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Third Quarter 2008
Investor Conference Call Prepared Remarks
December 9, 2008
Carin Fike, Director of Investor Relations:
Good morning and thank you for joining us. Before we begin, I want to remind you
that today’s discussion will include forward-looking statements. We want to
caution you that such statements are predictions, and actual events or results
can differ materially. A detailed discussion of the many factors that we believe
may have a material effect on our business on an ongoing basis is contained in
our SEC filings, but Kroger assumes no obligation to update that information.
Both our third quarter press release and our prepared remarks from this
conference call will be available on our website at www.kroger.com.
Now I will turn it over to David Dillon, Chairman and Chief Executive Officer of
Kroger.
Comments by: Dave Dillon
Thank you, Carin. Good morning everyone. Thank you for joining us today.
With me today to review Kroger’s third 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 performance.
First, I will discuss what drove our sales during the quarter and our outlook in
this economy. Then, we will be happy to take your questions.
Sales
Kroger’s third quarter sales continued to be strong in a tough economy.
Identical supermarket sales rose 5.6% without fuel, reflecting the strength of
our customer-focused strategy we developed six years ago and continue to sharpen
today.
Identical sales growth was positive across all departments and all supermarket
divisions. We are still seeing slowness in sales of discretionary general
merchandise and jewelry, a trend we have discussed with since the fourth quarter
of 2007. This slowing continues to get worse.
Overall, we are pleased with our strong sales trend, particularly in this
environment. We realize higher product cost inflation continues to play a role
but our business model is designed to deliver consistent results whether market
conditions are favorable or less than ideal.
Sales in regions affected by Hurricane Ike recovered particularly well thanks to
the outstanding efforts of our associates. Our teams worked tirelessly to get
stores back in business quickly to serve families as they recovered and
restocked their households. We appreciate the dedication of associates
throughout our organization who supported customers and colleagues in the
aftermath of the Hurricane.
Kroger’s focus on low prices, quality products and providing a convenient,
one-stop solution for their daily needs continues to resonate with customers and
drive sales. Several trends we’ve discussed the past few quarters continued
throughout the third quarter, namely a growing interest in private label
products and prepared foods as consumers choose to prepare and eat more meals at
home, and a sharper focus on price from customers in all segments.
Corporate Brands
Customer interest in our corporate brands continued to accelerate in the third
quarter for two reasons. First, the current environment is prompting customers
to try more of our private label products and second, the overall strength and
breadth of Kroger’s private label program appeals to shoppers on any budget.
For the second quarter in a row, we saw accelerated growth in our corporate
brand penetration – both in terms of grocery sales dollars and units. During the
quarter, corporate brands represented almost 27% of Kroger’s grocery sales and
34% of grocery units. And our proprietary loyalty card data indicates
approximately 14% of our customers are “trading over” in the purest sense by
simply buying the “same” for less by switching to one of our corporate brands in
any of the three tiers we offer.
Our robust corporate brands program is a fundamental part of our Customer 1st
strategy. Our quality products are strengthening our connection with our
customers as we work to earn their lifelong loyalty. Kroger’s corporate brand
products are produced and sold in three tiers: Private Selection, Store Banner
brand and our Value brand. We continue to expand our private label offering
across all three tiers.
While our entire private label portfolio is winning over customers, we are
seeing particularly strong growth in both our Private Selection and Value tiers.
In fact, as we outlined earlier this year, our premium line, Private Selection,
which includes organic lines and gourmet meats, cheeses and desserts, to name
just a few, is enjoying significant growth and is on track to reach $1 billion
in sales in 2008.
We expect to continue to see solid growth in this important area even after the
economy recovers and we will continue to invest in Kroger’s private label
program.
One other advantage our strong corporate brands program offers us is leverage
when a supplier approaches us with a product cost increase. This advantage has
become even more important in an inflationary economy. Rodney will discuss this
in more detail in a few moments.
Prepared Foods
I mentioned earlier that we continue to see growth in prepared foods as
consumers choose to dine out less often and eat at home instead. This is a
continuation of a trend we have seen for some time. We did see strong sales in
our Deli/Bakery and Prepared Foods departments again in the third quarter and
are pleased that customers are increasingly looking to us to fulfill their needs
for convenient ready-to-eat meals. Our sushi bars, hot soup and sandwich
counters and refrigerated soups and entrees are all doing well as a result of
this shift in consumer behavior.
