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Executives

Carin Fike - Investor Relations

David B. Dillon - Chairman of the Board, Chief Executive Officer

W. Rodney McMullen - Vice Chairman of the Board

Don W. McGeorge - President, Chief Operating Officer, Director

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

Analysts

John Heinbockel - Goldman Sachs

Deborah Weinswig - Citigroup

Edward Kelly - Credit Suisse

Scott Muschkin - Jefferies & Company

Karen Short - Friedman, Billings, Ramsey

Meredith Adler - Lehman Brothers

Doug Cooper - UBS

Mark Wiltamuth - Morgan Stanley

The Kroger Co. (KR) F1Q08 Earnings Call June 24, 2008 10:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the first quarter 2008 Kroger Company earnings conference call. (Operator Instructions) I will now turn the call over to 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. Actual events or results can differ materially. A detailed discussion of the many factors that we believe may have a material effect on our business on an ongoing basis is contained in our SEC filings, but Kroger assumes no obligation to update that information.

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

Before I introduce Dave, I want to remind you that our annual shareholder meeting will be webcast live on Thursday, June 26th at 11:00 a.m. Eastern Time. More information about the webcast is available on our website. We invite you to join us Thursday over the Internet or listen to the replay.

Now I will turn it over to David Dillon, Chairman and Chief Executive Officer of Kroger.

David B. Dillon

Thank you, Carin and good morning, everyone and thank you for joining us to review Kroger's first quarter 2008 financial results. With me today are Rodney McMullen, Kroger's Vice Chairman; Don McGeorge, Kroger's President and Chief Operating Officer; and Mike Schlotman, Senior Vice President and Chief Financial Officer.

I will begin with a brief recap of Kroger's first quarter results and our updated guidance for 2008. I’ll also discuss the progress we are making with our Customer 1st strategy. Rodney will share additional details about Kroger’s first quarter results and the 2008 guidance. Then we will be happy to take your questions.

We are off to a strong start for fiscal 2008. Today we reported record earnings of $0.58 per diluted share for the quarter. Net earnings in the same period last year were $0.47 per diluted share and recall that our 2007 results included charges related to labor unrest at one of our distribution centers. This reduced earnings by approximately $0.02 per diluted share.

First quarter sales were also strong. Total sales increased 11.5% to $23.1 billion. Identical supermarket sales increased 9.2% with fuel and 5.8% without fuel. Growth was broad-based across all geographic regions and most departments with particular strength in grocery, nutrition, and deli/bakery.

Kroger’s performance during the quarter demonstrates the resiliency of our Customer First strategy. Our associates are connecting well with customers as our strategy continues to drive identical sales growth and create shareholder value.

Based on the strength of our first quarter results, we are raising our identical sales and earnings guidance for fiscal 2008. We now anticipate full-year identical sales growth of 4% to 5.5%, excluding fuel. Our previous guidance on identical sales growth was 3% to 5%, also excluding fuel.

For earnings, the guidance we gave in March was $1.83 to $1.90 per diluted share. Today we are raising the lower end of that range to $1.85 with the upper end remaining at $1.90. In a few minutes, Rodney will share additional details on guidance.

Our updated earnings guidance reflects 9% to 12% growth over fiscal 2007 earnings of $1.69 per diluted share, which is a solid growth rate in a challenging economy, plus don’t forget our dividend. This compares favorably with the most recent earnings per share growth rate for non-financial companies in the S&P 500.

We continue to expect our 2008 earnings per share growth will be driven by strong identical sales, a slight improvement in our non-fuel operating margin, and fewer shares outstanding.

I want to take a moment now to talk about how the economy is affecting the purchasing decisions our customers make every day. Our latest customer research indicates the two biggest concerns on shoppers’ minds today are high gas prices and food costs. These two factors are driving some of the behavior changes we are seeing lately, such as shoppers combining trips and actively pursuing gas discount offers.

Our research also validates some underlying trends that we have seen for some time. These include families coming together more often to prepare and eat meals at home and the willingness of customers to try new private label products.

We did see solid growth in Kroger corporate brand share in the first quarter and recall the overall strength of Kroger’s corporate brand program has been building for several years. Our unmatched line of quality private label products -- Private Selection, Store Banner and Value brands -- can only be found in Kroger’s family of stores. For more than a year, our corporate brands team has been working to expand the private label products we offer customers. Nearly half of the new corporate brand items introduced last year were under our Private Selections label. That has led to great new products, such as our Private Selections Angus Beef Steaks and Artisan bread. Today, Private Selections is our fastest-growing brand and based on the first quarter trends, Private Selections will be a $1 billion brand for Kroger in 2008.

Listening closely to our customers is the foundation of our Customer First strategy. We focus intently on its four keys: our people, our products, our prices and the overall shopping experience of our customers. As a result, our strategy is helping us strengthen our connection with customers at a time when many shoppers are looking for the best options to stretch their dollars.

In addition to the growing private label business, we have introduced or expanded several programs in recent months to help customers stretch their household budgets. They include: expanding our $4 generic drug program to include 90-day supplies for $10; giving customers up to $120 in free groceries when they buy Kroger gift cards through our special tax refund gift card promotion; offering discounts on gasoline -- for every $100 customers spend in our stores, they can earn $0.10 off each gallon of gas on their next fill-up. In fact, just in time for summer travel, customers can accumulate and redeem gas discounts by shopping in almost all of our stores from Virginia to Arizona to Alaska; rewarding shoppers who have a 123 REWARDS MasterCard -- customers can earn discounts up to $0.15 off each gallon of gas per fill-up in participating markets and earn free groceries every quarter by using their 123 Rewards card. So far, customers have earned $48 million in free groceries.

These types of programs, and our associates’ exceptional ability to execute them well, are just some of the reasons Kroger’s business is growing. We have built the ultimate “one-stop shop” for customers in thousands of communities we serve. Our combination stores, many with in-store pharmacies and a growing number of fuel sites, help our customers combine shopping trips.

