克羅格 (KR) 2003 Q2 法說會逐字稿

Good morning, my name is Anessa.

I will be your kov facilitator today.

At this time, I would like to welcome everyone to the second quarter earnings Kroger Second Quarter Earning 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, please press the pound key.

Thank you.

Ms. Kelly, you may begin your conference.

Thank you.

Good morning, everybody.

As most of you know, Dave Dillon was elected Chief Executive Officer by the board of directors on June 26th.

Joe Pichler remains Chairman of the board.

Rodney McMullen was elected Vice Chairman and Don McGeorge was elected President and Chief Operating Officer.

Dave will be hosting the second quarter earnings call.

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

We want to caution you these statements are predictions, and actual results can differ materially.

A detailed discussion of the many factors we believe may have a material effect on our business on an ongoing basis is contained in our S.E.C. filing.

We will be presenting certain non-GAAP financial measures because we believe they're helpful is understanding Kroger's financial condition.

A reconciliation to the most directly comparable GAAP measure is contained in the tables attached to our earnings release which is posted on our website at Kroger.com.

One other note before we get started.

When Dave and Rodney have finished their remarks and we open it for questions, we ask you limit your questions to one per person so we can accommodate as many as possible in the allotted time.

Thank you.

Thanks, Kathy and good morning, everyone.

We appreciate your joining us today to review Kroger second quarter earnings.

With me today are Rodney McMullen, Don McGeorge and Michael Schlotman, who is Senior Vice President and Chief Financial Officer.

I'll begin with a brief review of Kroger's financial results and a few highlights from the quarter.

Rodney will provide additional detail about the quarter and some other areas of our business and then we'll be happy to answer your questions.

For the second quarter ended August 16th, Kroger reported net earnings of $190.4 million or 25 cents per diluted share.

Earnings in the year ago period were $264 million, or 33 cents per diluted share.

Our results for both years included several items that Rodney will discuss.

Total sales for the second quarter of fiscal 2003 increased 3.6% to $12.4 billion.

Total food store sales rose 3.3%.

Identical food store sales, including fuel declined .1%.

Identical food store sales excluding fuel, decreased .9%.

Comparable food store sales, which includes relocations and expansions increased .5% for the quarter.

Comparable food store sales excluding fuel, declined .4%.

We estimate that our product cost inflations including fuel was .5% and product cost inflation excluding fuel was estimated to be .2%.

Meat, produce and deli experienced the most significant increases in inflation during the quarter.

We were encouraged by our sales performance in the second quarter, especially in light of increasingly intense competition.

Continued economic uncertainty and the strength of our identical food store sales in the year ago period.

Our second quarter sales trend improved 20 basis points over the first quarter without fuel.

In addition, our associates did a great job of managing in the second quarter in the face of higher health care, pension and energy costs.

Our corporate brands which continues to be a competitive strength turned in another solid performance in the second quarter.

The market share of Kroger private label grocery items in terms of units increased to approximately 31.8% Private label grocery share, in terms of dollars, grew to 23.8%.

Another competitive strength for Kroger is our diversity of formats which allows us to meet the needs of virtually any customer.

One of the most exciting opportunities is our Fry's Marketplace store format in Metro, Phoenix.

Ranging in size of 100,000 to 120,000 square feet, these stores offer expanded general merchandise that includes outdoor living products, home goods and toys as well as full-service grocery and pharmacy departments.

We recently opened the first new Marketplace store, built from the ground up in Phoenix, giving us a total of 17 Marketplace stores.

Marketplace format is well received by customers.

Kroger continues to grow through acquisitions.

Last week, we announced the purchase of six Eagle food center stores in Illinois.

During the second quarter, we acquired 13 food town stores in northwest Ohio and southern Michigan.

Since completing the merger with Fred Meyer in 1999, Kroger has acquired more than 230 stores mostly in existing markets.

These in-market acquisitions have lower risks and generally produce a high incremental return because we can leverage our investment in overhead, advertising or distribution.

Now, let's turn to our earnings guidance for this year.

Kroger's previous earnings per share guidance for fiscal 2003 was $1.55 to $1.63.

This estimate did not include the previously announced annual net expense of 4 cents per diluted share for the Dynegy settlement and expense of one cent per share from the blackout.

Including these two expenses, the earnings per share range is $1.50 to $1.58.

The company now believes that earnings per share for 2003 are more likely to be nearer the low end of the range and could be as much as five cents per share below the range.

This possibility arises from an increase in the company's expected LIFO charge of 2 cents per share and increasingly competitive environment that may require an additional investment of gross profit rate as compared to plan, and a tough economy.

This cautious outlook may prove to be too conservative because identical food store sales, including fuel, are positive for the third quarter to date in a trend that started late in the second quarter.

The company continues to expect identical food store sales, including fuel to be positive for the year.

Several categories, core categories are showing product cost inflation and some economic indicators are showing signs of a recovery.

We remain confident to achieving earnings per diluted share of $1.50 or better, but the current environment remains very challenging.

I'll now ask Rodney to provide additional perspective on Kroger second quarter financial results.

Good morning, everyone.

As Dave said, the earnings in the second quarter were $190.4 million or 25 cents per diluted share.

