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The Kroger Co. (NYSE:KR)

F2Q08 Earnings Call

September 16, 2008 10:00 am ET

Executives

Carin Fike - Investor Relations

David B. Dillon - Chairman, Chief Executive Officer

W. Rodney McMullen - Vice Chairman

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

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

Analysts

Karen Short - Friedman, Billings, Ramsey & Co.

Deborah Weinswig - Citigroup

Meredith Adler - Lehman Brothers

Neil Currie - UBS

Charles Cerankosky - FTN Midwest Securities Corporation

Jason Whitmer - Cleveland Research Company

Edward Kelly - Credit Suisse

Mark Wiltamuth - Morgan Stanley

Scott A. Mushkin - Banc of America Securities, LLC

Andrew Wolf - BB&T Capital Markets

Operator

Welcome to the second quarter 2008 Kroger Co. earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today's call, Carin Fike, Director of Investor Relations.

Carin Fike

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

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

Before I turn the call over to Mr. Dillon I want to take a moment to remind you about our upcoming investor conference here in Cincinnati on October 15th and 16th. We hope you will be able to join us. If you need information about the conference, please feel free to contact me after this call.

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

David B. Dillon

With me today to review Kroger's second quarter 2008 financial results 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. In a few minutes, Rodney will discuss details of our quarterly and year-to-date performance. First, I'll begin discussing what we're seeing in terms of current economy and how we're managing our business successfully in this environment, then we'll be happy to take your questions.

Our performance in the last few years and the quarterly and year-to-date results we announced this morning highlight the underlying strength of Kroger's business model. Our customer-driven model, now in its fourth year of implementation, is comprehensive and leverages all facets of our business. While we manage this model on an annual basis, its inherent value is the flexibility it gives us to successfully navigate through various challenges we face from quarter to quarter. It allows us to remain focused on our plan and we are not forced to make short-term decisions that may negatively impact our long-term connection with customers. We believe this will create long-term sustainable earnings growth that will benefit our shareholders.

And through our customer first strategy, we are squarely focused on our people, our products, our prices and the overall shopping experience for our customers. This strategy is designed to satisfy all customer segments, not just a subset of those we serve. We believe it is possible to do this. We know it's difficult to accomplish. We also believe we are the only retailer that has the infrastructure in place to accomplish this objective.

In a moment I'll share some details on how our team is successfully applying Kroger's strategy to take advantage of opportunities in today's challenging environment. Before I do that, I will provide some context on current trends we're seeing.

During the quarter we did see more signs that the weak economy continues to drive consumer behavior. This was evident in some changes in our sales mix, such as corporate brands, for example. I will share some details about that in a few minutes.

We also saw some stronger sales trends in our value-oriented stores. Both of these changes would suggest that some shoppers are looking for ways to stretch their budgets. At the same time, we believe we continue to benefit from customers choosing to eat at home more often. While some may be choosing to do so for economic reasons, others are adopting this practice in response to compelling evidence indicating that children who dine regularly with their families have a better chance of avoiding risky behavior such as substance abuse. We think strong sales in our deli/bakery and prepared foods correlate with this shift and with declining sales trends some casual dining chains are reporting.

We also saw product cost inflation accelerate in the second quarter. We estimate that our year-over-year product cost inflation was 4.9% excluding fuel. This rate was influenced by double-digit inflation in produce, an area where product cost can be volatile, but it's also influenced by high product costs in the grocery department, in the 5% to 6% range, which is the highest level of center store inflation that we've seen since the late 1980s. Inflation was also strong in the deli/bakery department. We continued to successfully pass along higher product costs in the form of higher retail shelf prices so, while customer behavior continues to change, we believe there's an opportunity for Kroger to gain share in this environment.

Through the first four weeks of the third quarter, Kroger's identical supermarket sales, excluding fuel, are trending above 5%. We continue to take advantage of opportunities that promote the long-term growth of our business. We have many established competitive strengths to draw on to accomplish this successfully.

One of the most sophisticated tools we use to leverage opportunities in any economy is our vast collection of consumer data derived form our customer loyalty cards. We use this data to anticipate and respond to changes in consumer behavior. We've been building our extensive collection of consumer data since 1999. Today more than 40% of all U.S. households one of our shopper's cards. As a result, Kroger has one of the largest retail customer databases in America.

Our partnership with dunnhumby USA gives us valuable insight into our customer's shopping habits. Through this insight we're able to use our customer loyalty data to benefit our customers and increase their engagement with our stores. Our work with dunnhumby also allows us to segment our store base to offer customers in each store the right mix of products and services. This store segmentation strategy and Kroger's multiple formats allows us to meet the specific needs of various customer segments.

Our customer loyalty program also enables us to provide a valuable food safety service to our customers. We recently began incorporating receipt tapes and phone calls in our customer notification system for certain types of product recalls. Using our customer loyalty database, we're able to notify customers through their receipt tapes about the recalls of products that they may have purchased. We are one of the first retailers to use this personalized communication to our customers. Customers have told us how much they appreciate our effort to partner with them to keep their families safe.

Another key opportunity for us in this economy is our innovative private label program. We continue to see shares of Kroger's corporate brands increase. In this economy, customers are much more willing to try a private label item, and we're seeing signs that this is happening more and more as the year progresses. Our strong corporate brand program also gives us some leverage when a supplier approaches us with a product cost increase. This leverage becomes even more important in an inflationary economy.

Our three-tier program - Private Selections, Store Banner and Value brands - is the most extensive in the industry, with more than 14,400 items. We introduce new items on a regular basis to appeal to customers on any budget. Recent examples include Private Selections Organic meats, Active Lifestyle breads, and Three-Minute pizzas.

As I mentioned last quarter, Private Selections is our fastest growing brand. During the second quarter this line of premium products continued to do well with all customers, not just the customers who are upscale. Based on year-to-date trends, Private Selections will be a $1 billion brand for Kroger in 2008.

