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Executives

David B. Dillon – Chairman, Chief Executive Officer

W. Rodney McMullen – Vice Chairman

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

Carin Fike – Director, Investor Relations

Analysts

John Heinbockel – Goldman Sachs

Karen Short – Friedman, Billings, Ramsey and Company

Chuck Cerankosky – FTN Midwest Securities

Bakud Sonan – Banc of America

Meredith Adler – Lehman Brothers

Ed Kelly – Credit Suisse

Mark Wiltamuth – Morgan Stanley

Mark Stillman – MacKay-Shields

Deborah Weinswig – Citigroup

Robert Summers – Bear Stearns

The Kroger Co. (KR) Q4 2007 Earnings Call March 11, 2008 10:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to The Kroger Co.’s fourth quarter earnings call. My name is Grace Ann and I’ll be your coordinator for today.

At this time all participants are in listen-only mode. We will be facilitating a question and answer session towards the end of today’s conference. (Operator Instructions).

I would now like to turn our presentation over to your host for today’s conference, Ms. Carin Fike, Director of Investor Relations. Please proceed.

Carin Fike

Good morning and thank you for joining us. Before we begin I want to remind you that today’s discussion will include forward-looking statements. We want to caution you that such statements are predictions and actual events or results can differ materially. A detailed discussion of the many factors that we believe may have a material effect on our business on an ongoing basis is contained in our SEC filings, but further assumes no obligation to update that information.

Both our fourth quarter press release and our prepared remarks from this conference call will be available on our website at www.kroger.com.

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

David B. Dillon

Thanks, Carin, and good morning, everyone. We’re pleased you could join us to review Kroger’s fourth quarter and fiscal year 2007 financial results. With me today are Rodney McMullen, Kroger’s vice chairman, and Mike Schlotman, Senior Vice President and Chief Financial Officer. Don McGeorge is off today. It would seem that the flu season is indeed finally here.

I’ll begin with a recap of Kroger’s fourth quarter and fiscal year sales result and then provide our latest market share information. Rodney will review our fiscal year results and provide guidance for 2008 and then we’ll be happy to take your questions.

Total sales for the fourth quarter increased 2.2% to $17.2 billion. After adjusting for the extra week in the fourth quarter of 2006 total sales increased 10.2%. Identical supermarket sales increased 8.2% with fuel and 5.3% without fuel based on the same 12-week period in both years.

Our strong identical sales growth continues to be broad based across the company’s geographic regions. The strongest departments were grocery, produce, nutrition, and bakery/deli.

Net earnings in the fourth quarter totalled $322.9 million or $0.48 per diluted share. The LIFO charge in the fourth quarter was $0.05 per diluted share resulting from higher than expected inflation and was $0.02 per diluted share more than we anticipated when we reported our third quarter results to you back in December.

We continue to drive solid identical sales growth by improving service, value, product quality, and selection for our customers. During the quarter we continued to invest in lower prices for our customers providing meaningful savings for them in this uncertain economic environment.

We ended the fiscal year with a strong quarter. The fourth quarter and full fiscal year highlight what Kroger’s strategy is designed to do: deliver strong financial results today while we continue to invest in the future.

Rodney will discuss our fiscal year results in a few minutes. First I’ll share our latest market share results with you. Increasing market share is a corner stone of our strategy and I am very pleased to report that for the third consecutive year Kroger has shown impressive market share gains. The market share figures we report are based on our own calculations and consider the potential for sales in each market from all retail outlets where customers can purchase products Kroger sells, including supercentres and other non-traditional retail formats such as dollar stores, drug stores, and warehouse clubs. Most third-party market share data providers only consider traditional formats.

Kroger serves customers in 44 major markets. We define a major market as one in which we operate nine or more stores. In 2007 Kroger held a number one or number two market share position in 39 of our 44 major markets. Our overall market share in these 44 major markets rose approximately 65 basis points during 2007 on a volume-weighted basis. Kroger shared an increase in 37 of those 44 major markets, a decline in six, and remained unchanged in one.

Kroger competes against a total of 1,340 supercentres, an increase of 78 over last year. Supercentres have achieved at least a number three market share position in 36 of our major markets. Kroger’s overall market share in these 36 markets rose 95 basis points during 2007 on a volume-weighted basis. Our share increased in 31 of those 36 major markets, declined in four, and remained unchanged in one.

Of the 1,340 supercentres that I mentioned 1,065 are operated by Wal-Mart. This is an increase of 65 over last year. That increase is the lowest in seven or eight years. Wal-Mart supercentres have achieved at least a number three share position in 34 of the major markets where Kroger faces significant supercentre competition compared with 32 last year. Kroger’s overall market share in these 34 markets rose over 80 basis points in 2007. Our share increased in 30 of the 34 major markets, declined in three, and remained unchanged in one.

Despite the growing number of competitors in the grocery business we have increased our market share on top of strong gains in 2005 and 2006. During the last three fiscal years combined, Kroger’s share in our major markets has increased approximately 165 basis points. These consecutive year-over-year gains in market share are significant because they show that Kroger’s long-term strategy is working as we continue to deliver value to both our customers and our shareholders.

I want to thank our associates for their direct impact on increasing Kroger’s market share in so many of the markets we serve. They see first hand what happens when new competition enters one of our markets and they understand what it takes to distinguish Kroger from the rest in the eyes of our customers.

While these latest market share numbers are impressive, we know there is more opportunity out there for our company. Even with Kroger’s strong share in our 44 major markets, approximately 46% of the share in those markets continues to be held by competitors without our autonomies of scale. We estimate that their share as declined nearly 4% over the last four years.

Now I’d like to turn it to Rodney, who will review our fiscal year and discuss our guidance for 2008. Rodney?

W. Rodney McMullen

Thank you, Dave. Good morning, everyone. We delivered another quarter of strong results thanks to the contributions of our associates in every area of our business. Our associates continue to execute our customer first plan well as we continue to balance operating cost reductions with investments aimed at improving our customers’ shopping experience.