As our first quarter results show, we are making progress in our effort to be a reliable and relevant partner for customers by anticipating their needs and consistently delivering on their expectations. Through these types of investments, our customers are saving $1 billion annually.

Now I would like to turn the call over to Rodney for some additional details on our first quarter results, financial strategy update, and 2008 guidance. Rodney.

W. Rodney McMullen

Thank you, Dave, and good morning everyone. Dave highlighted Kroger’s strong sales and earnings for the first quarter. We realize that some investors want to know if our special tax rebate gift card promotion drove these strong results. Overall, the promotion had no material effect on Kroger’s first quarter sales or earnings. Let me give you a little more about how the promotion works.

Under this special promotion, which started May 2nd and ends July 31st, customers can receive up to $120 in free groceries from Kroger if they buy Kroger gift cards. We are evaluating this promotion internally, based on several metrics, to understand how this affecting customers' shopping behavior. So far, we are pleased with the trends we are seeing.

Some investors have asked us how we are accounting for the 10% bonus associated with the promotion. While the accounting is straightforward, an example might be helpful. A customer who turns $300 into a Kroger gift card will receive a card valued at $330. Kroger recognizes sales revenue of $300 as the card is used by the customer. The $300 in revenue reflects gross sales of $330 minus the $30 discount. So the 10% bonus reduces sales and gross margin as customers use their gift cards in our stores.

This is the same accounting treatment we use for other in-store promotions that are funded by Kroger. Our popular fuel discount program is another example. The cost of the fuel discount reduces our in-store sales and gross margin. If you have additional questions about how we account for these items, please follow-up with Carin offline after this conference call.

It’s important to note that merchandising strategies such as our tax rebate gift card program and our expanded generic drug program are merely components of Kroger’s overall Customer First strategy to deliver value to our customers. These merchandising strategies are not incremental to our regular investments and they are contemplated in the fiscal 2008 earnings guidance Dave provided.

There have also been some investor questions about the volatility of Kroger’s quarterly earnings due to fuel margins. Kroger operates over 700 supermarket fuel centers and nearly all of our 778 convenience stores sell gas. As we have said before, in the fuel business we do see margins fluctuate from quarter to quarter. Over a longer timeframe, margins in this business are more normalized. On a rolling four-quarter basis, the blended cents per gallon fuel margin for our convenience stores and supermarket fuel centers was $0.114 this year compared to $0.117 last year, a decline of $0.003 per gallon.

In the first quarter of 2008, the blended cents per gallon margin was $0.092 compared to $0.087 in the prior year. While our gallons sold were up on a year-over-year basis, our retail fuel operations had no impact on Kroger’s first quarter earnings per share growth in 2008. This is largely due to the impact of higher credit card fees on fuel sales compared to the prior year.

Our retail fuel business is a highly valuable asset, particularly because it strengthens our connection with customers. Our fuel centers eliminate an extra trip for shoppers and customers know they can count on a competitive fuel price at Kroger.

Now let’s turn to the performance of our core grocery operations.

Excluding the effect of retail fuel operations and the non-recurring labor expenses of the prior year, FIFO gross margin declined 5 basis points. Improvement in shrink expense helped fund continued investments in good prices for our customers. Kroger’s supermarket selling gross margin on non-fuel sales declined 9 basis points year-over-year.

Like many food retailers, Kroger continues to experience product cost inflation at levels not seen in several years. We estimate that our product cost inflation during the quarter was 3.5% excluding fuel. This relatively high inflation rate is reflected in our $40 million LIFO charge in this quarter. This amount is almost $20 million higher than the previous year and reduced Kroger’s non-fuel operating margin by 9 basis points.

The year-over-year increase in LIFO mainly reflects the timing of when inflation affected our business in 2008 compared to 2007. Recall that our full-year LIFO charge for fiscal 2007 was $154 million after rising product cost inflation caused us to increase our LIFO charge estimate every quarter last year.

If that full-year expense had been recognized ratably during the year, our LIFO charge for the first quarter of 2007 would have been more consistent with our current experience. I’ll talk more about LIFO in a minute when I provide some additional color on our 2008 earnings guidance.

As you know, the LIFO charge is a non-cash expense that results from the company’s choice of accounting method for its product inventories. But beyond the mechanics of the LIFO charge, we realize that what many investors want to understand is how inflation is affecting our business. On the whole, as we have said several times, we believe that a moderate level of food inflation is a positive for our business. At moderate levels, we are generally able to pass suppliers’ product cost increases on to customers without negatively impacting unit volume. And we get the benefit of the additional sales leverage over fixed costs in our business. We would describe current levels of product cost inflation as moderate.

Some of that additional sales leverage is reflected in our OG&A rate. Excluding the effect of retail fuel operations, OG&A declined 17 basis points. The improvement in our OG&A rate is primarily due to strong identical sales leverage. We also benefited from lower benefit costs associated with some labor contracts. While the effect of this particular benefit will diminish over time, we continue to identify other ways to reduce operating costs as part of our ongoing strategy.

A great example of our success in this area are the initiatives we have in place to control our utility costs. Since 2000, we have reduced overall energy consumption by over 22%, or 1.6 billion kilowatt-hours. That’s enough electricity to power every single family home in Denver, Colorado for a year. Many thanks to our associates who made this possible. You can read more about our energy reduction and recycling efforts later this week when our new sustainability report is published online at Kroger.com.

Let’s continue down the income statement with operating margins. During the quarter, Kroger’s non-fuel operating margin expanded 2 basis points. This also excludes the non-recurring labor expense in the prior year. As a reminder, our fiscal 2008 earnings guidance incorporates a slight expansion in Kroger’s non-fuel operating margins on a full-year basis.

Our tax rate for the quarter was 37%, compared to 38.1% in the prior year. The first quarter rate was lower in the current year due to the resolution of certain tax issues. We now anticipate a full-year tax rate in the range of 37% to 37.5%.