These results include the previously announced after tax expense of 5 cents per diluted share to resolve disputes related to the energy supply arrangement with Dynegy.

These results also includes expense of 1 cents per diluted share after tax from the power blackout in parts of Michigan and Ohio last month.

The blackout length, the largest in U.S. history and presented an enormous challenge for our associates in the Great Lakes division.

I want to take a moment to acknowledge their hard work and commitment to getting our stores opened as quickly as possible, so that we could serve our customers.

I also would like to thank our manufacturing division with which responded by sending several truckloads of drinking water to assist communities affected by the blackout and our stores.

Everybody did a great job and responded very quickly to get us back in business.

One more note on the quarter, our results also include a credit from the reversal of apportion of accrual for charitable contribution that acquired as part of the Fred Meyer merger.

All these items are shown in table 2 of our earnings release.

Earnings for the second quarter of 2002 for $264 million or 33 cents per diluted share.

These results include an after tax charge of $10.1 million or 1 cents per share from the items also shown on table 2 of the earnings release.

FIFO's profit margin was 26.39%, a decrease of 34 basis points from 26.73 end of 2002.

Excluding fuel at the company's convenience stores and supermarket in both years, the FIFO gross profit margin for 2003 decreased 6 basis points.

Operating general and administrative costs increased 77 basis points to 19.35%.

Adjusting for the OG&A items shown on table 2 for both years, the rate increased 23 basis point.

Excluding those items and fuel in both years, OG&A increased 46 basis points.

Higher health care, pension and energy costs accounted for 28 of this 46 basis point increase.

Net operating working capital totaled $137.4 million, which excludes invested cash.

This is an improvement of $36.2 million from a year ago.

The company continues to expect to reduce net operating working capital by $100 million this year.

Net total debt was $8 billion, a decrease of $208.3 million, as compared to the second quarter of 2002.

The company continues to make strong progress at de-leveraging its balance sheet.

In fact, Standard & Poor 500 recognized Kroger's improving financial stress by upgrading the long-term debt to BBB flat rating in July.

Our plan remains to use one-third of our cash flow to reduce debt and two thirds to repurchase stock, pay a dividend or a combination of both.

During the quarter, Kroger repurchased 6.5 million shares of common stock at average price of $16.65 per share for total investment of 108.4 million dollars.

Since January of 2000, Kroger has invested 2.3 billion dollars to purchase 117.8 million shares.

At the end of the second quarter we had $222 million remaining under the $500 million repurchase program authorized by our board in the fourth quarter of 2002.

At current prices, Kroger continues to repurchase shares.

We are very pleased with our strong cash flow.

Over the past four quarters, Kroger has repurchased $532 million in stock, reduced debt by $208.3 million, and invested $2 billion in capital project including a buyout of a synthetic lease.

We continue to achieve our triple play.

Based on current interest rates and expected return on our assets and company sponsored pension plan we estimate contributions to these plans over the next three years, starting in 2004, will have a net effect of reducing Kroger's cash flow by approximately $110 million annually.

During the second quarter of 2003, Kroger opened, expanded, relocated or acquired 36 food stores.

Total food store square footage increased 3.9% over the prior year, including acquisition.

Capital expenditures for the quarter totaled $449 million.

We continue to be more selective in approving capital project.

As a result, we expect capital investment for the full year to be $1.9 billion, excluding acquisitions and a buyout of synthetic lease.

This is a reduction of $100 million from our previous guidance.

While EBITDA is behind our expectations, cash taxes are significantly lower than our original expectations due to the current tax law.

This benefit will continue for the benefit of 2003 and 2004.

Under its current tax law, the bonus depreciation division of this law expired December of 2004.

So -- the benefit will reverse itself in 2005.

LIFO, we adjusted our full-year guidance as a result of product cost, inflations, some commodity.

We now expect a LIPO charge from 40 million for the year up from previous guidance of 15 to $20 million.

Primarily because of higher than anticipated inflation and dairy related products.

On the labor front we reached a new agreement with the USCW in Toledo earlier this year and negotiated a one year extension to the contract in Peoria in July.

A number of significant USCW contracts will be negotiated before the end of the year, including Portland, Oregon, Memphis, Tennessee, ravels of southern California, Charleston, West Virginia, Arizona and Indianapolis, Indiana.

As we said before, rising health care and pension costs will be important issues in all these negotiations.

We have been communicating these challenges to our employees and union members and leadership.

With that, I'd like to turn it back to Dave.

Thanks, Rodney.

It's now been nearly two years since Kroger announced the strategy growth plan.

Our goal is to reduce operating and administrative costs, find better ways to leverage our economic scale and do our best to drive core businesses and drive sales and improve market share.

The strategy plan is the best approach to grow our share by reducing the price gap with discount operators and widening the price benefit over traditional competitors and many marketers.

We have achieved $458 millions in cost savings through the end of the second quarter and we expect to exceed our original goal of $500 million savings by the end of 2003.

Kroger's financial strength is an important competitive advantage.

Over the past four quarters we have produced solid sales and earnings results in a challenging, economic and competitive environment while also reducing debt, repurchasing stock and maintaining a solid capital investment program.