Our Value brands, designed for more price-sensitive customers, are also building share. Our data shows that our private label grocery items in terms of dollars represents a record 26% of the company's grocery sales. Our share in terms of units is a record 33%. We believe investments we have made to strengthen our corporate brands program in the past several years will continue to drive future growth.

As our progress in these areas show, we may be a traditional retailer, but we have a decidedly innovative and insightful approach to our business. Our strategy continues to serve our customers, shareholders and associates well, as our strong second quarter and year-to-date performance demonstrates. Kroger is delivering sustainable results today while we continue to invest for the future. We know market conditions will continue to be a challenge, and we believe our strategy works well in good times and bad. Kroger's team and our overall strategy clearly stand out in the current environment.

Now I'd like to turn the call over to Rodney for some additional detail on our second quarter results and 2008 guidance.

W. Rodney McMullen

Dave just described how Kroger is managing through the current challenging operating environment. We are pleased with Kroger's second quarter results, particularly in the context of this environment, and we believe they illustrate the strength and flexibility of Kroger's business model in varying economic conditions. We remain focused on delivering our annual financial commitments to investors and believe we are on track to do so. During the next several minutes I will offer a deeper dive into Kroger's financial results and share some color behind our updated full year outlook.

Let's start with identical sales. We continue to see growth across most all departments. Our drug/general merchandise department identicals were flat compared to the prior year, and this is a little softer than the first and fourth quarters. Like some other retailers, we saw softness in certain discretionary items. This is consistent with what we've been seeing in those areas of our business for the past couple of quarters now. Yet still Kroger reported a 4.7% increase in identical supermarket sales excluding fuel for the quarter. This demonstrates the strength of our business and, as Dave mentioned, third quarter identicals, excluding fuel, through the first four weeks are about 5%.

Kroger's earnings for the quarter were $0.42 per diluted share, an increase of $0.04 over the prior year. About $0.01 of the increase came from strong margins at our retail fuel operations. I'll talk more about our fuel margins in a bit.

First, I'd like to discuss some metrics that describe the performance of our core grocery operations. As many of you know, Kroger's business model is designed to provide investment in lower gross margins. As a result, Kroger's second quarter FIFO gross margin excluding fuel declined 51 basis points. Our supermarket selling gross margin excluding fuel declined 59 basis points. The 8 basis point difference between these two measures is primarily explained by 15 basis points of margin pressure from higher diesel fuel costs, partially offset by a 10 basis point improvement in shrink.

Recall that Kroger's non-fuel FIFO gross margin and supermarket selling gross margin expanded by 51 and 38 basis points, respectively, in the second quarter last year, primarily reflecting the timing of passing on product cost inflation in certain categories such as dairy to customers. If our second quarter 2007 FIFO gross margin had been more normalized, our rate decline in the second quarter this year would have been less.

Another portion of the decline relates to product cost inflation and our practice of protecting penny's profit when we raise retail prices in response to product cost increases from suppliers. While this practice is designed to ensure that our gross margin dollars remain intact or even grow, it can have the effect of lowering our overall gross margin rate.

Turning to OG&A, our rate in the second quarter excluding fuel declined 28 basis points compared to the prior year. The prior year OG&A rate included pre-opening and transition costs associated with the Scott's and Farmer Jack acquisitions. The current year rate benefited from the absence of these costs. The current year rate also benefited from strong sales leverage and lower incentive compensation expense. Collectively, these benefits offset continued inflationary pressures that we face in several areas of our business, including credit card fees, utilities and store supplies.

Note that when I mention higher utility costs I am talking about the impact of higher utility rates. As we have told you before, our associates have done a remarkable job in controlling usage in this area. Since 2000 we have reduced our overall energy consumption per square foot by over 24% or 1.5 billion kilowatt hours.

While OG&A and FIFO gross margin were the main drivers of our second quarter operating margin, I also want to point out that rent and depreciation expense on a combined basis provided 6 basis points of operating margin leverage. One of the reasons we believe that a moderate level of inflation benefits our business model is because of the leverage we get from the increased sales dollars over the fixed costs in our business. This is a great example of that leverage.

Kroger's non-fuel operating margin declined 20 basis points as a rate of sales in the quarter, but we believe a longer view on operating margin is a more meaningful indicator of our business and our strategy. Excluding fuel and charges for labor unrest in the first quarter of 2007, Kroger's operating margin for the first two quarters of fiscal 2008 declined 8 basis points; 6 basis points of this decline can be tied to the higher LIFO expense in the first half of this fiscal year versus last year. Hold onto this thought because in a few minutes, when I discuss our updated 2008 guidance, it will help you understand why we are still predicting a flat or slightly improving nonfuel operating margin on an annual basis.

Kroger's tax rate for the quarter was 36.5% compared to 38.2% in the prior year. The current year rate benefited from a favorable resolution of certain tax issues, whereas an unfavorable resolution of certain tax issues in 2007 affected the prior year rate. We now anticipate a full year tax rate of approximately 37%.

Total debt increased $1 billion to $7.6 billion compared to the second quarter of 2007. This represents a decline of $176 million from the first quarter of 2008. Our net total debt to EBITDA ratio has improved to 1.9 times compared to 1.95 at the end of the first quarter of 2008 and 2.03 at the end of fiscal 2007. We expect our net total debt to EBITDA ratio to show slight improvement over time. This assumes capital investments of $2 billion to $2.2 billion for fiscal 2008, consistent with our prior guidance. It also assumes that we will use our current share repurchase authorization over the next six to nine months.

We are exploring some good opportunities to buy real estate we currently lease. If those opportunities are realized, our capital expenditures and debt levels could increase. This would be offset by lower rent expense.

Before I turn to our updated guidance, I know several of you are interested in some data points about our retail fuel operations. Recall that in the second quarter of last year we experienced stronger than usual fuel margins. Consequently, we anticipated a tough comparison in the second quarter this year. But as wholesale fuel prices declined through much of the summer, we saw some expansion in our fuel margins. This expansion reflects our typical experience in this business.