As Dave said, Kroger had a great year. For the full 2007 fiscal year total sales increased 6.2% to $70.2 billion. Adjusting for the extra week in fiscal 2006, total sales increased 8.2%. Identical supermarket sales increased 6.9% with fuel and 5.3% without fuel based on the same 52-week period in both years.

We delivered on a fiscal 2007 objectives we outlined for investors a year ago. Our original target for identical supermarket sales growth for the year, excluding fuel sales, was 3% to 5%. We raised the lower end of that range to 3.5% after the first quarter and raised it again to 4% after the second quarter.

At the end of the third quarter we said we expected identical supermarket sales growth of 5% for the full year excluding fuel sales. Today we reported full-year identical supermarket sales growth without fuel of 5.3%, exceeding all of our expectations throughout the year. On a two-year stacked basis, this marks the fifth consecutive quarter that we’ve reported identical supermarket sales excluding fuel of 10% or higher.

Kroger’s strong identical sales growth in 2007 was a key driver of our earnings-per-share growth, which is consistent with our business model. We originally expected to deliver earnings per share growth of $1.60 to $1.65 per diluted share for fiscal 2007. Today we reported earnings of $1.69 per diluted share. This equates to a 15% growth after adjusting for the extra week in fiscal 2006. This growth, plus Kroger’s dividend yield of slightly more than 1%, created strong value for our shareholders.

I want to note that we exceeded our original fiscal 2007 earnings guidance despite a pre-tax LIFO charge that was $104 million higher than our original expectations for the year. The higher than expected LIFO charge is a reflection of the current inflationary environment.

Like many food retailers, we continue to experience product cost inflation across many core grocery and perishable categories at levels not seen in several years. We estimate that our product cost inflation during the fourth quarter versus last year was 3.8% excluding fuel.

While the LIFO charge is a non-cash expense that negatively impacts Kroger’s operating margins and reduces earnings, it does create cash tax savings for the company. The impact of the higher LIFO charge on our fiscal 2007 earnings was mostly offset by higher than expected sales.

Let me turn now to some other highlights of our fiscal 2007 results. Our operating margin, excluding fuel, declined 3 basis points from a year ago. Excluding the impact of the higher than expected LIFO charge, Kroger’s operating margin expanded 14 basis points for the year, which is consistent with our strategy.

The 14 basis point expansion is the result of a 19 basis point decline in Kroger’s non-fuel FIFO gross margin and a 33 basis point improvement in our non-fuel OG&A rate for fiscal 2007 in comparison to the prior year. Kroger’s FIFO gross margin declined on non-fuel sales primarily reflects our strategy of continued investments and lower prices for our customers.

Our supermarket selling gross margin on non-fuel sales declined 20 basis points on an annual basis, which was consistent with the fourth quarter decline of 18 basis points.

The improvement in our OG&A rate is due to our strong identical sales leverage, increased productivity, and progress we have made in controlling our utility, health care, and pension expenses. These improvements continue to be offset by higher credit card fees.

Rent and depreciation expense as a result of non-fuel sales were comparable to last year. However, it’s important to note that fiscal 2006 contained 53 weeks of sales and only 52 weeks of depreciation expense due to the structure of our fiscal calendar. Fiscal 2007 contained 52 weeks of sales and 52 weeks of depreciation expense.

Now I’d like to spend a little bit of time talking about capital investment. At the beginning of fiscal 2007 we plan to invest approximately $1.9 billion to $2.1 billion in capital projects during the year, excluding acquisitions. Our actual capital investments for 2007 were $2.1 billion, excluding acquisitions, compared with $1.8 billion in fiscal 2006.

We completed 200 store remodels during the year and opened, expanded, relocated, or acquired 102 supermarkets. In 2006 we remodelled 158 stores and opened, expanded, relocated, or acquired 53 locations.

Another important element of our capital investment plan is our logistics network, a vital link between our stores and our customers. Over the last three years we have invested more than $400 million in our logistics network making it more efficient and an industry leader in many areas. These investments have covered a wide range of projects including transitioning three warehouses to automated systems and beginning installations of the same technology in others. Our investments in logistics are generating an excellent return.

Total debt at year-end 2007 was $8.1 billion, an increase of $1.1 billion from a year ago. On a rolling four-quarter basis Kroger’s net total debt to EBIDTA ratio was 2.0 compared to 1.9 during the same period last year. We expect to manage the use of our free cash flow to maintain a leverage ratio that supports our investment rate rating.

Also during the year, Kroger repurchased 52.5 million shares of stock at an average price of $27.05 for a total investment of $1.4 billion. Over the past four quarters Kroger has returned over $1.6 billion to shareholders in share repurchases and dividends. At the current share price we expect the $941 million remaining under our current authorization to be sufficient to fund repurchases throughout fiscal year 2008.

Since January 2000 Kroger has reduced its net total debt to EBIDTA ratio from 2.8 to 2.0, a reduction of 0.8 times EBIDTA. During the same time frame Kroger has invested $5 billion to repurchase 237.3 million shares of stock at an average price of $21.22 per share. The company has also paid $341.5 million in cash dividends to shareholders since it initiated its dividend program in 2006. In 2007 our board approved a dividend increase from $0.06.5 to $0.07.5 per share, reflecting its confidence in Kroger’s strategic plan.

Kroger performed well in 2007. We delivered on the objectives we established at the beginning of the year and we improved our position relative to our major competitors in the four key areas of our customer first plan: our people, our products, our prices, and the overall shopping experience for our customers.

We continue to deliver results today while making investments for our future. These investments include lower prices and better service for our customers, a wide array of products that align with the changing needs of our customers, a strong commitment to investing capital in our store base, our store remodels are producing results above our expectations, and the return on investment in our new stores continue to improve, and a share repurchase program that continues to demonstrate the confidence in Kroger’s future.

Our strategic plan continues to serve customers, associates, and shareholders well and we believe it will enable us to achieve our objectives in 2008.