We'll now be happy to take your questions.

We ask that you limit your questions to one per person so we can accommodate as many as possible in the allotted time.

Thank you.

At this time, I would like to remind everyone, in order to ask a question, please press star and the number 1 on your telephone keypad.

We'll pause for just a moment to compile the Q&A roster?

Your first question is Lisa Cartwright with Smith Barney.

Good morning, you mentioned the sales had improved in the first weeks of the next quarter can you say whether or not it's broad-based across geographies or whether or not more traffic in terms of what you're seeing in terms of volume?

yes, Lisa.

As we mentioned the first four quarters of this third quarter have been positive identical.

The first quarter weeks.

Sorry.

We have seen some inflation and been helped by fuel.

That shouldn't be any big surprise.

You've seen fuel prices around every market.

Perhaps what you wouldn't see is that we've had good results and improved results in grocery and deli are the two most improved departments over where we were running on the second quarter.

Based on where we've seen in these four weeks, we're pretty optimistic.

We think it's good sign.

Part of your question was what we've seen across geographies, I'd say this is fairly broad-based, we are seeing good sales results in many markets.

Thank you very much.

Your next question comes from Mia Kirchgaessner, from Sandford Bernstein.

Good morning.

Good morning.

When you talked about some of the new formats you're going into, how do you expect it to really impact sales.

You're piloting the dollar stores, you've rolled out some food for less stores, now, you're talking about the market places, which ones of these formats will help you most and how do you expect to roll them out across the country?

in each of these formats, let me talk really starting with Food 4 Less, because that's the one that we've actually taken to a whole new market when we went too Chicago.

You may recall, we had three open in Chicago now, another one scheduled to open later this year.

I think that's how we plan to roll that out, is roll out, in our minds, is to move to market that we think we can support, as we have in the Chicago market, where we think it will fit that particular format, as we think the Chicago market fits.

We also rolled the Food 4 Less format out into additional towns in California over the last couple of years and we've expanded it in Las Vegas.

The marketplace store is primarily a format in Arizona, although we've experimented with pieces of the format, smaller, much smaller pieces of the format in other places.

So what we're doing in Arizona is trying to see whether or not we can develop a concept that is worth exploring further in that market and perhaps in other markets.

I would think that that format makes good sense in Arizona, as an example as an extension of the current franchise, and that could give you some clues as to how we might further grow it in near term, but that's still a bit in its infancy stage.

The dollar stores, I would caution you to not necessarily refer to that as the new format, in fact, what it really is, is a use of some space in selected stores to see whether or not that group of products has a category, can get some attraction.

And it does not rise, on our radar screen, at least, to the level of being a new format.

Each of these will rise and fall on their own weight, on their own strength.

I suspect any format change and extension will be based as much on the individual characteristics that we experience in that format as anything else.

I should add one other thing.

I think more important to me than even the new format, and much more easily rolled out, are things that we learn in those formats.

Items or categories that show promise, that might be expanded into other stores or other markets.

It's far easier to do, and I think represents a real opportunity for us.

Rodney, do you want to add anything on the formats?

The only thing I would add to, when you look at the formats, obviously we're excited about the opportunity in terms of meaningfully impacting something that's more down the road, two or three, four years.

We really have to learn how to operate these formats and markets other than the traditional location and operate it profitably before you can start seeing a meaningful impact on the total numbers.

That's very true.

Thank you.

Thank you.

Your next question comes from John Heinbockel with Goldman Sachs.

Can you critique a little bit the progress you made and how happy you are with where food comps are with fuel.

There has been some progress but for most people in the industry, we're still in negative territory.

It looks like a very slow build here.

Can you critique where we are, progress we made, how happy and satisfied you are with where we are given the strategic plan.

David Dillion;

I guess, John, as I pointed out, we had a 20 basis improvement in the sales trend without fuel in the second quarter versus the first quarter of this year.

That's on top of the first quarter being 70 basis points better than the fourth quarter.

In addition, I'd add that the second quarter sales results, without fuel is the best in the last four quarters that we've experienced.

Some of it was helped by inflation, as we pointed out, meat and produce helped.

On a continuing basis, so did fuel and pharmacy.

But those have been inflationary before.

The only negative side here is that we're not as excited about our sales growth only because we're still in negative territory.

As you say, we want to be in positive ground.

That's our objective.

We believe that that's just around the corner.

Clearly, we're improving on our sales trend, and even though it may not be as high as we'd like it to be, we think it's good progress, very good progress.

And we expect it to be positive.

We expect the identicals to be positive for the year.

That comment is including fuel.

Really, the objective for us is to push ourselves to get into positive territory on these same-store sales in our growth.

The four that we've had in this quarter so far, we're optimistic as I mentioned.

We saw perk up in the sales of the latter part of the second quarter and that continued into the third.

That shouldn't be a big surprise.

I think most retailers have said essentially the same thing for August.

It's just that our four weeks goes into September.

We're quite pleased with that.

It's just not in positive territory yet for us without fuel, and I think we have to keep pushing until we get there.

Rodney, do you want to add any color to that?

Good.

John, thank you.

