克羅格 (KR) 2002 Q3 法說會逐字稿

Good morning.

My name is Melanie and I will be your conference facilitator today.

At this time, I would like to welcome everyone to the Kroger third quarter earnings conference call.

All lines have been placed on mute to prevent any background noise.

After the speaker's remarks, there will be a question and answer period.

If you would like to ask a question during this time, simply press star then number one on your phone key pad.

If you would like to withdraw your question, press the pound key.

Thank you.

Miss Kelly, you may begin your conference.

Thank you.

Good morning.

Before we begin today's call, I want to remind that you the discussion today 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 filing.

One other comment before we get started.

We'd like to ask that you please ask one question only so that we can get to a greater number of people to ask a question on the call today.

And now I'd like to turn it over to Joe Pichler.

Thank you, Kathy and good morning.

Welcome to Kroger's third quarter conference call.

Thank you for joining us.

With me today are Dave Dillon, Rodney McMullin and Mike Schlotman.

I'll begin with the third quarter results.

Later, I'll provide an update and discuss the current operating environment.

Rodney will present more detail about our third quarter financial results and offer some guidance for the rest of the year.

We will then be happy to answer your questions.

For the third quarter, ended November 9, earnings per diluted share excluding one-time items were 34 cents.

On this basis and adjusting prior year results to eliminate good year amortization, earnings per diluted share were equal to the year ago period.

These results were this line with the estimate we provided at the end of the second quarter.

Net earnings for the third quarter of 2002 were $263 million, a decrease of 6.6% from a year ago.

The number of diluted shares outstanding declined by 42 million or 5.1% as a result of share repurchases and reduced delusion from stock options because of lower stock price.

During the quarter, Kroger incurred one-time items totaling $8.4 million after tax.

Including these items, net income for the third quarter of fiscal 2002 was 254.6 million.

Net earnings per diluted share were 33 cents compared to 19 cents a year ago.

The year ago earnings per share figure has been adjusted for the elimination of good will and includes charges associated with the strategic growth plan, one-time expenses and an impairment charge.

Sales for the second quarter total $11.7 billion, an increase of 2.8% over the third quarter of fiscal 2001.

Total sales rose 2.7%.

Identical food store sales including fuel decreased .6%.

Identical food store sales excluding fuel declined 1.3%.

Comparable food store sales, which include relocations and expansions rose .2% for the quarter.

Comparable food store sales excluding fuel declined .6%.

If we include expansions as some of our principal peers do, IDENS declined .4%.

We estimate Kroger's product cost deflation was negative .5% in the quarter.

The market share of Kroger's private label grocery in terms of units increased approximately 50 basis points.

As a result of price reductions related to the strategic growth plan, private label grocery share in terms of dollars declined approximately 50 basis points.

These figures represent Kroger Company-wide results, which we began reporting in the second quarter.

Now I'll provide an update on the strategic growth plan.

One year ago, almost to the day, Kroger announced a plan that significantly changed our purchasing, merchandising, pricing and operating strategies.

As you will recall, the plan has three key elements.

The first is to reduce operating and administrative expenses by implementing a more effective operating structure from store level to corporate office.

The second is to leverage our size more fully in order to achieve even greater economies of scale.

These two elements are expected to reduce costs by $500 million over two years.

The third element of the plan is a targeted price reduction program designed to increase revenues in our core business.

I am pleased with the progress we've made over the past 12 months in implementing this plan.

We have eliminated approximately $1,500 management and clerical positions.

The Nashville division office and distribution center have been consolidated into our mid south and Atlanta divisions.

Kroger has centralized additional merchandising categories to drive down product costs and we've centralized additional replenishment buying.

We have reduced prices in selected product categories and improved our competitive position.

We expect to exceed our original goal of $500 million in cost savings by the end of 2003.

Through the end of the third quarter, we had taken out $241 million in costs.

Along the way, we have had our share of challenges, victories and disappointments.

We got off to a strong start in the first quarter with solid earnings and IDENTS of .6%.

The second quarter was more challenging, although our Idents increased .8%, we overinvested in certain ports, our earnings came in below expectations.

Such challenges are to be expected as we change course.

Kroger is a big ship, and we are navigating turbulent, competitive waters.

I'm very pleased by that navigation.

The economic environment proved even more challenging in the third quarter than in the second.

The entire sector, including discounters, is being effected by changes in customer purchasing patterns resulting from a combination of recession, rising unemployment, and concern over possible unemployment, and concern over possible war in the middle east.

Most of the industry is experiencing negative identicals and others show a negative trend in the past three quarters.

In addition, food retailers are facing significant deflation in food costs, especially perishables, and substantial increases in health care and pension costs.

As a result, Kroger expects earnings per share for the fourth quarter to be equal to or slightly better than a year ago.

This is consistent with the guidance we provided at the end of the second quarter.

The company also expects a continuation of soft identical food store sales in the fourth quarter.

Looking ahead to 2003, at this point, we expect a continuation of the weak economy, high unemployment, product cost deflation and aggressive competition.

It is not clear when consumer confidence will improve, and we expect that health care and pension costs will increase substantially again next year.

In view of these factors, we estimate that Kroger's earnings per share in 2003 will be equal to 2002 before one-time items and that identical food store sales growth in 2003 will be lower than the 2% to 3% goal targeted in the strategic growth plan.