Now I’d like to turn to our expectations for fiscal 2008. As Dave mentioned, we expect that our strategy will work even as economic and competitive landscapes continue to evolve. For fiscal 2008 Kroger anticipates earnings of $1.83 to $1.90 per diluted share. As in 2007, we anticipate Kroger’s earnings per share growth will be drive by strong identical sales, a slight improvement in non-fuel operating margins, and fewer shares outstanding.

Identical supermarket sales growth is expected to be in the range of 3% to 5% excluding fuel sales. Shareholder return will be further enhanced by Kroger’s dividend. The range for identical sales and earnings guidance takes into account the current uncertainty about future economic conditions. The upper end of the range assumes current economic conditions will continue while the lower end assumes economic conditions weakened slightly.

Our annual earnings guidance assumes fuel margins similar to fiscal 2007. As you know, due to the nature of the fuel business, there could be volatility from quarter to quarter as we saw last year.

Our earnings per share growth in sales guidance is based on a stable labour environment. This year we have labour negotiation covering store associates in Columbus, Indianapolis, Las Vegas, Louisville, Nashville, Phoenix, and Portland. In every negotiation we work to achieve a competitive cost structure in each market while meeting our associate’s needs for good wages and affordable health care.

While we do not give specific quarterly guidance, I do want to note that we anticipate earnings per share growth in the first and fourth quarter of 2008 will be higher than the annual growth rate and that the third quarter will be lower than the annual growth rate. This is important to remember when calculating your 2008 quarterly estimates. We filed an 8K earlier today that outlines some of our additional expectations for fiscal 2008.

One other point before I turn it back over to Dave, although it’s still early in the year and so far in the first quarter our identical supermarket sales trends are tracking at the high end of our identical sales guidance range, there are signs that there are some discretionary spending decreasing, but our business model is well suited for this environment.

Now I’d like to turn it over to Dave for some closing remarks. Dave?

David B. Dillon

Thanks, Rodney. I am very pleased with Kroger’s performance during the fourth quarter and full year. We did better than we said we would and our results clearly indicate that.

Our results highlight Kroger’s ability to consistently deliver results in the near term and at the same time make meaningful investments in the future.

This year Kroger is honoured to celebrate our 125th anniversary. Our longevity is our testament to our ability to change along with our customers. We’ve been fortunate as a company to welcome change decade after decade and to use it to benefit our customers, associates, and shareholders.

The success we have enjoyed along the way is a tribute to the hundreds of thousands of associates who work hard to set Kroger apart from the rest. And while I have additional comments for our associates listening in today after we answer your questions, I want to take this opportunity to thank the entire Kroger team. Every store, every division, every banner, every plant, every distribution centre, every office, and every operations centre, for a terrific year. Our growth has taken many forms over the years, but there is one constant that has never changed: the commitment of our associates to deliver value to our customers and shareholders. Thank you. We’ll now take a few minutes for your questions.

Question-and-Answer Session

Operator

(Operator Instructions). Please stand by for your first question. Your first question comes from the line of John Heinbockel of Goldman Sachs.

John Heinbockel – Goldman Sachs

A few things. I want to drill down on inflation a little bit and how that might change the way you look at the business. For example, if you look at wage rate pressure, does there come a point here, I don’t know if it’s this year or next year or beyond, when you start to get some pressure on labour costs because of contractually higher wage rate increases? That’s one thing.

And then secondly, in terms of how you buy product. When we had inflation in the past we saw a lot of forward-buying activity. Do you think we see that again or do you think we see an increase in consignment to kind of keep working capital under better control?

David B. Dillon

Well, good morning, John. On the wage question, actually, wages are a product of every individual market and that market’s conditions. Every contract would be different as to what contractual obligations there would be on wages. Of course, there’s always some pressure on wages, but actually the issue over the last several contracts in many markets has been we’ve had to find a way to reduce the ongoing cost of pension and some of the health care costs that were built into the contracts in order to afford the higher wages that actually the company even wanted to pay. So I don’t see the wage picture particularly changing with this inflationary environment, even though the inflation we described at 3.8% is higher than what we’ve seen for many years. It is still what I would characterize as still moderate in long traditional terms.

As for forward buy, I think we already saw some increases in forward buy in the year and certainly in the quarter. It’s one, it’s not the biggest reason, but it’s one of the reasons that our inventories are higher on the balance sheet because we’re fairly deliberate about it as we see costs go up of making sure we have made a conscious choice of how to buy products best to reduce the cost for our customers, therefore reducing the retail price for the customer.

John Heinbockel – Goldman Sachs

Okay. Secondly, and I’ve always asked you guys about price elasticity of pricing investments. It would seem in this market being the price of elasticity is higher and indeed get more bang for your buck by investing more, how do you look at that as a balance? Do you see the same level of investment as a year ago? You know, eight or some different amount?

David B. Dillon

Well, the customers do notice on some products as inflation draws the price out. Milk was the best example last year. And we have talked about it all year long where a tonnage or gallonage in milk actually suffered because of the inflated price. We remain competitive and, in fact, a couple of times during the year we were actually more competitive than what the costs would have ordinarily provided. But generally speaking, we have been able to pass through cost increases as we receive them and that’s our objective and that has been successfully done. For the most part, you’ve heard a lot of the national brand vendors talk about their volume, their tonnage does not seem to have been impacted by that. I don’t know that I can speak specific to any of them, but I can say that our tonnage has been strong this year and even when you take inflation into account our identical sales were strong. We were very pleased with the year’s outcome.

So you may be right a little bit on the price elasticity as it changes, as some costs go up, but I think it depends entirely on what the items are and how much they go up and I think we’re very conscious of what our customers see in pricing. So our investment in pricing is going to be based on what we think the customers want, what we think we can afford based on our cost structure, and what we think will produce sustainable results. I think that’s important. We’re trying not to put money into promotional practices that are not sustainable. We’re trying to do things that we can do for a very long period of time and that will sustain our sales for a very long period of time.

