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Safeway (NYSE:SWY)

Q2 2012 Earnings Call

July 19, 2012 11:00 am ET

Executives

Melissa C. Plaisance - Senior Vice President of Finance & Investor Relations

Steven A. Burd - Executive Chairman, Chief Executive Officer and Chairman of Executive Committee

Robert L. Edwards - President and Chief Financial Officer

Analysts

John Heinbockel - Guggenheim Securities, LLC, Research Division

Scott Andrew Mushkin - Jefferies & Company, Inc., Research Division

Meredith Adler - Barclays Capital, Research Division

Kenneth Goldman - JP Morgan Chase & Co, Research Division

Karen F. Short - BMO Capital Markets U.S.

Edward J. Kelly - Crédit Suisse AG, Research Division

Jonathan P. Feeney - Janney Montgomery Scott LLC, Research Division

Charles Edward Cerankosky - Northcoast Research

Priya Ohri-Gupta - Barclays Capital, Research Division

Colin Guheen - Cowen and Company, LLC, Research Division

Operator

Welcome to the Safeway Second Quarter 2012 Earnings Conference Call. [Operator Instructions] This conference is being recorded. I will now turn the call over to Ms. Melissa Plaisance, Safeway's Senior Vice President of Finance and Investor Relations. Please go ahead.

Melissa C. Plaisance

Good morning, everyone. With me today are Steve Burd, our Chairman and CEO; and Robert Edwards, President and CFO. Before we begin, I'd like to remind you that management will make statements during this call that include forward-looking statements within the meaning of the federal securities laws. Forward-looking statements contain information about our future operating or financial performance. Forward-looking statements are based on our current expectations and assumptions and involve risks and uncertainties that could cause actual results or events to be materially different from those anticipated. However, we undertake no obligation to update or revise any such statements as a result of new information, future events or otherwise. For a list and description of those risks and uncertainties, please see our filings with the SEC.

And with that, I'd like to turn the call over to Steve Burd.

Steven A. Burd

Thank you, Melissa. You may recall in January of this year, we indicated that we would be selling some stores under the Genuardi's brand. And those stores in January went into discontinued operations. So the vast majority of my comments today are going to be on continuing operations. So unless I call out something about discontinued, you will hear me focus on continuing operations. So starting with net income. Net income for the quarter was just under $122 million. This compares with the same quarter last year where we made $146 million. When we expressed the earnings in earnings per share, we made $0.50 this year as contrasted with $0.41 one year ago. So while the earnings per share increased 22% in the quarter and we beat the consensus estimates by $0.01 a share, net income was in fact down some $24 million. It's important to understand that this reduction in net income was almost entirely explained by 2 factors: the first is the one-time cost, which will go away, associated with the just for U rollout. And the second is the added interest expenses that we took on when we borrowed $1.8 billion to support the stock repurchase plan. The just for U rollout has significant expenses associated as it rolls out and as we build a loyal following. Now these expenses will continue a bit into the third quarter but will moderate as we end the quarter. So not only will they not be here 6 months from now, they clearly will not be here one year from now. The just for U platform, as you heard at the investor conference, is a key piece of our strategy going forward. Also, we have a wellness strategy and other loyalty programs, all of which are instrumental in building strong ID sales, market share and ultimately, increases in operating profits. And we believe that we can improve all of those dimensions, including operating profit increases, over the next 12 months as these programs mature.

In the short term, our aggressive share buyback program should yield some quite strong EPS growth just as it did here in the second quarter. So let me begin with some highlights, and I might start by saying that we're very pleased with our results for the quarter. And as I track through the highlights, I think it will become clear why we should be pleased with those results. First of all, volume improved significantly in what's considered a pretty tough environment. Our market share growth was positive in both the supermarket channel, and I'll quantify that later, and in what I call the all-outlet channel. Now the all-outlet channel, it includes mass, it includes drug, it includes 2 of the 3 club participants and includes all the dollar stores. So it's a pretty comprehensive measure of people selling food and food-related products. Our volume and market share improvements also strengthened as we moved through the quarter. Stated differently, our volume and market share numbers are stronger today than they were in the second quarter as we closed out.

The just for U rollout occurred essentially as scheduled. We said that we would complete the entire U.S. rollout by the end of the second quarter. We probably missed that by a couple of weeks. We didn't -- the quarter ended on June 16. We had one division yet to roll, that division has now rolled out. So at least we got it rolled out before we announced our second quarter. So we missed that by, maybe 20-plus days. The early returns are very encouraging. And I'll talk more about those returns, but we're beating our expectations. I was going to say by a wide margin, I've used the term in the past. I'm going to say by a country mile. We were beating the expectations that we laid out at the investor conference earlier this year.

So let me turn first to sales. Total sales increased versus last year, 1.9%. The increase in total sales, which is discussed in the press release, is largely explained by higher fuel sales. And that's really a combination of gallons, ID gallons going up with some softening, quite frankly, in the price per gallon. We also increased ID sales, excluding fuel, and then the combination of new stores and closed stores yielded a net number. And there are some other puts-and-takes, but basically, those things are the largest explanations.

Looking at ID sales excluding fuel, they increased -- they were positive in the quarter, they increased 0.8%. That's an improvement from the flat results of Q1. The sales increase occurred despite a price per item decline of almost 300 basis points. But if you want to think of price per item decline as a headwind, we had one this quarter and still produced a 0.8% positive ID. This represented a volume improvement of 160 basis points versus last year, and it also represented a volume improvement of 360 basis points when you compare it to the first quarter.

We still experienced an absolute volume decline. That decline was greater in Canada than it was in the U.S. Our U.S. sales were considerably stronger -- or excuse me, my volume was considerably stronger in the U.S. That 1%, by way of comparison, if you look at the top 10 CPG companies that we do business with, and you use no more than their publicly reported data on North America or the U.S. and we weight that, that group was down a negative 1.6%. I've seen some Nielsen reported data on all-outlet channels and those numbers are even greater for the large cap consumer packaged companies. Again, sort of confirming the market share gains that we've made both inside the channel and across the all-outlet channel. So tough to produce positive volume, although we're doing it now, tough to produce positive volume, when the people you rely on to give you products. In fact, that negative volume's in your geography. Our supermarket share -- and again, I'm using a volume measure, beceause that -- it takes out all the price issues. That tells you what's really happening. In terms of volume share, we increased 34 basis points in the quarter. Now the all-outlet share was positive. It was quite modest, but it widened as we moved through the back half of the year. So today, we could say it's a bit more than modest. And we continue to gain on that. And I expect that to continue, particularly with the rollout of just for U.

