克羅格 (KR) 2002 Q4 法說會逐字稿

Good morning.

My name is Lynn, I'll be your conference facilitator today.

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

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

After the speakers' remarks, there will be a question-and-answer period.

If you would like to ask a question during this time, simply press star then the Number 1 on your telephone keypad.

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

Thank you.

Ms. Kelly, you may begin your conference.

Thank you.

Good morning.

Before we begin today's call, I want to remind you that the discussion today will include forward-looking statements.

We want to caution that you such statements or 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 bases is contained in our SEC filings.

Now I'd like to turn the call over to Joe Pichler.

Thank you, Kathy.

Good morning and welcome to Kroger's fourth quarter conference call.

Thanks for joining us.

With me today are Dave Dillon, Kroger's President and Chief Operating Officer;

Rodney McMullen, Executive Vice President; and Mike Schlotman, Group Vice President and Chief Financial Officer.

I will begin with a few highlights of Kroger's fourth quarter and full-year results.

Later I will provide an update on our 2002 market share including our performance in markets where Kroger faces significant supercenter competition.

I will also offer a progress report on our strategic growth plan.

Rodney will present more detail about our fourth quarter financial results including one-time items and provide some guidance for 2003.

He will discussion our option of EITF issue O2-16 and our change to item cost method of accounting in the former Fred Meyer divisions.

We will then be happy to answer your questions.

For the fourth quarter ended February 1, Kroger reported earnings of 49 cents per diluted share before one-time items.

These results are equal to the year ago quarter on the same basis, and are consistent with our previous guidance.

Adjusted EBITDA totaled $974.4 million, a decrease of 4.5% from a year ago.

Total sales for the fourth quarter of fiscal 2002 increased 2.8% to $12.5 billion, total food store sales rose 2.4%.

Identical food store sales, including fuel declined 1%.

Identical food store sales, excluding fuel decreased 1.8%.

Comparable food store sales which include relocations and expansions decreased .3% for the quarter.

Comparable food store sales excluding fuel declined 1.2%.

Kroger estimates that its product cost deflation including fuel was flat, deflation excluding fuel was negative .5% in the quarter.

While we are not satisfied with our sales, we recognize that it was a difficult holiday season for Kroger and most retailers.

Consumers are still concerned about the weak economy, high unemployment, and possibility of war.

Our identical food store sales through the first five weeks of fiscal 2003 are trending higher than our results for the fourth quarter of 2002.

Kroger has benefited from both the weather and our strategic growth plan.

Our corporate brands had another solid quarter.

The market share of Kroger's private label grocery in terms of units increased to approximately 31%.

Private label grocery share in terms of dollars grew 23.5%.

These figures represent Kroger's company-wide results which we began recording in the second quarter.

For fiscal 2002, sales increased 3.3% to $51.8 billion.

Earnings from operations were $1.65 per diluted share, compared to the $1.59 per diluted share in 2001.

Earnings from operation for 2002 totaled $1.3 billion, equal to 2001.

Results for both years exclude one-time items.

Adjusted EBITDA for the year totaled $3.749b as compared to $3.742b in 2001.

Net earnings for 2002 were $1.52 per diluted share, as compared to $1.37 in 2001.

The 2001 earnings figure has been adjusted for the elimination of goodwill amortization as required by FASB 142.

Here's an update on Kroger's market share based on our internal estimates at year-end.

Kroger competes in 48 major markets.

A major market is defined as one in which we operate nine or more stores.

For 2002, Kroger held the Number 1 or Number 2 share in 41 of our 48 major markets.

Kroger's share increased in 27 of these 48 major markets.

On a volume-weighted basis, Kroger's market share was unchanged.

Kroger competes against a total of 849 supercenters.

There are 26 major Kroger markets where supercenters have achieved at least a number 3 market share position.

In 2002, Kroger's market share increased in 19 of those 26 markets, and declined in seven.

Kroger's sales increased 4.4% in those 26 markets, and EBITDA decreased .3%.

On a volume-weighted basis, Kroger's market share improved .4% in those 26 markets.

Kroger competes against 603 Wal-Mart Supercenters.

Wal-Mart Supercenters have achieved at least a number 3 share in 18 of the 26 major markets where we have significant supercenter competition.

Kroger's market share increased in 12 of those markets and declined in six.

On a volume-weighted basis, our market share improved .1%.

In 2001, December 2001, Kroger announced the strategic growth plan that significantly changed our purchasing, merchandising, pricing and operating strategies.

I am pleased by our progress during 2002 in implementing the plan.

Kroger reduced costs by $306 million.

Centralized procurement for additional categories, and consolidated the national division.

We now have one year of experience with our new structure and believe that our merchandising programs will be even more effective in 2003.

Kroger has improved its price position on key items, and, as you just heard, we have gained share in major markets where we compete against supercenters.

Pricing is only one element of our strategic growth plan.

We will continue to differentiate our stores to exciting departments that offer natural food, high-quality perishables, expanded general merchandise, and outstanding private-label products in convenient locations.

In 2002, Kroger established a strong foundation for the strategic growth plan.

We will build on this foundation in 2003.

We believe the continued enhancement of the plan will improve our competitive position and enable us to offer even better values to our customers.

Kroger has identified additional opportunities to reduce costs and operate more efficiently.

For example, last week, we announced the combining of our two retail divisions headquartered in Lavonia, Michigan, and Columbus, Ohio.