As a general rule, when wholesale fuel costs are rising, our margins tend to contract inversely when wholesale costs are declining, our margins in this business expand. This relationship makes it difficult to forecast the quarterly margin of our retail fuel operations, but over a longer time frame fuel margins normalize and that is why we manage this business from an annual perspective. Cents per gallon data for the second quarter and on a rolling four-quarter basis illustrates my point. For the second quarter, the cents per gallon fuel margin for our convenience store and supermarket fuel centers was $0.179 cents compared to $0.162 in the prior year. On a rolling four-quarter basis, cents per gallon fuel margin was $0.12 this year compared to $0.128 last year.

Now let's discuss Kroger's updated 2008 guidance. I want to point out that these expectations are before the effect of Hurricane Ike. As announced in our earnings release this morning, we raised the low end of the range of our annual identical sales guidance. We now expect identical sales growth of 4.5% to 5.5% excluding fuel for fiscal 2008.

We confirmed our annual earnings guidance of $1.85 to $1.90 per diluted share. Note that this confirmed guidance contains a full year LIFO charge estimate that is $30 million higher than the estimate we shared with you back in June when we reported Kroger's first quarter results. We now anticipate a full year LIFO charge of $160 million. We increased our estimate due to the latest projections we have for grocery and produce prices at the end of the year. Our outlook on dairy prices has not changed materially since we discussed our LIFO estimate with you back in June. Recall that our actual LIFO expense for 2008 will be determined in the fourth quarter based on inflation rates and inventory mix at that time.

We expect that our annual earning per share growth will be driven by a combination of strong identical sales, a flat to slightly improved operating margin excluding fuel, and fewer shares outstanding.

We expect some operating margin expansion in the second half of the year tied to the timing of our LIFO expense in fiscal 2008 compared to fiscal 2007. In fiscal 2007 we recorded a full year LIFO charge of $154 million. Of that full year expense, $94 million was recorded in the second half of the year, with over one-third of the full year expense recorded in the fourth quarter alone. For the current year, we have already recognized a little over half of our expected $160 million LIFO expense. We expect this timing issue will bring some operating margin leverage during the back half of fiscal 2008 and in the fourth quarter, particularly.

We've included the possibility of a flat non-fuel operating margin in the event we encounter continued inflationary pressures in key items.

Now turning back to Kroger's earnings per share guidance for a moment, I want to remind investors that our earnings guidance of $1.85 to $1.90 per diluted share reflects 9% to 12% growth over fiscal 2007 earnings of $1.69 per diluted share. Kroger's dividend rate yield of more than 1% further enhances shareholder return. That's a solid return in several economic environments, and especially in the current market.

Although it is not our practice to give quarterly guidance, I want to discuss some items that affected our quarterly results last year to help you adjust your financial models for the second half of fiscal 2008. We continue to expect solid results from our core grocery operations, but I want to remind investors, as we've stated throughout the year, we anticipate Kroger's lowest year-over-year earnings per share growth rate will occur in the third quarter.

Third quarter results last year included a $40 million tax benefit. We used some of this benefit to offset low fuel margins and to accelerate some strategic investments we had scheduled in our business plan for later periods. A portion of this tax benefit also benefited our bottom line. The net effect of our third quarter results was income of approximately $0.02 to $0.03 per diluted share. As a result, we expect that Kroger's earnings per share in the third quarter this year will range from slightly below to slightly above prior year results. After adjusting the prior year net benefit, this would represent an increase in this year's expected third quarter earnings per share.

As we have shared with you previously, we continue to expect that our fourth quarter earnings per share growth rate will be higher than the company's annual earnings per share growth rate, driven by solid results from our core grocery operation as well as the LIFO timing issue I described earlier.

As I mentioned earlier, the third and fourth quarter expectations that I have just described exclude any impact from Hurricane Ike. The Hurricane and its remnants affected Kroger operations in Texas and several inland states, particularly Indiana, Kentucky and Ohio. The financial impact of the hurricane will not be significant enough to cause us to alter our strategy. The final result of the damage and the disruption from the storm could affect much of the guidance we discuss today. A more detailed description of the potential impact on Kroger's guidance and the explanation of our insurance programs are included in the 8-K we filed today.

I'll wrap up with some comments on labor relations. During the quarter we reached agreement with unions representing our associates in Columbus and Nashville. Other negotiations we are engaged in this year cover store associates in 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'll turn it back to Dave for some closing remarks.

David B. Dillon

We had a solid quarter. Our long-term investments in our people, our prices and our stores pay off in this type of environment. Still, we know there are challenges ahead. Our associates in every area of our business focused on executing our customer-first strategy to meet the changing needs of today's shoppers. As a company, we are committed to delivering the results we have forecasted for the year.

Now we'd be happy to take a few moments to answer your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Karen Short - Friedman, Billings, Ramsey & Co.

Karen Short - Friedman, Billings, Ramsey & Co.

A quick question just on the gas margins. I know you tried to give some color on the rolling fourth quarter or 4Q gas margins, obviously, and gave the numbers for this quarter. Could you just tell us what the gas margins were in the third quarter and fourth quarter of last year?

W. Rodney McMullen

We will when we release third and fourth quarter, but I don't remember those off the top of my head. Sorry.

David B. Dillon

We thought the rolling four quarters would give you a good enough sense of what a full year looks like.

Karen Short - Friedman, Billings, Ramsey & Co.

And then I guess the second question I had is do you have some sense of what the generic impact is on your IDs or what it was this quarter versus last year and I guess versus the first quarter?

David B. Dillon

If you look for the quarter versus last year, pharmacy generics impacted our identicals in total by about 0.5%.

Karen Short - Friedman, Billings, Ramsey & Co.

And then I guess just comments in general on what you're seeing from the competition. I mean, you know, if you kind of look at the landscape, it seems that your conventional competitors are getting a lot more focused on offering value and obviously they're several years behind you in terms of that initiative. But, you know, can you give us some color on what your thinking is in terms of the competitive landscape as you kind of deal with that?

David B. Dillon

Well, it probably won't help you very much but we see the competitive landscape as continuing to be challenging. It's interesting in the dynamic of the changing economy and in particular the changing consumer behavior, and I'm sure each of the competitors are trying to read that and address it based on their own particular business model.