We're in the process of completing the business plan for 2003, and we'll provide additional guidance on these and other financial measures for 2003 when we're we report fourth quarter results in march.

At this time, we're not providing sales or earnings guidance beyond fiscal 2003.

Now I'll ask Rodney to provide additional perspective on Kroger's third quarter financial results and guidance for the remainder of 2002.

Rodney?

Thanks, Joe and good morning, everybody.

EBITDA totaled $804 million, a decrease of 3.7% from a year ago.

The FIFO gross profit right for the third quarter was essentially flat at 27.45% reflecting the investment in the strategic growth plans.

As you recall in the second quarter, we were disappointed with the results from our shrink reduction program.

Our shrink results showed improvement in the third quarter but they are still not where we want them to be.

On a rolling fourth quarter basis, EBITDA returned at operating assets before one-time items was 24.68%.

A decrease of 98 basis points from a year ago.

Operating general and administrative expense for the third quarter before one-time items increased 40 basis points to 19.26%.

These results reflect soft sales, rising health care and pension costs and higher credit card fees.

Year-to-date, OG&A is 18.73%, a decrease of 11 basis points from a year ago.

For the full year, Kroger expects OG&A as a percent of sales to be lower in 2002 than in 2001.

Net operating working capital totaled $493 million, a reduction of 52 million dollars from the third quarter of 2001.

Net operating working capital improved $96 million compared to the third quarter of 1999, when Kroger set a goal of reducing networking capital by $500 million within five years.

We remain committed to that goal and have plans in place to make solid progress in 2003.

During the quarter, Kroger repurchased 13.3 million shares of stock at an average price of $16.47 per share for a total investment of $219 million.

Since January of 2000, Kroger has invested $2 billion to repurchase 94.3 million shares.

Yesterday, the company completed the $1 billion buyback that was authorized in March of 2001.

As we announced in our press release, Kroger's board has authorized a new stock repurchase program totaling $500 million.

The timing of the repurchases will vary according to market conditions and the company's free cash flow.

But we anticipate the buyback to be spread over the next 12 to 18 months.

The new share repurchase plan reflects our belief at current prices Kroger shares represent an attractive investment opportunity.

Now, a brief update on debt and interest expense.

Net total debt was $8.4 billion, a decrease of $159 million as compared to the third quarter of 2001.

Adjusting for the refinancing of the synthetic leads.

Net total debt declined by $415 million.

Net total debt improved to 2.22 times EBITDA as compared to 2.28 times EBITDA a year ago.

The company continues to make progress toward the goal of net total debt equal to two times EBITDA.

Net interest expense totaled $134 million for the third quarter, a decrease of $15 million from a year ago period.

In terms of capital investment, the company invested up to $414 million in capital projects during the third quarter.

We expect capital investments for the full year to come in at $1.9 billion, excluding the synthetic lease and including the acquisitions.

This is a reduction of $200 to $300 million from our previous guidance.

During the quarter, Kroger opened, acquired, expanded or relocated 29 food stores versus 33 stores a year ago.

We completed four within the wall remodels and closed six food stores.

Square footage in the food stores totaled 134 million square feet, an increase of 4.3% versus a year ago.

A few additional comments on capital investment.

Last month, we completed the acquisition of 18 Raily stores in Las Vegas.

We believe that these stores provide an outstanding growth opportunity for us in one of the nation's fastest growing markets.

Seven of the former Raily stores have been converted to the Smith's banner and are now open.

Two of the stores being converted to food 4 less will open next week and the remaining six will be converted to food 4 less and open in the next several weeks.

Over the past two months, we've centered the Chicago market with our Food 4 less banner.

We've opened two stores in that area and both are doing well, and we'll open a third store in January.

We believe Chicago offers exciting growth opportunities for this format.

In terms of an update on free cash flow, during the past four quarters, Kroger generated free cash flow of $1.1 billion after capital investment of 1.7 billion excluding the synthetic lease.

This strong performance has enabled the company to execute our financial triple play by repurchasing stock, reducing debt and maintaining a strong capital investment program.

Based upon the strong free cash flow that Kroger has produced so far in 2002, we estimate the free cash flow for the year, excluding the synthetic leads, will total approximately $900 million, a significant increase from our previous guidance of $650 to $750 million.

The expected increase in free cash flow is a result of the reduction in capital investment I noted a few minutes ago.

In the third quarter, Kroger incurred one-time items totaling $8.4 million after tax.

These costs include $4.2 million after tax for systems conversions and $1.6 million after tax for expenses related to the excess utility contracts.

Now, a few brief comments on labor before I turn it back over to Joe.

In fiscal 2003, major USCW contracts will expire in Toledo;

Peoria;

Portland, Oregon;

Memphis;

Southern California;

Charleston, West Virginia;

Arizona; and Indianapolis.

As usual, we will also have dozens of smaller contracts expiring.

In all these contracts, rising health care and pension costs will continue to be an important issue in negotiations.

One that we will aggressively pursue.

Kroger believes our relationship with the unions is positive overall.

Now I'll turn it back over to Joe.

Thanks, Rodney.

Last December Kroger took decisive action in response to our competitive environment.

I'm pleased that we had an early start.

Today with a year of experience and a solid foundation upon which to build, I am confident that Kroger is on the right track with the strategic growth plan.