Capital investment, excluding acquisitions, totaled $637 million, compared to $556 million in the prior year. We continue to project fiscal 2008 capital spending of $2 billion to $2.2 billion, excluding acquisitions. This investment is expected to cover 70 to 80 major store projects and 175 to 200 store remodels, plus other investments to support our Customer First strategy.

Our 2008 capital budget also includes approximately $160 million for several high-return projects in Kroger’s logistics network. These projects will cause our logistics capital spending in 2009 to be higher than normal as well.

Turning now to free cash flow, Kroger remains committed to a solid investment grade rating. Our long-term financial strategy is to manage free cash flow to repurchase shares and pay dividends, while maintaining a leverage ratio that supports our investment grade rating. On a rolling four-quarter basis, Kroger’s net total debt to EBITDA ratio was 1.95, compared with 1.85 during the same period last year and 2.03 for the fourth quarter of fiscal 2007. So you can see that since year-end, we’ve improved our ratio. Total debt was $7.8 billion, an increase of $1.2 billion from a year earlier.

Our share repurchase and dividend programs delivered substantial value to shareholders. During the first quarter, Kroger returned over $430 million to shareholders in share repurchases and dividends. Of this amount, $381 million was invested to repurchase 15 million shares of stock at an average price of $25.46 per share. At the end of the first quarter, approximately $644 million remained under the $1 billion stock repurchase program announced in January 2008. At current share prices, we expect this amount will be sufficient to fund repurchases through the remainder of fiscal 2008.

Kroger paid nearly $50 million in dividends to shareholders during the first quarter, compared to $46 million during the same period of the prior year.

I want to now turn back to updated 2008 earnings guidance Dave shared with you. As we mentioned, we are raising the lower end of our earnings per share guidance from $1.83 to $1.85. The upper end remains the same at $1.90 per share.

Given Kroger’s strong first quarter results, some of you may wonder why we did not raise the upper end of our earnings per share guidance. There are several moving pieces to our thought-process, so let me walk you through several of the highlights.

First, there is uncertainty surrounding the economic outlook for the remainder of 2008 and how it will affect our customers. So far, we have not seen major shifts in our customers’ purchasing behavior. Our strong identical sales trends have continued through the four weeks of our second quarter. We are tracking at the high end of our updated identical sales guidance for 2008. As Dave described, we are doing everything we can to help customers stretch their budgets. With over 7 months to go in our fiscal year, it is too early to make predictions as to how continued economic pressures will affect customers.

Second, like many businesses, Kroger is facing headwinds in the form of higher energy-related operating costs such as diesel fuel, utility expenses, and even higher bag costs. In the first quarter, Kroger’s strong sales performance and the lower benefit costs associated with some labor contracts allowed us to absorb these higher costs and report strong earnings growth. While we expect our strong identical sales growth trend will continue, the effect of reduced health care costs will diminish over time.

The third factor is LIFO, which could actually help mitigate some of our higher energy-related operating costs in the back half of 2008, based on our current estimates. Our updated 2008 earnings guidance incorporates a full-year LIFO charge of $130 million, which is about $25 million lower than 2007 and the preliminary estimate for 2008, which we provided in March. Our current expectation declined from our original 2008 projection largely due to current commodity outlooks that suggest dairy prices will be lower at the end of the year. Our actual LIFO expense for 2008 will be determined in the fourth quarter, based on inflation rates at that time.

Given the current challenging economic environment, we believe that an EPS growth rate of 9% to 12% over fiscal 2007, plus the dividend yield of slightly over 1%, should be a positive for Kroger to deliver solid value to shareholders while continuing to invest in the long-term health of our business. Kroger’s first quarter results and our annual guidance reflect the balance required for our long-term sustainable business model.

Although we do not give quarterly guidance, please keep in mind our comments in March on quarterly earnings per share growth rates. We said that the first quarter growth rate would be higher than the annual growth rate. Clearly that forecast was accurate. We also said that the fourth quarter growth rate would be higher than the annual growth rate. The lowest year-over-year growth rate will likely occur in the third quarter due to last year’s tax benefit, which benefited Kroger’s third quarter results by roughly $0.02 to $0.03 per share on a net basis.

I’ll wrap up with some comments on labor relations. During the quarter, we reached agreements in Memphis and Louisville and last week our associates in Indiana ratified a new agreement. I understand that we reached an agreement in Nashville yesterday, subject to employee ratification. This year, we have labor negotiations covering store associates in Columbus, Las Vegas, Phoenix and Portland. In every negotiation, we work to achieve competitive cost structures in each market while meeting our associates’ needs for good wages and affordable health care.

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

David B. Dillon

Thanks, Rodney. We are off to a strong start in fiscal 2008. Kroger’s performance during the quarter demonstrates the resiliency of our Customer First strategy. Our associates are connecting well with customers as our strategy continues to drive industry-leading identical sales growth and create shareholder value.

The underlying strength of Kroger’s long-term business model is illustrated by our solid first quarter results and updated guidance. We continue to balance investments in our customers’ overall shopping experience with current economic conditions, including inflationary costs.

Now, we would be happy to take a few moments for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question will be from the line of John Heinbockel of Goldman Sachs. Please proceed.

John Heinbockel - Goldman Sachs

A couple of things -- how would you break the comp down between traffic and ticket? It looks like traffic is actually fairly robust.

David B. Dillon

If you look, in the first quarter it’s pretty consistent with the way it’s been for the last couple of years. It’s slightly favorable to traffic versus ticket but not hugely so. It’s about 55% one, 45% the other, so as you can see, it’s pretty balanced between the two.

John Heinbockel - Goldman Sachs

And then within ticket, what do you see with the number of items that make up someone’s basket? Obviously there’s some inflation there. Are there less items per basket or about the same?

David B. Dillon

It would be about the same, and as we’ve said before you can see it in -- a cut-back in certain discretionary items, that you can see but certainly if you look at the food side, it’s great growth there.