Now, some earnings guidance for 2003.

In the future, that is after this quarter, the company will report earnings after one-time items.

This conforms with regulation G, which was recently issued by the SEC.

As a result, the company's estimate for fully diluted earnings per share in 2003 is now $1.63.

This estimate is consistent with Kroger's previous guidance of $1.65, minus 2 cents of expenses in 2003 for systems conversions and the consolidation of Kroger's Michigan and Columbus divisions.

This guidance also includes estimated increases in Kroger's pension expense, and healthcare costs.

The effect of any gain or expense from the mark to market of the excess energy contracts in California is excluded from Kroger's 2003 earnings guidance because it is not possible to estimate an effect at this time.

Kroger expects identical food store sales, including fuel, to be positive for 2003.

These estimates assume that inflation will be flat in 2003, and that the economic and competitive environment remains unchanged.

Now I will ask Rodney to provide some additional perspective on Kroger's fourth quarter financial results, including one-time items, and some additional guidance for 2003.

Rodney?

Thanks, Joe.

And good morning everyone.

First I'd like to go into further detail about the one-time items in the quarter.

One-time items included expenses of $7.6 million pretax associated with system conversions and other merger-related items.

And income of $15.2 million pretax from the mark to market of the excess energy contracts in California.

Collectively, these one-time items increased Kroger's fourth quarter net earnings by $7.6 million pretax, or $4.5 million after tax.

Or approximately 1 cent per diluted share.

Including these items, net earnings for the fourth quarter of fiscal 2002 were $381 million versus $368.5 million a year ago.

Net earnings per diluted share were 50 cents compared to 45 cents a year ago.

The year ago earnings figures have been adjusted for the elimination of goodwill, as required by FASB 142.

During the fourth quarter of 2002, FASB's emerging issues task force reached a consensus on issue 02-16 that addresses the method by which retailers account for allowances from vendors.

Issue 02-16 became effective January 1, 2003.

Net earnings were not affected by the adoption of issue 02-16.

The FIFO gross profit effect of adopting issue 02-16 which affected less than 1% of the annual vendor allowances earned by Kroger was $27.6 million pretax.

This expense was offset by a corresponding $27.6 million pretax LIFO credit.

Most of this $27.6 million resulted from slotting and advertising allowances.

Kroger reported a LIFO credit of $34.3 million pretax in the fourth quarter of 2002, versus a credit of $3.7 million pretax a year ago.

The figure for the fourth quarter of 2002 excludes the effect of EITF issue 02-16 just discussed.

Deflation in the company's jewelry division and in general merchandise at Fred Meyer accounted for most of the credit.

In -- the 2002 amount was larger than expected.

For example, the inflation index of jewelry showed deflation of 5.3% in the fourth quarter, compared to deflation of .3% in the third quarter.

Obviously, a significant change in the rate of deflation.

Jewelry accounted for approximately $15 million of the LIFO credit.

However, Kroger's pension expense in the fourth quarter were $24 million pretax, higher than expected.

Considering both the LIFO credit and the increase in pension costs, Kroger's earnings per share of 49 cents reflects operating results that met our expectations.

During the fourth quarter of fiscal 2001, Kroger incurred one-time items of $55.9 million pretax.

The FIFO gross profit margin for the fourth quarter of 2002 was 27.10%, a decrease of 61 basis points from a year ago.

This reflects continued investment in the strategic growth plan, and the increasing proportion of sales accounted for by fuel.

For the year, FIFO gross profit margin declined 33 basis points.

The FIFO gross profit margin excludes one-time items and the adoption of issue 02-16.

Operating general administrative costs before one-time items increased five basis points to 18.1%.

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

OG&A for the full year excluding one-time items decreased seven basis points, reflecting the increasing proportion of sales accounted for by fuel.

The OG&A decrease for the year was in line with the guidance provided during the third quarter conference call.

As in the past, Kroger's OG&A calculations exclude depreciation and rent.

Net operating -- working capital totaled $337 million.

This is a reduction of $193 million from a year ago, and an improvement of $367 million as compared to the fourth quarter of 1999.

These improvements exclude the inventory reductions resulting from our conversion to the item-cost method of accounting and the adoption of issue 02-16.

The company continues to make progress towards its goal of reducing net operating working capital by $500 million from the benchmark set in the third quarter of 1999.

Kroger repurchased 7.4 million shares of common stock, at an average price of $15.43 for a total investment of $113.4 million.

Since January of 2000, Kroger has invested $2.1 billion to repurchase 101.7 million shares.

At year-end, Kroger had $446 million remaining under the $500 million repurchase program authorized in the fourth quarter.

At current prices, Kroger continues to repurchase shares.

We are very pleased with the progress that the company has made on deleveraging.

Net total debt was $8.1 billion, a decrease of $414 million as compared to the fourth quarter of 2001.

Net total debt improved to 2.16 times adjusted EBITDA, as compared to 2.27 times in the fourth quarter of 2001.

This represents the best fourth quarter coverage since Kroger's financial restructuring in 1988.

The company continues to make progress towards the goal of reducing debt to two times adjusted EBITDA.

Kroger's investment grade rating is very important to us.

We will continue to execute a financial strategy designed to achieve a mid BBB rating.

Net interest expense totaled $139.6 million for the fourth quarter.

A decrease of $1.8 million from a year ago period.

Net interest expense for the year was $599.8 million, a decline of $48.2 million or 7.4% from 2001.