We will continue to narrow the price gap with lower cost operators while offering better value to our customers.

In 2003, Kroger will sharpen that pricing focus in key markets and will centralize additional merchandising categories to continue driving down product costs.

We expect to exceed the plan's original goal of $500 million in cost savings by the end of 2003.

Kroger's financial strength is a key strategic advantage.

We have the financial resources to continue making the price investments needed to build our business, remodel and expand our store base and increase our market share.

As a result, Kroger is well positioned to continue generating strong free cash flow.

We will now be happy to take your questions.

At this time, I would like to remind everyone, in order to ask a question, please press star then the number one on your telephone key pad.

We ask that you please limit your questions to one question per person.

Your first question comes from John Hindbuckle of Goldman Sachs.

Hi, Joe.

Hi.

I'll see if I can keep it to one here.

One thing did you this quarter is you had better balance between sales and gross margin.

You had a little bit of a different look than last quarter.

Can you talk a little about how you are managing that?

You know, that process right now, and are you happy with where you stand, meaning, you know, where gross is, where IDs are given the environment or do you need to tweak it more in the fourth quarter, you know, maybe back toward promotions a bit.

As we pointed out at the end of the second quarter and I mentioned again today, we overinvested in some markets in the second quarter, and I am pleased that we have a more disciplined balance between gross and sales.

We're still not pleased with the level of our prices with respect to discount operators.

However, I am very pleased with our identicals compared to our comparable supermarket operators, and although I don't like being -- we don't like being negative .6, given the environment, I think it's a good performance.

Best of all, we've got a year of experience behind us.

The team has now had a full year in new positions as buyers, as merchandisers, as, you know, consolidated accountants and so on and so forth.

So the stage is set in addition to having a good performance thus far, the stage is set for a continuation and extension of the strategic growth plan, some of which will begin in the fourth quarter, John, although it won't have any appreciable effect.

But most of it begins at the beginning of the first quarter of next year.

So I think we're -- we have built a foun -- foundation and have the strategy that will accomplish the goals that we set out.

That is, to reduce our price Gap over discounters to improve our competitive position vis-a-vis all others to increase our market share and as we know a long-term, that means an increase in return on assets as a result.

So see, you are cognizant that the environment's only going to give you so much, and there's no sense in artificially forcing a positive ID number?

Yeah.

It varies by markets.

Some markets have continued to deteriorate.

The announcement of the 6% unemployment last -- rate last week is a national index but you get the same thing in local areas like the northwest, certain cities up there, Seattle, Portland, et cetera.

There's a point at which beyond which it doesn't make sense, you know, to go after business that's not there.

It does make sense, in our judgment, to continue to squeeze on prices to do it this a targeted fashion, to utilize our economies of scale, which are substantial and the best in the industry except for Wal-Mart to drive down our costs and to use that to build our share.

Our judgment is we're the most efficient supermarket operator and have an edge over all others.

And that edge will prove itself through the reduced prices and increased market share.

One final thing.

What's the early read on Cap Ex and free cash flow for '03 either, you know, absolute number or directionally?

In terms of Cap Ex, we would expect it to be in the $2 billion range, and your comment about early read would be very appropriate.

That is the early read.

If you recall, that's about 100 to $200 million lower than where we would have said we thought the number would be six months ago.

That number excludes the synthetic lease.

There's an additional $200 million in synthetic lease that's outstanding that we may bring on our balance sheet.

If we do, that will show up in Cap Ex.

That number excludes that, and it also excludes any additional acquisitions.

That would put free cash probably close to the level we're at this year or a little less?

I don't think it will be as much as this year.

One of the things that's negative on free cash flow is when we merged with Fred Meyer, Fred Myer had substantial net operating loss carry forward.

We've been able to significantly reduce our cash taxes over the last three years since we've been merged.

For next year, that's going down by almost -- cash taxes will go up to about 150, $175 million.

So that's one negative you need to reflect in our estimated free cash flow for next year that you wouldn't have had to worry about this year.

Okay, thanks.

One of the things that pleases me is the industry consolidates, and I believe the consolidation pace will stay as fast or faster next year.

We're able to utilize our capital more efficiently, John, through acquisitions of properties such as the Railys acquisition we made that's just been approved by the FTC in Las Vegas.

As we said before, that's a much more efficient way to build market share than building from the ground up.

I think there could be more of those opportunities.

Okay, thanks.

You bet.

Your next question comes from Mark Knewson with Merrill Lynch.

Hi, mark.

Good morning.

The first doesn't count as a question.

It's a definitional.

Nice try. [ laughter ]

On your guidance, you had said that you expect the fourth quarter to be equal with last year.

Now last year's 47 cents but obviously with no good will amortization, do you mean 47 cents plus the lack of good will am mortgage decision or including the benefit of good will amortization.

We always report that apples to apples.

Good.

Next year is a 53rd week unless I'm mistaken.

So again that's an apples to apples thing, flat on 52 weeks?

Mark, the 53 weeks is still -- I think it's three years away.

It's not next year, though.

Sorry about that.

The question I have, and this is the real question.

We started to talk about this last quarter.

Given the price reductions you've put into the marketplace and deflation out there, it's our impression that your volume growth is still huge and much better than your sales would lead people to believe.

And also that's a reflection of some growing market share.

Could you sort of put some numbers around first of all volume and market share?

It's hard to put a total on it.