John Heinbockel - Goldman Sachs

And the -- if you look at price elasticity, we’ve talked about this before, the price elasticity of the customer, the effectiveness of promotions and sometimes the elasticity is not there to get a good ROI. It would seem in this environment the elasticity is great or the ROI of price promotions is better, the money that you would spend in the circular is better. Is that true? Is the ROI tracking better than it might have in the past? What’s the color on that?

David B. Dillon

I don’t know that I’d answer it quite the way you’ve described it. I think it all depends on the promotions. Certainly in this environment, customers are responding to offers that really hit home with them, are important to them. But just as true as in the past, sometimes promotions, even in today’s environment, may not be the appropriate ones to run. So we are trying to actually balance that out pretty well and the use of data when we work with dunnhumby to evaluate our loyalty data helps us figure out which ones are the right ones to target.

Don W. McGeorge

We would have a pretty sophisticated analysis on what are items to target and how different types of customers react to those items.

John Heinbockel - Goldman Sachs

But in general, you can’t say that the promotional spending is more efficient today because of the environment than a year ago. It sounds like it’s about the same.

David B. Dillon

We think it’s more efficient in today’s environment because of improvements we’ve made in how we spend, not because of changes in consumer behavior.

John Heinbockel - Goldman Sachs

Okay. And then what would you characterize -- you said today’s inflation is moderate at 3.5. Where would it be not moderate? How high would it have to go? Is 5% not moderate? What do you think --

David B. Dillon

I don’t know that I’m going to speculate on that, but Rodney, do you want to go ahead on that one?

W. Rodney McMullen

With a setup like that -- I don’t know we can say the specific number. I think it really depends on how customers react and as you know, if there’s inflation that’s beyond what makes sense, that’s one of the things our wonderful corporate brand we have, we will not have those cost increases there so that does provide some offset to national brand pricing.

David B. Dillon

I think that’s really key. The important thing for us to remember is it’s not so much how high inflation is; it’s what’s the effect on our customers and their behavior and that isn’t always able to be predicted.

John Heinbockel - Goldman Sachs

All right, and then finally in your inflation -- what you put together, most people think meat pricing, protein pricing is going to go higher later this year on into next year. Have you kind of worked that in and is that a concern, or do you think dairy will offset that?

David B. Dillon

Mike, do you want to comment?

J. Michael Schlotman

I mean, that’s exactly what we see out there as well, John, and we have factored that into our expectation for LIFO, our sales guidance, and our earnings guidance.

John Heinbockel - Goldman Sachs

Okay, so protein is not going to push inflation higher, it will be offset by other things moderating in price?

J. Michael Schlotman

Well, that individual category we would expect to be higher. What we are looking at today is the guidance we gave you.

John Heinbockel - Goldman Sachs

Okay. All right, thanks.

Operator

Your next question will be from the line of Deborah Weinswig of Citigroup.

Deborah Weinswig - Citigroup

Congratulations on an amazing quarter. You mentioned on the call high return projects in the Kroger logistics network. Can you, without giving away any company secrets, can you elaborate on what we should expect to see in ’08 and ’09?

David B. Dillon

If you look, it’s actually over the last four or five years we’ve usually averaged one major logistics project every year. If you look at ’08 and ’09 in terms of number, it’s about the same. The difference is the areas that those warehouses are being done is a higher cost area for construction, so that’s the reason why the cost is a little higher than what it has been for the last couple of years.

In terms of specific locations, I don’t think we’ll get into that level of detail, other than saying what we are doing is consistent with some of the other projects that we’ve done and we’ve been very pleased with the financial returns we have had from those.

Deborah Weinswig - Citigroup

So are there any new technologies or it’s just consistent with what you’ve been doing in the past?

David B. Dillon

Consistent with what we’ve been doing but you know, you’ll have to know that what we put in would be something that would be a lot of new technology relative to the U.S. You will find quite a bit of it in Europe but you don’t see much of it in the U.S., if any.

Deborah Weinswig - Citigroup

Okay. And then obviously with the store remodels I think numbering this year somewhere between 175 and 200, can you talk about the change that you are seeing in those stores after a remodel is complete? And maybe if you can just give us kind of some feedback in terms of what customers are saying as well?

David B. Dillon

Well, good results. We do a lot of focus group work, both before and after remodels, and our feedback has been excellent and the sales results excellent. I don’t know if you want to offer any particulars. The return on investment has been good, particularly good on remodels, actually.

J. Michael Schlotman

The remodels are achieving above their budgeted expectations right now on sales and EBITDA. The net new stores are above the cost of capital but not all of them are at budget but that picture continues to improve.

Deborah Weinswig - Citigroup

And then last question, obviously you gave some qualitative measures around private label and kind of with [private label flexing] about $1 billion in sales this year, how should we think about private label growth versus the rest of the store? Is there anything else you can give us in terms of actual quantification of what you’ve seen in the quarter and expect for the year?

David B. Dillon

Well, a lot of the kind of discussion we’ve heard out in just the trade has to do with the economy maybe driving people to buy more Kroger brand or private label. And while I’m certain there’s a certain degree of that going on, we actually think most of our improved results -- and our first quarter was a good improvement -- we actually think most of our improved results was because of the plan, because of the team, because of the focus we’ve had on that area.

Certainly because the share growth has grown, we have some customers who are buying more. That’s the only way you grow the share of Kroger brand, but in addition to that when we dissect some of our data and we look at our very best customers, our very best customers are buying both more Kroger brand and more national brand, not just more Kroger brand. And we take from that, we believe that the way to read that is that there’s of course a shift from restaurants and other places to buying more food in our stores. We think there’s a shift to preparing food at home more, and we think our new product introductions in the categories like the private selections that we mentioned help contribute to that.

So we think those are the primary things driving our good strong Kroger brand private label performance. But I want to remind you, this is a trend we’ve seen for several years and while the quarter was good and we certainly recognize there’s some due to the economy, we think most of it’s due to the trajectory of the work we’ve been doing.

Deborah Weinswig - Citigroup

Okay, great, thanks.