Do you think we can get there by the fourth quarter or I assume it will be the third?

Can we get there by the fourth?

Is it a slower build than that?

at this point, what we're seeing is that we do expect the year to be positive by then, including fuel by then.

Thank you.

Okay.

Your next question comes from Phillipe Gusen (ph) with CSFB.

Good morning.

Given that Moody boost your ratings on review for potential upgrade on the 3rd of September, I wonder if you communicated with them prior to that date results for the year might perhaps be a little bit below expectations, as kind of a fall on that, would you be willing to consider temporarily adjusting your allocations of free cash flow toward more debt reduction if that would help Moody's bring over, bring Moody's over to upgrade your ratings of BB just like what S&P has done in the prior month?

Thank you.

I'll have Michael Schlotman answer that.

We do have ongoing discussions with all the rating agencies.

I will not comment on everything that we discuss with them.

It's private.

It's sometimes treated as insiders and sometimes they aren't.

It's a -- it's partnership and they are different than the broader analyst community.

Relative to that we temporarily modify the allocation and use of our cash flow, right now, we're very happy with the progress we're making on de-leveraging the balance sheet.

Two or three agencies have us at the mid-BBB, mid-B level, which is where our target has been for a while.

The fact of the matter is right now, we have over 270 million dollars in cash invested on the balance sheet and less than $100 million cash due over the next year.

When you look at the ability to take that cash flow and pay down current debt we really don't have much debt due in the next year.

Additionally we have continued to have strong cash flow from this slightly lower CapEx.

And from the reduced cash taxes compared to our original projections.

We continue to seek opportunities to invest there at cash prudently, won't make big leaves of faith with those dollars or do improved things.

We feel very comfortable all three rating agencies, buy into our plan and feel good about our plan.

thank you.

Good luck with Moody's

Your next question comes from Meredith Adler with Lehman Brothers.

There have been questions about what's happening geographically in terms of sales.

You seem to comment fairly broad base.

I was wondering if you could comment on what's happening with the competitive environment?

Are you seeing some areas becoming noticeably less competitive?

And tied in is the fact, you seem to be unclear yourself about how things are going to play out.

I guess my question ties into are you seeing improvement anywhere in terms of the competitive environment?

Meredith, thank you.

We are seeing improvement competitively in selected markets.

I would characterize the competitive climate as really spotty.

We're seeing some improvement in it in some markets and we seeing a little bit of aggressive competitiveness in selected markets as well.

We see some new stores opening, of course, in some markets, which adds to the competitiveness.

We see some stronger pricing by a few competitors but that again is in selective markets.

The biggest difference in the competitive climate is really is, versus what we had planned, which was we would pass through a little more of the OG&A costs and expenses and health and welfare and energy, past those through in the form of gross profit.

We found we had not been able to do that as much as we expected.

On the other hand, what we've seen in the last quarter, in the second quarter, we saw some inflation in some of the perishable categories.

That does seem to be getting passed through reasonably well.

So, that does create, as you described, a little bit of uncertainty.

It's the sense of that uncertainty that I think makes us cautious.

We have seen good improvement in August and early September.

And in that environment, we hope that that continues.

But some of that we know is driven by one time events, like the tax rebate checks, as an example.

We don't want to take a short term blip and predict whether or not it will be able to sustain us or not.

We are focused, I should point out, we are really focused on sustainable long-term sales improvement.

And that's really the reason for our caution is we didn't want to have to modify our plan later in the year for short term earnings change in order to be able to accomplish that and give up on our objective of sustainable long-term sales improvement.

I think you can say I'm pretty optimistic because we have seen some improvements.

But it's uncertain enough that cautious us to add this caution.

Great.

Thank you very much.

Your next question comes from Jack Murphy with CSFB.

Good morning.

Thank you.

Just a follow up on that same question.

I wonder if you could just say what the environment would need to be in order to not have the five cents lower you referenced relative to guidance?

Is that in an improving economy in order to be at the low end of the original range?

Related to that, when you look at the relationship between gross margin investment at the current levels you have now and identical store sales, what level of long-term gross margin do you think makes sense in order to achieve sustainable positive ID sales?

Jack, both good questions.

On the environment that we need to have, I don't think we know fully the answer to that.

But if I just talk about the economy which is what you were focused on, we have certainly seen, as we talked about in our sales recently, we've seen some improvement recently.

We saw sales generally for most retailers, certainly, everybody selling food, some declines in the early part of the year.

And now, we've seen some recent modest rebounds.

That's a positive sign of the economy.

While I'm no economist.

My own rating of what signs am I looking for in the economy, I'd like to see more money in the pockets of our customers and I'd like to see them willing to spend it in our stores.

We can talk about gross domestic product and all the other economic indicators which I don't fully understand, so I wouldn't try to describe those trends.

But I think we can clearly see, when our customers show it in the way they shop.

And it's really that issue that I think will help turn this around for us, and perhaps the rest of the industry.

Your second part of the question was the relationship between gross profit and identical sales.

I'm not sure we're prepared to answer that.

The gross profit caution that we gave really is slightly lower our guidance versus last year, or versus the plan that we had for the year.