In fact, the third quarter marked the 11th consecutive quarter of identical
supermarket sales above 6% in our Deli departments. This is nearly three years
of consistently strong growth. We will continue to invest in developing prepared
food options that are meaningful for our customers.
Price and Loyalty Cards
As we have discussed with you a number of times, Kroger has been investing in
lower prices for our customers for the past six years. Our pricing strategy
plays particularly well in this environment as shoppers are increasingly focused
on the prices of staples they buy week after week. We are seeing signs that
prices of staple items are increasingly becoming a deciding factor for customers
in determining where they should spend their grocery dollars.
We are pleased that millions of households are choosing Kroger’s family of
stores because of the value, convenience and quality we provide. We remain
focused on investing in lower prices for our customers, especially when they
need it most.
The strength of our loyalty card program helps us deepen the connection we have
with our customers. The scope and depth of our shopper card program is unmatched
in the industry. These cards link our customers to savings on groceries, fuel,
pharmacy needs, general merchandise and corporate brands.
We use data derived from our loyalty card program to tailor unique coupon offers
for specific households. A recent mailing went to more than 9 million
households. Of those, 95% of those offers were unique to each household because
we understand – and appreciate – that no two customers are alike.
Some may live in the same city, in the same neighborhood and even on the same
street, but we know they don’t have the same shopping habits.
This level of personalization is a direct link to our customers no other U.S.
grocery retailer can replicate.
These are just some of the competitive advantages fueling our sales performance.
In today’s environment, Kroger’s team stands out. We continue to post positive
identical sales growth consistently because of the unwavering commitment of our
associates to our Customer 1st strategy. And, as Rodney will describe, we have
the financial wherewithal to leverage our powerful strategy, even during a
difficult environment.
Guidance
We are on track to deliver another year of solid results. We have confirmed our
identical supermarket sales guidance for the year and raised our earnings
guidance for fiscal 2008. We are also looking forward to another year of
earnings per share growth in 2009, driven by continued strong trends in
identical sales even with current forecasts of a less inflationary environment.
Now I would like to turn the call over to Rodney for some additional details on
our third quarter results and 2008 guidance. Rodney?
Comments by Rodney McMullen:
Thank you, Dave, and good morning everyone.
We are pleased with Kroger’s third quarter results – particularly against the
backdrop of this tough economic environment – and believe they illustrate the
strength and flexibility of Kroger’s business model in varying economic
conditions. Today, I will offer some perspective on certain elements of our
results, including the effect of Hurricane Ike, LIFO expense, and strong fuel
margins. I will also discuss Kroger’s financial strategy, pension issues in
today’s environment and share additional color on guidance.
Effect of Hurricane Ike
I will begin with Hurricane Ike and its effect on our third quarter earnings.
Our results included a pre-tax charge of $25 million – or approximately $0.03
per diluted share – related to property damage and disruption to our business
caused by Hurricane Ike this past September. The $25 million figure represents
Kroger’s retention under its property insurance and business interruption
coverage. Our total losses exceeded that amount. The effect of the hurricane on
our business was far-reaching. Ike and its remnants disrupted our operations in
Texas and several inland states including parts of Indiana, Kentucky and Ohio
causing property damage, extended power outages and fuel supply issues in
several additional markets. While we did incur some expenses, we also realized
some benefit as customers restocked their households after the hurricane. We
believe these two outcomes likely offset each other. Further, we are preparing a
claim under our insurance coverage and, in compliance with GAAP accounting
rules, will record a receivable once an agreement on the reimbursement amount is
determined.
As Dave said, our associates did a terrific job to serve customers in the areas
affected by Ike. To give you one example of how quickly our teams moved, our
Kroger store in Galveston, which sits on Galveston Bay, was the first major
supermarket to reopen after Ike. The island was devastated but our associates
partnered with co-workers in other areas to get the right resources to Galveston
quickly to get our store there in shape to serve that community when it needed
help most. We want to thank our associates again for a superb job!
Without efforts like this, the effect of Ike would have been much worse.
LIFO
Another unanticipated item during the quarter was the magnitude of our LIFO
charge. We certainly expected a LIFO charge, but the detailed analysis we
conduct at the end of each quarter to update our estimate produced a result
significantly different than our previous expectations. Recall that when we
reported our second quarter results in September, we were estimating a full-year
LIFO expense of approximately $160 million for 2008. We now anticipate that
figure will be closer to $200 million. The incremental $40 million applies to
the entire fiscal year and disproportionately burdens our third quarter results.