Don W. McGeorge

Just in terms of some of the specifics, if you look at the grocery department as an example, on retail dollars corporate brand share improved 1.4%. If you look at it on units, it improved 0.33. Obviously a 0.33 share change in one quarter is very strong, as Dave mentioned. The dollars is a little more than the units because there are inflation in several of the categories.

Deborah Weinswig - Citigroup

Great, thanks for the color and once again, congratulations.

David B. Dillon

Thank you. In fact, Deborah, I would add just one other thing on the brand is that private selection, as we mentioned is going to be -- this year we expect it to be a $1 billion brand, and that’s more of an upscale brand. And the fact that it’s our fastest growing brand should suggest a little more evidence along the lines that I had illustrated earlier, so thank you, Deborah.

Deborah Weinswig - Citigroup

Thank you.

Don W. McGeorge

The other -- sorry to keep adding on, but Dave talked about the long-term trend. If you look at over the last 15 quarters, corporate brand has gained in 12 of those 15 quarters, so that just shows you the consistency over time.

Deborah Weinswig - Citigroup

Okay, great. Thanks again.

Operator

Your next question is from the line of Ed Kelly of Credit Suisse. Please proceed.

Edward Kelly - Credit Suisse

Good morning and great quarter. My question for you is on your fuel business. It’s clearly a competitive advantage for you. I think you’ve got fuel in about 30% of your stores. But you mentioned that consumers are responding more to fuel promotions and I was hoping you could comment on that, as well as maybe help us dissect the performance of IDs at stores with fuel versus stores without.

David B. Dillon

Well, the things we would really say about that is that it’s hard to know exactly what happens here but when you put a fuel station in, it gives the convenience of having fuel there at our store. We price our fuel stations really well on the street price, and so that drives some of the business too. So the mere quantity, the growth of more fuel stations certainly helps drive that and focuses squarely on the one-stop shopping idea. You were asking specifically about the fuel promotion, which I’m sure is part of this too. But I want to look at it as more of a full package because I think just the existence of the fuel is going to help us a lot.

The tie-in to the store helps remind people we have fuel and it’s been reasonably successful and you’ve seen it though at many other retailers around the country. I wouldn’t try to describe it as more significant than that. Do you want to add anything else?

Edward Kelly - Credit Suisse

Could your stores that have fuel, the non-fuel IDs of those stores be 100, 200 basis points higher than stores that don’t have fuel?

David B. Dillon

I don’t think we would comment on where that would be.

Edward Kelly - Credit Suisse

Okay. Second question for you on rent expense, it was a little bit higher than what we were expecting this quarter. Was there anything in there one-time related, maybe associated with future lease obligations or asset impairments?

J. Michael Schlotman

There was some store closure activity in there. There were some lease buy-outs in there. Some of it was also affected when you look at it as compared to the prior year. In the prior year, we actually had some positives going the other way, which helped lower rent expense a little bit last year and some payments. We had reserves for rent liability that we were able to get out of those leases for less than a reserve with the landlord last year and that wound up being a credit in last year’s first quarter.

So when you pull that noise out, it would have been a quarter like you normally would have expected. But because of store closure activity in both years, it came away with a little bit different picture.

Edward Kelly - Credit Suisse

Okay. And last question for you -- could you comment on whether you are seeing any change in mix in regard to how customers are actually paying? You know, Wal-Mart recently mentioned that they’ve seen a significant shift away from credit cards, which clearly helps the gross because you lose the fee. Are you seeing any of that?

David B. Dillon

I didn’t actually look at this last quarter’s specific numbers but my impression is that we are continuing to see more of a shift towards credit card. That’s been true now for, I don’t know, 10 or 15 years and it continues down that path.

Don W. McGeorge

And debit cards.

David B. Dillon

Yeah, debit -- I put them all together. And we’ve called out, specifically called out credit card and debit card fees, credit card in particular, both at the fuel pump because it gets escalated just purely because of the cost of fuel, because it’s on a percentage basis, which is not a very good way really to look at fuel, and also because of the increased use of the card in our stores. That has driven that fee higher and higher, which is problematic of course for us. So that’s an issue, but that’s what we are seeing. We’re not seeing the opposite.

Edward Kelly - Credit Suisse

Okay, great. Thank you.

Operator

Your next question will be from the line of Scott [Muschkin] of Jefferies.

Scott Muschkin - Jefferies & Company

I just wanted to -- Rodney talked a little bit about the union. I just wanted to get the temperature on how they are handling negotiations. We are hearing some rumblings from other retailers that employee costs could rise as we get into ’09 as we do get some wage inflation. Do you guys have a thought on that?

David B. Dillon

Well, the comment I would offer is really the same thing we’ve said every quarter; is that we try to approach our negotiations in a balance way. There are obviously, in individual markets depending on the contract and situation, things that our associates need us to take a look at, and we discuss those of course and try to solve for those issues. Sometimes it’s wages, sometimes it’s healthcare but there are legitimate things that need to be reviewed there.

On the other side, in order for our strategy to be successful, I think the union sees this and understands that we have to be able to balance our overall cost because our whole strategy is to reinvest where we have savings into things that actually matter and are important to the customer. That’s what’s driven our sales. That’s what ends up with the business model working.

So it’s striking that balance and it’s really a market-by-market situation and I don’t think today’s economic climate makes that any different than it has before. We’ve got to look at it one place at a time, one contract at a time.

Rodney described the contracts that we have before us still and of course the settlement that was just reached yesterday in Nashville. We’ve been particularly pleased at the pattern and discussions and the active dialog that we’ve had with our union partners.

W. Rodney McMullen

We work real hard with our union partners. We understand that the associates, their need for good wages and a very affordable healthcare plan and we work very hard to accomplish that in each market we operate in.

Scott Muschkin - Jefferies & Company

Okay. And then I guess I was a little bit surprised by the change in lower in the LIFO down, given DOW just raised its prices today 25%. And I hear you on dairy but it just seems to me you would want to be pretty cautious as we are starting to see people put in huge price increases. And so I just wanted to get your thoughts, a little bit more thoughts on why you would actually lower it this early.