We're much more focused on our customers and responding to our customers than we are focused on trying to respond to any particular competitor, and as a result I don't think it's likely that we'll comment on specific competitors.

W. Rodney McMullen

Yes, I wouldn't in terms of addressing specific competitors, but obviously this is a journey that we embarked upon several years ago. And we feel like we have a great lead in terms of investing pricing for our customers and using the data that we have from dunnhumby and our loyalty data in segmenting our stores. So we feel very good about where we are positioned and we continue to move even more aggressively on improving where we are.

Karen Short - Friedman, Billings, Ramsey & Co.

And is there any geographic pattern to where the markets might be more challenging? Are you seeing anything that's discernable?

David B. Dillon

There's certainly some geographic patterns but every quarter that tends to shift based on what's happening in various markets. Some markets - if you just look, as an example, just look at unemployment rates across the country - it is quite variable from one market to another and as a result we're going to see each market as a little different. And so we do see some variability. But we have quite a few of our markets that are performing very well and a few that are a little more challenged. But if you look at across all regions of the country, we would be positive meaningfully on identicals.

Now, the area that I mentioned that, on discretionary items, you can clearly see consumer behavior changes there, and that's not unique to a region. That's really for all those discretionary categories.

W. Rodney McMullen

Right.

Operator

Your next question comes from Deborah Weinswig - Citigroup.

Deborah Weinswig - Citigroup

In this environment, you really seem to be widening the gap with the competition. Do you think that you're gaining sales from new customers or gaining a greater share of Wal-Mart from existing customers?

David B. Dillon

I don't think we try to pinpoint who it's coming from as much as it's coming from our customers. And, as you know, we target our existing customer base because of the opportunity we see, that in even our very best customers, there's still a lot of purchases they make outside of Kroger and, by targeting them, we have had very good results. And, of course, they tell their neighbors and then some of their neighbors who are not shopping as much with us start shopping with us.

So it's obviously both of those factors, but I don't think we try to identify where we're picking that up from.

W. Rodney McMullen

But it's certainly, if you look at it from a transaction standpoint and customer count standpoint, it looks pretty evenly matched between the two in terms of where we're getting our growth, and that's pretty consistent with prior quarters when you look at that data.

David B. Dillon

Yes, when we've looked at that data, too, we have to be mindful that there's some inflation in the average sale. But both are up in about equal amounts.

Deborah Weinswig - Citigroup

And then secondly, Rodney also referred to higher credit card fees. Are you seeing an increased usage in terms of credit card transactions or what's happening from that line item?

David B. Dillon

It's being driven from three perspectives - one, the higher fuel costs obviously creates a higher transaction fee, the credit card companies have raised their base fee rate, and the usage is up. So it's actually all three components that's driving that expense.

Deborah Weinswig - Citigroup

And then lastly, obviously in this environment, with higher fuel prices, transportation management is increasingly important. Can you talk about specific initiatives that cover has in place?

David B. Dillon

A couple of years ago our transportation team really worked really hard in terms of identifying some outside sources from a software standpoint to help us better manage our fleet and optimize our fleet utilization throughout out system both into our warehouses and out to our stores and maximizing the cube utilization or, you know, the amount of space that you drive around with empty, by significantly decreasing that. And that's something that our team has been working on for really over two years.

Obviously, with the higher fuel prices, the returns from those projects are even higher than what we'd thought they would be originally.

W. Rodney McMullen

Our results there really are - I think they've been outstanding despite the large increase in fuel costs, and I think they've identified - the example he gave is a good one, but there's several other smaller examples that all contribute to successfully reducing the amount of miles that we have to drive, which can help reduce the overall cost.

David B. Dillon

If you look at our percentage increase in those expenses, the percent increase in expense is less than the change in diesel price increases, as an example.

Operator

Your next question comes from Meredith Adler - Lehman Brothers.

Meredith Adler - Lehman Brothers

I'd like to talk a little bit more about consumer behavior. You did talk about private label but I was wondering whether you're seeing consumers shopping for deals more? Any sense that there's particularly cherry picking going on or anything like that?

David B. Dillon

Well, we identified this quarter publicly that we're seeing an increase in sales in our value-oriented stores, and that's a reasonably recent phenomenon in the last three to six months, where we've seen some increases there that were discernibly different than the past pattern. That would suggest, to me at least, is that people are seeking out value, particularly in those pockets of our stores that are focused more on the value customer.

But we're also seeing other trends which we've identified. For instance, we believe people are combining trips, which makes a combo store really good, in order to reduce the amount of fuel that they use. Our gas offer is still getting good uptake from the customers. That's still very popular, and I think that's being driven, of course, by the high price of gas and people are seeking out the opportunity. And we obviously have commented about the less use of restaurants. Consumers clearly are eating at home more often and buying their food at supermarkets, ours and other supermarkets, too.

And then the only other clear trend that we've identified is some additional softness in discretionary items that we've wanted to call out. That, of course, shows up primarily - not entirely, but primarily  in drug GM department sales.

Meredith Adler - Lehman Brothers

And if you could talk a little bit about the trend of sales in the quarter, because I believe you had started out pretty strong and then it clearly, just to do the math, it must have softened in the latter two months, but then the trend seems to be picking up again in the beginning of the third quarter. So maybe just - I'm sure it's very volatile, but if you see any patterns at all.

David B. Dillon

It is. In the quarter, the 4.7%, on the whole, we thought, were good results. They were pretty close to the kind of longer-term trend we've been running of about 5%. The last several weeks of the quarter, though, were the weakest. There's lots of reasons, we think, for that, although you have to speculate a little bit. Among them, though, we're pretty sure would include softness in some of the discretionary items, seasonal and probably back-to-school would have begun to be impacted at that timeframe, too. So that's the picture.

And we thought it would be helpful, as a result, to identify the first four weeks of the third quarter as trending about 5%, and the reason we wanted to do that is to illustrate that that trend at the end of the quarter was not continuing on into this quarter.

