Safeway Management Discusses Q3 2012 Results - Earnings Call Transcript

Oct.11.12 | About: Safeway Inc. (SWY)

Safeway (NYSE:SWY)

Q3 2012 Earnings Call

October 11, 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

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

Deborah L. Weinswig - Citigroup Inc, Research Division

Charles Edward Cerankosky - Northcoast Research

Andrew P. Wolf - BB&T Capital Markets, Research Division

Brian Cullinane - Jefferies & Company, Inc., Research Division

John Heinbockel - Guggenheim Securities, LLC, Research Division

Colin Guheen - Cowen and Company, LLC, Research Division

Shane Higgins - Deutsche Bank AG, Research Division

Mark Wiltamuth - Morgan Stanley, Research Division

Kelly A. Bania - BofA Merrill Lynch, Research Division

Priya Ohri-Gupta - Barclays Capital, Research Division

Operator

Welcome to the Safeway Third Quarter 2012 Earnings Conference Call. [Operator Instructions] Today's 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. Welcome to Safeway's Third Quarter Conference Call to discuss earnings. 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 such 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 me today are Steve Burd, Chairman and CEO; and Robert Edwards, President and Chief Financial Officer. And with that, I'd like to turn over the call to Steve to discuss our earnings.

Steven A. Burd

Thank you, Melissa. So let me start with net income. Net income from continuing operations was $108 million in the quarter. This compares to $130.3 million from the same quarter one year ago. And while that reflects a $22 million reduction in net income, it's interesting to note that a couple of factors that contribute to that were activities that really occurred as onetime events in the quarter that will not be repeated. For example, our just for U launch cost in this quarter, which we identified a quarter ago would essentially end at the end of the third quarter, represented about $16 million of that $22 million. And another $5 million was associated with the disposition cost related to the Genuardi's stores that we sold. So but for those 2 factors, net income would have been flat.

If you look at earnings per share, which benefits from significant share repurchase that we made, we have $0.45 a share we earned this quarter contrasted with $0.38 a share 1 year ago, representing an 18% increase in earnings per share. So if I were to try to describe the quarter as succinctly as I could, I would say it was a quarter of significant progress.

Turning first to some highlights, our EPS results were above first call estimates and frankly, above our own internal estimates. We gained market share in both the food channel and across all outlets. ID sales were softer than expected, largely due to a decline in price inflation.

While our gross margin rate was down, more than half of this decline is explained by non-repeatable events, another 25% resulted from mix changes and less than 5% was really related to changes in price. On O&A expenses as a percentage of sales, they were down and representing another quarter of well-controlled operating expenses.

So turning first to sales, total sales decreased 0.2% from last year. This decrease is primarily the result of the disposition of the 17 Genuardi's stores in combination with a lower Canadian exchange rate. The decrease was partially offset by higher fuel sales and net new stores not depicted in ID sales. ID sales, excluding fuel, increased 0.1%. This 0.1% sales increase was heavily impacted by decline in the rate of nonpharmacy inflation and going from 1.8% last quarter to 0.8% this quarter. Sales were also impacted by a rather significant increase, which was expected, in the number of generic script sales, lowering total company IDs by 0.7%. Now this would be something that virtually anybody in the pharmacy business would also experience.

Our U.S. volume was significantly better than rest of market inside the food channel, and our U.S. volume was slightly better than rest of market in the all-outlet definition. Our U.S. food channel market share improved for the third consecutive quarter, finishing at a positive 0.4. Now that's measuring on volume. And then Safeway's U.S. all-outlet market share improved for the fourth consecutive quarter and was positive for the second consecutive quarter in a row.

Giving you a brief update on fourth quarter to date, our volume has continued to improve during the fourth quarter. The inflation rate, as we expected, has increased and now stands at just under 2% in the U.S. It has declined a bit in Canada and is just under 1% in Canada. The U.S. divisions, which as you know, all have -- are all supported by our just for U platform, are currently running at 1.4%, and total company sales are currently at 1%.

Generic drug sales, which are more profitable than branded sales, will negatively impact IDs in the fourth quarter -- will sort of peak, we'll have our largest negative impact. Generic drug sales will cost us about 0.9%. So we're probably not quite at that 0.9% delta right now. We're somewhere between 0.7% and 0.8% but -- or excuse me, 0.7% and 0.9%. But if you had that 0.8% in your ID sales, and you have the profit equivalent of a 0.8%, we'd be sitting here in pretty good shape with a number that would be north of 2%. So we feel good about that.

ID sales growth should be further impacted positively by a fuel partnership that we initiated with Chevron. It really launched just this week. But if you just think about it, in the Southern California market, we have 20 fueling stations. By the end of this month, with all the Chevron stations up and running, we will add 900 fueling stations, which basically gives us the effect of having a fueling station in the parking lot of all of our stores just from a pure convenience standpoint.

And we've talked in other venues about the impact of stores with fuel and stores without fuel. And even though it's just been 3 days, we can see that impact in the districts that -- where we introduced the Chevron relationship. And then we'll also have the Wellness initiative, which will launch in the fourth quarter.

I want to talk briefly about operating margin. Operating margin declined 30 basis points, you saw that in the press release. 23 of those basis points or 74% are associated with the just for U launch costs. Our launch costs for just for U were in quarter 2 and quarter 3. And so those launch costs are now behind us. And then 7 basis points were represented or associated with the Genuardi's closures. Even though we had listed Genuardi's as a discontinuing operation, there were some costs that affected continuing operations, which related to the disposition. So they're really related to the fact that we no longer operate these assets. So but for those 2 events, which will not be repeated in the fourth quarter, we would have been flat in operating margins.