John Heinbockel – Goldman Sachs

And then finally, your guidance and corporates, what LIFO charge?

J. Michael Schlotman

Similar to this year, John.

John Heinbockel – Goldman Sachs

About 155-ish?

J. Michael Schlotman

Yes.

John Heinbockel – Goldman Sachs

Okay, thanks.

W. Rodney McMullen

One other thing, John. Dave mentioned it a little bit. But in terms of what we would invest in pricing will also be driven by what we take in on costs for OG&A and we’ve said overall we expect a slightly improving operating margin and we would expect that would continue this year as it has been in the past for a strategy.

John Heinbockel – Goldman Sachs

Okay. Thanks.

Operator

Your next question comes from the line of Karen Short of Friedman, Billings and Ramsey.

Karen Short – Friedman, Billings, Ramsey and Company

Hey there. Thanks for taking my questions. I just want to ask, you know, there’s been a lot of discussion about generics in general and I’m wondering if you could give some colour on what maybe the negative impact of generics on your identical store sales and on the flip side the positive impact on gross margins? And then I’ll just follow up.

David B. Dillon

Karen, when you’re referring to generics are you referring to corporate brands? Our own brand?

Karen Short – Friedman, Billings, Ramsey and Company

Oh, sorry. I meant on pharmacy.

David B. Dillon

Oh, on pharmacy. In pharmacy we have, of course, tracked the change from the patented prescriptions to the generic prescriptions as everyone else has. I think we would characterize that shift for us in the same ball park as what you’ve heard from other retailers in the same sector. It’s not much different than what they’ve described.

Karen Short – Friedman, Billings, Ramsey and Company

Okay. And then the benefit on the gross margin.

David B. Dillon

I don’t know whether we have said anything on that.

W. Rodney McMullen

When you look at pharmacy by itself you can clearly see the improvement in margin, but by the time you look at the total company results it gets pretty blended when you look at it across all departments.

J. Michael Schlotman

It would help percent, the dollars would be a little different because the dollars on the sale are so much lower, but the percent on a generic item like that is much higher.

W. Rodney McMullen

By the time you look at total Kroger it really doesn’t have much of an influence relative to that.

Karen Short – Friedman, Billings, Ramsey and Company

Okay. Great. And then just thinking about leap year, the extra day in this quarter, I guess the first question is what would be the impact of that on your comp? Would your ID be tracking at the high end of the range of guidance if we exclude the benefit of the extra day?

David B. Dillon

Karen, actually there is no extra benefit of an extra day for us. The way the calendar works for us, every few years we have a 53rd week as we did last, not last year, but in ’06. The reason we do that is to actually adjust for that leap day every few years. So we have the exact same number of days and weeks in our totals for the first quarter of ’08 as we would have had last year. More importantly, as we give identical sales we always make sure that there are a comparable number of days and weeks and we adjust for those kinds of things.

W. Rodney McMullen

Our 52-week years have 364 days and the 53rd week year to catch up to the calendar versus our fiscal calendar, they’ll have seven more days.

Karen Short – Friedman, Billings, Ramsey and Company

Okay. Great. And then do you have any comments on what you’re seeing in the acquisition landscape?

David B. Dillon

It would be very similar to what we’ve said for the last several years. Continue to see quite a bit of availability. Pricing expectations really aren’t consistent with what we think the economics work as a general rule. As you know, though, last year we were able to acquire almost 40 stores in a couple of different markets. but we continue to look at several opportunities and at the right price we’ll deal with it.

Karen Short – Friedman, Billings, Ramsey and Company

Okay. Great. Thanks very much.

Operator

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

Chuck Cerankosky – FTN Midwest Securities

Good morning, everyone. Just to check on one thing, you have wild food purchases last weekend a head of the snowstorms in Cincinnati.

David B. Dillon

That would be true, yes.

Chuck Cerankosky – FTN Midwest Securities

I just want to make sure the customers respond as usual. Dave, could you talk about the whole prepared foods category last year? How you thought it progressed and especially what kind of trends you saw in the fourth quarter.

David B. Dillon

Chuck, before we turn to that I want to go back to your first comment about the snowstorm. We did have a snowstorm across this part of the country and, yes, it does give us a good strong sales boost for those couple of days. You would expect, in fact, if you went in right after the snowstorm you would see some holes in place of soup and milk and some places like that. I was in stores on Sunday, which was the day after that, and we had recovered actually pretty well. So I want to tip my hat to both the store associates and the division associates and all of our logistics people and the manufacturing people who just did a remarkable job of making sure we had product to sell during that time. So it’s a tricky time.

Now to your specific question. Prepared foods, those are developing both at Kroger and I think generally within the US. I would go to say it’s a rapid pace. It’s probably a rapid percentage, but it’s still a pretty low base. As a result it’s not going to be meaningful in anything that you’re going to see in overall data for a while. But yes, it is clearly increasing, both for us and across a number of our competitors.

W. Rodney McMullen

And as Dave mentioned in his prepared remarks, deli/bakery is one of the departments that had very strong sales growth and a lot of that is driven by prepared foods. It’s not just new prepared food items, some of it is existing items too.

David B. Dillon

In fact, I’m speculating here, but I believe that the sales growth is more by the existing items even than the new prepared items.

W. Rodney McMullen

Certainly on a dollar basis.

David B. Dillon

Yeah. On a dollar basis. Percent wise what I said before is right.

Chuck Cerankosky – FTN Midwest Securities

Do you think that reflects quality improvements in the traditional items or the price of gas or what’s affecting that?

David B. Dillon

I think it’s improved on the traditional items for us and the reason our deli/bakery sales are up is we have improved our quality, improved our price position, improved the offering. All of that I think contributes to that. Certainly our sales overall are at least modestly helped by what’s happening with gas, as we have discussed before. That is a slight positive for us.

Chuck Cerankosky – FTN Midwest Securities

Dave, can you talk about, and Rodney as well, looking at your choice between stock repurchase and improving the yield on the stock with the dividend. What would you thinking about their going forward.