It’s important to remember that the LIFO charge is an estimate for the first
three quarters because we calculate our actual LIFO expense in the fourth
quarter. Of all the estimates required for our quarterly financial statements,
LIFO expense may involve the most variability, particularly during periods of
product cost changes, as we have seen over the past year or so. The LIFO
calculation is complex and depends on a variety of factors, but the two primary
drivers are year-end inventory level and product cost inflation at a particular
point in time during the year. For Kroger, that snapshot is the 48th week of a
52-week fiscal year.
For the past two years, determination of the LIFO charge has added significant
volatility to our quarterly results. We don’t enjoy the volatility any more than
you do! When product cost inflation was non-existent to moderate, the impact on
our financial results was not as significant. Now, with grocery inflation at
levels we have not seen in almost 20 years, the effect of the volatility is
magnified. During the third quarter, our estimated product cost inflation was
roughly 6% with levels over 7% in many center-of-the-store grocery categories.
To give you just one example, canned vegetables is one category where we saw
high product cost inflation in the second quarter and an even higher percentage
increase in the third quarter. The dollar amount on that inventory is also high.
Even with the added earnings volatility, our objective in using the LIFO method
of accounting for our product inventories remains the same – to reduce Kroger’s
cash tax obligation. So while the non-cash LIFO charge hurts earnings and can
increase the variability of our projections, it ultimately helps cash flow, and
we believe that’s a wise trade-off.
In order to maximize this benefit, Kroger carries over 95% of its inventory
balance on LIFO. This is higher than nearly all of our supermarket peers. Kroger
has been using the LIFO method for a longer period of time than many of our
industry peers, and this also affects the magnitude of our expense. As you
consider the effect of LIFO accounting on other food retailers, keep in mind
that some of our discount competitors carry a significant amount of general
merchandise inventory in addition to grocery inventory. For those retailers,
deflation in certain general merchandise categories can mask inflation they may
experience in their grocery inventories.
We understand that raising our full-year LIFO estimate for 2008 may seem
counterintuitive to many of you at a time when certain commodity prices have
declined from historic high levels. And while, in general, prices of some
commodities have leveled or dropped, we continued to receive cost increases from
several of our product suppliers during the quarter. Those higher costs are the
primary driver of the higher LIFO estimate.
As you would imagine, we are discussing pricing issues with many of our vendors
to make sure the price they charge Kroger reflects the appropriate input costs.
As we have described for you several times, Kroger’s manufacturing business and
strong Corporate Brands portfolio give us additional leverage in these
discussions. As product costs do come down, keep in mind that we plan to pass
along that benefit to our customers; we do not view lower product costs as a
margin expansion opportunity. This mindset and approach is in line with our
overall customer-focused strategy.
Retail Fuel Operations
Now, I would like to comment briefly on our retail fuel operations. We did see
exceptionally strong margins in our fuel business, reflecting our typical margin
experience when wholesale fuel costs decline as they did throughout the quarter.
Consider the following year-over-year comparison: the cents per gallon fuel
margin for our convenience stores and supermarket fuel centers was 23.9¢
compared to 8.7¢ in the prior year. While the effect on Kroger’s earnings was
quite favorable, we’ve been in the fuel business long enough to know that fuel
margins do tend to normalize over a longer period of time. On a rolling
four-quarters basis, the cents per gallon fuel margin was 15.6¢ this year
compared to 10.9¢ last year. But even that rolling four-quarters figure is
skewed by two quarters of very strong fuel margins this year. We expect a more
normalized margin would be approximately 11¢.
Financial Strategy
Next, I would like to update you on our financial strategy. Our company’s
financial strength has long been a competitive advantage and is even more so in
the current environment. Kroger’s balance sheet is strong and our financial
position gives us the flexibility to continue investments in our successful
Customer 1st strategy and store base that will create value for our shareholders
in the future while delivering near-term financial results.
We have realigned Kroger’s cash flow priorities to leverage our financial
strength and support an appropriate level of liquidity necessary under current
economic conditions. We are now allocating cash flow primarily to capital
investments, debt reduction and dividend payments. Given our current bias toward
debt management, we were less aggressive in buying back shares during the
quarter. Under current market conditions, this continues to be our position
regarding share buybacks. As market conditions change, we will adjust our
buyback activity accordingly.
We are on track to invest $2.0 to $2.2 billion in capital projects for fiscal
2008. For fiscal 2009, we expect capital investments similar to 2008. Our
emphasis on store remodel activity and infrastructure investments will continue.