In terms of gross margin, when you exclude fuel sales, our gross margin rate declined 45 basis points. So on the surface that looks like a significant decline but when you take it apart, you see that 14 basis points are associated with just for U. So just for U costs find themselves in both gross margin, on launch, and they find themselves in O&A expenses. Seven basis points are associated with the sale of Genuardi's, 7 basis points are associated with the fact that Blackhawk is a high-growth piece of our business, and it carries a lower overall margin, and so it affects our gross margin for the company 7 basis points. The point there is it's not related to what's happening to gross margin in the food business.

And then we did have 8 basis points of reduction in growth that's associated with higher shrink in the nonperishable areas. We've been very good on shrink for years. We expect that to reverse itself in the fourth quarter. So of the remaining 10 basis points, 3 were associated with the storm event that we called out earlier and 5 for the fact that we're now selling liquor in Washington state after spending several years to get the right to do that. And spirits simply have a lower margin than the rest of our store, and that affected us by 5 basis points. So call that a mix issue. So that leaves 2 basis points that are the result of making some price adjustments to maintain our competitive price position in those markets.

Now we did benefit from an improvement in the LIFO charge, and there were a combination of other things that basically offset the improvement that we got on the LIFO side. So that gives you a pretty good understanding of what went into that gross margin decline that was reported at 45 basis points, again, x fuel.

Turning to O&A expenses. Excluding fuel sales, the O&A expense ratio declined 14 basis points. The largest positive contributions to this improvement were higher gains on the sale of property and lower impairment charges and then frankly, lower occupancy cost. Just to comment on the property gains, the gains -- the higher gains in property were almost exclusively from our PDC, Property Development Centers, entity. This was all built into the plan. You recall at the investor conference, we called out that we would make $31 million this year from PDC. And so the PDC gains will be even larger in the fourth quarter than they were here in the third quarter.

I would remind everyone that this is a business that we elected to invest in. We think it's a natural business for us to be in. We elected to invest in it in 2009. By year end, we will have invested a total of $352 million in an effort to build this income stream. We will have harvested a total of $136 million in pretax cash, and we will have produced by year end, since the beginning of this venture, $36 million of cumulative pretax income. In another 3 years at our current pace of investment, we expect to produce an annual income stream approaching $60 million. Now the positive improvements in O&A were partially offset by an increase in the corporate pension expenses and, of course, an element of just for U launch costs.

Turning to interest expenses. Our interest expense increased $10.6 million due to higher average borrowings, again, partly offset by lower interest rates. Our average borrowing level of debt outstanding was higher -- excuse me, our average level of debt outstanding was higher by $1.8 billion due to our previously discussed share buyback program. Our average borrowing rate was lower by 73 basis points. That average interest rate went from 5.27% to 4.54%. We ended the quarter with total debt of $6,430,000,000 compared to -- with $6.9 billion last quarter or a reduction of $468 million. On August 15, we repaid $800 million that was due with a combination of free cash flow, asset sales that had been contemplated and commercial paper borrowings. At the end of quarter 3, we had $696 million of commercial paper outstanding at a blended rate of 96 basis points and an average maturity, if you will, of 27 days. So we have great access to commercial paper. On taxes, our income tax rate in the quarter was 31.5% in quarter 3 compared with 33.6% last year.

Turning to capital expenditures. We spent $160 million on capital projects in the third quarter. This compares with capital spending of $288 million in quarter 3 of last year. We've also sold or closed 23 stores, including 16 Genuardi's stores in a single transaction.

Looking at free cash flow. Free cash flow for the quarter was $505 million. This compares with $167.5 million from last year's third quarter. The cash flow difference is largely explained by the sale of some properties, again, we're talking about PDC, net cash from the Genuardi's sale, lower capital expenditures and lower inventories. We remain confident that we will achieve our free cash flow target of $850 million to $950 million by year end.

And then in the category of sort of other notable events, just to finish off, Blackhawk had another very strong quarter. The load value of cards sold increased 17% in the quarter. Year-to-date, load value has increased 24% over last year. We expect Blackhawk to have another strong quarter. We commented often about just for U, so I thought I'd give you just a little bit of an update. The last time I had a chance to talk about this publicly was at a conference in New York.

We now have 4.5 million registrants and as a reference point, we see about 9 million unique households per week. These registered households represent about 40% of total sales. Our incremental spend continues to exceed our original estimates by more than 50%, and we believe that we're on track to have 5 million just for U registrants by the end of the year, and we expect that will represent about 45% of our sales.

Just to comment on guidance, it was in the release, our EPS guidance remains $1.90 to $2.10, which is the range that we talked about at our investor conference. Our operating margin change, we still believe will be in that plus or minus 5, 5 basis points. And again, free cash flow should be in the $850 million to $950 million range.

So with that, I'm prepared to take questions.

Question-and-Answer Session

Operator

[Operator Instructions]

Melissa C. Plaisance

Before we take a question, we just have one thing.

Steven A. Burd

Yes, I misspoke. I said that our commercial paper outstanding was $696 million, and the answer is $796 million they tell me.

Melissa C. Plaisance

Okay, let's go.

Steven A. Burd

That says something about my ability to read my own notes.

Operator

Our first question comes from Karen Short.