Capital expenditures for the quarter including acquisitions totaled $458 million.

Capital investment for the year was $2 billion, including a synthetic lease buyout of $192 million, and acquisitions of $119 million.

The net capital investment of $1.7 billion is a reduction of $400 million versus our original 2002 guidance.

We continue to ration our capital in a disciplined fashion.

During the fourth quarter, Kroger opened, expanded, relocated, or acquired 49 food stores, and 151 for the full year.

Overall, food store square footage increased 4.3% over the prior year.

The company also completed 138 remodels during the year.

In fiscal 2002, Kroger generated record free cash flow of $1.3 billion, well above our third quarter guidance of $900 million.

This was a result of the reduction in net operating working capital and lower capital expenditures.

This performance enabled the company to repurchase stocks, reduce debt, and execute a strong investment program.

Let me briefly discuss our item cost accounting.

In the second quarter of 1998, before the Fred Meyer merger, Kroger changed its method of accounting for certain store inventory from the retail method to the item cost method.

The change improved the accuracy of product cost calculations.

During the fourth quarter of fiscal 2002, Kroger adopted the item cost method for the former Fred Meyer division.

The possibility of converting to the item cost method was previously mentioned in the inventory footnote of Kroger's 2001 annual report.

As a result of the conversion, Kroger incurred a noncash charge of $90.7 million pretax.

Generally Accepted Accounting Principles require that this change be reflected in the first quarter of the fiscal year in which the change was adopted.

Consistent with our treatment in 1998.

This change will be reflected in the quarterly information that will be provided in Kroger's 10-K for fiscal 2002.

Let me briefly explain the main differences between the two methods.

First, the item cost method.

Kroger's information systems permit us to track the cost of each SKU in the grocery and drug GM departments.

As a result, we can value inventory in the cost of goods sold on an individual SKU basis, rather than a broad pool of items.

As each SK is sold, we know its cost.

In other words, cost of goods, and the retail markup are based on actual items sold.

Under the retail method, inventory values and retail markup were calculated on a pooled basis as goods were received into the store.

When products are sold, they're costs were calculated to the average value of products ever received in that store.

The primary benefit for the item cost method include, first, a more accurate calculation of the cost of products that are actually sold.

Second, a more accurate calculation of inventory.

And third, a more accurate calculation of shrink.

The item cost method will enable us to make better operating decisions.

One other note for 2002, in the fourth quarter, Kroger completed its annual review under FAS 142.

And just to remind you, this is where you actually calculate the goodwill on all acquisitions.

This review showed that an impairment charge was not required.

Now, I'd like to turn to some additional guidance for 2003.

Joe already provided guidance for our earnings per share in 2003.

Kroger will file an 8-K today with additional details for our guidance, but I wanted to highlight some of the items with you here.

We are estimating square footage growth of two and a half to 3% before acquisitions and operational closings.

Capital expenditures should be $2 billion, excluding acquisitions and the balances of synthetic lease buyout.

As you know, our capital is allocated on a rolling three-year basis.

Our original capital investment budget for 2003 was $2.3 billion.

We now expect 2003 capital investment to be $2 billion.

When combined with the 2002, this represents a reduction of $700 million over the past two years.

Kroger regularly reviews our capital investment program to evaluate the performance of past projects, and to ensure future projects will meet or exceed our hurdle rate.

Our disciplined approach to capital investment enables us to allocate our investment dollars in an efficient manner.

Kroger's storing program for 2003 calls for 100 to 110 new, relocated or expanded stores, excluding acquisitions.

We are also planning to complete 160 to 200 within-the-wall remodels, and 100 to 110 new supermarket fuel centers.

With regard to our pension plan, we have lowered the assumed rate of return to eight and a half % from nine and a half %, and reduced our discount rate to six and three-quarters from seven and one quarter.

The effect of these changes is factored into the earnings guidance that Joe provided earlier.

Now, I'd like to turn it back to Joe.

Thanks, Rodney.

I believe that Kroger's strategic growth plan is the appropriate response to the economic and competitive conditions in the food retail industry.

Through the end of fiscal 2002, Kroger had achieved cost savings of $306 million.

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

Kroger is narrowing the price gap with discount operators, and extending our price advantage over traditional competitors in most markets.

We built a strong foundation in 2002 with cost reductions and centralized procurement and we are positioned for an even stronger 2003.

The company will continue to implement the plan by improving our competitive price position in selected categories and markets, offering better value for our customers.

Kroger's financial strength is a competitive advantage.

We have the financial resources to continue making the price investments necessary 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 and build shareholder value.

We will now be happy to answer your questions.

Lynn, we're now ready for the Q and A.

At this time, I'd like to remind everyone, to ask a question, press star and then the Number 1 on your keypad.

We'll pause for just a moment.

Your first question comes from John Hindbuckle with Goldman Sachs.

Can you provide some color on the comment of cutting the price gap with discounters, widening it versus conventionals?

I know it varies market to market, but any color on that?

You know, the rate of progress in both of those areas, what type of competitive response you're seeing, you know, how much further do you think you need to go?

Well, to review, we launched the strategic growth plan in February of 2002, and of course, the plan was phased in.

We didn't do it all at once.

We phased it in as cost savings came out.

You'll recall, John, we got a little bit exuberant in the second quarter of 2002 and backed off a bit, regrouped while maintaining the core of the plan, but modulated it so that we could better balance our earnings and our cash flow and our sales.