J. Michael Schlotman

It’s actually a little bit of the inverse of why we raised it every quarter last year. We have a pretty firm methodology of how we estimate our annual LIFO charge and when we look at that calculation, this year’s first quarter and try to project out where the various categories and commodities are going to wind up by the end of the year, which is what we try to do, it indicated to us at the end of this first quarter that overall we will have a lower LIFO charge than we originally expected.

I understand what you are saying -- why not be cautious and keep it a little higher right now? It’s primarily because the accounting approach and the methodology we’ve picked estimated on a quarterly basis. We don’t go about changing that every quarter based on where a particular quarter comes in or what our needs are. We do it consistently every quarter and that’s the result it gave us at the end of the first quarter.

W. Rodney McMullen

And as we mentioned on the call, it’s driven by expected dairy --

J. Michael Schlotman

Dairy is a huge drive of what our ultimate LIFO charge winds up being and right now it looks like dairy is going to come in nicely lower at the end of this year than it was at the end of last year. And keep in mind the LIFO calculation is a point in time calculation done in the fourth quarter and all we are trying to do is to estimate what that point in time is then. It’s not an accumulation of inflation during the year -- it’s actually inflation at that one point in time in the fourth quarter.

David B. Dillon

Scott, one way I like to think about LIFO too is in addition to the point, one point time is it’s a reflection of the inventory mix we hold, not a reflection of the actual inflation we’ve experienced in the sales. They are two different mix calculations and so you have to really understand it to understand how it can happen, but that’s why dairy can drive it so strongly.

You had a follow-up?

Scott Muschkin - Jefferies & Company

How much is dairy?

J. Michael Schlotman

I’m not going to get into the specific components of the LIFO charge, but just the fact that as fast as milk moves in our stores and the fact that we produce most of the milk, so we own it not only at the store level, we own it at the diary and manufacturing level as well. We have a lot of dairy inventory so when those prices move, it can change the LIFO calculation.

Scott Muschkin - Jefferies & Company

Great. And just one quick one -- did I understand you guys right that you said the rebate had no sales effect?

J. Michael Schlotman

We said it had no material effect on sales or earnings for the quarter and keep in mind that for the quarter, the program was out there for three weeks and if you looked at sales trends and profit trends before and after the launch of that program, you see nothing material that happened during the quarter. And our trends, as Rodney said in the prepared comments, for the first four weeks of the second quarter continued at the high end of our guidance for the year.

David B. Dillon

Remember the way those cards work is you don’t record any sales at all until the cards are actually used, as it is being used. So that’s why --

Scott Muschkin - Jefferies & Company

So it is potential that we could see a lag here because it was three weeks and it could be $1330, so we could see a lag effect, so you really won’t know if it’s having a major effect until you can get through the second quarter. Is that a good way to look at it?

J. Michael Schlotman

Keep in mind the $120 in that $1320 never gets reflected as a sale.

Scott Muschkin - Jefferies & Company

Right.

David B. Dillon

That’s one of the things we were trying to illustrate on the prepared remarks, is if you look at for the quarter, it really didn’t have much of an effect. When you look at it overall, it’s still too early to really be able to give you insight, other than what we are seeing, we’re pleased with overall.

Scott Muschkin - Jefferies & Company

Okay, guys, great. Thanks for answering my questions.

Operator

Your next question will be from the line of Karen Short of Friedman, Billings, Ramsey.

Karen Short - Friedman, Billings, Ramsey

Thanks for taking my call. Great quarter. A couple of questions actually just on food stamps; I guess are you guys seeing an increase in food stamps? And I guess how do you think about that from a positive/negative standpoint? And then is there any geographic focus if you are seeing an increase?

David B. Dillon

The answer is we’re looking around and don’t know the answer. I think we have looked at that but I don’t have a specific answer for you on that today.

Karen Short - Friedman, Billings, Ramsey

Okay. And then on Ralphs, you know, there were some press releases or things that hit the trade journals on your strategy, on changes in your strategy at Ralphs. Could you just elaborate on that a little bit?

David B. Dillon

I don’t really plan to elaborate more on Ralphs strategy other than what they would describe to their customers, except to say this -- that we are pleased with the strategy they have developed as a management team. We are real focused on improving results in California, in Southern California. It’s a terrific market, both for us and the potential is also there strongly for both Ralphs and for Food For Less, and they are meaningful players in our organization.

So I would really just offer our support for what they are doing in strategy but would not add any elaboration to it.

Karen Short - Friedman, Billings, Ramsey

Okay. And then on private label, I guess obviously you’ve talked a lot about inflation. How do you think about maintaining gross profit dollars versus margins with what we are seeing in private label? I mean, obviously there’s some benefit to you guys from consumers trading into private label, but I would assume you are also seeing some cost pressures from your own, from manufacturing on your side.

David B. Dillon

Rodney pointed out that we are seeing some inflation, of course, cost pressures in our own Kroger brand and that was one of the reasons that the dollars were up on the numbers he gave. But we are -- we look at this from the point of view of the profit that we make on Kroger brand is typically a higher percentage than national brand and frankly even a higher penny’s profit when you add into it the profit that is produced in our manufacturing plants. That’s a very important point not to forget because that’s what actually makes well over half of our private label sales, are products that we produce in our plans. So on the whole, that actually works pretty well for us.

And our pricing strategy, we typically look at the relationship of what customers buy and what price they buy and how much below a national brand you want to be targeted in order to get those sales. We also recognize occasionally we’ll make a little less profit on a private label because it will help the overall picture of what Kroger brand can do. The more customers we convert to more Kroger brand, the better off we are and the better we like it.

Karen Short - Friedman, Billings, Ramsey

Okay, and I guess just a last question -- I mean, there was a little bit of noise that you might have, prior to your earnings release, that you might have been seeing some weakness on general merchandise sales at Marketplace and Fred Meyer stores. Do you have any comments on what you are seeing in general merchandise?