Now let's look at the last 12 weeks. Often, people want me to comment on what's happening this quarter. Well, we're just into this quarter, we had a holiday earlier in this quarter. So I think the best way for me to give you a sense for how the business is performing is to speak about the last 12 weeks. So that covers really from week 18, on our calendar, up until today. And the reason I picked 18 besides it worked out to almost 12 weeks, was that with week 17, we got some benefits from the calendar, so I didn't want that to cloud these numbers. So over the last 12 weeks, in the just for U divisions, we've grown volume. So we're no longer negative. We've grown volume actually 4/10 of 1%, 0.4%. We've also experienced price per item inflation of just under 1%. So the inflation number is quite moderate right now. We think that's going to change particularly with commodity prices moving up. And we still think that on the year, we're going to see inflation in that 2% to 3% range. We gained market share across all classes of trade and during that 12-week period, experiencing a 1.2% ID sales increase with, as you know, very little help from inflation. We expect sales to continue to build over the next several months as the just for U platform matures. Again, later in my remarks, I'll talk more about the maturity of that program and maybe touch on some of the expenses associated as U initially launched.

Turning now to gross margin. When you exclude fuel sales, our gross margin declined 26 basis points versus last year. Now if you remove 3 basis points of decline that would be related to Blackhawk, and let me explain that. Blackhawk acquired a business called Cardpool earlier in the year. And Cardpool, the nature of that business is lower margin. So this 3 basis points that affected our gross margin is merely a mix change relative to the Blackhawk business. The balance of the gross margin decline is explained by the one-time cost associated with the just for U rollout, and then almost in equal proportion, some additional advertising spend that we made to support the broader business.

In terms of O&A expenses, excluding fuel sales, the O&A expense ratio declined 17 basis points. So that's a good thing. Yielding an operating margin decline of only 9 points. So if you look at the gross margin decline, the 26, you look at the improvement in O&A of 17, you've got a 9-point difference. The just for U launch costs were, by themselves, 20 basis points. And those are not repeatable numbers. Again, they'll be with us a bit in the third quarter, but they will not be with us after that. So we think that, that bodes well for operating margin on a go-forward basis.

Turning to interest expense. Interest expense increased $12 million from last year's second quarter. Now this increase is the result of increased borrowings. We increased our borrowings a bit more than $1.8 billion to support the stock repurchase plan. Since this $1.8 billion was financed at interest rates well below our other borrowings, our average interest expense actually fell from 5.38% to 4.70%. Also noteworthy during the quarter, we borrowed the remaining $400 million under the prearranged term loan, and we're currently paying about 1.5% for that $400 million. We also replaced $250 million worth of commercial paper with an 18-month floating rate note, and the interest rate on that is currently running just under 2%. So again, we think those are relatively cheap cost for money.

In terms of capital expenditures, we spent $219 million on capital projects in the quarter, and this compares with capital spending of about $209 million in the same quarter last year.

Looking at free cash flow, free cash flow for the quarter was just over $200 million. This compares with the last year number, which is quite soft, of only $4.5 million. Now our third quarter cash flow is going to get a benefit from the fact that we will be closing out on those Genuardi stores mentioned earlier. And that will give us an additional $105 million of net proceeds.

Now turning to just for U, and I don't know how interested you might be in the details, but I suspect we'll get a lot of questions. And keep in mind that we first piloted this program just under 2 years ago in Chicago and in Northern California. So the experience that we talked about at the investor conference was largely that experience. And we've made enormous changes to the platform. We've gone from using an outside hosting source to doing it ourselves. We've dramatically improved the stability of the site. We've basically been without issues with the new site. And so we began to slowly roll that out. We rolled out Vons at the end of January, so we have 24 weeks experience with Vons. We then rolled out Portland and Seattle on the same day. That was in the middle of May. So we have 9 weeks experience with that. So that is still maturing, meaning that there's still a fairly active increase in registrations as we move along. And then in the middle of June, we rolled our Eastern division, our Denver division and our Phoenix division, all in the same day. And so we have about 5 weeks experience with each of those. And then we just recently again, early in July, went live with our final U.S. division.

And so there's a lot of registration and a lot of trial and a lot of conversion to regular use that has yet to go on in these later divisions. And we are also -- just last week, we launched, call it a relaunch, if you will, we never marketed, in any serious way, the Northern California launch because we had some concerns about the stability of the platform. And so we expect probably between now and the end of the year, we'll double our registration in that market alone. So by the end of the third quarter, we should increase our users, both regular and more casual users, by more than 70%. Between now and the end of the year, we should increase those users by more than 100%. The site has performed well. The consumer experience is significantly better than it was 80-plus weeks ago when we launched in Dominick's in Northern California. And we make enhancements to the experience virtually on a weekly basis to constantly listen to consumers and improve that consumer experience. Each launch has performed better than the previous launch as we continue to learn. And we will be shifting here on the back half of the year from what I call a very active registration process, which you can translate into one that's more expensive, to one that's more passive, which is one that relies on less expensive mechanisms to encourage registration and use.