By the end of the year, we'd had a lot of experience with the plan.

We were very fortunate in staffing our positions for centralized procurement.

We were able to bring in seasoned, qualified buyers and merchandisers, as well as some new blood into the organization.

And by the end of the year, we knew where we were and we have now sharpened the plan by targeting some additional areas in the -- in categories, but also turning up the heat a bit in certain markets.

Where we believe that we have strong competitive advantage.

As you will recall when we began the plan, our judgment is -- our estimate is that if you take our major markets and you extract the market shares held by companies with strong economies of scale, that would be most supercenter operators, most of the national center market operators and strong regionals, if you take all that market share out, there's still 50% of the market available -- market share available to be had by those of us who have strong economies of scale.

And that's where we're headed with the strategic growth plan.

That has been unwavering since the beginning of the plan.

So as I look forward to it, to 2003, my own judgment is competitive reaction has not been much different from expected.

It varies, as you point out, by area.

But we've made substantial progress and I'm particularly heartened by our performance in areas against supercenters with the market share numbers that I indicated earlier.

So, with a year's experience, with folks having been on board now a full year, with the relationships, the new relationships between our divisions, and our general office merchandising now much more understood, and with a lot of experience in it, I'm very bullish about the year.

As a follow-up to that, a number of the studies we've done, have you -- probably high single digit, maybe very low double GAAP versus Wal-Mart, but making progress almost every quarter.

Is there more room to go there?

What level do you think we get to where they respond to that and take, you know, reestablish a gap, are we getting close, pretty far away?

Have you seen that in certain markets?

John, we lost you.

Did you get the question or no?

No, we lost you right in the middle.

You said we see in certain markets and then we just --

In the price studies we've done, we see a gap between you and Wal-Mart of, you know, high single digit, this includes sale items, high single digit, maybe very low double, but with progress almost every quarter being made.

When you look at that, I don't know if you agree with that, if you look at that number, how much further progress is there to be made there and what -- do you have a sense for what point at which we get to, by experience, where they might respond and try to reestablish some type of gap?

I'm sure they're not going to let you get too close.

How much more work is there to be done on that one issue?

Well, I think there are a number of keys to responding to the question.

First of all, as I indicated, we'll sharpen the plan with additional categories and targeting certain market areas where we think we have particular opportunities, not all of those are necessarily supercenter markets, I might note.

Secondly, there is a gap and, you know, we have a pretty fair idea of what is -- at what point, let me put it this way, customers will increasingly find the value that we offer to be attractive.

We're certainly not going to be the lowest-priced operator in the market.

But we go to market in a different way from the discount operators with greater service, stronger private label, expanded perishables, strong natural food, et cetera.

So our offering is different.

And people look at the whole basket.

They look at the loyalty offerings, the doubled coupons.

And when you factor all of that in, we have a pretty good idea what the gap is at which we will maintain our enhanced share against discount operators generally, and also where the full force of our merchandising and price program will attract competitions from that 50% that don't have our economies of scale.

And that's where we're going.

Now, do we talk about what the gap is?

No.

We don't.

But believe me, we have a pretty good idea where it is.

One final thing: you're doing a pretty good job, the industry is doing a better job responding to Wal-Mart on price and supercenters on price.

How good a job do you think you're doing on the other flank, being fresh food and perishables?

Because obviously, you know, Whole Foods is expanding and gaining share, some of the private guys are doing a good job, Costco had this fresh concept that's been tabled but may still get revitalized.

How well positioned do you think you guys are?

What do you need to do differently to take care of that competitor on a whole other flank?

Well, we spent a lot of time on the merchandising of perishable side of the business, and the perishable side also includes meals ready to eat.

A couple points I would make, you know, we recently appointed Mornette Perry [ph] here as Group Vice President of Perishables.

Mornette [ph] has long experience in that area.

She was here when I arrived at general office 17 years ago, and we've worked together these years.

She brings as fresh approach and lots of energy to this area and a great deal of experience.

Secondly, it's interesting what's happening in the market on customer selection and opportunities for time-pressed customers to have a really good meal.

And in the product categories I'm thinking about here, are the preprepared foods which we have in large sections, some of our divisions, at which you can walk up to 24 feet of product.

I was in one of our divisions a couple weeks ago, saw the display and the range of opportunities for a meal that's not only microwavable, but very delicious because I've tried them, is phenomenal and is a growing part of our business in addition to what we serve in our delis, in our bakeries and so forth.

There's a great deal happening here, John, in the area of solid meals, delicious meals, ready-prepared, and I think when you combine our expanded perishables with the growing share and availability and identity of meals ready to eat, plus the most rapidly growing part of our business, which is our natural food departments, you get a very solid set of assets to compete against any format, including the fresh formats.

Okay.

Thanks.

Thanks, John.

Your next question comes from Jack Murphy with CSFB.

Hi, Jack.

Good morning.

I may have missed it, but could you give us a sense of what you're looking for in the first quarter, both earnings and from a sales perspective.

And have the identical store sales improved the first five or six weeks, is that an improvement including or excluding fuel or both?

It's both.

Both, yes.

To answer those -- the second question.

On the first, we're not providing quarterly guidance.

We're providing guidance for the year on both sales and earnings.

Without being overly specific about it, and giving, you know, a point number, could we expect the year to be a bit more back-end loaded or is it pretty flat throughout the year?

We're just not giving quarterly guidance.