David B. Dillon

Sure. There are actually two major product categories we are seeing noticeable weakness. We’ve commented on these before. One is in general merchandise and the other is in jewelry. If Rodney wants to add anything on jewelry, that area reports up to him and he may want to do that but in general merchandise, we are seeing some weakness there, not just at Fred Meyer. Fred Meyer of course has more general merchandise than other places but it would show up there, but it’s also showing up in other stores as well and it’s showing up in our seasonal merchandise sales, you know, patio sets and things like that in the summer.

But it’s driven by a couple of things, particularly the seasonal. It’s driven not only by the economy and a lower amount of spendable income, we think, but it’s also driven by weather. Weather has been noticeably different this year in many parts of the country -- cooler, and by being cooler people were not inclined to go out and buy a patio set for the summer, as an example. And then you get deep enough into the summer and they say well, we’ll wait until next year.

We of course track every day, every week where our sales are and what our sell-through is on things like that and it’s a little less than where it was last year, but our merchants are taking close watch of that and are devising strategies to help give our customers -- already have been giving our customers some really good deals.

W. Rodney McMullen

In terms of jewelry, if you look at for the whole company for a year it’s less than 1% of our business, so just so that everybody recognizes that. If you look at our performance in the quarter, it would be very similar to the other public jewelry companies if you look at Signet and some of the other ones. Obviously a negative identicals. If you look at in the last few weeks, the trends have been a little bit better than what they were early in the quarter and what they were in the fourth quarter last year. So we are seeing some improvement. How much of that is a tax rebate check and how much of it is trend changes, that’s too early to say.

Karen Short - Friedman, Billings, Ramsey

Okay, great. Thanks a lot.

Operator

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

Meredith Adler - Lehman Brothers

Great quarter. I was wondering if you could talk, I think you have said that you haven’t seen price wars in a really long time and I just want to confirm that you are not really seeing any significant change in the competitive environment with this slowing economy.

David B. Dillon

Well, I tend to define a price war as more irrational pricing behavior and I have not seen that sort of thing in our industry in a long time. We occasionally see some tiny erratic changes in individual markets and there’s always something like that going on but nothing that would be noteworthy.

I think the industry is quite rational. I think the industry recognizes, as we recognize, that you need to get a return on your assets and I just think that’s been the picture of this kind of industry for actually 10 or 20 years.

Meredith Adler - Lehman Brothers

And when you look at -- you guys don’t usually talk much about the boost to the total volume or units that comes from making acquisitions, but you did do a couple last year and I was just wondering, it would be great actually if we kind of had that on a regular basis. Maybe it’s not significant but what the outlook is for more of those kinds of local acquisitions that’s highly accretive, I think.

David B. Dillon

We like those a lot. Rodney, do you want to --

W. Rodney McMullen

Yeah, I was just going to say we always like end-market acquisitions for us. It seems to work very well and we are always on the outlook of it. We want to make sure we don’t build our business model around where we have to do those in order to make our numbers work and that’s one of the reasons why you don’t hear us talking about it, except when we actually do something. But anytime something becomes available, we will take a look at it. We think it’s important to make sure that we pay a fair price for the seller and for us as the buyer and that’s what we are always looking at, something that ties in and works for us, and we’ve been very pleased.

And the two that you talked about that we did last year, both of those are working very well and our store teams have just done a great job of integrating it into Kroger and providing something additional for the customers.

David B. Dillon

Also keep in mind the new stores haven’t been around long enough to be in our identical sales calculation yet.

Meredith Adler - Lehman Brothers

Okay. And would you say that this environment makes it more likely that you will see opportunities or not really any change?

W. Rodney McMullen

There’s no shortage of things that we see. There’s still a gap in valuation and we see -- we are seeing -- probably right now we see a little bit more things where people put stuff on the market and then nothing actually happens. I assume that means they weren’t satisfied with the price but I don’t know that for sure.

Meredith Adler - Lehman Brothers

Okay, and then another comment or question really is you haven’t commented at all about the flooding in the Midwest. I guess you -- presumably you’ve got that baked in somehow into your outlook for inflation. Did it have any impact on your business itself? I’m not sure where the flooding compares to where your stores are completely but is that something that is going on right now?

David B. Dillon

Well, we’ve had some disruption but it’s not been significant or material. Do you want to comment on any specifics?

J. Michael Schlotman

We had a couple of stores, a C store in Iowa, a grocery store in Indiana and a C store in Indiana that were affected by floods, and all of those -- the cost of any of that is reflected in our results already.

David B. Dillon

I would add to that -- we also had a few stores that had major power outages because of storms and things like that. And I want to add, even though it’s not maybe relevant, Meredith, to what you are asking but it is relevant to anyone else listening on the call, the employees and the management teams and all the employees associated with those geographic areas when that happens have to absolutely work their fannies off and they really do a wonderful job. And this last series of storms was a really good illustration of that. They recovered quickly, got back open quickly in nearly every case, minimized the damage and helped our customers because customers in times like that really need our services more than almost any other time. So trying to get us back into position like that is a huge thing to do.

So I don’t want to reduce the impact of that by saying the financial impact is not going to be important here but the contribution that our associates make is significant.

Meredith Adler - Lehman Brothers

Okay, great. Those are my questions. Thank you.

Operator

Your next question will be from the line of Neil Currie of UBS.

Doug Cooper - UBS

This is Doug Cooper in for Neil Currie. I have a couple of questions here. The first question is can you quantify or tell us a little bit more about where you are gaining the share from? Wal-Mart had made comments to the point that higher incomes were now shopping, higher household incomes were now shopping in their store. Can you quantify a little bit more about where that share gain is coming from?