Our debt leverage metrics are improving. On a rolling four-quarters basis,
Kroger's net total debt to EBITDA ratio was 1.96 compared with 2.02 during the
same period last year. At the end of the quarter, total debt was $8.0 billion,
an increase of $553.0 million from a year ago. As a reminder, the third quarter
is typically our seasonal peak for debt levels as we build inventory to prepare
for the holiday season.
While the credit markets remain under stress, Kroger has ample sources of
funding available to meet both short and long-term financing needs. The
Company’s $2.5 billion committed five-year credit facility, maturing November
2011, continues to be available. Even on peak borrowing days, we expect that
more than $1.2 billion of this facility would remain available. We also maintain
uncommitted money market lines totaling $75 million. Furthermore, our access to
the commercial paper markets has improved, and we continue to obtain short-term
funding as needed.
Our long-term funding sources are also well-managed. In 2009, our only
significant debt maturity is $350 million in senior notes due on June 1. Under
normal market conditions, we would typically refinance that debt within a few
days of maturity. Current market conditions are anything but “normal”, so when
we saw an opportunity this past November to issue debt, we did so. We were
pleased to place $600 million in long-term bonds with a coupon rate of 7.5%,
particularly in this environment. There was significant demand for this
offering. This illustrates bond investors’ assessment of the strength of
Kroger’s balance
sheet and business.
Pension Funding
Many investors are wondering how current market conditions are affecting both
company-sponsored and multi-employer pension plans.
For company-sponsored defined benefit plans, we expect 2009 expense to be
comparable to 2008. We expect to contribute between $150 million and $200
million to those plans in 2009. This is more than 2007 and 2008, but comparable
to 2006.
For the company’s 401(k) plan, we expect a slight increase in our cash
contributions and expense. This is the result of higher enrollment by our
associates as they respond to our efforts to encourage employees to save for
their retirement.
For multi-employer plans, we do not expect a significant increase in
contributions – and therefore, expense – for 2009. Should current market
conditions persist into 2010, we would expect contributions for
company-sponsored defined benefit plans and multi-employer plans to increase
during 2010.
Labor
Regarding labor relations, we are currently negotiating agreements that cover
our store associates in Las Vegas, Phoenix and Portland. Looking to next year,
we will enter negotiations covering store associates in Albuquerque, Atlanta,
Dallas, Dayton, Denver and Roanoke.
Our objective in every negotiation is to achieve competitive cost structures in
each market while meeting our associates’ need for good wages and affordable
health care. The likely increase in pension costs and how they align with other
labor priorities will need to be addressed in bargaining. Our ability to balance
competitive costs with associate benefits allows Kroger to invest in our
business and create new job opportunities for existing – and future –
associates.
Guidance
Turning now to guidance, as Dave said, we are confirming our identical sales and
raising our earnings per share guidance for fiscal 2008. We expect identical
supermarket sales growth of 4.5% to 5.5%, excluding fuel for the full year.
Excluding the $0.03 per diluted share charge related to Hurricane Ike, full-year
earnings are expected in the range of $1.88 to $1.91 per diluted share. This
equates to an annual growth rate of 11% to 13% over fiscal 2007 earnings of
$1.69 per diluted share and implies a fourth quarter earnings range of $0.49 to
$0.52 per diluted share. Kroger’s dividend yield of more than 1% further
enhances shareholder return. This guidance range considers the cautious mindset
of many consumers this holiday season.
Looking to 2009, we are currently projecting identical supermarket sales growth,
excluding fuel, of 3% to 5%. We do think inflation will be lower next year than
in 2008. Our current expectation for product cost inflation would be in the
range of 2% to 3%. This identical sales growth will enable Kroger to generate
earnings per share growth that, combined with our dividend, will create a solid
return for shareholders.
Now I will turn it back to Dave for some closing remarks.
Comments by Dave Dillon:
Thanks, Rodney. Before we take your questions, I want to offer some additional
thoughts on Kroger’s third quarter performance.
On the whole, we are pleased with our strong sales in the quarter, particularly
considering the difficult economic environment. Our identical supermarket sales
are among the best in the industry and we achieved those even with the
considerable challenges Hurricane Ike presented. Our sales show our Customer 1st
strategy is working: We are increasing customer traffic in our stores and
selling more to customers who already shop with us. Our industry-leading
corporate brands are gaining momentum and our pricing strategy is resonating
with shoppers. We are making our customers’ lives easier by offering them a
one-stop solution for their daily household needs.