Fair enough.

On the information you talked about on the market shares, you mentioned sort of the sales gains that you had there.

Both the supercenter markets and the nonsupercenter markets.

Could you talk about where you have gained market share, whether you were adding new stores or whether that was, you know, on a same-store basis?

And I guess the kind of leading to the question: Do you see improvement in return on invested capital in those markets where you've gained share?

Well, we -- you know, a one-year calculation, you're talking about invested capital, doesn't really tell you a whole lot.

We talked about the EBITDA effect in those markets, I would probably let it go at that.

This is total market share which would include our expanded and replacement and net new stores which -- and we gave you those numbers.

When you're talking about 48 major markets, we give you the share numbers and you take a look at the number of net new stores, clearly it's coming from places in addition to the effect of new and replacement stores.

This industry is consolidating at a blinding speed.

And we see that as an advantage.

We can point to markets in the past year such as Dallas, such as Las Vegas, where we are able to purchase strong assets at very attractive prices and enhance our market share by consolidating.

In other cases, we've enhanced our market share as regional, local competitors have closed, or closed some stores.

In some cases, we're just taking the business from folks to the strategic growth plan.

Short answer, it's all of the above.

Okay.

Thanks.

Your next question comes from Meredith Adler with Lehman Brothers.

Hi, Meredith.

Hi, folks, how are you?

Fine, thanks.

Couple of questions for you: I was wondering if you could talk a little bit about the consolidation divisions that you did.

I mean, I think Columbus is a division that you've done very well in, Michigan has been very competitive.

Is it that kind of thinking that makes you want to look at consolidations, you know, trying to take costs out of a difficult market?

And are you looking to do more consolidations?

Is that a potential?

I'll ask Dave Dillon to respond to that.

Meredith, we look at a number of factors.

In this particular case, you're right, Columbus has done very well and so has Michigan.

We look at the geography, we look at the comparability, who the competitors are, we look at our particular market positions.

We look at the compatibility of the way the divisions work together already.

These particular divisions already add a number of areas of overlap.

For instance, the folks in Columbus, until we consolidated it, had been doing all of the buying for the folks in Michigan.

So those teams had actually worked quite a little bit together prior.

Some of the individual executives in the divisions have worked in both divisions.

So there was pretty high knowledge there.

So, it was a natural fit for us, one that we actually had been considering for a long period of time.

As far as other future consolidations, we don't have anything currently in the works and nothing that we've announced.

We always consider a number of possibilities for the company going forward and so I wouldn't rule them out, but I also wouldn't put them up on the front platter saying this is going to be announced any time soon.

Okay.

I was wondering if you could also talk a little bit about, I mean, clearly your [inaudible] are benefiting from selling gasoline.

Can you talk at all about what impact fuel price increases are having on the expense structure of the company?

Yeah, clearly, as we indicated, it's affecting our OG&A, because of the fuel increases.

You can see the impact of fuel, if you take a look at our [INAUDIBLE] with and without.

It's a pretty substantial effect.

There are puts and takes, Meredith, as gasoline prices increase.

Looking at the market information, as I do on a regular basis, it's pretty clear that as the price gets up there, customers do respond and either drive less or walk more or both, because you can see the effects on gallonage.

People do respond to economic incentives.

It's also not a one-to-one correspondence between the price, retail price of gas and margins.

Those move around in very different numbers.

But there's no question that the impact is there and you can, you know, without getting too detailed, you can about figure it out by looking at the impact on IDENTs [ph] and the comment that we made on gross profit.

Rodney, would you add anything to that?

The only other thing, in terms of -- if you look at the absolute OG&A rate in the quarter, fuel helped that rate by 13 basis points and that is a number that we've started disclosing each quarter.

Just a couple of other notes while we're talking about OG&A, our increase in LH&A expense increased the rate by 19 basis point, the pension increase cost increased it by 14 basis points and credit card fees were five basis points, just so that when you're -- you can't just look at one piece of that, you've got to look at all of them together.

Actually, I wasn't talking about how it helped you, I was actually thinking that your own fuel costs for your business must have also gone up.

For transportation?

Yes.

Oh, yeah, I can't tell you what the impact -- our DCs had a good quarter, I know that, as far as the overall expense on warehousing and transportation, and I just don't know the answer to that question.

It's not huge.

I mean, it's not big enough that it's causing us to focus more on that than the other.

Obviously is a negative, but not a huge amount.

Okay.

And I'd just like to end by asking you a little bit more about vendor allowances.

I don't know if you can explain to us what 02-16 within the EITF [ph] is, and whether there is -- if you are taking any harder look at the way you're accounting for vendor allowances, or whether you think there's going to be more scrutiny.

Clearly there has been a lot of stuff in the press about vendor allowances and how it gets accounted for.

I'm just wondering if you could clarify a little bit what you guys are doing?

Well, I'll make a couple of comments and then ask Mike Schlotman to talk about EITF 02-16.

The first comment I would make is we initiated implemented financial cost building in 1998 in the Kroger side of the business, and then since then, have taken it through the Dillon divisions and now in this quarter, on into the Fred Meyer.

One of the advantages of that is that we got very good information on product costing and it triggered the inclusion in product costs of allowances which perhaps others might take the income a little differently.

So that we got closer to a dead net cost on product.

That gave us a real advantage.

We think it's -- first of all, it was good economics.

We thought it was the right thing to do, that you earn the money, you sell the product.