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

BMO Capital. Just turning to just for U, can you maybe give a little more details on the number of, I guess, regular users of the 4.5 million that have registered? And then, maybe can you talk a little bit about trends that you're seeing with the used, I guess, utilization with the mobile app in the iPad versus the desktop?

Steven A. Burd

Sure. On regular users, the regular user number continues to run about 25%, 26% of registrants. So that puts us in the 1.1 million to 1.2 million range. A regular user, defined as somebody who has a pretty heavy spend and would visit the site with a lot of frequency. The incremental spend on the nonregular is about half of that of regular, so we used to be very focused on regular. But the nonregular incremental spend is actually equal to if not slightly greater than what we expected from regular spenders. So we no longer focus a lot on that separation, and the percentage of people that are going from nonregular to regular continues to grow. We started at about 20%, I think I saw a number yesterday that's around 26%. In terms of desktop versus mobile, there is a much greater propensity for people that have downloaded the mobile app to be on the high incremental spend side. I'll use the term become regular users. There's a 30% greater chance that they are regular users. And then also, mobile users spend between 40% and 50% more than desktop users. And it makes sense. I mean, we developed the site so that people could access it on their own time. And with all the mobile devices today, we all have downtime, and it's that downtime that people are using to access the site. We recently introduced an iPad application, which is organized a little bit differently than the traditional mobile application or the desktop. And I find in my own case, that I go on less often but do a more comprehensive application, and I'm quicker. So if somebody out there is just looking at number of times people go on, from comScore or somebody, it's not going to give you quite the same read. The way we organize the iPad application, it integrates your personal deals with coupons, and it separates things you buy from things we think you might buy. And so the speed at which someone can go through that is much faster than they could with either the desktop or the phone application.

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

Okay. That's very helpful. And are you seeing any competitive response? And what about, I guess, competitive response just from promotional perspective but also a competitive response on other retailers who are kind of trying to develop a similar program?

Steven A. Burd

I think it's fair to say that others, I think, will make an effort to do something similar. We think that -- we've been at this a long time. It took us a long time to develop what we did. We started with a partner, and we dispensed with the partner, developed the platform internally and dramatically improved the stability of the platform. So we have seen one competitor. We would have 200-plus digital coupons, virtually every coupon in the market, digitized. We would have very tailored offers that would number 35 to maybe 45. We do communications periodically, maybe even more than once a week to people that are responsive to that. And what I've seen from one competitor is they have 5 offers that they say are personalized, but I would challenge that. But I would expect that over time, that others will try to do something similar. But I would also expect that we would have a substantial lead, and we would have it for a long time because if you want to think of just for U today as just for U 2.0, then we have already on the chalkboard, have 3, 4 and 5. And that doesn't even count the fact that in the course of the quarter, I would bet you that we made more than 1 dozen changes to the site. So it's a very dynamic site. And when I think about 3, 4 and 5, I think about some pretty substantive changes, but we're making changes to the site on a near constant basis.

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

Okay. And then last question. Obviously, gas prices have reached very high levels in California. Did you see any impact in your comp, I guess, in the fourth quarter so far? I mean, I know you gave the generic impact, but what are you seeing in terms of shopping patterns, given what's going on with gas prices?

Steven A. Burd

We have not -- as you recall in the past, when fuel just really takes a jump, we've seen an impact on food sales. We have not seen that in California with this recent jump, and it is largely a California phenomenon because of a refinery capacity issue. And so we've not seen that. Now I also think that we might get a bit of an exaggerated response with our new fuel partner because we had this $0.50 jump in price per gallon. And if I look at 3 days' worth of activity, I would say that we're seeing a quite pronounced jump.

Operator

Our next question comes from Deborah Weinswig.

Deborah L. Weinswig - Citigroup Inc, Research Division

Citigroup. Steve, in your prepared remarks, you talked about the incremental spend continues to exceed original estimates by 50% on just for U. I was wondering if you could provide some more color around that.

Steven A. Burd

I'll give you a little bit of color, I'm not going to give you the exact number for competitive reasons. I just find it, it might be too motivational. But what we do see is we do see the effect of just for U is to cause people to come to the store more often and to buy more when they're there. And we are seeing a more pronounced impact on conventional competition than we would see on the nonconventional competition. And we know from our history of card data that people shop multiple channels. And so with what we've done with just for U and personalized pricing, it gives them an opportunity to consolidate more of their business with us and pay no more, and in fact, more often than not, pay less. The Personalized Deals are essentially designed to be the best prices in the market. And so that's what makes it so powerful and that's what causes people to devote more of their spend with us and much more loyalty on the upper end. So our top shoppers, again, very large increases; second group down, equal increases. So it's the most occasional shopper that is less attracted to this. But if you think about it, the really occasional shopper that might be spending $8 a week with us, we don't have that much of a history in order to be that personal with our offers with them. So it's really -- it's correlating just the way we thought it would.

Deborah L. Weinswig - Citigroup Inc, Research Division

Okay. And then in terms of your pharmacy business, I was wondering if you could provide an update there and just talk about how that customer is shopping the rest of the store as well.