So how are we performing? At the investor conference, we gave you some information about registration. We talked about the need to register people. We talked about the need to get people who are registered to actually try the service. And then we talked about the conversion to regular use. And finally, we talked about the incremental spend. In terms of registration, I would say that we're on track with the registration, not breaking any track records there, but we elected to actually compress the time period in which we register the people we anticipated registering. And that's where some of the one-time expense is associated. So we thought better to run hard for say, 8 weeks than to sort of drift this thing out over a period of 16 to 24. So registration, on track, trial. We indicated at the investor conference that we were getting about 70% of our customers who had registered to actually try this. And that holds true today. We actually think that as this matures, that we will get actually better trial than even that. And we have some ideas on how to do that. The conversion to regular use is running 20% greater than what we anticipated. And most importantly, the incremental spend for regular users is 100% greater than what we anticipated. And the incremental spend for that casual user is more than 50% greater than what we anticipated. So all in, we're very pleased with the results of just for U and looking forward to continue to increase that registration and ultimately, regular use.

Shifting to other notable events in the quarter, we purchased 11.6 million shares at an average price of $20.78 per share for a total of $240 million. This left us with 239.5 million shares at the end of quarter 2. And so we've now purchased 30% of the outstanding shares of the company in the last 9 months. Touching very briefly on Blackhawk, as we expected, Blackhawk continues to run strong numbers. And they had a 23% increase in load value on the quarter.

And then finally, let me just touch on guidance. Our guidance remains unchanged from what we provided earlier in the year. With that said, I want to give you a little color for those of you that like to be correct on the quarterly pattern. The sale of the Genuardi's, results in some expenses which are clearly associated with the sale and the closing of those stores. But under accounting convention, some of those expenses will be booked in continuing operations as opposed to discontinued operation. I'm not an accountant, and maybe Robert can explain that, but I can't. So that will affect us $0.02 a share. Again, it has no effect on our guidance for the year, but that will happen in the third quarter. So if you anticipated that, I didn't. If you anticipated that, it's in your number already. And then also, we had a pretty significant weather event. Again, it doesn't affect our guidance at all. But we at one point had 53 stores without power in our Eastern division. And we had some product loss, had some sales loss, and that will cost us $0.01 a share in the quarter.

Now separately, we expect to book a pretax gain against discontinued operations of some $75 million. But in the continuing number, you will see this $0.03 a share. So from my vantage point, it nearly affects the pattern. It doesn't really affect the final number. We expect our volume and sales numbers to continue to improve. We think we've figured out how to take share across the all-outlet channel and we expect that to continue. So with that said, Melissa, I'm ready to take questions.

Melissa C. Plaisance

Okay. Shirley?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Deborah Weinswig.

Unknown Analyst

I'm Amy [ph] with Citigroup. So Steven, as you dived into the details, and we appreciate the transparency on just for U, why do you think that the results have been so much better than you expected?

Steven A. Burd

It's a good question. I think that I would attribute it to a couple of factors. When we first launched in Northern California in Dominick's and we were using a third party to host the site, we had some pretty significant growing pains. And so, we didn't have the confidence to go out to the media and explain what we were doing. Once we put it on our own site and it became stable and we were confident of that, which is post the Vons launch, we actually did a lot of media outreach. And so in virtually every market where we launched, we got extensive, I mean tens of millions of impressions, 2 and 3 minutes on television, introducing this concept and often with the newscasters themselves having signed up for just for U. So that's one factor. The other factor is that we didn't know how to gauge the mobile application at the investor conference. And so the mobile application came into the Vons environment after that launch, whereas in all other launches, both the iPhone and the Android application went coincident with that. And then I think third, we got a lot smarter about how to use our in-store data to explain the benefits of just for U. Professionally trained, very knowledgeable and can be just as helpful as the call center might be should someone struggle with the registration process. So I think all of those things clearly helped on the registration front and it helped on the consumer experience front. The mobile application is really important here because what we've always said was the virtue of this thing is you can do it on your downtime. And so the downtime is really important. You don't have to be wedded to a desktop. And so mobile users use just for U at a rate 50% greater than those that are confined to a desktop. So all of those factors, I think, have led to our success. And then I guess I would give you one last factor. I think the -- as I look at the maturity and relevance of the offers, they are so much more relevant today. It's really like having your own personal ad. And so the personal -- what we call the personalized deal section, that's very tailored to every single household. Those are the things you actually buy. And so I think all of those factors have contributed to better results than we expected.

Unknown Analyst

And one really super quick follow-up on this. I know that you've partnered closely with the vendors on this. Would you say that they've also been impressed with the results?

Steven A. Burd

I didn't hear the question. Melissa's repeating it, are the vendors impressed? I would say the vendors are very impressed. They're -- we're doing a number of things with the vendor community. Obviously, they're supporting this effort, but we've done some things with new trial where the numbers are off the charts. We talked about those at the investor conference. So early on, we started with a small handful of vendors and I can think of one major player that didn't seem that interested. And so we just sat back and waited for the phone to ring and now, they're in. And everybody wants in on just for U. So very good support from the vendor community.

Operator

Your next question comes from John Heinbockel.

John Heinbockel - Guggenheim Securities, LLC, Research Division

Guggenheim. So Steve, a couple of things on just for U. Maybe talk about the -- as any competitor, doesn't really matter who it is, would launch an offensive against you or others in the market, just maybe just contrast how you would deal with that in a just for U environment as opposed to pre-just for U, how that would be different and what the benefit would be to you?

Steven A. Burd

John, I was thinking this morning as I came into the office, the vision for just for U actually started about 12 years ago. And I thought how ironic. We had this notion of being able to personally price items to people before the Internet even existed, before the iPad existed, before the iPhone was created. And now all of that enables us to do what we're doing today. So in the case of a competitive opening, we can look at our loyalty card data, we can see who is attracted to try that new competition, and we've done this. And we can see what business -- we don't lose all of their business, we lose some of their business. We can see what business we're losing. We can look at the competitor and see what might be attracting them. And then we can tailor a program that is just for them and put it in a secure place that only they can access it. And we've been able to take, I think I commented on this at the investor conference, take a store that had a competitor open a large volume store, doing over $800,000 a week. A competitor opened literally a block away, we lost about $50,000 of business. We then tailored our offer to those that were attracted to that competitor and 5 weeks later, we had $70,000 business back in our stores. So we got the $50,000 back plus added to that. So right now, we're busy getting registration, getting trial use, getting conversion, but we have an entire effort here that is solely devoted to that kind of competitive activity.