Nowadays you buy it.

We reached that conclusion 1996, '97 implemented in '98, because it -- the item cost method matches the economics of the business to a much closer extent than the retail system that we'd used before.

So that gave us a leg up, Meredith, and with that, I'll ask Mike to talk about the 02-16 further effect.

I'll try to be brief.

Basically, what 02-16 deals with is any allowances that a retailer receives from a vendor.

Our review of 02-16 which originally had a consensus reached in November and then was modified on January 27, retroactive to January 1, which is kind of an unusual way for them to do it, but nonetheless they did, in a nutshell, directs you to put all vendor allowances into your carrying cost of inventory.

As Rodney said in his comments, most of what our adjustment was for was for sliding allowances and vendor co-op advertising allowances.

EITF O2-16 is specific on advertising allowances that says unless you actually provide proof of performance on each and every ad that you're supposed to do, you should carry it as a component of inventory, rather than taking into income to offset an ad.

While we have proof of performance on all of our advertising that we're required to do, we don't actually supply that to all of our vendors or each and every ad.

So we made a decision to put all of those kinds of dollars into the cost of product as far as adopting 02-16.

For sliding allowances, our internal approach was, when an item was actually received into the warehouse, or at the store, we would take into income the sliding allowance that the vendors gave us to offset our cost of establishing that new item in our system. 02-16 did not specifically address sliding allowances.

In fact, they said there will be more on that in the future.

But we took perhaps a conservative approach, and followed the same accounting treatment for sliding allowances that I just described for vendor advertising allowances, and that is to put anything we get from the vendor to the best of our ability, into the carrying cost of our inventory.

That makes up the bulk of our adjustment and, you know, you -- just to reiterate, what we were doing in the past certainly complied with GAAP because we completed the revenue cycle to get the money, we'd either done the ad or slotted the product.

This is just an approach where, going forward, I believe it makes us more of a selling organization because we'll actually record the revenue when we sell whatever product we're advertising or putting into the warehouse.

So were incentivised to seel products, not buy products.

And that's a great place to end, because that's also where we began, that was exactly the point of financial cost billing which swept up a lot of this years ago and put it where it ought to be.

As Mike said, what we were doing was consistent with GAAP and the adjustment for us was quite modest representing less than 1% of our annual vendor allowances, as we indicated in our materials.

And if I could just, I mean maybe this goes beyond what you can talk about, but everybody talks about somebody like Wal-Mart being everyday low cost, forget about how they are on the everyday low pricing.

But it sounds like you are in pretty much the same place; that you're putting all of the vendor allowances into the costs of the product and then you can choose to promote it how you think is appropriate?

Is that the right way to think about it?

There's a variety of ways to capture your vendor allowances into cost, and to try to go on to them here would probably take longer than anybody wants to hang on to the phone.

But we do endeavor to marry up the reflection of promotional allowances from vendors to the selling of the product.

Does that mean each and every product comes in with every allowance reducing the cost into the system?

Not necessarily.

What it does mean is that the allowances associated with those products go into our income when we sell the product, not when we buy the product.

We probably ought to go ahead and move on.

That's the key, one of the things to point out, we're a promotional merchant, not an everyday low price merchant.

So the bottom line is we take it into income with we sell it, that's what we try to establish in '98 and I give great credit to our financial and accounting folks and our operators for making that work to a large extent.

There is some adjustments as a result of 02-16 which were modest for us and as Mike indicated, if anything, we probably are on the conservative side on slotting allowances.

But we are promotional.

It's not like we have an everyday low cost going in, an everyday low price going out, you get promotions at different times.

Big buy, big sell, for example.

But those promotional allowances are earned as the product is sold, not necessarily to the constant day-to-day, because that's not the nature of a promotional merchant but what is constant is we take them in income as the product is sold.

That's great.

Mike, I wouldn't be bored if you spent 15 or 20 minutes going through it.

I'll invite you to come out for a corn beef sandwich and we'll do it.

Okay.

We'll do it.

She bought me one once.

Your next question comes from Lisa Cartwright with Salomon Smith Barney

Hi, good morning.

Not to belabor the point too much, but with the item versus retail, I think you mentioned earlier that your IT systems now permit you to track the item cost for these items.

Was part of the choice or the decision to go to item cost based on the improvements in your IT systems and are you -- is one method based on using scanned data at -- POS data, and the other method is based on back-door scanning?

No, no, it has to do with the costing.

The costing of the product.

The difference as Rodney explained, first of all, it's starting point.

You're right, as a result, we are able to do this as a result of the information systems that our MIS group has put in -- that we can match the allowance dollars to the SKU.

In the past, what was done is you couldn't identify the items, so you had the items placed in pools in the store, and the allowances went in.

And as you sold items from the pool, you took the allowance money.

Or you took the cost of goods sold based upon the gross profit of the pool.

Now, in any one pool, you can have enormous differences in gross profit.

But that was the best we could do, and the whole industry could do, is to consider these items as a pool.

So you have a pool of, you know, part of general merchandise, a pool of certain grocery categories, and so forth.

So --

Now what we can do is we can -- what we did was refine that.

So instead of talking about the pool, we talk about the item and so all those variances within pools get resolved item-by-item and we're able to take it to former Fred Meyer divisions this quarter because of the implementation of our MIS systems, which Mike Heschel and the team have done on the western side of the company.

So we now have the systems and the experience to take it to the West.