Steven A. Burd

Sure. Our pharmacy business, if it weren't for the generics, would just be on fire. In fact, I meant to comment when I talked about our market share gains, we think that our market share is understated, and it's understated for a couple of reasons. We know from separate data that we're doing better in the pharmacy channel than a lot of our competition, and that's across all channels. And so we think that -- and that's not reflected in the market share data we get from Nielsen. The second thing that's not reflected, our volume numbers in perishables are significantly better than our nonperishable volume, and by market share numbers against volume. So we have reason to believe that our market share, because perishables are doing so much better, is really understated when I say we picked up 40 basis points of share in the food channel and positive, not a large positive number but positive across all outlets. So as we attract more customers to our stores, we had an opportunity to pick up some customers from a PBM that we were serving. But as you know, there was a PBM or some new business came on the Street. And where those new customers became -- if they were not food customers, we got an extraordinary spend. Let me just understate it by a wide margin and just say more than $60 a week, okay? And that's an understatement. So where we got a new pharmacy customer and they became a food shopper, they became a very loyal food shopper. And our expectation is that we've done a good job servicing those new customers. We're expanding our pharmacy business significantly in terms of services offered, and we expect to hold on to those customers.

Operator

Our next question comes from Chuck Cerankosky.

Charles Edward Cerankosky - Northcoast Research

Steve, when you're looking at the just for U progress, how do you feel about it in the next couple of quarters, especially the fourth quarter, because it's seasonally important, based on the way just for U ramped in the original test market stores?

Steven A. Burd

Sure. The launch involved having people in the store and actively helping customers get on the site and get registered. That all ended in the third quarter. So we've developed -- we've developed an alternative method to continue to get registrations. And that alternative method is still delivering about 50,000 new registrants per week. And keep in mind, we're only in the U.S. So we also have e-mail activity that has proven to be pretty effective. We took a group of folks that had registered but had never used just for U. And we made a targeted e-mail to 400,000, and 200,000 of them became users. So it's not just about registration. It's about building the volume of business from those that are already registered and are either nonusers or could be more regular in their use. And then keep in mind, we'll be unique in our ability to tailor fuel offers. So once we have a full complement of fuel, we can use just for U to be very specific to customers and tailor -- just as we tailor everything else in the store, we can tailor fuel offers as a function of their response rate or their level of interest in the fuel offers. So just for U is more than about bathroom tissue and cookies. It really opens up possibilities on the fuel side that exist when you have a full complement of fuel.

Charles Edward Cerankosky - Northcoast Research

Having seen things like this and simply the just for U program maturing, how confident are you the 1% fourth quarter to date comp is sustainable?

Steven A. Burd

Here's what I would say. We believe that, that number will grow. We believe it will grow because we have a Wellness initiative yet to be launched. And of the 3 legs of the stool being just for U, fuel and Wellness, Wellness is the biggest leg of the stool. And so wellness will launch, admittedly, in maybe only 1 or 2 markets in the fourth quarter, but one market for sure. And fuel will continue to grow, and just for U matures. Now what you're probably thinking of, Chuck, we were in a similar position when we announced our second quarter, we were running around 1%. And what happened in August, and I think this may have happened in more than just food retail, but it clearly happened in food retail. If you were to talk to CPG manufacturers, they would say, August was just a horrible month for them. And then the way Labor Day fell this year, it was -- it didn't work well relative to the pay period. So it was a soft Labor Day. So it doesn't matter who you're talking to in the food business, they had a downturn in August, and they didn't do well on Labor Day relative to previous year. So that had a pretty impactful effect on us. Now the only thing that will impact us coming forward is the way the calendar fell last year was really strong. And so the way the calendar Christmas and New Year's fall this year will work against us. And that will cost us about 40 basis points on sales. So what we have to overcome is we have to overcome that 40 basis points, the 90 basis points in pharmacy, which is 1.3%, but with what we have working for us, just for U, fuel coming on and the Wellness initiative, our judgment is that we overcome those things. And so I think -- my bet would be that things get better than they are right now, certainly in the U.S., and we're not expecting a falloff. But if there is a falloff, it will affect everybody. There is nothing that would cause us to do anything but be differentially advantaged between now and the end of the year. So market share should be strong and should grow.

Charles Edward Cerankosky - Northcoast Research

When -- looking at the -- oh, I wanted to ask, anything you would like to discuss about the Wellness program to put more details around that concept?

Steven A. Burd

We're getting close to launch, and I think I'm going to save it for that.

Charles Edward Cerankosky - Northcoast Research

Can you give us a time frame when it will launch, when we should expect that news?

Steven A. Burd

Fourth quarter.

Charles Edward Cerankosky - Northcoast Research

All right. It's really -- any day now, perhaps. If we're talking about the fourth quarter, what kind of debt decrease should we expect to see, Robert?

Robert L. Edwards

We don't, Chuck, give specific direction on that. But the -- as we've indicated on the prior calls, our current focus is, of course, paying the dividend. But next pay -- reducing debt. We had a substantial reduction in debt. Sequentially, Q2 to Q3, it's on the order of about $468 million. But we should expect a substantial reduction in the fourth quarter. I'm sure you noticed that free cash flow in the quarter, in Q3, was very strong at a bit over $500 million. And we expect a strong cash flow quarter also in the fourth quarter as well.

Operator

Your next question comes from Andrew Wolf.

Andrew P. Wolf - BB&T Capital Markets, Research Division

BB&T Capital Markets. I wanted to ask you about volume. It looks like it improved sequentially. Just want to confirm that the way you're -- you look at it internally, you see that number too.

Robert L. Edwards

Yes.

Andrew P. Wolf - BB&T Capital Markets, Research Division

And are you taking it -- if we take out the generics, it looks like it was flat. Is that how you're looking at volume for Q3?