John Heinbockel - Guggenheim Securities, LLC, Research Division

But what about -- I was thinking more pricing, right? So someone adjusts pricing in a market, what do you do in a post just for U world? Do you discuss -- it's not going to be one geographic location you can zero in on. Do you look at, okay, changing patterns in the frequency of shop and then target those customers who've clearly changed their pattern? And if you do that, how long do you wait to know that it's changing pattern?

Steven A. Burd

Yes. You would typically look at a pattern probably in no period short of a month. In addition to people that are signed up for just for U, we have other people that are registered from safeway.com. We have others for which we have their e-mail address. And we can actually focus in and provide a unique offer with a unique price to about 70% or 75% of the sales represented by the households that shop with us. And so in -- without just for U, you were stuck basically doing something for everybody in the trade area. And so, we basically can provide the right prices for the right relevant items to the right customers. In the rollout of just for U, we promote the notion that this is a way to save an additional 10% to 20% off your grocery bill. The average just for U household today is saving 10%. Some are saving north of 20%. So you can -- and so that makes us for those individuals who have chosen to sign up, and it's easy to be relevant on unique items for them as opposed to take your prices down on all items for everybody. I'd rather have the prices that were right for me than right for somebody else. So in the scheme of things, it doesn't really cost us any more money, particularly given the support that we have, and it allows us to be extremely price-competitive on a totally sales basis.

John Heinbockel - Guggenheim Securities, LLC, Research Division

So you would say you can see the reaction faster than you could before and the cost to react to whatever somebody is doing is a fraction of what it would've been before?

Steven A. Burd

The cost to react is a fraction. You're absolutely correct.

John Heinbockel - Guggenheim Securities, LLC, Research Division

Okay. Now -- and how does just for U impact -- we're headed back toward a more inflationary environment next year. How do you think that changes your ability to manage that? I guess there are some households that can absorb it more easily than others and have shown in the past that they're willing to take the price increase. Does it change the way you manage putting through price increases?

Steven A. Burd

I think over time, John, the shelf prices become less and less relevant. We'll still have to go to the shelf with a respectable price. But we look at our shoppers lots of different ways and we know who's more price sensitive than others, and we can accommodate that to win their business. So the incremental spend is about giving them prices on things that we know they would buy. And then they consolidate their shopping experience, and they buy other things with us that wouldn't necessarily be on a digital coupon or on the personal deal. And so, I think the opportunity here is an Internet opportunity to be able to give individuals what they want or what they need. And I think that's really -- that's why we're being successful right now.

Operator

Your next question comes from Scott Mushkin.

Scott Andrew Mushkin - Jefferies & Company, Inc., Research Division

It's Jefferies. I want to take a little bit of a turn on the questions here. I want to talk a little bit -- you bought in 30% of your stock at a much higher price. Kind of the verdict's in today, a little surprising to see the stock down as much as it is. Is there anything else that you contemplate, Steve, when you look at this? I mean, clearly, the management team and the Board use it much differently than the public markets. Do we -- one of your competitors just announced they've gotten people in to think about what to do with that company. I mean, do you go further with this? I mean, kind of frame it for me how you're thinking about it, especially with the market reacting the way it is today, which seemed to be at least decent results?

Steven A. Burd

Yes. I think that -- I mean, it's always difficult to predict the market reaction. What we act on is what we believe is the intrinsic value of the stock. And we, who work the business, will forever have more information, more confidence in what we think we can do than certainly the street during uncertain times. And so we have -- we talked pretty extensively here about how we intend to grow ID sales, how we intend to capture market share. We're now doing it across all channels and how we intend to grow operating profits. You're really saying -- what you're seeing is the first leg of a 3-legged stool here. And you're seeing it in its infancy. And that's where our confidence comes from. So I think that when -- sometimes when somebody else struggles, people say, "well, gosh, I guess everybody is struggling." And it never really occurs to them that others who might be having some level of success might actually be contributing to the struggles of others. And so I think that -- I'm a big shareholder in this company. I've never felt better about my shareholdings in the last 5 years than I feel today.

Scott Andrew Mushkin - Jefferies & Company, Inc., Research Division

Great. And then a follow-up on -- I want to make sure I understood something. When you were going through kind of the 12-week period, you had said in just for U divisions, did that apply -- did that apply to the 1.2% ID sales that you're running in those 12 weeks or was that for Safeway overall?

Steven A. Burd

That was in those divisions.

Scott Andrew Mushkin - Jefferies & Company, Inc., Research Division

Do you want to provide the number for Safeway overall?

Steven A. Burd

It would be -- to be honest, I haven't -- I haven't looked. I think it's probably down a tick. It's probably around 1%, something like that. When I prepare for this call, I look at -- I had to look at so many different timeframes and dimensions. But if I say 1%, I'm at least within 1 tick of that number. I think it's 1%.

Scott Andrew Mushkin - Jefferies & Company, Inc., Research Division

Great. And then one final one, just for U performing better. But I think at the Analyst Day, you talked about a 200 basis point lift in Chicago, if I'm remembering correctly, in the comp. It doesn't seem like you're getting that. So I'm trying to triangulate the idea of what happened in the...

Steven A. Burd

Yes, first of all, I would remind you that it's early in the cycle. Secondly, we just experienced about 300 basis points of price per item decline. And so I actually think that under the circumstances, that's a 0.8%, and now that 1.2% is a pretty good number. And then I agree with John Heinbockel's comments that I think that you will see -- I think we're at a low point on price per item right now. And I think what you're going to see is you're going to see that move north as we move through the balance of the year. And as you know, the price per item inflation at retail has been around 3% for an extended period of time. I think we'll be below that this year. I think the new sweet spot for inflation is probably closer to 2% than it is to 3%. And right now, we're running below 2%. And if you look at the center of the store, the price provided by the consumer packaged goods industry, that inflation is pretty consistent with those historical numbers. It's in that 3%, 3.4% range. It's in the perishable side of the business that -- and probably part of that is going against some extraordinary inflation from a year ago, particularly right now on the produce side. But what we're doing on the produce side is we're compensating with large volume gains on the produce side. So we have to do that to make up for it. So I think that follow the volume numbers, inflation will follow its own path as long as that is hovering in around the 2%, 2.5% range, I think that'll be good. And then we'll have 2 more legs to the stool. And so -- we said at the investor conference, I think, that we thought that you would be able to see the benefits of just for U late in the third quarter. Well, we would argue that you've seen them actually here in the second quarter. You will clearly see it throughout the third quarter.