So it is based on information technology and also based on an analysis that goes back to '96 '96-'97, where we said, what are the real economics of this industry?

And the economics you begin with, you make money when you sell product, not when you buy it.

So the goal was to get the allowances and get the costs right including all allowances, and make the money as you sell product.

Rodney, would you add anything to that?

The only additional point, the point you made, Lisa, that's the back-end that Joe described, as we recognize the sale and recognize the income with each SKU, that is based of the POS data.

So now do you know --

You bet.

Do you now know your sales on a realtime basis in any store and how close are you to sharing that information with vendors now that you're centralizing procurement?

I guess my question is: Are you closer to implementing sort of a retail link-type system that Wal-Mart has and does with its vendors?

How close are you to doing something like that?

Dave, how would you answer that?

First of all on our sales, of course we know in many of our stores where we are at any particular moment in time, I regularly review yesterday's sales today, but I don't see much value in me knowing how our sales were between 8:00 this morning and 9:00 this morning.

So we've not actually spent the money to try to draw that together in one place.

We have, however, done a lot of work both with our data warehouse and other data in our systems to draw together information that is useful for us going forward.

A portion of that project is gathering data that will be useful and is currently useful for our vendors going forward.

And we have a few vendors that we've tested this process with, and plan to have further sharing of data that's useful for them and useful for us.

That data-sharing really has a lot to do with smoothing out the channels of distribution, reducing the costs, reducing the number of interfaces, projecting sales more effectively, that sort of thing.

And so I think we're very far down the path in that regard and would believe, among our supermarket competitors at least, that we're very far forward in that initiative.

Thanks.

And just one quick follow-up question for you, Joe.

In terms of your outlook for ID sales, you mentioned that you expect to end the year positive.

And you said that that includes fuel and also excludes fuel.

I think.

Includes fuel.

So that -- are you also saying excluding fuel?

No, we're not saying excluding fuel, for this year going forward, we're saying including fuel.

Okay.

Just to extrapolate on that, are you basing that on just where you are in terms of current trends?

I know you mentioned that you're not looking for any improvement in the macro environment.

Are you assuming a certain amount of response from competitors in that outlook?

Yeah, we always do.

It's part of the building block, Lisa, as we build our business plan.

And we go market-by-market through it.

And the business plans sum up to the corporate plan.

While we're not completed with the business plan, you know, the judgment that we've reached is that given the strategic growth plan, given the competitive stores we know are coming elsewhere, et cetera, that our plan is, you know, nets out to a positive identical store total for 2003.

Now, that's based on the assumption that the economy stays where it is, that consumer confidence stays about where it is, and so forth.

If things improve on those regards, things should improve for us as well.

Isn't it a little bit difficult to --

Zero inflation, as we indicated this past quarter was negative .5 as it was in the third quarter.

Isn't it difficult to include fuel, not knowing what's going to happen with that over the next year?

I mean, would it be better to exclude fuel?

We've got it both ways, but we're giving you the guidance with.

Okay.

Let me put it that way.

All right, thanks, Joe.

Your next question comes from Mark Husson with Merrill Lynch.

Hi, Mark.

Good morning, this is Monica Hargold for Mark Husson.

Hi.

Hi.

First of all, has your reduction in working capital hurt your sales at all?

No, we don't believe that it has.

Okay.

And what are the --

We believe there's more working capital we can take out without hurting sales.

Do you have any target in terms of working capital or debt reduction for '03 and also free cash flow generation?

In terms of working capital reductions for '03, the objective is a further reduction of $100 million on net operating working capital.

On-free cash flow at this point, we're not giving the specific number because we actually -- our interpretation of regulation G, we're not sure that we can, but in the 8--K filing today, there will be enough detail that I think you can develop your own assumption with that.

Okay.

And then how much could you afford to pay for an acquisition and still maintain an investment grade rating?

And if the right acquisition came along, would you be prepared to sacrifice the investment grade rating?

The answer to the second question is no.

In terms of how much debt can we take on and maintain an investment grade rating with an acquisition, obviously, with the rating agencies, that would depend on what specific acquisition it was, what kind of conditions, what's the price being paid, and the resulting coverages.

So it's really hard to answer that without knowing a specific one.

And the quality of that.

As you've heard us talk about in the past, and when we look at buying something in a new market, we're -- we don't -- we're not fixer uppers, we like to buy assets that have very high sales volume, great stores, store size and condition and all of those things.

You shouldn't expect us to go into a new market with that that need to be turned around.

And the final question is.

What was the hit from pension and healthcare for the full-year '02 and what's built into expectations for '03?

In terms of for the full year, I did not calculate that.

We calculated just for the quarter.

Okay.

And in terms of next year, we're not breaking out the specific pieces, just by itself.

You will see in the 8-K -- I'm just trying to find my -- the 8-K that will be filed today, we do expect overall an increase in OG&A of 40 to 50 basis points, and obviously healthcare and pension are major contributors to that.

Okay.

Great.

Thank you.

You're welcome.

Our next question comes from Chuck Serenkowski [ph] with McDonald Investments.

In looking at the switch to the item cost method, I guess this is a Rodney and Mike Schlotman question, is there a tax benefit to that?

Chuck, yes, and the tax deduction will flow in over five years and we will get a deduction for that $90 million, so it will be $30 some million of cash flow.

Over five years?

Yes.

In taking a look at what's happening in the marketplace right now, there seems to be a lot of increase in the number of closings, many by your competitors.