Meredith Adler - Lehman Brothers

And then I'd just like to talk a little bit about labor. And I think you got this question last quarter, but are you beginning to feel like there are changes in the discussion from the unions about sort of how to allocate the dollars? Are they, you know, really asking for higher wages and accepting an offset in terms of benefits?

W. Rodney McMullen

Not really. The focus still in most of our negotiations, although I should quickly add that every market is different, it's really tailored to the needs in that particular market, but generally speaking we're seeing benefits and pension as the two primary issues that need to be addressed, to find some way to reconcile the high cost of those areas with the genuine needs of our associates.

And as we've tried to approach negotiations, we really try to approach them in a balanced way. We want our associates to end up feeling good about the outcome and, of course, we need to have our costs contained in a way that's effective for us to continue to serve the customer.

So I would say we're not seeing any particular change today from where we were in the last six months or so on those negotiations.

Operator

Your next question comes from Neil Currie - UBS.

Neil Currie - UBS

I just wanted to ask a question about inflation. You mentioned a 4.9% increase in product cost. How does that translate on the sales line once you take into account a changing basket and increased private label? I'm trying to get a feel as to how much volume growth there may have been in the quarter.

David B. Dillon

Well, it's a little bit difficult to read. If it had just simply been throughout the grocery department, you could probably just do the math and come out that way. You still can do that and should recognize that the higher the inflation, of course, the lower our tonnage.

We did see some tonnage gain in total tonnage for the quarter. We did see some tonnage gain there. But because of the softness in some of the areas we've identified and because of that inflation, there's not the kind of tonnage gain in it that we had previously had.

With that inflation we're seeing success in being able to pass along costs. And one other thing you've got to think about is that in produce, particularly in a fresh food department like produce, you'll see high variability in what people purchase. And what we saw in inflation - as we noted, it was double-digit inflation in produce during the quarter - and you see high volatility in the pricing, and you see quite a bit of change in mix of what people buy because if one thing is higher priced, they buy something different. And as a result, it's a little bit harder to track dollar for dollar and track it back to tonnage in produce.

But in the other departments, I think it's pretty fair just to do the math and see where we are. Clearly, that's been a change for us and, I think, in the whole supermarket industry over time.

One other thing we probably ought to note - and Rodney noted this in his comments - is that as the prices go up, with prices being passed along and inflation, it will tend to have a dampening effect on our gross margin unless, of course, you were to get the full percentage gross margin that you were achieving before. It ends up sort of falsely indicating that your gross margin is declining when in fact what's happening is you're raising some of the prices on those costs that have increased.

W. Rodney McMullen

I don't know if this helps but if you look at our tonnage growth, it was meaningfully more than if you just took identical sales minus inflation.

Neil Currie - UBS

Yes, that's what I was trying to get at.

W. Rodney McMullen

Tonnage growth was meaningfully more than that, and the thing that makes it so hard - and internally we talk about this all the time because of the things that Dave talked about, where you have mix changes - and we know as you have inflation in produce it's real clear to see somebody switching from buying one item to buying bananas or something. When you look at grocery, you can see shifts from people buying a national brand to a private label or corporate brand item. So you can see those types of shifts, but it's really hard to decided, you know, how much of it really fits into where. But when you look at tonnage growth at the end of the day, it was meaningfully more than what just netting those two numbers would get you.

Neil Currie - UBS

That's what I suspected. I suspected that the product cost number you gave was a base-weighted basket and, you know, when you look at a current weighted basket and how the basket changes that you're actually seeing some volume growth.

David B. Dillon

Yes.

W. Rodney McMullen

Yes.

Neil Currie - UBS

Just another thing, if I may. Obviously market share is never always a one-way street and there are gains and losses from various different retailers and restaurants, etc. At the lower end of the scale, do you feel as if the Value products are protecting that lower-income customer from going to super centers or dollar stores or are you seeing some slippage there?

David B. Dillon

Well, I don't know that I can answer for sure, but the mere fact that our Value-oriented stores are showing noticeable improvement in sales picture would suggest that we're at a minimum holding our own and probably actually gaining a little share in that segment of the business.

Neil Currie - UBS

Oh, just to come back to the previous question asked, I'm sorry, in terms of that tonnage growth, how would you say that compared against the first quarter?

W. Rodney McMullen

It would be a little bit lower, but not substantially lower.

Operator

Your next question comes from Charles Cerankosky - FTN Midwest Securities Corporation.

Charles Cerankosky - FTN Midwest Securities Corporation

I'd like to start out, you were talking about some of these properties, these store properties, you lease. You said you might be buying them. What's sort of driving that? Is it the real estate market?

W. Rodney McMullen

For the most part it's the real estate market. There's one specific property that's on the market right now that would be a pretty big expenditure if we could buy it, and that would be more opportunistic because it's available. But as a general rule it's just because of the weakness in the financial markets and when somebody has an asset to sell, especially if it's a store where we want to expand, it works out really well to buy that property and be able to expand the store.

Charles Cerankosky - FTN Midwest Securities Corporation

You say it'd be a fairly big expenditure. Are you talking about a group of stores or [inaudible] location or what?

W. Rodney McMullen

As of right now they're all one-off type transactions but, I mean, if every one of them came to be, you could see where it could be $100 or $200 million. But I don't want you to assume that that's going to happen because not everything always happens.

Charles Cerankosky - FTN Midwest Securities Corporation

I understand. I understand. It's the function of the marketplace and you think your balance sheet allows you to take advantage of it, I guess. How about on the acquisitions, some end-market acquisitions? Are those opportunities looking anymore likely these days?

David B. Dillon

We continue to look at quite a few things, but I really don't see a trend change there at all at this point. You know, the valuations are much more reasonable, but people that don't have to sell usually don't like the current valuations.

Charles Cerankosky - FTN Midwest Securities Corporation

So you guys still remain very price conscious?

David B. Dillon

You know, one of the things that - as you know, you've known us for a long time - we would do the same analysis in today's world as we would, you know, two years ago when the market was rocking and rolling. So our valuation wouldn't change as much as what the market might suggest from an external standpoint.

