonable to expect when last year’s quarter didn’thave a lot ofinvestments that that will happen this year.

Mark Wiltamuth – Morgan Stanley

Okay. Isthere anything we should be thinkingabout for the fourthquarter coming up?

W. Rodney McMullen

Only that weexpect the year to wind up with the metrics wehad and I think if we hit those we’re going to be pretty happywith what we delivered on a full-yearbasis. Certainly compared to what return there will be for the shareholdersin addition towhat we expected at the beginning ofthe year. It looks likewe’re on track to have another year where we exceed every promise that we madeto our shareholders.

Mark Wiltamuth – Morgan Stanley

Okay. Thankyou.

W. Rodney McMullen

Thanks.

David B. Dillon

Operator,this will be our lastquestion.

Operator

And our lastquestion comes from Ed Kelly from Credit Suisse. Please proceed.

Ed Kelly – Credit Suisse

Yeah, hi.Good morning.

David B. Dillon

Good morning,Ed.

Ed Kelly – Credit Suisse

I was hopingyou guys could just help me work throughsome numbers. I was just looking at what youpresented and it seems to me that core gross re EBIDTA, ifwe were to sort of take out fuel all together,was probably up somewhere in the high singleto maybe even lowdouble-digits given almost the 6% comp andwhat looks to be about 15basis points of margin expansion. Is that a fairstatement?

David B. Dillon

Yes.

Ed Kelly – Credit Suisse

Okay. So given thatyour reported EBIDTA was down modestly it looks likefuel obviously was down significantly and potentially even incurred a loss thisquarter. Would that be right?

David B. Dillon

It wouldn’t be a loss, no.

Ed Kelly – Credit Suisse

Okay. Butthere’s been a lot ofquestions asked about the volatilityof fuel, but can you just maybe help us understand why quarter to quarterthere’s so muchvolatility in thatbusiness?

David B. Dillon

Well, twothings you should think about. First, if you look at last yearversus this year, we think about pennies of margin per gallon. Wedidn’t, it wasn’t quitehalf this year versus last year, but darn close. And the same kind ofswing occurred from the secondquarter to the thirdquarter. If you took the secondquarter as a number andthen looked at the thirdquarter it was almosthalf in the thirdquarter. And what that suggests, and I think it’s true, is that in the thirdquarter last year and in the secondquarter this year we had unusually high gas margins and in the thirdquarter this year we had unusually low gas margins. So you had sortof a doubleswing. When you’re comparing to the previousyear, that’s why you had such wide swings like that.

But when youlook at the course of the year, yearto date this year, we’re a little bitunder where we were last year, but not much, on a year-to-datebasis through three quarters. So it tends tosmooth itself out over the course ofeven three quarters. And certainly over the year wethink it will havesmoothed itself out. That’s I think a fair way todescribe it.

Ed Kelly – Credit Suisse

Is thatvolatility related to the change in price?

David B. Dillon

It’s relatedto the interactionbetween the retail priceat the pump and the cost of the commoditythat we buy to fill. It’s really a cash marketand what you see is a cash market in the sense thatas you see us buyingfuel several times a week foreach station, replenishing that immediately, but as costs go up, costs go down,the costs ongasoline change not onlyevery day, but every minute. That kind of volatility just produces differences in margin.

It’s beentrue, we’ve been in the fuelbusiness, at least I’vebeen involved in the fuelbusiness even before I was in thisbusiness, Dillons was in it since 1960,and through all the time I’vewatched it it’s alwaysbeen the same. Youcan’t try to judge what’s happening with fuel in any one weekor any one quarter. You have to look at a couple ofquarters or three quarters or a year to get a good senseof that because of all of the volatilityof the cost and the volatilityof the pump. It’s the most pricecompetitive item that we would sell. It reacts notdaily in price, butevery hour. If you were to see a change in the localmarkets you would change your retailprice. That’s just the nature ofthat business.

Ed Kelly – Credit Suisse

Can wegeneralize and say that youmade maybe more or less money as prices, as cost increases?Or you make less money as costs go up and more money –

David B. Dillon

I’ll letRodney answer that because we actually have studied that.

W. Rodney McMullen

Yeah, in terms ofyour comment, that’s correct. As a general rule– it’s not always true – but as a generalrule, when costs go up margins contract. When costs come down margins expand.As a general rule.

Ed Kelly – Credit Suisse

Okay. Great.And then just last question for you. Any insight on your capex plans for nextyear? Either qualitative or quantitative? It’s been up pretty good that lastcouple of years. Do we thinkabout that trend continuing?

W. Rodney McMullen

In terms ofspecific numbers, we would do that when wegive our fourth quarter. But in terms ofintent and where we would spend the money Ithink you’ll see us continuewith a heavyemphasis on remodels and expansions would be the biggest key focus point.You’ll also see us continueto aggressively spend on logistics and technology.

Ed Kelly – Credit Suisse

Okay. Great.Thank you.

David B. Dillon

Thank you.And in wrapping uplet me offer theseclosing comments. Before we sign off I wanted to share a few thoughtswith the associateslistening in today. In our businessthe holidays are obviously a veryexciting time of year. Our stores look great, our plants and distributioncentres and offices are runningwell. As we all worktogether to create special experiences for our customers it just is a great timeof year.

This seasonoffers each of us a chance toreflect. Just before Thanksgiving I had the opportunityto visit our store in Greensburg,Kansas. You may recall that this past summer a tornadodevastated that community and we lost both the small Dillonstore and a Quickshopconvenience store. As the town wentabout the difficulttask of rebuilding, associates from Dillons worked together with a group of ourassociates from our convenience stores to come up with a solutionthat works for Greensburg. Today that community is served by a combinationstore; one that is a DillonsQuickshop, which meets the dailygrocery and household needs of Greensburg residents and provides the communitywith a much neededfuel centre and other conveniences the Quickshopoffers.

During myvisit I spoke with associates who are so proud, they are so proud ofserving the community.And I listen to customers who are so grateful tohave a store thatmeets their needs. It was a clearreminder to count our blessings every day. I’m thankful to count each of you,our associates, among mine.

Thank you forall you do for ourcustomers and each other every day. Have fun this holiday season and take timeto celebrate with your friends and your family.

Thank you all for joiningus today, Merry Christmas, and Happy Holidays.

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