You look at certain categories reported in our private label sales and grocery were up in terms of units 50 basis points.

And you're quite right, the unit growth was strong.

On the other hand, you look at the sales dollars and they were down 50 basis points because of the investments that we immediate in private label price.

You look at the meat category, you know, we had meat deflation in the 5% range.

It's hard to overcome declines like that, and you have to kind of treat each category separately as its own story to tell.

I think as a general principle, you know, relative to our competitors certainly, we've had solid growth in units.

I don't know if I could put any more precision around that other than those categories that I mentioned, Mark.

Anything you want to add to that?

No.

To have --

The growth is better than what our sales would suggest.

That's the bottom line.

The tonnage growth is better.

It's hard to fully evaluate, Mark, is we talk about product cost and cost inflation or deflation.

We think that's the most accurate number to follow because when you talk about retail prices, you mix up deflation and competitive effects.

Having clarified that, there's no question that there's substantial retail.

I wouldn't call it deflation.

I'd say reduction as a result of the product cost deflation plus competitive adjustments beginning with our own strategic growth plan.

As competitors react to that, we react to them.

There's no doubt there's pressure on revenues as a result of the competitive effect.

I believe that the strong guy wins.

And we're the strong guy here in terms of our purchasing power, our economies of scale and our balance sheet.

I guess we're just looking for some confirmation that all this effort is actually returning something in terms of, you know, market share that in terms of customer reaction which you can quantify which makes you perform better than your peers.

Our comparative index would suggest the same thing.

Okay, thank you.

Great.

Your next question comes from Jack Murphy with CSFB.

Hi, Jack.

Good morning.

I wonder if could you just let us know if you considered the flat number in '03 kind of the worst case scenario and maybe walk us through what type of sales margins and wage and benefit assumptions go into that '03 number?

We can't do that because we haven't completed the business plan.

And as we indicated, we would give you the full financials when we report in the fourth quarter.

The point that you raised initially is that we're assuming that the world stays as it is.

And it's hard to evaluate the effects, the full effects of recession, deflation, unemployment and maybe most significantly, you know, reduction in real wealth as a result of the stock market decline, and concern over war in the middle east.

Those are tremendous burdens on every industry, you know, not just Kroger but every industry.

And that world -- some of that world is bound to change next year.

I just don't know which pieces and how much is the problem.

So we're making the assumption the world stays pretty much as it is.

Okay, let me just add on to that a little bit.

Given the fact that you have a $2 billion number in mind for '03, maybe one piece of that puzzle I was asking about earlier you could put into place.

What type of square footage growth do you think that means for '03 if the $2 billion is right?

The square footage growth will be lower than the four something we had this year, but, you know, one of the things that's helping this year is the acquisitions we've been able to do on fill-in market.

And try to predict where those will come up is pretty tough to predict other than I would expect that they will.

The square footage growth off the $2 billion number would probably be in the 2 1/2 to 3% range, but that's very, very early, Jack.

Okay, thanks.

Welcome.

Your next question comes from Meredith Adler with Lehman Brothers.

Hi, Meredith.

Hi, guys.

A question if you could talk more about labor.

You gave us a list of contracts that are coming due yesterday from Albertson's.

We heard about what sounded look a real success in the small market in Eugene, Oregon, and then safeway's talked about what seemed to me to be a very aggressive posture they are taking with the unions.

I was wondering if you could give us any sense right now whether you believe that you will make progress on labor costs in the coming year, that the unions understand the situation you're in, and that there's a chance of duplicating what happened in Eugene and other places?

And what's the risk?

I listened to safeway and thought the risk of strikes was very high.

How do you see it?

That's a great question and I'm pleased you asked it.

We have worked very hard on our contracts over the past 15, 20 years.

There is a big difference between the east and the west in terms of contract structure.

Partly as a result of fine work by our predecessors here at Kroger.

We have a much larger percentage of contracts that have, say, two tiers.

We've used buyouts in the past.

We have second tier not only wages but benefits.

And so forth.

So this has been a topic of strong emphasis in the past on the Eastern side.

The west is a little bit different.

It's a bit of a catch up game including our own western divisions.

That would be west of Denver.

Having said that, you know, the big element, two big elements have changed the game.

One is the rapid growth of Wal-Mart, who's nonunion, pays low benefits, and if you netted out lower salaries or wages as well, plus the rapid inflation in health care costs and partly result of the stock market pension costs.

So now, although we made progress, it's a new ball game.

And we're playing the game hard.

Not in terms of aggressiveness but in terms of openness and communication with our employees.

Today, Kroger employees are much more knowledgeable about the wage gap with Wal-Mart and the benefit gap than they were in the past.

And, you know, we're careful to try and provide everybody a full picture.

We're working hard with our local unions.

There's no doubt in my mind, absolutely no doubt.

One of the reasons I know for sure is that the union USCW local President is well aware of the price gaps, is well aware of the wage gaps, excuse me, and compensation, is well aware of it, is very concerned about it, and, you know, is, I think, would welcome some process that would work things out provided there's reasonable assurance of protection for a current employee.

That attitude varies widely contract by contract and a lot depends on local leadership.

Our job, as I see it, is to work to communicate the situation clearly to both or employees and to the local union leadership to look for innovative creative ways such as buyouts, buydowns, two tiers to address the problem in a manner that does not unduly penalize long-term Kroger employees but, in fact, you know, the world has changed for them as well.