Charles Cerankosky - FTN Midwest Securities Corporation

Now if we were to look at, say, just your Fred Meyer and Marketplace stores, can you comment on the general merchandise sales trends in those formats?

David B. Dillon

Well, the point we made earlier on discretionary spending, particularly in drug GM - in fact, we identified drug GM department - was flat on sales in the quarter on an identical basis, and we identified that for that reason. And of course we would have disproportionately high dollar sales in that department in the Marketplace stores and in the Fred Meyer stores. So that comment would particularly apply to them.

Charles Cerankosky - FTN Midwest Securities Corporation

So that might suggest they were seeing down sales in those categories and flat across the entire company. Would that be accurate?

David B. Dillon

No. If you look at those categories when you look at the whole company, it's flat. And when you look at - those businesses would still be growing nicely, but it would be driven by the grocery side of the store.

Charles Cerankosky - FTN Midwest Securities Corporation

Well, I was just referring to the GM side of those, Fred Meyer and Marketplace stores, suggesting that the sales trends would be down on the general merchandise side.

David B. Dillon

It wouldn't really be that much different than where the whole company is on - flat. You can find some specific categories that would be down, but when you look at overall, flat is a pretty good assumption.

W. Rodney McMullen

It would have a little bit bigger effect on the total sales in those divisions, in those areas, because they have a higher percentage of their business coming from the drug GM department. That's certainly true.

David B. Dillon

But if you look at the impact on identicals for all of Kroger, we think it's 0.1% to 0.15% or 10 to 15 basis points when you look at all of Kroger, just to give you a scale of the number.

Charles Cerankosky - FTN Midwest Securities Corporation

And then I tried to quickly go through the 8-K regarding the discussion on insurance coverage relative to hurricane damage. It looks like in total here you've got about a $50 million deductible. Is that correct?

J. Michael Schlotman

No, it's one deductible of $25 million since it's one store system. There's $725 million of coverage for business interruption and wind. In our program, there's a $500 million sub-limit for flood. Both of those coverages are subjected to the same $25 million retention.

Charles Cerankosky - FTN Midwest Securities Corporation

And the coverage includes or would be applied to lost sales and earnings, damaged buildings and lost inventory?

J. Michael Schlotman

Correct. But also cover extra expenses to get stores back up and running. For example, if we went out and rented a bunch of generators to get the store open, those are considered extra expenses and it would pick up that kind of a claim as well.

Operator

Your next question comes from Jason Whitmer - Cleveland Research Company.

Jason Whitmer - Cleveland Research Company

Dave, I was hoping you could talk a little bit about dunnhumby. You talked about this briefly in your prepared remarks, but how maybe within this environment you've been able to glean incremental insights from a macro context on your business that you might not have had in prior cycles, and maybe how that has enabled you to respond a little quicker because of that, if you can talk and give us some examples. I know you've given some just from the environment itself, but maybe from that application and what's that providing for you competitively if you can provide some color.

David B. Dillon

Well, I'll provide a little bit of color perhaps. On a macro basis we try to take several different looks and vantage points at our customers. For instance, we segment - one of the ways we've looked at it is to look at customers who are shopping more with us, buying more items with us now than they were, and try to look at their behavior and what's important to them. We look at a group of customers who are maybe buying less items from us. And we look at a group of customers whose behavior hasn't changed.

And it allows us to see lots of different things in terms of the decision points they make based on decisions we made about promoting. We look at the kind of promotions we run in our ads and see what kind of reaction we get based on those various segments and see whether or not we're getting the behavior we'd like to get.

Take the tax rebate program that we did as an example. We continue to track customers who took advantage of that to see what the long-term trends of that would be. We made a big investment, of course, to give them the discount on certificates, but we want to get a sense of what does that mean to the long-term shopping behavior of that customer. And it's too early to tell that, of course, but we're tracking that as an example.

So those would be a few illustrations that would give you an idea how we use it. I don't think I'm prepared to give outstanding specifics that would give you any more detail than that.

W. Rodney McMullen

Well, one other thing that is a little bit longer term but dunnhumby has helped us a lot in terms of understanding how to serve all customer segments and what all customer segments want. And, you know, we've done a lot of work, our merchandising teams have done a ton of work and our divisions to position us to serve all customers. And as customers change, they change segment, and we're already doing work to serve a value customer better, so we get a double benefit from that. And that's something that started happening several years ago, not something that's just happened in the current economic environment.

Jason Whitmer - Cleveland Research Company

So you can see with a little bit more granularity within your customer segments the trading effect, the channel shift, the impact of inflation, if I'm catching you. And is there any sort of competitive behavior that you can interpret from all that, either from what your peers in the conventional grocery channel are doing or in the mass and club channel as people seek out value, which is clearly happening in the last three to six months, as you mentioned.

W. Rodney McMullen

Well, we could look at some patterns that would be helpful from a competitive point of view, but we're not likely to describe them today.

David B. Dillon

But if you look at our strength, our strength would be against all competitors. It just wouldn't be with one particular competitor.

Operator

Your next question comes from Edward Kelly - Credit Suisse.

Edward Kelly - Credit Suisse

I have a question about your gift card promotion that you ran a few months ago. Now that the program's over and you've had a chance to sort of assess the program, in looking at the margin and sales impact, can you sort of help us understand the impact that it's had there as well as whether you think that program ultimately has been a success or not?

David B. Dillon

Well, I mentioned in Jason's question a little bit about the tax rebate gift card program, but let me just add a little bit more. In the quarter we had around $22 million in expense, and you should think of that as basically cash that we gave to the customers. It also reduces the sales and sales as reported so, in other words, when we sell a card for $300, we gave $330 worth of goods or value on the card and we only ring up $300 worth of sales even though we gave $330 in value. So it has a dampening effect on the sales a bit. Of course, it would hit the margins a little bit.

And based on the behavior that we've tracked on the customers, it would appear to us that the lift that we received from those customers during the quarter did cover that $22 million expense. But time will tell in the long run whether or not it was a long-term good investment. And that's the reason, as I'd mentioned to Jason, that we continue to track the customer behavior who purchased those cards.