Operator

Your next question comes from Meredith Adler.

Meredith Adler - Barclays Capital, Research Division

Just for U sounds very exciting. I actually -- I think I'll ask a big picture question, and this is just something that I've been struggling with. Any idea why we're seeing such weakness in volume in all channels? Where are consumers eating? It's not restaurants.

Steven A. Burd

Yes. I think that what's happening is that there is so much uncertainty in the economy that, that is contributing toward a consumer that is very, very cautious. And you've heard me talk for over a year now about the bifurcated recovery. So you have to x out that 20%, 25% that feels confident is maybe seeing some recovery in their net worth, hasn't lost their job, doesn't think they're going to lose their job, and it's the high-end retailers and everything is going fine for them. But for the other 75% of the economy, they believe they're in a recession. It doesn't matter what the GDP says. And so when you look at the center of the store, which contains a lot of processed foods, that is going to be -- it's going to be affected by that. And so their volumes are down, and it's probably also true that some of those companies with international operations are spending a little bit more energy on the international front because those look like opportunities for growth and not in the U.S. So that's probably affecting them a little bit. But I -- I've always said that I think that consumer confidence is the single most important thing for you to look at as a bellwether of what's going to happen in the overall economy. And I haven't done this, but I would bet you that if you correlate CPG volumes with consumer confidence, you would find a very tight correlation. So what we're trying to do here is we have -- we can't affect the economy. We can only affect ourselves. And while I know, looking at some of the banner headlines this morning, what people are looking at, net income being down, somebody had to be thrilled that we're gaining market share across all outlets because that's really where it starts. It starts by gaining share and if any -- if -- we've done a terrific job of controlling costs and we're one of the most efficient operators out there given our cost structure. And so we don't have that much opportunity. We -- every year, we become more efficient. But basically, you've got to gain market share. And you've got to gain it across all channels. And we think we have a strategy that will do that. You haven't seen all of it, you're seeing a piece of it. But nice to know that the first piece actually got the boat going, and that we're gaining share across all outlets.

Meredith Adler - Barclays Capital, Research Division

And so what you're saying is there is actually pantry de-loading?

Steven A. Burd

I think people are making different choices about what they buy. And they're really trying to stretch their budget. I mean, I don't want to pick on any particular commodities, but let's take, I guess I have to, let's take ice cream, okay? Let's take filet mignon. I mean these are luxury items, maybe not ice cream so much, but it was a treat when I was a kid, so I think in some households, it is. Popsicles could fit in that category. And so people make different decisions and they spread their money further. And they buy more chicken than beef and those kinds of things. So I think that's what drives it, and processed foods can carry a premium. So if you stay away from processed foods and do more work yourself, you can actually put together a budget that spends less money.

Meredith Adler - Barclays Capital, Research Division

And then if I could just follow up with this because we started talking about what may happen to inflation next year, and this is a theory of another big food retailer that 2% to 3% is certainly better than 6%, but it's 2% to 3% on top of 6%. And next year, you may get another 2% to 3% on top of what you had this year and the year before, doesn't that make consumers even more cautious?

Steven A. Burd

Well, first of all, we don't see 6% this year.

Meredith Adler - Barclays Capital, Research Division

No, no, no. Last year.

Steven A. Burd

Oh, last year. Well, we didn't have 6% last year, either. So inflation this year, if you look over the entire recession period beginning in 2008 and you look the cumulative effect of 2 years of deflation as 1 year of inflation now return to moderate inflation, subpar inflation, and I'm not among those predicting more than 3% inflation next year, I think you're going to have a 5-year period that's less than normal. Now the other factor that you currently talk about repeatedly is what happens with gasoline. I mean, I think that has this -- that's this exogenous factor that affects the way people spend money on food. And while those prices have come down recently and now they're a bit stable, very important to keep an eye on the price of gasoline as well because it does affect how people spend money on food.

Operator

Your next question comes from Ken Goldman.

Kenneth Goldman - JP Morgan Chase & Co, Research Division

JPMorgan. Can you talk a little bit about what you're seeing in Chicago, if anything, from your competitor, your main competitor there who's struggling a little bit right now? They've talked about being a little bit more aggressive there. What are your expectations? How aggressive do you plan to be in response, if necessary?

Steven A. Burd

When they first made their announcement, and I remember the day because their stock were up 12%, there was this impression that somehow, they were going to invest heavily in price and somehow that was going to affect us. Well, when we look at our full book price check, it's really not possible for them to do any price reduction that could be sustained without turning their cash flow negative that would even allow them to get anywhere near our prices. So there really is no need for us to react. They're free to lower their prices, but there will be no need for us to react. And I think that's true, I think that's true of most people. Now what we have seen in Chicago is we -- over 20 years, I have seen a lot of people say, lowering 10,000 prices. Well, they don't tell you if 3 days later, they raise 12,000 prices. They just tell you about the low rate. Now I'm not saying that's happened in Chicago, but we saw the announcement, we saw some price reduction and in the last 3 weeks, we've sort of said, "Well, what happened to that?" And so we don't worry about this at all. In fact, we view this as a marketplace opportunity.

Kenneth Goldman - JP Morgan Chase & Co, Research Division

Okay, that's helpful. And then can you talk a little bit about the long-term potential for just for U? A couple of questions embedded in that. Number one, how do you -- I know it's -- like as you say, early days, so maybe I'm looking too far ahead here. But how do you look at the percent of customers you want to, and eventually can be, on just for U as regular users? What's the long-term opportunity there? And then how do you protect, if you are successful, and it sounds like you are, against competitors coming in and doing something similar? Just curious how you intend to answer those.