It used to be a recognition of that, and to work constructively with both our colleague companies and with the unions, which we're doing, to look for avenues.

Some of which we may disagree with on the union.

Some of which we may agree with.

To reduce the costs of pensions and health care and reduce this Gap between ourselves and the discount operators.

So there's a very broad scale of activity here, and it's active.

I wouldn't call it aggressive, but it's very active.

And I think it will bear out.

And I guess my follow up question is I did think Safeway took a much more aggressive sort of in-your-face tone, and yet they talked about wanting to part with you and Albertson's and others in the market.

Do you see that as a risk to Kroger to have a partner that's much, more aggressive or do you think that in the end you guys are really going to be working with the unions in a partnership?

Well, first ever all, we have a lot of markets where Safeway isn't present where we have collective bargains.

My hunch is that you know, over 50% of the employees are not in Safeway markets.

I haven't done the math, but would I guess that is the case.

Secondly, every company has its own style.

As you know, mine is passive, friendly and modulated. [ laughter ] That's my staff, or our staff.

Everybody faces a slightly different situation and you have to respond to your own situation in a way that is best.

And our situation is a bit different from Safeway's at this point from Albertson's.

Nevertheless, we have common interests in certain markets and we'll pursue those in a way that, you know, builds common benefits.

Reporter: Okay, great.

Thank you very much.

You bet.

Your next question comes from Phillipe Jasons with CSFB.

Good morning.

The fixed income research, despite the difficult operating environment, you've actually managed your credit profile very well.

Given that you have no problems funding yourselves basically at directive rates, the question I have is should we conclude on that basis perhaps there's less of an incentive to seek an upgrade from the rating agencies and other use from financial flexibility to fund, let's say, new initiatives to enhance shareholder value, ie, a dividend program or enhance your market position?

I'm kind of thinking about over the years Safeway always told the rating agencies please don't upgrade me.

Give me the flexibility to buy back shares and make acquisitions.

Are you thinking in the same line at this moment?

As we've said on numerous occasions, our goal is to have a financial structure for our get to EBITDA ratio is 2.0 and to achieve a credit rating of triple b flat.

That's because we believe that is our long-term lowest cost to capital.

And we run the company for, you know, cash flow long term.

We remain committed to that goal.

We're, because of our strength and the skill of our operators, we have been in a position where we can eat our cake and have it, too and have what Rodney referred to as the triple play.

Our free cash flow has been so strong that we've been able to simultaneously maintain an aggressive Cap Ex program and appropriate Cap Ex program, pay down debt and buy in stocks.

And at those kinds of levels, that's the way to build long-term shareholder value for everything that I know about.

Beyond that, that goal, we believe, would give us the financial flexibility as well as enable us to do P2 commercial paper.

Commercial paper is part of -- it's a lot of attraction to that.

One other point.

Until last May, we could not even consider a dividend because of our credit agreements.

The topic is certainly one under discussion as I indicated before both in management and with our board.

And what we are interested in doing, of course, is taking the route that will build long-term and shareholder value.

That is a combination of, you know, the combination to achieve that varies greatly.

When your stock is selling at the EBITDA multiple we're selling, that's a pretty good investment.

When stock gets up, the world changes a little bit.

So we're thinking very seriously about all of those factors.

Bottom line, long answer is we're committed to the cheerful b -- triple b and contribution of the triple play and are open to the full range of activities to build shareholder values from additional stock buybacks to dividends.

Maybe just as an add on to the financial flexibility, can we solicit any comment as it relates to the attractiveness of the Chicago market now that Dominic's is up for sale?

We don't have a comment on acquisition or merger possibilities.

I knew, but I thought I'd give it a shot anyhow.

Thanks very much.

Don't mind you asking.

Your next question comes from Steve Chick with JP Morgan Chase.

Hey.

Hi, Steve.

I guess, Rodney, I was wondering if you might be able to give us a little color on the increase in the SG & A, I guess the 40 basis points and what piece of that relates to the health care and pension costs.

And if that's the type of trend that you are kind of thinking about as you look into '03 or is it going to be higher than what contributed this quarter?

In terms of if you look at the 40 basis point increase, it will look at some of the key pieces and these are numbers that we've given out before.

LH & A was about 18 basis points to that increase.

Pension was about 18 basis points and credit card fees were four basis points.

I kind of start with the easiest one first and go backwards.

On credit card fees relative to next year, we would expect it to continue to increase in that neighborhood or slightly more, but not significantly more.

In terms of LH & A and pension, we think the increase in this quarter was unusually high when you look at it on a run rate basis.

But we do believe we'll have significant increases going forward.

When we release earnings on the fourth quarter, we'll give a little bit more color on lh & a and pension because we'll have been finished our analysis where we are but certainly increases there were reflected when we said we expect next year to be equal to this year on earnings per share.

Okay.

Second thing and separately, I was wondering, the system convergence, can you just comment on that and where that stands?

You guys still on track, I think, to have it all completed by the end of '02 '03.

Yeah yes, we are.

As far as routes as we have announced in our original business plan did not include converging of Fred Meyer.

We have now decided to include Fred Meyer and will do so at a total cost below the amount that we announced at the time that we did the merger.

So we're on track.

We'll finish -- we'll well along at Ralph's.