Steven A. Burd

Volume -- the volume measure we're using is essentially a Nielsen volume number. So it doesn't include pharmacy, it doesn't include random weighed items, non-scannable. I think if you -- so we haven't tried to sort of overlay the pharmacy volume on that. But the pharmacy volume would be strong. And I -- but I haven't -- I don't have a pharmacy volume number in front of me. That help you? But your first assumption that we've had sequential improvement in volume is correct.

Andrew P. Wolf - BB&T Capital Markets, Research Division

Right. And if you threw in pharmacy and like you said random weighed items, produce and so on...

Steven A. Burd

Yes, it would be much higher. Could it get to flat? I'd have to think about that. I don't have the numbers in front of me. But it would be much better.

Andrew P. Wolf - BB&T Capital Markets, Research Division

And I just wanted to ask about this gas spike in California that has been recorded nationally. And has it -- I know that's going to abate or in the process of abating. But did you see any little demand shock from that? And I'm trying to ask you about that just to see how the stability of sales now and as you know we -- fiscal cliff comes in, and people are talking about perhaps things like the payroll tax holiday going away. Just trying to project how strictly the consumer is when these -- when they get a shock like the price of gas going up.

Steven A. Burd

Yes, I think that -- I think that in California, I think people are -- they're sort of understanding what created it, and they're -- California is looking for ways to accommodate the ability to bring in other fuel products. And so I think people are viewing it as somewhat that's temporary. I don't have a Consumer Confidence Index number for California. But I'm sure you saw the consumer confidence -- actually, to my surprise, actually improved in the last month's report. So I don't think that -- we have not seen -- although I might have predicted that there would be a negative reaction on food purchases from that $0.50. We have not seen it.

Andrew P. Wolf - BB&T Capital Markets, Research Division

Got you. My last question --

Steven A. Burd

It could be because of all the other things that we're doing that attract people to our stores. I don't know.

Andrew P. Wolf - BB&T Capital Markets, Research Division

Okay. I just wanted to -- with such a strong event, as you're watching the news, gas above $5. Okay. Thanks for that color. Lastly, it looks like just from the numbers you gave us, as the U.S. is strengthening both in dollars and inflation, Canada's maybe softening a bit. You don't give out those numbers every quarter, but, you just give us a broad brush stroke of what's going on in Canada? Is there anything competitively that's part of the reason the inflation rate's slowing and maybe the sales are a bit as well?

Steven A. Burd

Canada has tended to sort of track about a couple of quarters behind the U.S. So when we were experiencing a decline in inflation, they were either holding or seeing some increases, so. I think that -- I think that the pattern in Canada will be similar to the pattern in the U.S. It just seems to lag by a couple of quarters. So if right now, they're seeing a decline in inflation, that will probably -- that will probably hold. In a quarter or 2, it will begin to go north again. That's been the pattern for the last couple of years. But I don't see anything from a competitive standpoint that really affects us differently in Canada.

Operator

Your next question comes from Scott Mushkin.

Brian Cullinane - Jefferies & Company, Inc., Research Division

This is actually Brian Cullinane on for Scott, from Jefferies & Company. Just wanted to touch on just for U and kind of as we go forward, so you've seen good usage, and I just wanted to ask about how long you think these benefits will last. And do they snowball, do they keep picking up, or after a while, do they kind of flat line and that's just part of your IDs? Just wanted to touch on that quickly.

Steven A. Burd

Well, I think that we constantly learn with the information that we're getting. And so I think there will come a time where it just kind of gets integrated into the business. But I think that the upside for just for U, really lies ahead of us. I think I had commented on an earlier call that we hope to cover 45% of our sales by the end of the year with registrations. I don't think, realistically, you can get that number above 65%. And I think that's fine. But I think just for U, in combination with all the other things that we're doing to build loyalty, there may be a time where it's -- it could be difficult to say, well, is it the fuel program that's doing that? Is it the Wellness program that's doing that? Or is it just for U? Because just for U -- think of just for U as a communications vehicle. So it might be communicating what's going on at Wellness, it might be communicating what's going on in the fuel program. And so it -- I think it has legs that go beyond making offers for basic items in the aisle. And so we think that this should be able to build sales for several years. I call it the -- it's really our marketing platform for the next decade.

Brian Cullinane - Jefferies & Company, Inc., Research Division

Okay. That's helpful. And then maybe just, it almost follows on that point, but anything else strategically as Walmart has talked about penetrating some of your markets, especially Southern California and Chicago. Is anything else that you're -- you'll think you'll have to do over the time when they start to open up a big amount of stores as our research has suggested?

Steven A. Burd

Yes, several years ago at an investor conference, we essentially laid out the competitive impacts of different vehicles compared to a conventional supermarket. And it's still true today that the conventional supermarket has the most impact. We've experienced a number of competitive openings, actually in the last 4 weeks. So my fourth quarter numbers reflect a fair number of those openings. So they're embedded in that 1.4% sales increase number. And what typically happens, it doesn't matter who the competition is, there's a curiosity for people to go look at that competitive format. And our experience is that the effect in the first week or 2 gets cut in half about 4 to 6 weeks out. So it's really too early, except I would tell you that the pattern of competitive impact is about what we predicted. So there's nothing -- nothing extraordinary happening there. And we think that with the -- with the 3 elements that we're going to market with to build loyalty and grow sales and market share, that we shouldn't have any difficulty with the new competition coming in. It's -- maybe fourth quarter sort of driven this year, but it's not an abnormal year for competition.

Operator

Your next question comes from John Heinbockel.