We do expect gross profit to continue to improve through the year, as it often does this time of year, going into the holidays.

It's just that, given the environment, we're not sure that the sales growth will be where we want it to be, if grosses were to rise to levels we had previously planned.

We've had some shrink improvement, which obviously helps, and we'd like more.

We're hopeful to see some pass through in OG & A. If that happens, if that happens in the industry generally, that will help our picture as well.

Those are some of the characteristics.

Rodney, do you want to add any others that might help Jack?

The other thing is we are seeing inflation in some of the key categories.

Does that get passed to the customer?

Time will tell.

That certainly will influence both of those questions.

Thank you, Jack.

Your next question comes from Mark Husson with Merrill Lynch.

Good morning.

I'd like to ask a relate to gross margin question on procurement.

Since 0216 has come in, there have been some deferral of gross profit by some retailers and experiments with debt net costing, given Kroger has moved to a more centralized buying model, can you talk about the changes that have happened and whether there's any impact on gross margin this year.

I'm not sure I understand the question.

Did you want comments on what we've done structurally and how we go to market for buying or did you want to understand more the relationship on 0216?

Both, really.

I tried to smuggle two questions through in one.

all right.

Let me start with the structure, and then I'll turn to Rodney or Mike to comment on 0216.

We have brought into our general office the number of categories being coordinated from here, and that has improved our ability, I think, to buy, and to streamline that whole buying process as part of the strategy growth plan where we identify not only do we want to reduce costs, we want time prove our effectiveness and improve our ability to get some clout from the $52 billion a year company.

We've been, I think pretty successful with that process.

We continue to go after really any promotional money available just because 0216 has changed the way in which it may get reported.

Money on cost of product is money on cost of products.

While there may be different ways we would approach it today versus the environment in the past, we're interested in the ultimately the cost of the product that we resell, and that cost gets reduced by a number of things.

Better bargaining, better negotiations, better pro-motions on our part and better negotiated deal.

All that is currently like it has been before.

Rodney, do you want to come on 0216?

Yeah.

From the perspective of 0216, the impact last year was very modest.

If you look at the impact between quarters, you can measure it in basis points.

It's well less than 10 basis points if you look at impact between quarters.

If you look at the impact on the year, Tom, we really don't expect any.

There's no sense in which the dollars have decreased this year against last year?

No.

Thank you very much.

In markets we always tried to make sure we got everything in cost of product we could.

That has been something, probably ten year plan, not a one year plan because we've always felt it's better.

We make money when we sell stuff not when we buy it.

That's how we try to report our accounting.

That particular objective is embedded pretty deeply for us.

It helps us think about the business in a, I think in a more constructive way.

That's why we wanted to get the costs in the cost of product.

Thank you, mark.

Okay.

Your next question comes from Charles Cerankosky with McDonald Investments.

Good morning, everyone.

Sounds like it might be easier to pass through increases in cost of product, Dave, but can you also talk about what's happening with industry consolidation, where we're at, in that process's ability to impact pricing and markets, I.e. where we're seeing capacity go down, as well as where -- whether it's a strong or weak competitor, simply responding to Kroger's promotions and how that's impacting gross margins?

Chuck, let me answer it this way, industry consolidation has been a long-term trend, and I think will continue for a long time.

We continue to see, particularly individual stores and individual groups of stores available for sale.

Primarily driven by the various things we described before, the competitive environment on one hand and advantages of size and purchasing power and so forth, on the other.

That trend certainly is continuing.

I commented earlier about stores that we've acquired.

I think that's the result of that particular trend.

As whether or not it produces a healthier economic market in any particular market is wildly varied as there are markets that vary.

I don't know -- is there any answers to that question.

In a market you have excess capacity and the capacity gets used up, on one hand you have a better potential market.

But often the way this thing works out is the stores that were grocery stores before often continue as grocery stores, you don't end up with less capacity, you just end up with fewer owners.

That doesn't always lead to that outcome.

I think time will tell.

I think this sort of change in an industry has to work its course and take its time.

It will produce a different looking industry than what we've had years ago.

Rodney, you wanted to add anything to that?

This is something we don't update every quarter.

As you know, we continue to see, when we look at our major market half the market share is helped by people without our economy scale, both from a procurement standpoint, advertising standpoint, from logistics, overhead support standpoint.

So there's still a lot of market share held by people without our economy scale.

I think there's a lot left to go.

A lot of opportunity out there, Chuck.

Thank you.

Your next question comes from Robert Alkerhol (ph), with Oppenheimer Capital.

Thank you.

I'd like you to elaborate a little on the cost saves from the strategic growth plan.

It seems to me in the past quarters, you talked about the difficult of reducing shrink.

That was part of the 500 million in cost savings you have to reach your goal.

What's turned out better?

Do you have more cost saves beyond the 500?

Robert, first, let me comment about costs generally.

Let me put it maybe in two parts.

We've exacted costs from two points of view.

First, we did identify the $500 million we were pushing to reduce.

That was a very specific goal and had very specific items in it, one of which was including strength.

Which is an area I'll comment about in a second.

The second big area of cost control is our general efforts to contain costs in the ongoing business.

That actually will be something we'll probably be doing forever.