David B. Dillon

Doug, we’ve said before that we’re getting it from lots of different places. At the end of the year, I guess last quarter, we released our market share data and when we released that, we illustrated that based on our estimates that Wal-Mart’s market share actually is growing in the markets where we are growing too. So it’s obviously coming from other areas especially and some of it obviously is restaurants. Some of it is from other outlets that would not be classified as groceries, you know, local independents and things would not be under that heading. But then of course, then you do have the local independents and some of the regional chains that may have given up some market share too. But it’s all of those things, and our focus at Kroger is not so much on individual competitors as it is on our customer. And if we draw from our customers’ needs and fill their needs, we’ll get the business from wherever they were previously going, whether it’s a supermarket or some other form of business.

W. Rodney McMullen

And if you look at the stuff that we work with dunnhumby on, we actually see the gains really in all types of customers. It’s not just lower income or higher income. It’s really all customers.

Doug Cooper - UBS

Great. Now in terms of your Ralphs price cuts that you announced recently in the L.A. Times, I guess there was an article but can you quantify a little bit about how you are approaching those price cuts?

David B. Dillon

No, we are not going to talk about individual markets today.

Doug Cooper - UBS

Okay. In terms of -- you say moderate for inflation. You know, we’ve noticed year over year comparisons are higher for most categories. Is that compared to absolute, relative pricing? What can you say about absolute pricing?

David B. Dillon

I’m not sure I understand the question exactly but we characterized it as moderate inflation primarily because lots been written about it and if you read the press, you would think that inflation and food products was like off the charts.

One of the reasons for that is we’ve had a 20-year period of time where we’ve had basically no inflation, zero. You know, half a point up, half a point down, but really zero. So now that we’ve had a year or two now of low level and moderate inflation, people are writing a lot about it and seeing it. So that’s why we wanted to make sure we characterized it as moderate. Do you want to add anything?

W. Rodney McMullen

Well, and there are some areas where there’s deflation. And if you look at pharmacy as an example, you know, there’s significant deflation in pharmacy. So what gets the headline are the things you have inflation in but when you look at the business overall, we are seeing about 3.5% inflation that we talked about before.

Doug Cooper - UBS

And the deflation in pharmacy, is that a direct impact of the up-tick in generics?

W. Rodney McMullen

I would say that was the biggest driver of it, it’s certainly generics. Some of it is obviously our own $4 program and $10 for 90 days.

Doug Cooper - UBS

Okay. Thank you.

David B. Dillon

Thanks, Doug. I think we have time for one more question.

Operator

And that question will be from the line of Mark Wiltamuth of Morgan Stanley.

Mark Wiltamuth - Morgan Stanley

Good morning. You had mentioned that you own and manufacture more of your private label products than competitors. Is it better to own your own private label in an inflationary environment or is it better to use third parties during that period?

David B. Dillon

Well, we like it for a lot of reasons, one of which is that we know exactly what the cost increases are. While you could have, if you were buying from a third party, you could have potentially some lag between when the costs actually are incurred and when you get increased costs. But if you have too much of a lag, those third party operators actually will need to push the prices up even higher yet than they need to be, so there’s a lot of put and take there in the short term.

In the long-term though, I would much prefer to be in the position of owning the assets. I think it actually works well and we can control our own destiny better.

Mark Wiltamuth - Morgan Stanley

Obviously by cutting out the third party there, you have the opportunity for either higher margin or going lower on price -- which do you lean towards with your own product?

David B. Dillon

It depends entirely on the product, how customers in our view would react, how targeted a particular item would be for them. We’re not afraid actually of either way, of getting a lower price but we’re also not afraid of getting a higher margin.

Mark Wiltamuth - Morgan Stanley

Okay.

David B. Dillon

If you look at our corporate brands overall, about half of those corporate brands, we would manufacture, half of it we do buy from third parties. So we have the opportunity to see both sides of it.

We love owning the plants. The other thing that by owning the plants what it allows you to do is improve the supply chain, where you can eliminate any type of wasted efforts through the supply chain and give that benefit to our customers.

Mark Wiltamuth - Morgan Stanley

Okay, very good. I just wanted to ask if the mix of promotional buying from your customers has changed dramatically over the last couple of quarters.

David B. Dillon

I wouldn’t characterize it as a dramatic change, no.

Mark Wiltamuth - Morgan Stanley

Okay. And how about the pricing gap relative to your competitors? Have others tried to follow your lead on lowering prices?

David B. Dillon

I’m not going to comment on our competitors’ pricing strategies.

Mark Wiltamuth - Morgan Stanley

Okay. All right. Great quarter and congratulations.

David B. Dillon

Thank you. And for everybody listening, I want to have a few wrap-up comments here before we sign off, especially for some of our associates who we encourage to listen in on the call.

To our associates, thank you for your contributions to our strong first quarter results. Our performance is tied directly to the efforts you make every day and we appreciate your commitment to keeping our customer first in your daily decisions.

One customer summed it up well in a recent letter to me that he wrote about great service he and his family consistently enjoyed at their local Ralph store at Porter Ranch, California. He wrote that although he and his wife have more than 12 supermarkets in a 10-mile radius of their home, they shop only at Ralphs because of the amazing professionalism and courteous treatment we get from the wonderful staff you have there. From cashing in our coupons to simply saying hello or asking where something might be found, this staff is fantastic. We’ve never encountered anything but the highest level of kindness, respect, and cooperation. He went on to say about how proud I should be of the team there and indeed I am. Rick Foley and all his team members do a really great job. This is another terrific example of what does happen when a team is committed to delivering exceptional customer service.

Congratulations to each one of the great team members at our Ralph store Porter Ranch. Our results tell us that there are examples like this in every store and in every workplace throughout our whole company. As each of our paychecks reminds us, a satisfied customer made this paycheck possible. Thank you for keeping your focus on our customers, and one final note -- we hope you and your families enjoy a safe and happy summer.

Goodbye and thank you all for joining us.

Operator

Thank you for your participation in today’s conference. This concludes our presentation and you may now disconnect. Have a wonderful day.

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Source: The Kroger Co. F1Q08 (Qtr End 5/24/08) Earnings Call Transcript
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