John Heinbockel - Guggenheim Securities, LLC, Research Division

Guggenheim. So Steve, when you look at the geographic variance in the just for U adoption, how variable is it? And when you can identify where there's a very high rate of adoption, what are the common factors? Or is there no common thread?

Steven A. Burd

Yes. A couple of things. Generally, the more mature the market, the more loyal users we have, which makes sense. I think that where we were able to launch the mobile app simultaneously to the desktop, which occurred for the first time, that did not happen with AmEx or NorCal, or even Vons, that those markets have matured more quickly. And so I would tell you that if you looked at -- if you looked at markets where you have -- where you introduced the mobile app, and you look at the -- let's just take the 12-week market maturity or the 16-week mark, there would be remarkable similarity. So there's no real geographical difference in terms of rate of adoption. If you look at markets where you didn't have that, it didn't mature at the same level. Now the other thing, I think there's a -- there might be a bit of a misconception about how hard we've marketed this. We used a lot of store labor and we used some incentives on the gross margin side to get registration. But we now have -- we have banners in the entrance of all of our stores, which I think is -- has been fairly impactful. Those banners haven't been up for more than 8 weeks, maybe even less. We -- we've not done radio spots specifically to just for U. We've simply tagged those. Of course, we mention it in our weekly inserts. We have never done television. One of our competitors who has a -- I'll call it a -- I don't know about that -- I don't want to -- I'll call it the poor man version of just for U, okay, where they make 5 offers, right? I mean, I think we could all agree that, that's not 300, okay? They launched a TV commercial. We will do TV, we haven't done it. And we'll get ourselves in a position to do that. But I think that will also be additive. And then there's so many other ways we can communicate to our shoppers in our stores, and there's so many other ways we can interlink these 3 legs of the stool that we should continue to build a following here.

John Heinbockel - Guggenheim Securities, LLC, Research Division

So that doesn't correlate with market share very well?

Steven A. Burd

No. No, it does not.

John Heinbockel - Guggenheim Securities, LLC, Research Division

Okay. The other thing, so the fact that you've seen a pickup in inflation, it's early relative to what I would have thought. I would have thought maybe January or so. Where is that coming from?

Steven A. Burd

It's really -- it's coming -- the pickup in inflation is coming from the perishable area, and it's a comparison issue more than some of the other issues, I think, John, that you're looking for in the long term. And that's -- so it's a comparison to -- we've been going against some much stronger inflation from previous years and that's why it's been down. We're cycling that in some of the perishable categories. So the kinds of things that would affect fundamental crops, I think that's kind of a 2013 number.

John Heinbockel - Guggenheim Securities, LLC, Research Division

And does that suggest that we could be -- I thought maybe, 3 to 4 is the right number by middle of '13. Because of what you're seeing now, might we be higher than that? Or not...

Steven A. Burd

I think that -- I haven't sat down with our sort of forecasters on this. I think that most people would bet with you that if you approach 2% in the fourth quarter, you'll be higher next year. We've come to believe that in this economy, with consumer confidence where it is, that 2% is the new sweet spot. And that if you get north of that, you can have some demand-depressing effects. Now if the economy gets better, the long-standing sweet spot has been 3%. So if we get an improvement in the economy, then we wouldn't be bothered if this thing moves to 3%. But again, I think from a competitive standpoint, if it does go to 3%, it affects everybody. And then if you have -- if you have some things going for you on points of difference like we do, we should continue to gain market share. I mean, I don't see any reason why our market share shouldn't get better over the next 5 quarters. I mean, they're -- absolutely should get better. And if we can figure out a way to incorporate pharmacy and perishables into market share, I think it'd be a little bit more clear to people that our market share gains are more substantial than I've been able to describe.

John Heinbockel - Guggenheim Securities, LLC, Research Division

And one last thing. Profit growth at Blackhawk, I guess should be running north of load value growth, is that fair or no?

Steven A. Burd

It -- historically, as you move through time in a small business, you should be leveraging -- should be leveraging some of your fixed cost. The counter to that is that we are investing in a number of new businesses. Like we've -- I think we've talked about our investment in the digital wallet. And so we haven't provided specific guidance on that, but it's going to -- it's going to be a high-growth company for, we think, an extended period of time.

Operator

Your next question comes from Colin Guheen.

Colin Guheen - Cowen and Company, LLC, Research Division

Okay, just a question on just for U. When you refer to maturation, is it fair to assume you're speaking about registrations, not actual usage of the program?

Steven A. Burd

I think that's -- and that's kind of what I'm -- I'm thinking about, there is a maturing in the registration cycle, but I also think there's a maturing in the use cycle. So I think it really affects both. I commented that our regular users had gone from 20% to 26%. So I would call that maturing post registration in just the amount of use. We think -- we haven't done this yet, but I've asked the marketing team to specifically communicate with iPhone users who probably have iPads, to get them to think about converting to the iPad because the iPad is a -- that site is much easier to navigate, it's much quicker, and the people I know that have iPads, they tend to take them everywhere. If they're at home, they take them from room to room. I mean, the phone may not be very far behind, but it's a much smaller screen. So I think that we can get some real maturity by converting desktop to mobile, and we can get more maturity in terms of use by converting phone to tablet. And so I think you have to think about maturity on both registration as well as usage.

Colin Guheen - Cowen and Company, LLC, Research Division

Okay. Then the logical next steps, I think you referred to them as steps 3, 4 and 5, those again would be aimed at building basket as we look at the comp number?