And what do you think that's attributable to?

Do you think you're getting more market share in such markets versus your overall operating area? and then can you talk about what you're seeing and what I would consider a discretionary category like floral, using that as sort of a barometer ,and finally would you consider Dominic's a fixer upper?

Well, to answer in reverse order, we don't ever comment on any potential or any question about acquisitions at all.

Second to the last question, you know, floral is weak.

And it's weak nationwide and it's weak for Kroger and to some extent, my own belief is when floral picks up, we'll know that spring is about to come in terms of the economy.

We're doing some things incidentally, to address floral given the economic conditions that we've had for the last two and a half years.

Consolidation, we've talked about this for two years, about the industry consolidating, and the speed.

I can remember a year ago Rodney had calculated and we talked about this, Rodney had calculated, there had been something like 1200 supermarkets or pharmacies sold or closed within the preceding two years.

That was a year ago.

We haven't recalculated that number today.

My hunch is it's at least that high, if not higher.

And we have benefited from this in certain markets.

I alluded earlier to Las Vegas and to Dallas.

Where we have picked up stores and share as others exit the market.

My own judgment is there's a lot more coming.

And the strategic growth plan, you know, that we announced December of 2001, you know, I give great credit to my colleagues, they took a look at what was happening nine or eight months before that and went to work on it, and I think it's exactly the right response that will enable -- positions Kroger to benefit from the consolidating environment that we have.

We're also blessed to have a very strong financial base that enables us to continue the investment in gross profit while we continue the investment in assets at a more modest level than in the past.

We think that's prudent at this time.

But at the same time, knocking down debt.

So we have the triple play again this quarter, buy in stock, pay down debt and have a strong capital program.

And you know, the financial strength of the company is very significant for us during this time of economic recession and time of consolidation because it gives us the stamina and the staying power to stay on this strategic growth plan, and it utilizes the full range of our resources.

So my judgment, Chuck, there's a lot more coming.

On the point of acquisitions, as we have said before, our goal is not to grow, our goal is to grow profitably.

And we submit any capital -- potential capital investment and acquisition, whether it's one store or 50 stores, to the same economic financial discipline that we do on every investment that's over a million bucks.

It's vetted by our finance group, it's reviewed by our senior officer group, and it's got to meet the hurdle rate, risk adjustment or we just aren't interested.

Last question, Joe, can you comment on how returns are tracking in the pharmacy part of your business?

Pharmacy business is good.

I can tell you that, I don't want to say too much here.

Let me say I'm very pleased with the contribution performance of pharmacy as well as the sales.

Thank you.

We have time for one more question, unfortunately, so we'll take one more caller, please.

Your next question comes from Philipe Gusens [ph] with GCSSE [ph].

Good morning, Fixed Income Research here.

Pleased to hear that more and more of my equity peers are starting to ask fixed income related questions, it seems like we are finally getting some validation for the fixed income profession her.

But two questions this morning: When I look at the balance sheet, there's about $130 million swing in the mark-to-market value of the interest rate in place right now.

Can you just kind of share perhaps with us a little bit more, what strategies you have in place right now with regard to hedging interest rate risks and what your mixes of floating versus fixed rate?

That and I have one follow-up question.

Our strategy has all been to have floating rate exposure at approximately $2 billion or less on any point in time.

A couple of years ago, Mike and our finance team decided to be closer to that upper limit of that on floating rate exposure, so we took quite a few long-term debt instruments and swapped that back into floating rate.

That number on our balance sheet is the value of those swaps when you look at it on a present value basis because the interest rate declined since we entered into those.

And the swing on year to year is just where interest rates have declined so much this year versus a year ago.

Okay.

And then as we are already a couple of months into '03, any update in terms of which major labor contracts are coming due and whether you have already renegotiated any of those contracts?

Thank you.

Yeah, Dave or Rodney, have you got those?

The collective agreements, and this is in our 8-K, would be Toledo, Ohio;

Peoria;

Portland, Oregon;

Memphis, Tennessee;

Southern California, Charleston, West Virginia;

Arizona; and Indianapolis.

And obviously we have a lot of other ones that are smaller that expire at various times during the year.

In terms of -- I don't believe any of these are complete at this point, but there's none of them expired yet either.

And do you plan to basically negotiate jointly with some of your peers in certain markets?

Yes, we have done that in the past, it's on a market-by-market and contract-by-contract basis, but we have done that, as you know, and most recently in Portland, in the Portland, north western area.

Actually in Eugene, Oregon.

The final part of that question.

You commented already on the topic in the previous call, I believe, Joe, but have you found the union base more receptive to your need to narrow the cost gap based on what the current market conditions are?

Well, it's clear the union has a full understanding of the effect of low-cost operators on our business and of the gap, I would give the union credit for communicating that to their own members.

What we've been able to do in a number of contracts is, you know, to jointly look for ways to take the cost out and to narrow the gap without overly penalizing long-term employees.

And I would say we've been successful in numerous instances in doing that.

You have to look at the structure of every contract and every opportunity to know what the alternatives are to achieve that.

But there's, I can assure you, open and full communication between ourselves and our unions, between ourselves and our associates, between the unions and their members, about the environment that they're in and the competitive relationship between what discount operators pay and what unionized companies pay.

Thank you very much.

Thank you very much, we appreciate all of you joining us this morning and we'll talk to you soon.

Bye.

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

You may now disconnect.