David B. Dillon

Rodney or Mike, do you want to comment on that?

W. Rodney McMullen

If you look on the stock repurchasing dividend we continue to be slightly biased to stock repurchase, obviously. If you look at last year that’s what we actually did. At current stock prices that would certainly be our bias.

Chuck Cerankosky – FTN Midwest Securities

Okay. And then last thing, Dave, could you give us some colour on what you saw in the changes in spending among discretionary categories?

David B. Dillon

Well, overall I’m assuming you’re wanting to get a sense of how the consumer’s behaving in this environment.

Chuck Cerankosky – FTN Midwest Securities

Yes.

David B. Dillon

At Kroger we really do not see clear signs of the customer pulling back. We do see improved sales in Kroger brand, but we’ve been seeing improved sales in Kroger brand for a number of years now. So it’s not just the result of the economy. It’s also the result of what we’ve done in improved packaging and in quality on Kroger brand. We have seen some declines in selected categories, but they are the obvious categories that you’ve heard elsewhere. Jewellery, as an example. Selected non-food areas like domestics and home furnishings are other examples. But one of the reasons that Rodney made the comment he did about where we are so far in ’08 was to help you see what we’re seeing in today’s economy. Just to refresh your memory, what Rodney said is the identical sales trend so far in 2008 is tracking at the high end of the sales range that we gave for guidance so far.

We think Kroger’s well positioned as a value proposition and better positioned than even in the past. Our strategy, our pricing approach, the work our associates do really positions us well to weather in this economy, in our opinion. So yeah, we’re maybe seeing some changes as I’ve described in these few categories, but there are really no clear signs of the customer pulling back at Kroger.

Chuck Cerankosky – FTN Midwest Securities

All right. Thank you.

Operator

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

Bakud Sonan – Banc of America

Hi. This is actually Bakud Sonan (sp) for Scott here. I just wanted to touch on in terms of food inflation. At what point do you, you know, you’re 3.8 for the quarter. At what point do you start to get concerned about that input inflation. What number would we kind of look for as far as becoming less orderly in your minds?

David B. Dillon

Well, the 3.8% is an annualized number first. I want to make sure that you have that in mind. I characterized it as moderate inflation and I genuinely feel that it is moderate. I don’t think I want to speculate on how high ends up being trouble. You could get to a high enough level I suppose that it could be disruptive in the economy in ways that creates other issues for us. But generally speaking, particularly moderate inflation like we’re seeing, is a net-net positive for us. As I mentioned, we’ve been successful in passing along the costs this past year.

I will tell you also that in ’08 we’re seeing so far in ’08 pretty much what we saw last quarter. A continuation of that same trend. It’s not much higher, not much lower. It’s basically the same picture.

W. Rodney McMullen

You’ve heard us say it many times before on inflation, but that’s one of the things about having such a wonderful corporate brand program that we have. At any point in time if CPG companies would pass in prices on more than what the actual inflation is we have our corporate brand product that’s excellent product that customers will routinely switch over. And you can see whenever a CPG company raises prices more than what the economics makes sense, corporate brand always picks up share in a reasonably quick period of time.

Bakud Sonan – Banc of America

In terms of traffic versus, I know you guys don’t give this, but traffic versus ticket. Are you seeing reasonably stable trends there? What’s it look like there?

David B. Dillon

Both the traffic and the ticket increased and if you were to try to inflation adjust the average sale that would give a little stronger emphasis on the traffic than on the average sale. But they’ve both improved.

W. Rodney McMullen

And I was just going to say it’s very consistent with what we’ve seen for the last three or four quarters.

David B. Dillon

Yeah, not much difference.

Bakud Sonan – Banc of America

Okay. Nice quarter, guys. Thanks.

Operator

Your next question comes from the line of Jason Whitmer of Cleveland Research Company.

Jason Whitmer – Cleveland Research Company

Hi, good morning. Dave, can you talk a little bit about the slowdown in square footage growth you’re seeing from some of the non-traditional outlets? It seems like there’s been this continuing trend of rationalization consolidation within the grocery channel, but this seems to be a little bit more of a newer phenomenon where other good retailers may be slowing it down a bit. Is that something that is starting to have an impact within some of your markets or what would you expect over the next couple years in how that, how Kroger can respond in that sort of environment?

David B. Dillon

Well, the example that I gave in the earlier comments was last year we had 65 Wal-Mart supercentres opening up against us in the major markets. that’s the lowest number of new Wal-Mart supercentres we’ve had in seven or eight years. That’s significant in one sense, but in the other hand that’s still a very large number of stores. In our view Wal-Mart is still doing very well in groceries. That’s actually, you see that in our sales trends when they talk about it. I think every traditional and non-traditional retailer like we do makes their own rational choices as to where they think they get the advantages and what works for them and what doesn’t. I just simply read into the Wal-Mart statement that they maybe felt they were cannibalizing too much on their own sales and so they were going to slow it down a bit. But that slowdown still looks like 65 last year, which is a big number.

Bakud Sonan – Banc of America

And is your step up in square footage, it looks modest, but noticeable, up to 2%, 2.5% for next year. Is that going to be pretty broad based or do you have certain geographic markers and certain formats in mind for that?

David B. Dillon

Well, we’re targeting a number of things, but as you know we’re bullish on what we’ve done with our marketplace store. So that’s important. We still continue to emphasize remodels. Even though that doesn’t increase square footage we think it connects well with the customer, particular with what we’ve been doing. Rodney or Mike, do you want to add?

W. Rodney McMullen

And we continue to focus on expansions. The increase in square footage would primarily driven by additional marketplace stores versus the base. Not so much additional number of stores.

Bakud Sonan – Banc of America

Okay. And then lastly, you talked briefly about the market acquisition you did in ’07 and some of the availability of opportunity going forward. But what’s been the impact so far of those? It obviously doesn’t move the needle for the entire company a whole lot, but as far as the return on that investment and with some of the in-market impact, especially as things continue to rationalize in some of those key markets for you.