Steven A. Burd

They would be aimed at building basket, they would also create some features that we don't have today that would, I think, increase usage of the existing registrants and I think also attract new registrants.

Colin Guheen - Cowen and Company, LLC, Research Division

And then a question on the fourth quarter, with the rollout of Wellness, I think you articulated that this -- the onetime spend for just for U goes away. Does that just get replaced with spend against the Wellness program?

Steven A. Burd

The Wellness program, we're obviously working on the launch aspects of that now. I don't think I could give you a number. But I'm not expecting there would be sort of any material event in the fourth quarter, relative to Wellness.

Colin Guheen - Cowen and Company, LLC, Research Division

Okay. And I guess with the guidance, with one quarter to go, the guidance range is wide. Is there anything versus where consensus expectations are that you'd like to highlight?

Steven A. Burd

The only thing I would comment on, it's a fairly -- you're correct, it's a fairly wide number. And the -- it's the same number we gave early in the year. It's common as you come in to the fourth quarter at this point to kind of narrow that range. We've chosen not to, and the real reason for that is that embedded in the guidance that we've provided was an expectation that we would settle an outstanding lawsuit, and we still expect that to happen, and we expect that to happen in the fourth quarter. And because you don't have absolute certainty on that, we're leaving the range just as it is, because that covers it settling, and that covers it not.

Colin Guheen - Cowen and Company, LLC, Research Division

Okay. But you've not provided a magnitude of that settlement?

Steven A. Burd

No.

Operator

Your next question comes from Charles Grom.

Shane Higgins - Deutsche Bank AG, Research Division

It's Shane Higgins from Deutsche Bank for Chuck.

You just -- Steve, I just wanted to drill down a little bit into the core gross margins. You said shrink was a negative 8 basis points impact during the quarter, and that's been an area where you guys have really made a lot of progress and it's been a nice tailwind for you guys. Can you just give us a little color on what happened with shrink and was that linked to the slowdown in inflation?

Robert L. Edwards

Yes, that was actually part of it. So there was slightly higher shrink in the quarter, primarily on the nonperishable side of the business. We've addressed those issues, and we expect a strong quarter in the fourth quarter of the year. And you're right, this has been a competitive advantage for us and had to do somewhat with the comparables from last quarter. But any issues there, we fixed, and shrink should be fine in the fourth quarter.

Steven A. Burd

We've continued to make progress on shrink. So our shrink numbers are lower this year than last year, and if you just look at -- if you think about our shrink as a waterline in a glass, if we didn't get any better in the fourth quarter, we'd be a lot better than last year. And we have a chance to continue to get better in the fourth quarter. So we think that our fourth quarter performance will erase this blip on the screen.

Shane Higgins - Deutsche Bank AG, Research Division

Okay. Great. That's helpful. And can you guys speak to the impact of the growth in generics on your gross margins? I know that's generally a higher margin sale than third-party brands.

Steven A. Burd

I've quantified that from time to time. It is higher margin. The way to think about it, is that when you look purely at ID sales, the effect of generics is as if -- I mean, it's a 90 -- it's a 0.9 negative on IDs. But from a margin standpoint, it plays out as if it were, our sales were 0.9 higher. So I don't think I could give you a specific number. But it would easily be 15 basis points higher than branded and could be north of that.

Shane Higgins - Deutsche Bank AG, Research Division

Do you think that had -- I don't -- I know you guys didn't call it out, did that have a positive or negative, or was it kind of a flattish impact on GPM for the quarter?

Steven A. Burd

Well, it would have a -- it would have a positive impact on gross margins for the quarter. I mean, there are other things that we've done in the pharmacy area. So our pharmacy profitability is considerably higher than it was a year ago, considerably. I mean, it's one of the larger profit growth areas of the enterprise.

Shane Higgins - Deutsche Bank AG, Research Division

Do you think you guys have kept some of the traffic that you guys got from the Walgreens Express disruption?

Steven A. Burd

We know we've kept it. I get a daily report, and we know we've kept it.

Shane Higgins - Deutsche Bank AG, Research Division

That's great. And could you guys, just one last thing, talk about the impact of trading up, maybe to organics, I know that's been an area we've heard from some of your competitors that continues to grow. And I know you guys have the O Organics line. Can you just speak to that and maybe where trends are there?

Steven A. Burd

Yes, I mean, I think that -- I think there's a long-term interest in organic, and I think there's a long term interest in natural products. I think people are striving to -- people understand the relationship between nutrition and health. Now we, ourselves, are not attributing any particular nutritional benefit to organics, but people like the fact that those are organic products and feel more comfortable buying those products. I think it's a -- it's not a fad, I think it's a trend. I think it'll continue to grow. Our O Organics business continues to do well. Our organic produce items continue to grow. And I think that, that's a long-term trend.

Shane Higgins - Deutsche Bank AG, Research Division

Has that been contributing to your private brands penetration?

Steven A. Burd

Yes.

Operator

Our next question comes from Mark Wiltamuth.

Mark Wiltamuth - Morgan Stanley, Research Division

Mark Wiltamuth from Morgan Stanley. Steve, could you give us some insights on where the packaged food companies are in terms of asking for price increases? Because given what happened with the drought this year, I would think many of them are at least looking at cost up to them. And I'm curious if they feel like they can get a price increase through, given that volumes are running negative.