Edward Kelly - Credit Suisse

And is it possible to quantify the impact of the lower pre-open and transition costs from Farmer Jack and Scott's?

J. Michael Schlotman

We don’t have it right off the top.

W. Rodney McMullen

It's not a humongous number, but it's a meaningful number. But I know that doesn't help you too much. Ed, it's $8 million.

Edward Kelly - Credit Suisse

On commodity costs, you know, we've been seeing commodity costs come down a bit. I know there's a lag there between the time those costs come down and they begin to impact package [inaudible] companies because they had a hedge, but is there a chance here that, you know, we look at inflation at the end of the year when you do your calc on the LIFO charge and that it's lower than where we are today?

David B. Dillon

Well, let me just comment that if you look at the rate of inflation, LIFO's calculated just purely at a spot market at the end of the year. And it's our estimate. We try to project out where we think the year end will be, and that is what we end up with our charge and that's how we revised it in this quarter.

One issue for us is commodity costs do appear that they may be declining and that would be good news, I think. But in addition to that we still have fuel costs to contend with because suppliers embed it in their inflation, which they pass onto us, would be higher costs than what we had the year before on diesel fuel to get the goods to our warehouse. And that would be embedded and what we would see as product cost inflation.

W. Rodney McMullen

Well, the only other thing is that we always - the inflation that we see from the CPGs always lag what the commodity cost increases would be. So we have no idea how long that flow-through will last because usually it lags a couple of quarters on seeing it. We would expect going down it probably would take a couple of quarters.

But as Dave mentioned when he was going through his prepared remarks, it's one of the benefits of having our own manufacturing plants and having such a strong corporate brand program. We get the benefit of those reductions in cost immediately so that it's a great opportunity to pick up share and provide a great value for our customer as those costs come down.

Operator

Your next question comes from Mark Wiltamuth - Morgan Stanley.

Mark Wiltamuth - Morgan Stanley

I wanted to ask a little bit about package sizing from the consumer package goods companies. We've seen a lot of the companies raising their prices by shrinking package sizes. Have the consumers really picked up on this and can you see any change in demand trends there? And does that in any way effect how you go to market with some of your private label offerings?

David B. Dillon

Well, you, of course, are correct. Many of the CPG companies have done that. They, of course, do a lot of research with consumers before they do it, and as a result are generally reasonably sure they're not going to have much impact when they do it.

Most of those packages, as best we can tell, have been reasonably well accepted in the marketplace. Our private label brands, Kroger brands, often follow suit when we think it's a good idea, but there's a few times when we have not. We make a deliberate, intentional choice in those cases. And I would say no, we're not seeing much change in consumer behavior as a result of that change.

W. Rodney McMullen

A couple of years ago, we had one example where somebody didn't - everybody decreased the size of their product except for one, and the one that didn't did not pick up share even though their pricing was the same. So it appears at this point that the sizing change really doesn't affect customer behavior as much as what probably any of us would guess.

David B. Dillon

Obviously, there's an end to that. I mean, there is a point at which you get diminishing returns. But we haven't seen it yet. Put it that way.

W. Rodney McMullen

Yes, we joke about at some point there'll be a super size ice cream. It'll be a half a gallon again.

Mark Wiltamuth - Morgan Stanley

In our surveys on price we did in July, we found that you were much sharper on your private label pricing on the low end, but it sounds like from your comments that your fastest-growing brand is your prestige brand in private label. Maybe just comment how the Value brands are doing.

W. Rodney McMullen

The Value brands are actually doing really well. We're having good increases there. And you could certainly discern what's happening with customers because of that. But I ought to be quick to point out that our whole corporate brand program has worked well. We've identified before a number of changes we've made there, the way we're trying to address the market, both our marketing and the quality we're putting in the packaging and the quality in the products and all of our plans there have improved.

And one illustration of that is that actually a little bit more than half of the increase in items sold in the quarter were our Private Selections and Private Selection Organic products. And those are not targeted at Value customers particularly, and we're seeing customers across all income streams interested in that product. So it suggests that there are several things going on here in our improved corporate brand mix, and it's not just the economy. In fact, I would argue it's actually more the marketing efforts that we've applied to it and some effect by the economy.

Mark Wiltamuth - Morgan Stanley

So in those cases where you're going for the Organics or the Private Selections, people are just trying to add value, maybe enhance what they're getting for that price point?

David B. Dillon

Yes. And in some cases there's not a comparable product in the national brands to compete with the Private Selection items and as a result it's just a great product.

Operator

Your next question comes from Scott A. Mushkin - Banc of America Securities, LLC.

Scott A. Mushkin - Banc of America Securities, LLC

I just wanted to see, I mean, clearly your business model's worked really well with consumers being under a lot of pressure and inflation rising. Your price leadership, kind of like Wal-Mart, is really paying off for you. Take us forward like six to 12 months, assuming that the commodity prices continue to evaporate, unemployment goes way up, you know, how does the business model work when we see maybe no price increases?

David B. Dillon

Well, we were specific to say in our comments that we think our business model works in any conceivable picture that we can describe anyway. We think it works well because it's tailored to the customer at that time and in their particular situation. One of the reasons we talked about the corporate brands program on the high end, the Private Selections and PS Organics, and the growth we've had there is I think that illustrates something that is sort of outside of the trends in the economy today and a consumer that's maybe pinched. It illustrates that there are lots of things that we're doing that are paying off with other customers, too.

So if, as you describe, those were to occur, we think we're well positioned. And in fact, if you want to roll the clock backwards maybe two years and you'd have an environment much like what you just described, and we were rocking and rolling then. So I would say that that would paint what the picture might look like.

Scott A. Mushkin - Banc of America Securities, LLC

Are you seeing any market - because we think the Northeast market, which you guys don't participate in, is getting, you know, very, very competitive. We see actually people holding the line on price and not passing them along at all. Are you seeing any markets like that and is it, you know, are you still feeling very comfortable with how your business performs when other people get really aggressive to try to hold their traffic?