During the quarter, we were in a good position to take advantage of
opportunities afforded by strong margins in our fuel business, but as Rodney
mentioned, fuel margins do vacillate from quarter to quarter and tend to
normalize over a longer timeframe. We do not run our business based on margins.
Still, we could have done a better job in managing expenses during the quarter.
Our OG&A performance was disappointing and we will improve. We must be
relentless in our efforts to reduce expenses so that we can continue to drive
cost savings back into lower prices and a better overall shopping experience for
our customers.
We are keenly aware that the economy will continue to put pressure on our
customers and our organization. Our Customer 1st strategy is designed to give us
the flexibility to perform well in good times and in bad. We are focused on
maintaining our strong financial position so that we can continue to invest in
our successful Customer 1st strategy and produce a solid return for our
shareholders.
Now, we would like to take a few moments to answer your questions.
Closing comments after Q&A:
Thank you. Before we end the call, I would like to share some additional
thoughts with our associates listening in today.
First, thank you for another quarter of strong sales. Our sales performance is
the result of your individual contributions. The economy is pressuring more and
more families every day. You heard us mention low prices are one of the primary
reasons customers are choosing our stores over others in this environment.
Kroger is able to continue to invest in lower prices for our customers because
of cost savings we work to find every day.
Your personal commitment to saving costs – no matter where you work in our
organization and no matter how small the savings – makes our lower prices
possible, helping to drive customers into our stores. Every time a customer
chooses us, we are in a better position to take advantage of opportunities to
grow our business. As your family members, friends and neighbors celebrate this
holiday season, please remind them about our low prices and great products they
can find at their neighborhood “one-stop” Kroger store.
As we close, I want to thank you for your commitment to our customers and each
other. I hope you each take time to enjoy this season with those close to you.
Thank you for taking time to join us today. Merry Christmas and Happy Holidays! ###
The remarks contain certain forward-looking statements about the future
performance of the Company. These statements are based on management’s
assumptions and beliefs in light of the information currently available to it.
Such statements are indicated by words or phrases such as “on track,”
“guidance,” “will,” “looking forward to,” “expect,” “projecting,” and
“anticipate.” These forward-looking statements are subject to uncertainties and
other factors that could cause actual results to differ materially. Our ability
to achieve identical supermarket sales and earnings growth and earnings per
share goals may be affected by: labor disputes, particularly as the Company
seeks to manage health care and pension costs; industry consolidation; pricing
and promotional activities of existing and new competitors, including
non-traditional competitors; our response to these actions; the state of the
economy, including interest rates and the inflationary and deflationary trends
in certain commodities; weather conditions; stock repurchases; the success of
our future growth plans; goodwill impairment; and our ability to generate sales
at desirable margins, as well as the success of our programs designed to
increase our identical sales without fuel. In addition any delays in opening new
stores, or changes in the economic climate could cause us to fall short of our
sales and earnings targets. Our ability to increase identical supermarket sales
also could be adversely affected by increased competition and sales shifts to
other stores that we operate, as well as increases in sales of our corporate
brand products.
The extent to which our corporate brands continue to grow will depend primarily
on continued acceptance of these products and economic factors which could cause
our customers to substitute other products. Our LIFO charge and the timing of
our recognition of LIFO expense will be affected primarily by food inflation
during the year. Our fuel margins could fail to normalize at 11% if the current
pattern of rapid decreases in fuel costs continues. Our capital expenditures
could vary from our expectations if we are unsuccessful in acquiring suitable
sites for new stores; development costs vary from those budgeted; or our
logistics and technology or store projects are not completed on budget or within
the time frame projected. The extent to which our investments in our Customer
1st strategy and our store base return value to our shareholders will depend
primarily on the continued success of our strategy and our ability to satisfy
the needs of our customers, and extent to which the markets recognize and reward
such success. The amount of our pension expense and contributions to our pension
plans will depend primarily on the performance of the investment portfolio in
the case of our defined benefit plan and the multi-employer plans, and on the
number of participants and level of participation in the case of our defined
contribution plans. Our estimates of product cost inflation could prove
incorrect, which could affect our ability to achieve our identical supermarket
sales growth and earnings per share growth projections. We assume no obligation
to update the information contained herein. Please refer to Kroger’s reports and
filings with the Securities and Exchange Commission for a further discussion of
these risks and uncertainties.
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