Steven A. Burd

Sure. Well, first of all, I think that in the -- let's talk about the short term. In the short term, I believe, and I'll describe that as by the end of this year, we'll probably have households representing about 35% of our business that will be just for U participants. Now we've invented this from whole cloth, we're not following anybody's lead, so you're guessing a little bit. I'm not -- I think had you asked Apple how many iPads they might sell in the year 2012, when they first introduced it, they couldn't really tell you. But I think it's logical to think that about 65% to 70% of our sales maybe 2, 3 years from now would be represented by just for U participants. I think that's not an unreasonable number as people start feeling left out and not participating. And to me, everything that you read about in the world of marketing probably launched originally by somebody like Amazon. Is all about personalization. And so we stand here as the first retailer, clearly food retailer, to have this kind of personalization. Now I believe that those that can -- that others will follow. That others are trying to do this right now. I believe that we have a substantial lead. Remember, the vision started 12 to 14 years ago. The effort itself started about 3 years ago. The pilot was almost 2 years ago. And so I think to get to our current level of play, minimum of 18 months, maybe longer, and we'll be so much better 18 months from now that it won't really matter who else is in this game. But I think those that survive in the conventional space will be about personalization. I think that personalization will permeate the retail industry, the bricks and mortar industry in a very broad way. It's the only way for them to compete with the Internet. We don't have that much Internet competition. We have some, but not that much. And so I commented earlier it may have not been focused on by others on the call. But one of the reasons I said that we're doing so much better than we thought, the relevance of what we offer consumers is so much better than it was 2 years ago because we've gotten better at this. And we have -- think of this as just for U 2.0. And we know what 3.0, 4.0 and 5.0 looks like. And we literally make a change either to how we go to market or more often than not, a change, a subtle change on the website virtually every week. And the list of things that we want to do would fill a small binder.

Operator

Your next question comes from Karen Short.

Karen F. Short - BMO Capital Markets U.S.

BMO Capital. A couple of questions just on, I guess, gross profit and SG&A. First, on gross profit, you gave the 20 basis points that you called out on costs and I guess ad spend for just for U. So I mean, I got about $108 million. What was the split between the 2, I mean given that ad spend's usually only about kind of $450 million to $500 million for the full year? That number just seems very high.

Steven A. Burd

Yes, you're off by a 0 in your number. And the 20 basis points of one-time costs for just for U actually cuts across both gross margin, O&A. So I was talking about that shortly after I looked at the operating margin decline of 9 basis points, and then just saying keep in mind that of that 9, 20 of that, which means it consumes the 9, is explained by the one-time cost associated with launching just for U.

Karen F. Short - BMO Capital Markets U.S.

But all of those go away by the end of the third quarter?

Steven A. Burd

Yes. The -- there are some ongoing costs associated with just for U, and I am not including those in this definition. I mentioned earlier that we have a fair amount of support in the stores, employees equipped with iPhones and iPads. I've got a deli manager. We've allowed -- it used to be against the rules for our employees to have a cellphone on the sales floor. If they have a smartphone and they are registering a customer for just for U, that's a perfectly permissible application. And so we have employees throughout the store with smartphones that maybe are not assigned to duties of registering customers, but if they have a smartphone and they're installing the virtues because remember, they all play in this game. One of the first things we did was we made sure that the employees got all signed up, understood the benefits, understood what we launched 2 years ago versus what we launched today. So that employee cost of people assigned a task of registering people, that's a launch cost. The point-of-sale material that we put in the stores, that's a launch cost. The advertising focused entirely on just for U, that's a launch cost. And then there was some training associated with the employees to get them ready to deal with this, that's a launch cost. And so those are all investments that have been made. And then we have a modest amount of cost that, where we spiked early on, some of the markdowns. But we're not doing that anymore. We're allowing the 10% to 20% potential savings is the primary benefit as the rationale to sign up. When we launched historically, we would offer free eggs as an inducement. But we don't offer free eggs anymore. So those are launch costs, and what we envision, particularly with the engaged employee workforce, is that we'll have help in the store virtually for perpetuity because we're going to have so many experts in-store that have their own experience that -- and they'll be identifiable by the customers so that if they're having any difficulties -- one of the challenges with doing this is that people often have multiple phone numbers on how they access their club values or they have multiple cards. And in that case, it's a -- it can be a struggle to register someone. That's why this employee is so important, that's why the call center is important. So that gives you a feel for the launch costs, and then we have to make a decision about how long we engage some of that. We have a basic plan, but if the sign-ups are happening at rapid pace, we might extend some of that employee help in the stores or we may pulse it. But essentially, we believe that by the end of the third quarter, you'll see largely what I call passive mechanisms to encourage registration and use.

Karen F. Short - BMO Capital Markets U.S.

Okay, that's helpful. And then on SG&A, just looking at your SG&A dollars, excluding depreciation, basically flat year-over-year. Anything to call out there in terms of cost control or was there anything one-time in that?

Robert L. Edwards

Well, if you recall at the investor conference, we laid out our cost savings plan for the year that we're on plan with that, performing well. Some things have done better than planned and some below plan. We've actually, as we normally do, added items to that list as the years progress. So I think the key takeaway on cost reduction is we're on plan.

Karen F. Short - BMO Capital Markets U.S.

Okay. And then last question. Steve, you mentioned some -- the competitive environments in your opening remarks. Has it gotten worse? Are there any comments on what the changes have been in the competitive environment or the customer environment given your -- one of your competitors' comments, last week?

Steven A. Burd

Yes. I think that -- I'm not sure what I said at the opening, I think the environment is a tough environment. I don't think that the competitive environment is any tougher than it was anytime in the last 3 years. I don't consider this to be a particularly competitive environment.

I mean, I think that it's the economic melees that is overhanging, particularly on 75% of shoppers. But again, I don't want anybody in this call to get the impression that we're sitting here hoping the economy gets better. We're contemplating that the economy gets no better. And we're contemplating that we're going to take market share in spite of it.

Operator

Your next question comes from Ed Kelly.

Edward J. Kelly - Crédit Suisse AG, Research Division

Crédit Suisse. Steve, what percentage of the company has just for U in it today?