David B. Dillon

This is obviously a challenging environment. The customers are challenged and so forth. But given that picture, I'm very bullish with what I'm seeing in our business. I feel very good about it. Having said that, I do think that we have several markets that, on selected items, we'll see some competitive actions where they may hold the line.

As we've pointed out, we've increased our prices as we've had costs go up, but we've not maintained - intentionally have not maintained - the percentage of margin we had. We've exceeded, though, the penny's profit that we had, which of course helps pays the bills of other items that have accelerated in inflation, too.

So I think on the whole I don't see it entirely different today than it was last quarter when we described it, and I feel pretty good about the position.

Scott A. Mushkin - Banc of America Securities, LLC

Just one follow up on the tonnage. As you looked at the third quarter sales, the 5% acceleration, did you have any feel about what inflation was doing there or did you feel that the tonnage and the traffic were the same as you looked at the 5%, the little bit of acceleration in the first four weeks of the third quarter?

W. Rodney McMullen

It would be pretty similar to what we saw in the first and second quarters both, pretty much equal.

Operator

Your last question comes from Andrew Wolf - BB&T Capital Markets.

Andrew Wolf - BB&T Capital Markets

Dave, you mentioned it's been 20 years since the industry's seen rapid inflation, at least on the CPG side. Given that, you know, I see your inventories are up a lot less than the inflation rate and, in years past, the way I've thought of the industry, it might have been just the opposite. You might have seen big retailers engaged in forward buying to get in front of price increases. So a two-part question: Is that something we might want to look for, look for some increases in your inventories as you engage in that kind of forward buying to keep your cost of goods down? And related to that or if not, what other ways are you working with suppliers? I mean, you mentioned small package size, but what other ways do you work with suppliers to try to lower your cost of goods sold?

David B. Dillon

Let me answer it this way. First, the way we work with suppliers, we've done a variety of things. Some of the things we're doing are trying to reduce the cost to bring products to market, and that's actually been very successful with several suppliers. It takes cooperative work and I think we have several homeruns, but none of them are so large as to move the needle by themselves. But cumulatively over time they actually generate some value.

Now as to how we buy in an inflationary environment, of course we're doing some forward buys. We'd be, I think, crazy not to. But the total dollars of forward buy would not be enough for you to really see it on our balance sheet because we have such a large amount of inventory.

And one of the reasons you don't see it is that the opportunity for forward buy today is a little bit less than it would have been 20 years ago. The reason for that primarily is that we now have methods of distributing products that are so efficient that you flow through and you don't want to have very many stopover points. And in forward buy, you actually take delivery of the inventory, you put it in storage, you have double handling, and you have, more importantly, the disruption of the supply chain and that can be a bit traumatic.

So I would be surprised if you would see forward buys from us or really anybody large enough to move the needle on balance sheet, but that doesn't mean we're not doing them. We are doing them, and we have actually increased them in the last quarter from the quarter before.

Andrew Wolf - BB&T Capital Markets

And just to follow up on the commodities side, the USDA and other forecasters are looking for a pretty big ramp up in protein pricing and, again, a two-parter. Just technically, is that part of your LIFO index and is that one of the reasons you raised the outlook? And secondly, similar question, what kind of forward buying can you engage in with the large protein producers to sort of get more predictability around your price, especially in protein if and when it starts to run up in price?

J. Michael Schlotman

We do have meat on LIFO, which is different than some of our competitors. Not all of our competitors that use LIFO use LIFO for meat. We did see an increase in protein prices through the quarter. It was actually negative as we ended the first quarter and accelerated in inflation through the quarter, and ended up the quarter with a slight bit of inflation.

David B. Dillon

Well, the question on procuring proteins, whether or not you take forward buy positions, do you want to comment on that, Don?

Don W. McGeorge

Not so much calling it or labeling it forward buy, but we do negotiate with some manufacturers or suppliers, if you will, for contracts that may cover extended periods of time and in effect those contracts, then, can help hedge a bit against rising costs or falling costs.

Andrew Wolf - BB&T Capital Markets

And do you vary, let's call it a hedge ratio or the amount of product you buy forward based on your outlook, and can that be a substantial change depending upon your outlook or is it fairly constant?

Don W. McGeorge

No, it's not so much and don't label it so much a hedge, but rather a negotiated contracted price for a period of time and/or volume.

David B. Dillon

Before I turn to a couple of closing comments, I do want to actually have Don ask a question that no one asked because - or answer a question no one asked - because you saw we filed an 8-K, we talked a little bit about the hurricane damage through the Houston area and then up through the Midwest. And Don has a very current update on how we're doing on stores open and I thought he might want to comment briefly on that.

Don W. McGeorge

Actually across all regions, including Texas, as of this morning we've got less than 50 stores closed, and we're quickly bringing those stores online as well.

The other thing that is of particular note is, particularly in the Houston area where the mayor there, Bill White, has asked for support, our local president there, Bill Breetz, is working with the mayor locally. We are donating ice and bottled water and so on. It'll be distributed throughout the Houston area.

And so far things look great. We continue to expect our stores back online very quickly.

Operator

There are no further questions.

David B. Dillon

Let me close with these few notes. I want to second the invitation that Carin extended at the beginning of the call. We hope that you're able to join us for Kroger's 2008 investor conference. You will hear from several members of our leadership team and have a chance to observe some of our latest customer-first initiatives and programs in one of our stores, so we look forward to seeing you next month.

I want to thank you for joining us on the call and before I end the call I want to add some additional comments for our associates who are listening in today. To all of our associates in the communities that are dealing with the aftermath of Hurricane Ike, as Don pointed out, we've made great progress. We know this is a difficult time for you and your families, and we keep you in our thoughts and prayers. And we want to thank all of our associates, who are doing a tremendous job of taking care of our customers and fellow colleagues whose lives have been disrupted by this hurricane. On behalf of the entire company, we thank you for your extra effort and we appreciate your overall commitment to safety and service.

Thank you all for joining us today.

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Source: The Kroger Co. F2Q08 (Qtr End 08/16/08) Earnings Call Transcript
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