We'll finish early next year at Ralph's and we'll be hard at work at Fred Meyer.

And does Fred Meyer --

If you look at merger-related costs at the end of the second quarter, we estimated remaining merger costs to be $25 million to $35 million.

This quarter, there's about $10 million 6 of merger related costs so if you look at the remaining balance it would be $15 to $25 million, and that would cover the completion of Ralph's and also accomplish accomplish the Fred Myer that Joe talked about.

Okay, thank you.

We're on track.

Your next question come from Lisa Cartwright with Salomon Smith Barney.

Hi, Lisa.

Hi.

You guys rolled out or you announced your strategic plan, I guess, this time last year, and you started promoting or ramping up your promotional activity, I think, the following quarter.

Since that time, you know, Safeway and Albertson's have now kind of announced that they are going to be ramping up their promotions.

Albertson's, I think said yesterday that they are going to roll out something called price knockdowns.

Safeway's been rolling out the 28-day price locks.

Is your guidance for next year, does it include a further ramp up in promotional or advertising activity or do you feel like your plan is solid the way it is, you will stay the course?

Now that you are telling me you're passive, I'm a little worried about you.

Don't be worried about me.

Just kidding.

First of all, wish you a happy holidays if I didn't.

First of all, just a minor and it's not so minor but just make sure we're communicating.

Okay.

The strategic growth plan was far more than a promotional program.

I just meant the one part of it.

Okay.

And I think that's an important distinction, however, because a lot of planning went into this thing.

And if we didn't start planning nine or ten months before --

I guess the point --

so everyone --

you guys are definitely ahead of everyone.

Right.

Point number two is as I indicated, we're going to centralize additional merchandising categories.

We will take more than the original $500 million out by the end of 2003, and we will invest the addition in additional retail prices.

Okay.

So, you know, what I like about our position is we got off to an early start.

We worked through some things that don't surprise me when you've got a lot of new people in new positions, nevertheless did very well if you like at our IDENTS in the last three quarters, vis-a-vis competition, and we know where we're headed with respect to decisional categories and investment.

Have you learned anything along the way?

Obviously, you said earlier in response to John's question that, you know, you wanted to balance investment with sales growth a little more.

Have you learned anything with regard to the trade off between promotions and just lowering shelf prices?

Oh, we've learned a lot.

One of the things that humbles me is about the time I think I know something about the business, I get surprised at, you know, programs that you think will work in certain markets don't work there but work somewhere else.

And one of the great things about the organization here is we're very sales-or oriented people, and we have a lot of, you know, great division as well as general office personnel whose lives are devoted to this.

And what I like, Lisa, is the learning process that you talked about, you know.

We changed the organization structure dramatically beginning in February.

Those changes weren't -- worked all the way through.

We did it by phases to make sure we didn't lose control until probably third quarter.

So we, you know, we've got some people who have been in the position three-quarters, two-quarters, one-quarters, whatever what have you.

Secondly and most important, you know, the divisions and our general office now have a year of living with a different set of relationships and the communication pattern is very strong today, playing back individual experiences in individual markets.

And I think, you know, that's one of our strengths, is to have the economies of scale combined with the diversity of approach, appropriate to different markets that have different demographics, different competitive structures.

Different economic situations.

I'm more convinced than I was a year ago, we've got that capability because people are talking and listening to each other.

We've had a year of experience with that.

That sounds good.

One final quick question.

You mentioned doing acquisitions filling in markets.

Have you seen over the past couple of years a change in the FTC and more of a willingness to allow for number one and two players to make in-market acquisitions ?

I know ATB picked up some of the Albertson's stores in the markets where they clearly had number one shares.

Our experience is that it's a case by case situation.

You really have to know and understand each case.

Would I never make a broad statement about any government agency.

Especially one that deals with anti-trust because every individual case is just so many differences that, you know, I wouldn't begin to make a general statement.

Okay, thank you very much.

You're welcome.

Your next question comes from Chet Sarinkofsky with McDonald's Investment.

Good morning, Chet.

Good morning.

Looking at the acquisition you are reopening some of the stores as food 4 less.

I want to get an update on what the status is of the stores in Chicago and in Las Vegas.

Whether they are union, nonunion or have a special contract.

And that going forward, how you see this supply of Raily's-type acquisitions progressing.

Well, the Las Vegas food 4 less stores are union.

In Chicago, they're not union.

And of course whether they become union or not will depend upon the choice of our employees.

Do they have a separate contract from the Smith stores in Las Vegas?

It's a similar contract.

There's some differences.

Okay.

As you know, the Food 4 less stores in California are unionized and it's a strong model that provides real competitive advantage on price even though the rates in California are high and benefit rates.

How about the supply of Raily's type acquisitions going forward in a very competitive marketplace right now?

Well, you know, it's anybody's guess.

My own guess is there's going to continue to be substantial fall out going forward.

You know, I've said it, we've said it, we've said it for two years.

We've been right two years.

If you go back 18 months ago and look at the environment then and you look at the environment now and just tick off the names by major markets, it's sort of a stunning amount of change.

And I think that's going to continue because the forces that triggered it are, if anything, stronger today than they were then, chuck, many terms of, you know, the spread of low-cost competition.

The economies of scale available to big players that represent real efficiencies in terms of technology, best practices, buying power, et cetera.

That's if anything been enhanced.