We made, I think, very good progress there.

I am very pleased with the OG & A position we were in the second quarter.

You saw the biggest increases were in health and welfare pension and energy, and, of course, the absolute sales level we experienced makes it difficult for OG & A to decline.

We need sales growth in order for that to occur.

We control very well work labor during the quarter.

We continue to take aggressive steps on energy and health and welfare and general operating costs like supplies and things like that and labor.

Let me turn to some of the specifics included in the $500 million area.

Shrink was the biggest one.

We are, in shrink, still running little bit behind our goal.

We are tackling a number of issues, but we're very cautious to make sure we don't hurt our sales trend because shrink can do that if you overdo it.

The shrink has huge opportunities for us.

We have made, recently in the second quarter, we begun to make some improvements, you saw some trend change, so we're optimistic, but it's still not running at the level we had hoped that it might.

We're seeing, in some other areas, not able to quite accomplish what we had set out to be, but in other areas, we've been able to do better.

In the administrative area, for instance, we have done better than originally planned.

We've done better in labor, generally.

We've done better in product costs.

Energy, we haven't quite done as well as we had expected.

We think there's some improvement there yet to be had and are making some capital expenditures on a number of projects to improve on energy utilization..

So we are optimistic, as you have heard us say we will exceed the $500 million.

We're pleased at the progress we have made and also pleased in some of the other cost areas we addressed.

Rodney, want to add anything?

Good.

Robert, thank you.

Your next question comes from Bob Summers with Banc of America Securities.

Real quick, just what are the blackout costs in terms of ident and we took a slight haircut to Cap Ex.

As you condition to review that, are there additional opportunities to take that number down?

On the blackout, I'll answer that and have Mike Schlotman respond on the CapEx.

On the blackout, we really experienced very modest sales impact in the days of the blackout.

The quarter then ended, as I recall, the Saturday night following the blackout.

We had a little bit of sales pick-up on Sunday and Monday following that.

So sales impact was not noticeable on the way we would measure your identical sales.

Most of the cost that we experienced, and I believe it's in table 2, which is not in front of me.

I think it's $9.4 million pretax that was mostly the result of lost product, product in freezers and coolers and warehouse that was outside of refrigeration too long to be salvaged.

It was not primarily the result of lost sales.

And on CapEx, you want to answer that?

Bob, we continue to be judicious in our spending of capital.

We continue to follow the same path we've been following the last couple of years on making sure the returns we set out to get in our capital budget are there, on a project by project basis.

Are there opportunities for additional reductions?

That remains to be seen.

We don't turn down good projects fundamentally.

If we get projects that are high quality projects that will get a return, that anybody would love to have, we're going to spend the money.

If we don't get projects that meet that criteria, we won't spend the money.

It's just our current thinking right now, we're going to be in that $1.9 billion range instead of the $2 billion range.

I don't know if any -- if you've noticed yet that's been filed today, we took our estimated store openings for new relocater remodel stores down from the original 1 to 110 to 90 to 100.

That's a reflection of improved capital process we go through on every new project.

Thanks.

Thank you, Bob.

Your next question comes from Steve Chick with, JP Morgan chase.

Thanks.

The first thing, there was the question earlier about quantifying in terms of trip -- [ inaudible ] I didn't hear what the answer to that was.

If you can answer that.

My question is related to sales.

I know it's been asked a bit, the sales improvement the industry has reported seem to be somewhat cosmetic.

Either your comparisons of higher fuel costs, I guess we would otherwise not expect, you were expecting to be positive, heading into the first four weeks of the third quarter.

I think, when you guys set out two years ago to set the strategy plan, I think you were focused more on the structure of things, and, you know, gaining market share.

Relative alternative of the trade.

My question is, how do you compare the environment today versus two years ago, how would you characterize it?

Secondly, when do we look at it maybe a phase two, in order to, I guess, make sales a lot more robust, above and beyond the cosmetic improvement?

Steve, let me first start with the average sale and customer count.

You're right.

We didn't answer that.

The average sale in total, all our stores combined or in identicals, either way, was solidly improved.

Customers are buying more when they're in our stores.

The customer count, when you look at all of our stores is increasing.

The customer count, when you look at just our identical stores, has a slight decline.

That trend is one that has continued for some time.

We've commented on that before.

Let me go to the sales environment now, versus two years ago.

Two years ago, we were faced with, I think a competitive landscape driven in many cases, by the discounting, discount operators of various types and also the fragmenting of where people buy groceries, the clubs and some of the other category killer kinds of stores.

And some of the other channels, like direct chains.

They were picking up on business.

We were seeing as an industry, a traditional supermarket industry seeing a challenge to where people wanted to buy their groceries.

That environment continues through then and continues today to be true, it was true then.

Although I believe we have made modest progress on that, at least here at Kroger.

But the thing that was not necessarily the case then, and certainly has been the case, though, in the two years since then, has been what's arisen and fallen and risen again, I hope, on the economy.

What we saw again in the way of people willing to spend money, have money in their pockets and willing to spend it declined during that period of time.

Also, in that period of time, we had 9/11 occur two years ago now which set a climate that was different than anything most of us had experienced before.