Steven A. Burd

Yes. My response to that is, I think that volume has been negative for the packaged goods folks for some time. And so there is a -- there is a reluctance to raise prices, and not that we don't get price increases, but if I were -- sitting here today, this time of year, often we're hearing about the desire to sort of raise prices. But I think if you've been running negative 3%, negative 4% on volume, you're looking internally at ways to cut cost. And so if you get an extraordinary commodity increase, people are going to have to react to that. But basically, where there are some commodity areas like dairy, cheese and eggs and -- those are really, those are real commodities, and they -- those things get passed on and many of those happen to be Private Label items, not cheese but certainly eggs and dairy. So that gets passed on by the market. But I would say that I think the packaged goods sector is behaving cautiously with respect to cost increases, as you would expect them to.

Mark Wiltamuth - Morgan Stanley, Research Division

Okay. And just to follow up a little bit more on the guidance, this quarter, you were kind of mute on the ID guidance outlook. Last quarter, you were still carrying the 1% to 2% ID guidance. So what really made up the difference to keep you at the EPS goals? Was it that the buyback was so substantial that it makes up the difference? Or was there anything happening on the margins that kind of keeps you in that range?

Steven A. Burd

Yes, I mean, I think that whenever you prepare your plan and prepare your guidance, you have -- you give yourself some room to deal with unforeseen circumstances. And we just can't predict the rate of inflation, which has -- which could have a material effect on IDs, as it did here in the third quarter. But everything we're doing gives us comfort on the earnings and the cash flow in the margin side. So I think that we expect to hit those predictions.

Mark Wiltamuth - Morgan Stanley, Research Division

Okay. And then so the comp does look like it's going to be something probably under 1 here for the year? 0 to 1, in that range?

Steven A. Burd

It's -- yes, to hit 1 would be quite challenging on the year.

Operator

Our next question comes from Kelly Bania.

Kelly A. Bania - BofA Merrill Lynch, Research Division

It's Kelly Bania from BofA Merrill Lynch. Steve, I was wondering if you could go back to some comments that you made earlier on the call. I think you mentioned that your total company IDs are running about 1% in the quarter and then divisions with just for U were running about 1.4%. So I was wondering, one, if that is just the difference of Canada not yet having just for U launched and if there are still plans for Canada to launch. And then two, are you still guiding the about 2% ID lift that you guys expected from the just for U launch?

Steven A. Burd

Yes, I think that the difference between say, the U.S. and Canada is probably a combination of 2 factors. One is not having just for U and a differential rate of inflation. I didn't comment on this earlier, but I did in the last quarter. I think that I could -- I can attribute virtually all of the market share gains to the just for U platform. Not that we aren't doing a lot of other things, but I think without just for U, we would not be sitting here with positive share change across all outlets. And we wouldn't be sitting here with 40 basis points of volume improvement inside the channel. In terms of what just for U is delivering, the just for U expectation was that, when we get to a decent level of maturity, we should be getting something in the 2% range. Now there are lots of other things that get in the way and are offsets to that. Changes in inflation affect that number. We're sitting here, and I'm looking forward to the day when we don't have these extraordinary changes in generics, at least from an ID sales standpoint. Because even though we love the profitability aspects of it, we seem to get beat up for not having the IDs. And everyone should just think about -- if since the 0.9 negative has the profit effect as if it were a positive 0.9, we're basically having the profit experience of somebody with a 2.3% ID. And there are people out there with a 2.3% ID that the Street thinks are masters of the universe. And they don't have nearly -- the pharmacy make-up in their sales isn't nearly what ours is. And so I think that we've done quite well. I think that we're not happy with the level of IDs that we've put in this quarter, but if you think about -- I've used the expression 3 legs of the stool, the other way to think about this is sort of -- I could only imagine what it's like to turn an aircraft carrier 180 degrees, and it seems to me it takes a lot of effort and a lot of energy and a little more water. And that's what the launch costs of just for U are all about, that's what the preparation for fuel is about, that's what the 2.5 years of time and effort in building the Wellness initiative are all about. So I think if you look forward, if you believe as we do, you should be quite optimistic about what this company can do in terms of market share gains, in terms of operating income performance. And we always said that you wouldn't have to wait forever to see this, that you would see it the second half. We think you're clearly seeing it in market share, we think you're seeing a stabilized EBIT margin and the next thing to come is frankly, a strong ID. And that happens when at least 2 of these initiatives are in full swing. We've said that we will be working -- we'll have all 3 of them operative, maybe not in full swing, but in the fourth quarter. And then by the end of next year, they're all operating at full throttle. You've got a mature just for U, you've got a completed fuel loyalty network and you've got a very robust, all U.S. market Wellness initiative in play. So frankly, I don't know how people will read today's results, but we read them as very significant progress on a mission that we started 2.5 to 3 years ago.

Melissa C. Plaisance

Thanks. We're running a little long, so we have time for one last question.

Operator

Thank you. Our final question then comes from Priya Ohri-Gupta.

Priya Ohri-Gupta - Barclays Capital, Research Division

Barclays. Robert, you had previously alluded to your CP balance being close to 0 by year end, as that was your historical sort of trend. Is that something that we should continue to expect in the coming quarter?

Robert L. Edwards

Yes, that is our objective.

Priya Ohri-Gupta - Barclays Capital, Research Division

Okay, and that will come from free cash flow and what, in addition to that?

Robert L. Edwards

Well, yes, free -- yes, that's primarily it.

Melissa C. Plaisance

Okay, everyone. Thank you so much for participating today. Christiane Pelz and I will be available for the balance of the day with any clarifying questions. 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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