On top of that, you throw a recession, which squeezes out, puts a hard squeeze on people who have, you know, a shaky financial situation.

I think it's going to accelerate.

Thank you.

You bet.

Your next question comes from Mia Kirchguessner with Sanford Bernstein.

Hi.

I have a question about your Cap Ex cuts.

And you talked about going down a couple of hundred millions dollars in each year.

Can you address whether that has to do with specific areas where you won't be targeting putting in new stores or whether it's across the board that you found ways of cutting your investment into the refurbishments that you are doing or how that is going to affect possibly what the footprint could end up looking like?

Sure.

I'd ask Rodney to comment on it.

It's a little bit of both.

Certainly one of the things that we've gone through over the past year and a half or so was after the merger with Fred Meyer is consolidating purchasing on our facility engineering equipment, some of the reduction is just flat out being able to buy items cheaper than we were buying before.

Some of the reduction is really a result of the smaller acquisitions that we've done.

If you look at the stores we bought in Las Vegas, a few of those stores were located in trade areas that we were trying to get into.

If you look at the stores we bought from Albertson's in Houston, same case there.

So some of it's due to that.

And the other pieces, just probably about nine months ago, we just got a little bit more selective on must capital spending to make sure that there wasn't anything -- a little more focused on existing markets rather than going into the new markets.

That's really all three of those pieces together.

And we wanted to make sure that we got a little tighter on capital but didn't make a left turn or right turn because we just don't think that would be good for the business long term.

Okay.

Thank you.

Thank you, Mia.

Your next question comes from Mark Wiltoneth with Morgan Stanley.

Good morning.

Hi, Mark.

My question is on the OG&A line.

Can you discuss some of the other avenues of cost cutting you might be able to explore over the next year and also as we think about cost cutting, are you comfortable with your current store platform and are there any stores which you think need to be closed now that you've seen how they performed in the weaker environment?

Yeah.

Take those questions kind of in order.

There are a number of areas of cost cutting beyond OG & A. I think the first observation to make on the OG & A increases, we had weak sales this quarter compared to where we expected to be.

And I don't back up to those comparatively, they are quite good.

Nevertheless, that has a real effect on overturning all of the fundamental changes that we're making to drive down OG & A through best practices and through technology.

My belief is that those activities, which continue which continued and letting me into free programs and to accelerate the improvement once the business environment improves a bit in terms of unemployment, recession, war concerns and so forth, that we're building a solid base here on OG & A. Secondly, there are a lot of other areas for -- so that has an effect.

Secondly, there's no question that the effect of the stock market on pension plans is one that's well known throughout all industries.

And if there's some improvement in the market, the world changes but right now, you know, pension plans have taken some hits.

And health care is one in which we're working as we talked earlier, very hard on both the union and the nonunion plants.

Nevertheless, any paper that you read says, you know, these are going up 14%, 15% not only this year but also again next year.

There is a compounding effect when you look at those.

We still have strong opportunities, I believe, in labor productivity, smart productivity, taking ours out or using our using ours more efficiently so they yen rate higher sales and improve that sales for labor hour.

There's a lot of opportunities there plus shrink.

As Rodney indicated, this quarter, we changed the trend in shrink and I'm very pleased with that.

I'm pleased by the movement and result.

There's a lot of money there.

There's a lot of bucks there, and we intend to get it.

And the second question was on your store platform.

Are the returns acceptable across the platform?

Are you thinking about any store closures given the environment?

Well, I I'll start and let Rodney or Dave chime in here.

We systematically in our Capitol capital investment program among the pieces or first of all, any investment that we make is over $1 million is reviewed by the officers here very carefully, and it has to meet the 11-3 hurdle rate adjusted.

And any division that spends the dollars gets the projected sales and EBITDA impact added to their bonus plan as it does to our bonus plan including mine here.

And the third element is we follow up on each investment and systematically review its performance in terms of its actual performance versus projection beginning six, nine months after the store opens and we carry that forward for five years.

In that process, we find opportunities to call the stores, identify operating results that we don't think are adequate, determine whether or not there are unique situations or unusual situations through which we expect the trend to change.

If there are, and they seem reasonable, we give them a shot.

If they're not, we close the store, sell it, trade it off, do something else.

At this point, I don't see anything unusual on the horizon at all compared to our usual practice.

If you look through our history, we closed a couple, a dozen or more stores a year.

Or from relocations when you build a new store.

Rodney, would you add anything to that?

No.

Next question?

Any other questions?

Your next question comes from Bossin Molluck of Newburgher Bermen.

Hi.

I wanted to ask you what is your flexibility in terms of your dividend policy to the extent that there's a change in the double taxation of dividends.

And second is in terms of your capital spending, it seems to me that you need to kind of, even though you have this bottom up checks and balances in terms of returns in Cap Ex, you get a look at this junction chore, you know, what's the efficiency keeping your noise down, you know, for the quarter by a percent?

Maybe it is something sort of anticipated rather than at the bottom up roll out basis.

Man you ought to review that and take more aggressive action on the Cap Ex given where the demand is in industry overall in terms of same-store sales group for the industry.

Well, as I said earlier on the dividends, our goal is to increase shareholder value.

You know, we do that not only by the business plan but also by our financial practices, and until last may, we could not even consider a dividend as I think I indicated earlier.