So much of what we've gone through, in addition to the competitive climate that drove us towards the strategy growth plan, much of the climate of that is true, but there's been other things imposed on us that were not predicted, and not in our previous experience.

I think we have weathered those well and we have seen modest improvement.

I'm pleased with the improvement.

I would like to see more.

That is how I would characterize it?

Rodney, you want to add?

Good.

Thank you, Steve.

Your next question comes from Mark Wiltamuth with Morgan Stanley.

Good afternoon.

Rodney, a question on inflation areas.

It sounds like you're having some success in passing on price.

Are you able to maintain inflation dollars in those inflation areas.

It seems like you're going to accept a margin degradation as cost increases come to you.

It's been pretty mixed.

It's pretty early.

If you look at inflation that's picked up only significantly in the past four to six weeks.

It's early to answer your question.

In some areas we can see it pass through, in other areas it has not been passed through.

Part of that may be to deal with the industry in terms of if you look at where different supply retailers are getting supplied, there may be a lag in terms of costs getting passed through to them.

I think that's affecting them.

Right now, it's probably too early to answer the question.

There are a lot of puts and takes in the moment.

If I can sneak in one strategy question for Dave?

We haven't had a lot of chance to ask you strategy questions, I'm just curious, if you can give us your longer term view on capital expenditures, I'm wondering if you would ever consider backing off CapEx to take a slower growth approach and focus more on returns?

Mark, our answer on CapEx, really, I think Mike essentially gave the short term outlook, the same as the long-term, we assess our capital spending plan based on how we see the current situation, balanced with the opportunities to spend capital.

We typically don't make a decision on CapEx independent of thinking about the opportunities that we think are available to spend capital on things to spend capital on.

We always consider each of the angles before we would decide what our capital budget is and some of the thoughts that you were expressing are part of that equation, as we set about setting our objectives for capital spending for future years.

Mike Schlotman, you want to add anything?

No.

Good.

Thanks.

Thank you, mark.

Your next question comes from Margaret Kannell la with JP Morgan.

Thank you.

In terms of the California labor contracts, can you talk about what the timetable is for the upcoming negotiations and if other supermarkets will be involved?

A second question, if I may, have you seen any traiting by customers across your stores, in terms of going into a little higher price point with the improvement in the economy?

Thank you.

Margaret, we are in our labor contract areas, we have several contracts that we're negotiating this fall, as Rodney listed.

I believe the southern California one expires in October and there's been a number of discussions, both internally, and within the industry, and even with the union, already on that contract.

On that contract, and on others, we're pretty confident but not certain of what those outcomes will be, because we have communicated very well with the unions and with our associates.

We think we've reached a pretty common understanding of the challenges of our industries.

There's certainly disagreement between us and the union how best to solve for those.

We tend to favor contractual changes that would be structural in nature, that would impact some of our new hires, but maybe not impact our existing employees quite so much.

We have worked very closely with safe way and Albertsons in the southern California market as well as other markets where we have common labor contracts.

So, it's too early to say how that one will work out.

That obviously is an important and big contract us to and everybody else, so it will be big on our radar screen and I'm sure big on yours.

Oh, yes.

The second part of your question was or your second question was training.

Have we seen any signs of that?

I think that's a hard thing to actually see.

Tracking customers, not training customers, with starting to be able to see that.

Maybe one sign, if you want to take it as a sign, as I mentioned in the first four weeks of the current quarter we saw some improvement in twend in deli, as an example.

That could be a signed of that, trend in deli.

It could also simply be we had great deli sales during the period.

I'm not sure I can add to that.

Don, I don't know whether you want to add any color to that?

No.

Okay.

Thank you, Margaret.

Your next question comes from Jason Whitmer with Midwest research.

Good morning.

I wonder if you could break down gross margins a little further Essentially this is the quarter of the year where you spent more than you thought you would spend.

Where was the hick cup this quarter?

You broke down some of your plan and pricing increases, was there any cost savings that didn't come in as expected or pricing that couldn't be passed on?

Could you break down further where you're at?

Well, the cost savings areas that we didn't accomplish, like we said, I think I outlined that already, probably the biggest of which is shrink.

There are a few other smaller ones, we have many we made progress on.

The single biggest issue in the quarter and even looking forward on gross profit is competitively in the competitive climate, whether or not we'll be able to raise any of the gross profit areas in order to pay for some of the increased cost in health and welfare and pension and some of those areas we described.

Those particular categories have risen at a disproportionately higher rate, especially give an sales climate essentially flat on same-store sales.

In that environment, it's hard to cover those costs unless you can improve your gross margin, competitively we did not see the ability in the quarter to do that.

Going into the rest of this year, I am cautious whether or not we'll be able to do that.

We have seen some signs in some markets, where costs seem to be being passed through and margins seem to be improving just a little.

That's a good sign.

But our experience in the second quarter would suggest we need to be kind of careful because our interest is, again, in long-term sustainable sales growth, and so we want to be sure not to get off of that target.

Rodney, anything?

Okay.

David Dillion Jason.

Thank you.

Your next question comes from Eduardo Auburn with Deutsche Bank.

Just a follow up question on what you have just said.