Steven A. Burd

Well, essentially, you've got all U.S. divisions. So only Canada is left out. The U.S. divisions represent 85% of sales. But keep in mind, our last division, where we are with that is the employees have been on-boarded and are using just for U. The mobile application is out and exists, and so consumers at large can access it. But we have not begun the marketing and -- in that division and that will happen shortly.

Edward J. Kelly - Crédit Suisse AG, Research Division

Okay. And is this something that you think you would be rolling out to Canada at some point?

Steven A. Burd

Absolutely.

Edward J. Kelly - Crédit Suisse AG, Research Division

And my other question for you is that, it's just on ID guidance. And the midpoint of your ID guidance seems like it assumes in the back half about a 2.5% ID. And I have to imagine that this is going to ramp. So it may even assumes that Q4, for instance, has a free handle on the ID. And I think this is where the market has some questions around guidance.

So maybe could you just help us understand sort of why you have the confidence that, that's the type of ramp that we're going to see in the back half of the year? And I'm sure it's related to just for U, but I don't know if there's a way that you can help us better get our arms around that.

Steven A. Burd

Sure. First of all, we always believe that the fourth quarter would be our strongest quarter. And I'll go back to the 3 legs of the stool. First on just for U. I said that by the end of the year, we will have more than doubled the participants in just for U. And frankly, there is an opportunity to triple that number. But right now, I would say safely that we should be able to double that number. And that will be very incremental to sales. We have a fuel loyalty program that will be materially enhanced in the back half of this year. And then I have also mentioned, beginning with the investor conference, that we have a wellness play that also plays out, in all likelihood, in the fourth quarter, not the third quarter. So those are the 3 factors that give us the confidence that we're going to have an impressive number come the fourth quarter. Again, one of the comments that I made at the investor conference because I think people were -- I think people looked at just for U and thought, "Wow, this is pretty impressive. I wonder if they can pull it off." And what I said at that investor conference is that there is nothing that I have talked about, particularly in building sales and market share, that doesn't materialize in -- by the end of this year. So it's not like we're going to be talking about this thing 2.5 years from now and say, "Well, gosh, did it work?" It happens as you've described. It's embedded in the guidance that it happens in the third and the fourth quarter. And that's always been our point of view

Edward J. Kelly - Crédit Suisse AG, Research Division

You would encourage us, I guess based on the guidance, to probably think about Q4 as a bigger weighting, which means sort of a 3% or better idea, I guess?

Steven A. Burd

I would encourage you to think about -- yes. Despite -- the comments that I made about some things affecting the third quarter EPS, that's one factor. And then you correctly pointed out that this much larger increase in ID sales, I'm not going to put a number on it for you, but a much larger increase in ID sales as a result of the things that I just said, that's a fourth quarter event which is the reason why the fourth quarter is expected to be so much stronger, both in terms of EPS than the third quarter. So you've got it.

Operator

Your next question comes from Jonathan Feeney.

Jonathan P. Feeney - Janney Montgomery Scott LLC, Research Division

It's Janney. I want -- you turned around a few numbers, Steve. I just wanted to be clear. Your price per item declined 40 basis points, you said? And if that -- correct me on that number or let me know, and how do you think that price -- your price per item would -- compared with all channel or some of your direct competitors, will you -- do you think you are more competitive than others in the marketplace or was that not -- was that a marketplace number?

Steven A. Burd

Okay, you're confusing the numbers. I didn't actually give a price per item number in the quarter. I can give you one now. It -- the price per item for us was 1.8% increase. Now let me just clarify why you got maybe a little confused on the numbers. I also said that our price per item right now was running a little less than 1%, but we expected that to sort of pick up. Now we measure -- that's our measure of inflation. We measure that at retail. So there are some other retailers that measure that at cost. And one of the last earnings reports that I heard, they had a substantially higher number although their number had come down, and they were predicting it to come down more. And so I think that if you could -- if you could ask other retailers to give you the number comparable to ours, they should have a fairly comparable number, although it does move around by geography. And I said that I think that inflation will be, on the year, 2% to 3%, but much closer to 2% than it is to 3%. And so I think the fourth quarter will have more inflation in it.

Jonathan P. Feeney - Janney Montgomery Scott LLC, Research Division

That's good to know. But you -- so the 1.8% for this quarter, for the second quarter, would you say roughly comparable to what you think competitors did in the marketplace -- in your marketplace?

Steven A. Burd

In terms of inflation?

Jonathan P. Feeney - Janney Montgomery Scott LLC, Research Division

Yes.

Steven A. Burd

Yes, I would think it would be roughly comparable.

Jonathan P. Feeney - Janney Montgomery Scott LLC, Research Division

And I guess just as a follow-up to that. When I think about just for U, I mean, I think ultimately, if success is going to be more effective use of basically the Holy Grail, I mean a personalized, more effective use of promotional dollars. But that said, the more effective it is, the more you'd be tempted to spend, right? So I guess given that implementation, do we -- do you expect to -- you made a little gross margin adjustment here. Do you expect it to grow out -- you've said that your implementation of just for U is very successful and you're probably going to want to lean on that leverage and drive a little bit more traffic and maybe sacrifice gross margin or is that a -- or wouldn't that work the other way?

Steven A. Burd

Yes. I think that you got to separate the short term from the intermediate term. And so we still have launch costs associated with the third quarter because some of the costs that I referred to will be born between now and the end of the third quarter. But I think that -- we have some temptation to spend a little bit more money and accelerate our growth in registration and use, but we'll only do that if I can find some money to pay for it. So we don't get -- we're interested -- we've always been interested in growing sales, share and profits. And we don't put any effort constraints on our ability to grow earnings per share. We believe that if we've done something unique that we ought to get rewarded for that and we ought to reward the shareholders accordingly. So I think that what I just said sort of translates into a tougher gross margin in the third quarter, a much stronger gross margin in the fourth quarter as you try to think about that. But we're -- as we interest others in the vendor community, they have things that they like to do with just for U that we haven't even done yet. And so we don't think that this is -- we think long term, this is a gross margin enhancing. So why wouldn't you want to provide the right milk price to people that really need a certain milk price, and then provide, let's say, a ground beef price to somebody where ground beef is important, and the list goes on. So you're really going from a mass-marketer, where all you have is your advertising to promote that, to something that's really highly personalized. And we've got countless examples of people that used to spend $50 for this and now spend $150 for this. So we want more of that.