You know, we're open to the combination of dividend and/or stock buyback.

As I said, both topics are under continued discussion by by management then by our board.

At this point, the stock multiple we have, stock repurchase very good investment, solid investment and it's served us well.

I'm not quite sure where you're going on the Cap Ex question, but we have a, as we indicated last year, when we lost the strategic growth plan, our EBITDA plan on operating asset assets would decline and it has.

That's no surprise.

Given the capital discipline that we've had, I think we've indicated that we're going to take out substantial or reduced Cap Ex substantially below where we have said it would be, but the disciplines we have in place, hey, they're as good as I've ever seen.

And we earn our returns.

I'm very pleased with the returns on the incremental capital we have invested over the past five or six years.

So there is some adjustment as Rodney indicated earlier in terms of the amount spent.

We've tightened up a bit.

And we think that's prudent in this type of operating environment, but it's only a bit.

And I am satisfied and happy with the returns that we've made on the incremental investments we've made.

They have built shareholder value, earned returns as a group well above our cost to capital and have been an economic value and that's what we're in business to do.

I am not detracting from that.

The only thing I was pointing out is that the environment has changed and if you have more acquisitions and more attractive acquisitions buy versus build, those decisions may not be as optimal from the bottom up rather than from the top down given how tough the industry is.

I see where -- I'm sorry, I misunderstood where you were headed.

Look, on an acquisition, it takes both bottoms up and top down.

There has to be commitment from the division that's going to run those stores that they know how to run them, they want to run them, they believe in them.

If there's not, if you go top down, you can buy stuff that just flat doesn't work.

Got you.

Similarly, our job from the top down side is to make sure the division doesn't get too enthusiastic about buying something that doesn't have shareholder return.

I think your comment's very well placed here because if we're right, if consolidation is going to continue or accelerate, we'll a lot of additional opportunities for acquisitions like the Las Vegas acquisition that we made this year or the Texas acquisitions that we made this year and so forth throughout the entire organization.

That will build returns in shareholder value.

I assure you that we will exercise the same financial disciplines on any investment whether it's new stores, technology, purchase of assets from others, dividend versus stock buyback, you know, we're cash flow driven.

And we look for the highest present value on future cash flows.

That's a good observation.

At this point, we have time for just one more question.

If there is one.

Your final question comes from Neil Curry with UBS Warburg.

Oh, thanks, just got in the end there.

I want to ask again about the question of inflation.

Excuse me, you cut out.

Oh, sorry.

I wandered if I could ask a question again about deflation and try to flush out what was asked earlier because I think it is important to try to get to what's going on the underlying growing growth.

The deflation you reif referred to of course this's cost deflation and that impacts your cost to goods sold.

Looking at the government data for cpi versus PPI, it looks as if for the industry there's been no price deflation over the quarter that you're recording but there was quite a bit of cost price deflation.

Could you confirm that you, if fact, had shell price deflation during the period and was it enough to actually show that you had underlying volume growth?

We did have underlying volume growth, yeah.

So in cash terms, hu price deflation including carpet -- you had price deflation including the 0.5 deflation you saw on the cost side?

I can't give you, you know, we just don't calculate our retail deflation number.

I'd be very uneasy about even speculating on that.

So maybe just ask it a different way.

If you get at it on a tonnage side, there's no doubt our volumes increased.

If you look at the relative Idents versus carpet competition, it will be stronger.

Obviously.

I was just trying to get to the -- just looking at the government data, it doesn't show the cost price deflation that you are seeing right now is being passed onto the consumer.

I was just trying to get down to the --

It isn't being passed on because a major portion of it is in perishables.

And the returns are a split second in perishables.

Okay.

And if anything, my bet is, and I'm going out on a limb here, but what the heck, it's the holiday season, that the deflation caught many companies, including Kroger by surprise in perishables.

And when you see, you know, prices of pork chops or middle meats drop 10, 12%, the temptation is to get enthused to lay out impressive prices and then you realize where's the gross margin here.

I think one of the dynamics in my observation on the deflation in perishables is if I had to lay my wallet on the table, I'd say the retail deflation is even faster.

That's really what I was trying to get to.

Again, I can't give you any statistics.

I'm working on what I see.

I don't have a calculator to give me the exact number.

The second part of the question is, you know, looking at the, you know, what's starting to come the first quarter of next year, we're starting to come up to the points of which we did start to see quite big price deflation.

Maybe we'll start to see cost prices going up again.

Yeah.

How easy to you do you think it's going to be to pass on possibly inflation or at least reduce to deflation in a competitive environment without, you know, damaging the top line or the volume growth that you are seeing right now?

Well, you know, I don't think it would be instructive to give a general answer.

It will vary market by market.

And, you know, as we indicated, we intend to continue and enhance our investment retail.

It will be a targeted investment in terms of products and locations, so the best way to answer your question is, you know, in some markets that may be the case.

I don't think as a general rule for us, it's going to be something that we're counting on because we are counting on narrowing the Gap between ourselves and the discounters and broadening our competitive advantage over our supermarket peers.

So even if we start to see costs by inflation, you are still determined to try to lower that price gap?

Absolutely.

Great, thank you.

With that, we thank you very much.

We appreciate your diligence this morning and your interest.

And we wish you all a happy holidays.

Thank you.

This concludes today's Kroger third quarter earnings conference call.

You may now disconnect.