David B. Dillon

The two that we did we’re very pleased with the results of both of those and where they are tracking. We’re starting now to focus on the remodelling of those stores and that’s when it really becomes special for our customers and associates.

Bakud Sonan – Banc of America

Great. Thank you very much.

Operator

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

Meredith Adler – Lehman Brothers

Hi, everybody. I’d like to start with, 18 months ago when you had an analyst meeting you gave us a slide that looked at customer perception of areas that were important to you. Pricing was one of them and service and I forget exactly what all the others were. I think there were four of them in total. I was wondering if you could talk a little bit about what customer research says now about all those things beyond price because I think we know your pricing image has gotten better.

David B. Dillon

If you look, the other three that we talked about was people, shopping experience, and products. On all three of those we continue to make progress relative to our traditional and non-traditional competitors. If you ask us internally, we would tell you we’re not making as much progress as we would like to be, but if you look at where we are, we are making progress. On all three of them.

Meredith Adler – Lehman Brothers

Great. Wonderful. And then another question I’d like to ask is, we’ve been talking a little bit about Wal-Mart. First, do you believe that you are taking share back from Wal-Mart in any of these markets? I mean, it sounds like your share went up in markets where you compete with them. And then I have another question about Wal-Mart.

David B. Dillon

Meredith, our market share in the markets where Wal-Mart has gained a one, two or three share for the last several years has increased and my view, my personal view of where we’ve gained that share and the way in which we’ve looked at it is the same as it was last year and the year before that. That is that what’s happening in those markets is that we’re gaining at Kroger, Wal-Mart continues to gain in share – sometimes that’s because they’ve added new stores, but Wal-Mart does continue to gain in share – and that both Wal-Mart and Kroger are taking that share from other sources. Other places that people are shopping. I think that is not true every place, but that’s true in the bulk of the situations. So I think the answer is no, I don’t really see us as taking a share from Wal-Mart, I see us taking it from the other traditional and some other non-traditional grocers that are out there.

If you look at the traditional companies that track these sorts of things, and we look at AC Nielsen, for instance. What we see there is remaining, what they call remaining food, which would exclude us and exclude Wal-Mart. That continues to decline year after year. I think that’s mostly where it’s coming from.

W. Rodney McMullen

An awful lot would be from people without our economies of scale. And as you know the way we define markets there’s still well over 40% market held by people without our economies of scale.

David B. Dillon

The number I used was 46 and we said that that’s declined, the share for that group has declined about four percentage points in roughly four years, so about a percent a year.

J. Michael Schlotman

The other thing, Meredith, is last year there were 32 major markets where Wal-Mart was at least third of our major markets at and this year that increased by two to 34. So just that statistic would lead you to believe that they continue to either grow sales in their existing boxes and/or build new boxes to move up into more markets like that to at least a number three position.

Meredith Adler – Lehman Brothers

Okay. And then we talk about 65 new Wal-Mart stores. Would you say that the majority of those are in markets where they are not yet fully established? Fully west, Ohio, those areas.

David B. Dillon

Actually, I don’t know the answer to that. Sixty-five is a lot of stores and so there are a lot of places. They’ve certainly opened a lot of stores around the Cincinnati market in the last couple of years. So it’s been a big deal here. I think you could call that maybe a new market from that point of view. And the fact that there’s two additional markets where they’ve gone up to the number one, two, or three in that market that’s probably significant to, to your point.

W. Rodney McMullen

And would over index a little bit for Ohio, especially Cincinnati and a little bit Columbus and some of the other areas. It would over index the further west you go and a little bit in Texas. And the rest would be spread out pretty normal looking.

Meredith Adler – Lehman Brothers

Okay. And then I’d like to, you know, you’ve already commented that you are seeing a little slow down in some of the discretionary categories and yet you’re still very excited about the marketplace stores. Do you have any concern that those stores are going to start out more slowly or slow (inaudible) in the next year or so? Because obviously they do carry more discretionary general merchandise.

David B. Dillon

Actually, I’m not because the marketplace stores win in a variety of ways. Only one of those in some of those products. And while those products may be down on the whole, or at least less than the growth that we were experiencing in some of them, they still are an opportunity for us. So no, I’m not at all discouraged about that.

Meredith Adler – Lehman Brothers

Okay. And then I just have one other question back on the topic of inflation. I think you folks have said that CPG inflation is a bit of a tailwind, but the perishable items and more commodity items, are you managing gross profit dollars more than you are managing gross margin and does that have the potential, just optically, mathematically, to make your gross margin percent go down? Even though the dollars may be flat or up?

David B. Dillon

I suppose mathematically. That gets to be pretty hypothetical, but yeah, I think mathematically it certainly could do that. But what we are looking at making sure we maintain the penny gross. But we also are looking, we’re not just doing that. We are also looking at the percentage gross. And most importantly we’re looking at the balance of where our financials come out because, as we said before, we are trying to balance where we end up on gross margin investment and where we have found savings in OG&A. Or if you prefer, our total cost on one side and our selling gross on the other. We take all of our pricing into account on that, including the inflationary environment.

Meredith Adler – Lehman Brothers

Okay. The reason I’m asking is because people assume that any decline in your selling gross is absolutely a function of price investments you’ve made where in fact it could be, again, on an end result of how you’re managing the inflation and gross profit dollars.

David B. Dillon

On that point I would agree. Yes.

Meredith Adler – Lehman Brothers

Okay. Thank you very much.

Operator

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

Ed Kelly – Credit Suisse

Hi. Congratulations on a good quarter. My first question for you is on gas. It looks to me like it may have been relatively neutral this quarter. Is that a fair assessment?

David B. Dillon

If you look at gas for the whole year we would have said, from our perspective, in the fourth quarter it was slightly positive versus the overall year. If you look at it for the year it was almost exactly where we expected it to be and pretty consistent with ’06 when you look at it for the whole year. So slightly positive in the fourth quarter, pretty neutral for the year.