Operator

Our next question comes from Chuck Cerankosky.

Charles Edward Cerankosky - Northcoast Research

Northcoast Research. Steve, can you talk a little bit about a couple of things? One, what's going on with Northern California labor negotiations? They seem unusually complex with the 3 players, at various levels of disagreement, if you will, with the UFCW. And then also, how would you look at debt reduction from the midpoint of 2012 over the next 18 months?

Steven A. Burd

Okay. On the Northern California labor, I think from the outside looking in, I'm sure these things -- they always look tougher on the outside looking in, than they do if you've been doing what Maria and I have been doing for the last 20 years. Northern California is a market where more often than not, we bargain alone. And I think in this particular case, we're very comfortable with that. There are other markets where we prefer to bargain with competitors, but you got 2 competitors in this market that I think are struggling. And so they have independently done their negotiations, didn't want to be tied to anybody else, and so that will follow its path. And I think this will -- we're confident we'll get a good result, we're confident that things will settle, but they'll settle in their own time. So we're not worried about Northern California, even though it's our largest market.

Robert L. Edwards

And Chuck, on the debt reduction question, given that we've front-loaded our share repurchases, the primary use of cash between now and the end of 2013 will be first, paying the dividend and then secondly, debt reduction. So it'll be a major focus over the next 15, 16 months.

Charles Edward Cerankosky - Northcoast Research

Robert, how do you think CapEx will look in 2013 versus this year?

Robert L. Edwards

We haven't given guidance, Chuck, on CapEx, but consistent with the 5-year plan numbers we gave at the investor conference, I think we'll be in that range. Again, we're ramping up CapEx on PDC, but given the condition of our assets, the percent of stores that have been Lifestyled and relative to our historical spending and looking at other competitors, CapEx as a percentage of sales, we should be in good shape there.

Operator

Your next question comes from Priya Ohri-Gupta.

Priya Ohri-Gupta - Barclays Capital, Research Division

Barclays. I just wanted to ask 2 quick questions, if I may. Can you please discuss the uptick in debt that we saw sequentially in the quarter and sort of what drove that? And then secondly, just a follow-on to the last question. If you think about debt reduction, should we continue to expect the CP balance to be close to 0 by year-end, and to see that $800 million August maturity paid off using cash versus CP?

Robert L. Edwards

Yes, the debt that we have coming due in August, we expect to pay off. It will be -- we have a strong cash flow quarter in Q3. We have the cash coming in from the Genuardi's sale. The real estate activities that have been in our plan, we talked about at the investor conference, will impact that, and so we feel pretty good about paying the debt off in August. The increase in debt sequentially is primarily the $250 million of floating rate notes that we issued during the quarter. So we feel good about our ability to pay the debt off and the focus.

Priya Ohri-Gupta - Barclays Capital, Research Division

So the FRN issuance to be cleared would not use to refinance the outstanding CP? It was...

Robert L. Edwards

Oh, no we did. Yes. No, we did. Yes, we used that to pay off CP, right.

Priya Ohri-Gupta - Barclays Capital, Research Division

So -- but that wouldn't have led to an uptick in the absolute debt amount...

Steven A. Burd

It was share repurchase.

Robert L. Edwards

Yes, it was the funding of the share repurchase program.

Priya Ohri-Gupta - Barclays Capital, Research Division

Okay, that's helpful. And we should still expect CP to be close to 0 by year-end?

Melissa C. Plaisance

Yes.

Robert L. Edwards

That's our goal.

Melissa C. Plaisance

And in addition, we do have cash that has been building in Canada that we'll bring down, that will help pay off the $800 million dollars in August. But we will draw some commercial paper to that because some of our cash flow for this year will come in the fourth quarter. We'll pay that off before year-end.

Priya Ohri-Gupta - Barclays Capital, Research Division

Could you talk about the split between CPM cash that's going to be...

Melissa C. Plaisance

No, we can't be that precise.

Operator

And our final question comes from Colin Guheen.

Colin Guheen - Cowen and Company, LLC, Research Division

Cowen & Company. Question is I understand the timing of the rollout by market. Steve, can you just give us a sense of the number of people that are actually registered for just for U, and how you expect that to trend going into the back half, as I understand the success and converting those registered users into trial users? But just wanted to get a sense of how many people are actually registered and how that ramps throughout the year.

Steven A. Burd

I can understand your interest in the number. Because I believe others will try to replicate what we're doing, I don't want to put that number out there.

It might provide too much encouragement. But suffice it to say, we feel very, very good about the number and our ability to continue to grow that. We have multiple ways to grow registration once we have a nucleus that doesn't require a lot of incremental spend. The other thing to think about is that once I have somebody registered, I've got a group of regular users that are high users and then I've got some casual users, and so I can now spend modest amounts of money to convert those casual users into regular. And I can do that spending less money than registering new people. And those are sort of the ways we think about it.

Colin Guheen - Cowen and Company, LLC, Research Division

Great. And just unrelated. Just maybe a little color on the recent green price inflation it seems to be. It could be fairly long lasting. I mean, what's the likelihood that, that could fuel another 3% plus inflation environment in grocery where it's had some demand pushback?

Robert L. Edwards

I think it's too soon to tell. I mean, obviously you're reading the same articles and following the price curves that we're seeing. But I think it's too soon to tell how that's going to affect prices next year.

Operator

Thank you. And I'll turn the call back over to the speakers.

Melissa C. Plaisance

Okay. Thank you, everyone, for participating today. Christiane Pelz and I will be available for any follow-ups for the rest of the day. Thank you.

Operator

Thank you. And this does conclude today's conference. We thank you for your participation. At this time, you may disconnect your lines.

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