Ed Kelly – Credit Suisse

Okay. And then gas prices right now are rising, obviously, which is not good. But it looks like they increased for almost the entire first quarter last year as well, so to me it seems like the comparison is not very difficult there anyway. Is that true?

David B. Dillon

That we wouldn’t give any additional insight on.

Ed Kelly – Credit Suisse

Okay. And then regarding your guidance. The last two years you kind of got it to 6% to 8% EPS growth and meaningfully exceeded those estimates. You’re guiding to 6% to 10% EPS growth today and saying that if current conditions hold you’ll be at the high end of the range. But it just kind of seems like history would suggest that if current conditions hold there is a possibility that you could do better than that. Is that a fair way to think about it?

David B. Dillon

I think we would position it more in terms of if you look at the targets we’ve given it reflects the fact that we did exceed the last two years and we’ve tried to reflect that up front. So I wouldn’t necessarily assume that.

Ed Kelly – Credit Suisse

Okay. And one last question for you on your outlook for capex. Your level of spending increased in ’06 and ’07. I don’t know. Did you give an outlook for 2008? Was it $2 billion?

J. Michael Schlotman

It was in the 8K we filed today and we gave a $2 billion to $2.2 billion range.

Ed Kelly – Credit Suisse

Okay. How should we think about the level of spend that you’re undertaking right now versus a normalized rate of spend? How much of that is due to the fact that you seem to be more in a remodel cycle? Is this a rate that we should be thinking about longer term?

David B. Dillon

I think there’s two things out there. One is we’ve been very happy with the remodels that we have done. As we said in the prepared remarks, they continue to generate a return above our expectations, which we believe always winds up meaning that we’ve made a very good choice with the use of our shareholders money. And the returns on our new stores, which a few years ago we were disappointed with, continue to improve. If you look at the guidance we gave today as well in the number of new stores and back out the number of acquisitions we had from our store count in ’07 it’s actually a slight increase in the number of new stores in ’08 as a result of our improving returns. And there are a few more marketplace stores in that number which causes the square footage growth to be a little higher than we’ve been tracking.

W. Rodney McMullen

The other thing is that we’re seeing some nice opportunities with logistics projects and some IT projects that we feel really good about the return potential. And as long as we see those out there we’ll continue to fund them in a balanced sort of way.

Ed Kelly – Credit Suisse

Okay. Thank you.

Operator

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

Mark Wiltamuth – Morgan Stanley

Hi. Good morning. I wanted to ask you a little bit about what you’re seeing in food away from home trends versus food trends at the grocery stores in general. And also, if you look across the spectrum here we have seen some very strong sales out of the club stores, and I’m curious if you think the consumer is shading a little more in that direction now that we’re in a more price focused environment.

David B. Dillon

On the food away from home, I don’t get a lot of data from the restaurant industry, but what little data I see and episodically what I hear from restaurateurs has not been pretty for them that in this economy that their sales have been less than they would like them to be. We have believed this year and this past year and in the year before, even, that trend has actually been of benefit to not just Kroger, but probably to all supermarkets. You saw the supermarkets as a whole, as an industry, are identical sales intended to move up a couple years ago and my personal view is that that’s probably the reason why. But I think that continues.

We think we’re doing a particularly good job in our deli/baker and in some other parts of our store which helps us catch that particular time, which is perhaps one of the reasons that our sales are strong.

As for the club stores, I would be speculating if I answered that, but I would think that one of the reasons that you’re suggesting is probably right. That in a tighter economy I could see people turning to a number of places, including our Kroger brand and including the club stores, as a way to save money.

Mark Wiltamuth – Morgan Stanley

Okay. And then you mentioned you were probably taking share from some of the independents and those that don’t have scale. Do you think this environment could foster more consolidation? Are those players under more pressure than usual? You’ve made a lot of price investments. I’m curious when you’re doing your price comparisons what are the independents doing with their prices?

David B. Dillon

Well, consolidation is a funny thing. It takes a lot of years. And most industries we’ve watched, it’s not just a linear movement, it’s some starts and stops and some diversions and so forth. But I think it’s generally continuing as it has been continuing. I don’t think that there’s any greater pressure today than there was before or less pressure than there was before. In my view, anyway.

As for pricing, you have been able to see pretty well what we’ve done with our pricing. And I think it’s generally true that relative then to our competitors, our pricing, not in every case but in many cases, has gently improved. If they stayed the same and we lowered our price that’s what would produce that improvement. And I think that’s more of what we’re seeing. I don’t see really any radical change in pricing strategies out in a competitive environment right now.

W. Rodney McMullen

Another thing I’d add on, Dave, if you look at consolidation, if you look at a long-term trend there’s been a consolidation in our industry for 20 years. Certainly don’t see anything that would cause that to change looking forward. that’s something that we’ve been saying for the last five or 10 years, I know for sure.

Mark Wiltamuth – Morgan Stanley

Okay. And then lastly on inflation. We’ve seen several periods now of rising inflation. I’m wondering if you think there’s at some point, maybe late in the year, when we’ll lap out of inflationary trends.

David B. Dillon

That’s hard to predict. That’s why I mentioned that in ’08 so far, based on what information we have on cost increases expected this quarter, we don’t think that it’s abating at this point in time.

Mark Wiltamuth – Morgan Stanley

Okay. Thank you.

Operator

Your next question comes from the line of Mark Stillman (sp) of McKay Shields.

Mark Stillman – MacKay-Shields

Hi, good morning. I just wanted to, I didn’t catch all of the earlier comments. Did you break out on the comp, do you have a sense of price versus volume?

David B. Dillon

It’s pretty even between the two.

Mark Stillman – MacKay-Shields

Okay. Great. And as far as, I think somebody touched on it as far as the economic trends, do you guys discuss traffic at all as far as, you know, since the end of the year?

David B. Dillon

You mean currently in this year?

Mark Stillman – MacKay-Shields

Yeah. Currently. Or even last quarter. Whatever information. I mean, I would assume that you would have, or I’m wondering if there’s some statistical back up.

J. Michael Schlotman

As we said earlier, about half of our identical sales gain came from traffic and about half from higher traffic. Which is pretty much, or from higher sales per customer, and that’s pretty much consistent in the fourth quarter and all of last year.

Mark Stillman – MacKay-Shields

Okay. Great. Thank you.

Operator

Your next question comes from the line of Deborah Weinswig of Citi.

Deborah Weinswig – Citigroup

Good morning. Can you talk about your fuel strategy as it relates to your promotional efforts and specifically when customers are using their Kroger Plus card or their 1-2-3 Reward MasterCard?

David B. Dillon

Well, we don’t have the same program in every market, but in most markets if you make purchases at Kroger with your Kroger Plus card you’ll get a discount on gasoline. And if you use your 1-2-3 plus Kroger MasterCard, which is from our Kroger Personal Finance Group – and this is a commercial, Deborah – you will get a $0.15 per gallon reduction at the pump if you’ve spent, in most markets, if you’ve spent $100 in purchases. I had my card and got that same discount just this last week.

Deborah Weinswig – Citigroup

Okay. Great. And then could you just provide us with an update on Kroger Personal Finance and how has it contributed to your recent results? Also, if you look out further, when can we expect KPF to represent a significant enough driver to your overall results to really see it broken out on your financials?

David B. Dillon

Yeah, I was just up in the KPF office last night and really pleased with the progress they made this past year, but, Rodney, do you want to comment on KPF?

W. Rodney McMullen

Well, to me it’s really two aspects when you look at Kroger Personal Finance. Obviously the business itself, and we have a great partnership with Royal Bank of Scotland. It’s just been outstanding. They really do bring the expertise to the financial industry and we obviously have the connection with the customers and the customer traffic. So working together we’ve been able to create several products that have really been very positive with our customers.

The other thing that we really like is the loyalty that it creates from our customers. Clearly we can see a change in customer behaviour when they become a Kroger Personal Finance customer. So it really is both.

In terms of at what point does it show up in overall results, I guess it really depends on how you define showing up. Because from a loyalty standpoint we would certainly say that it’s showing up today.

One other thing that you may know, when a customer uses a Kroger credit card they earn gift certificates and so far our customers have earned over $40 million worth of gift certificates to reuse at Kroger. And the redemption rate is incredibly high on those, so we know that our customers love that $40 million.

Deborah Weinswig – Citigroup

Great. Thanks so much. Best of luck in 2008.

W. Rodney McMullen

Thanks, Deborah. Congratulations to you.

David B. Dillon

Yeah. Congratulations to you.

Deborah Weinswig – Citigroup

Thanks.

David B. Dillon

We’ll take one more question.

Operator

And your final question comes from the line of Bob Summers of Bear Stearns.

Robert Summers – Bear Stearns

Good morning. You touched on corporate brands. I’d wonder if you could give us some metrics around performance, either talking about increased penetration levels, maybe what the drag to comp has been, and your thoughts on how that progresses through 2008?

David B. Dillon

Well, I don’t know about 2008 for a moment, but our market share on Kroger brands on the whole continued to increase in the year. I don’t think we gave any specific data this time on that. In grocery, which is the way we’ve traditionally looked at it, that definitely has continued to grow. So we’re pleased with that progress.

You talked about a drag to comp, I don’t really think it’s causing a drag on our comps because I think it’s improving our sales. But I suppose if a person trades from a higher priced item to this item then you could have some impact on comps. But I don’t think that’s been meaningful.

W. Rodney McMullen

Well, if you look in the fourth quarter, we didn’t give the specifics, but we did gain share in both dollars and units. The gain in dollars was a little bit more than units, but if you look at the inflation is a little bit higher in a lot of the corporate brand categories. Especially milk and some of those.

Robert Summers – Bear Stearns

Okay. And then there’s been a lot of talk about Wal-Mart potentially taking price up at a slower rate than either CPI or product cost inflation. I don’t know, pick your metric. Is that something that you’re seeing?

David B. Dillon

You’ll have to go look in Wal-Mart for yourself. We of course watch them and lots of other competitors to see, but I’m not going to comment on their pricing strategy.

Robert Summers – Bear Stearns

Okay. And then one last thing. I think you outlined the LIFO charge for next year that’s about on line with what you did this year, but if I try and extrapolate the trend in the fourth quarter I get to a number that’s a lot higher. Help me understand that.

J. Michael Schlotman

Well, the reason the trend looks like that in the fourth quarter, Bob, is that at the end of the third quarter we were projecting $130 million charge for the year and it wound up being a $154 million charge for the year. So we had to take all of that $24 million in the fourth quarter. If we had known at the beginning of the year it was going to be $154 million about $16 million of that $24 million would have been spread over the first three quarters of the year.

Robert Summers – Bear Stearns

Okay. Thank you.

David B. Dillon

Thanks, Bob. And before everyone hangs up we just wanted to close with and share a few thoughts with our associates who have joined us, because we encourage them to call in. Once again, congratulations on a great year. I’m particularly pleased with the gains that we continue to make in market share. Those numbers only move in a positive direction when customers choose us over our competition. Our increases to market share mean you are doing what you do so well: making sure our customers want to return to our stores time and time again.

Our performance during the quarter and year points to another significant achievement you should all be proud of because it is the result of your individual contributions. You’ve heard us mention that Kroger continues to make progress in our four key areas: our people, our products, our prices, and the overall shopping experience for our customers. One example where you have a huge impact is in helping to keep costs low. Kroger is able to invest these lower costs in lower prices for our customers because of the choices each of you make on the job every day.

Our family, friends and neighbours are making different choices in today’s economy than they did a year ago because household budgets are not as flexible. Your personal commitment makes our lower prices possible. We hope your friends and neighbours appreciate the help that you provide, particularly when they need it most.

That completes our call today. Thank you all for joining us.

Operator

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

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Source: The Kroger Co. Q4 2007 Earnings Call Transcript
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