Not to be specific about banners could you provide some indication on your performance of western and eastern operations over the quarter?

Is it fair to say overall traditional operators have passed through inflation in most markets where they have small prices as opposed to other areas where your earn operation is all located.

Eduardo, sorry, we can't comment on geographic markets like that.

I think we already answered your general question on inflation.

The specific one relating to geography, we aren't willing to address.

Sorry.

Thanks.

Your next question comes from Frank Hinson with Morgan Stanley.

Good afternoon.

How are you?

Two quick questions.

Number one, I was wondering if you could provide a little more clarification with respect to your guidance for free cash flow?

I know you stated you plan on using two thirds of cash flow for share repurchases and dividends and the remaining for retainment.

It looks like in the first half of the year you used a little over 50% for debt repayment.

I wonder if that implies you'll be using more than 100 percent of your free cash flow in the last half of the year or share repurchases or dividends.

The second question.

Looking you have 200 million remaining under your share repurchase agreement.

And abut 740 to 745 million shares expected to be, you're expected to end the year, excuse me, with 740 to 745 million shares outstanding.

Does that mean you'll be issuing a dividend?

I thought you were only allowed to have one question.

I'm sorry I didn't get all those.

The ones I didn't scribble down quickly, just ask me again.

As far as clarification for free cash flow, we talked in terms of cash flow these days, not free cash flow, only because free cash flow is not a GAAP term.

We don't endeavor to reconcile this as a GAAP term.

Our use is, over the course of a year, we would expect that to be the balance to be able to say I'm precisely going to be one-third and two thirds.

We all like to think we're pretty good at what we do.

But I am not that good.

We'll take advantage of buying stock when we believe the price is advantageous.

We'll take advantage of buying in debt when we have the opportunity to.

As I mentioned earlier, in response to Philip's question, we really don't have a lot of short term debt available for payment on our balance sheet.

We have a lot of debt issues that deal with maturity calls embedded in them.

We only do things based on economics, not on any other basis.

We'll continue to use our cash flow based on what the underlying economics of the situation are.

I wouldn't speculate on what the exact spin will be on any one of those categories in the second half at this point.

Relative to a dividend, you know we've raised that prospect a little over a year ago, when our credit agreement got rid of the prohibition against the dividend as Joe said at the annual meeting this past year, we don't have one in the pipeline at this point.

And our fundamental belief is, with our stock at this price, and our view of the long-term, it's something we're going to continue to invest in, is our stock.

We've fundamentally want to keep our financial flexibility, as high as we can, while we're in the middle of changing our business model, so we can react to whatever we have to react to, without having a commitment, a firm commitment, like a dividend is, to writing checks on a quarterly basis -- like a dividend is.

In the short term that's the most important thing to us is keeping our flexibility.

Thank you.

That's very helpful.

My second question is pension plan, you're planning to contribute $110 million annually between 2004 and 2006.

I believe, this year you contributed 100 million in February. 50%, which was discretionary and 50% a requirement.

I was wondering if you can tell me if the same percentages apply in 50% discretionary and 50% is a requirement?

if you look at the 2004 and three years from that at this point it's $110 million, an estimate, based on where interest rates are and where we expect the pension plan to earn on return on assets.

We thought the $110 million was meaningful enough to talk about it publicly.

In terms of the breakout between what's required and what is optional, that really depends on the timeline of the contribution.

And we would make the contribution when it was in the best economic and advantageous situation for Kroger to make.

Sometimes that might be early, sometimes it might not be until we're required to make that contribution.

Mike, anything you want to add to that?

I agree with you.

The $100 million you noticed the contribution we made in February, that is a pretax amount.

You get a tax deductions for that $100 million contribution because it was fully deductible.

On after tax cash flow basis, that was really about a $65 million check we ended up writing, not 100 million check.

Thank you very much.

we have time for one more question.

From Kelly Garity with Scotia Capital.

My questions have been answered, thank you.

We have time for one more after that if there's someone else waiting.

Your last question will come from Gary Gibblen (ph) with CLCare.

Hi, good morning.

Just to clarify on the inflation pass through questions, a lot of people are trying to understand, is the main determinant of that, the alternative format composition or is it the supermarket competition the reason that's important because, you know, it's possible to interpret the data to show Wal-Mart is allowing price increases to be passed on more than usual but it's also possible to look at that as the wrong way to look at the data.

So that's what we really want to understand.

Gary, there's no one answer that can answer that question.

It's a market by market situation.

And, really, what determines whether or not costs are anything gets passed through in a retail price is the competitive nature of the market.

We're after, as we said, long-term sustainable growth in our sales, and if we're able to get that, at the same time recover these costs, that's what we intend to do.

If we can't get that and recover these costs we're going to try to get that on the sales.

There are some markets, where the discount formats might be keeping costs from getting through because of the way in which they particularly price in a particular market.

There are other markets where it's traditional groceries.

There's other markets where we are able to do so.

It is very spotty, and you'd have to look at individual markets to know the answer to that.

Okay.

So it's a function of markets, not class of trade, and there's no change in behavior by any class of trade, that you're --

That would be my opinion, yes.

That's very helpful in tying it all up with a ribbon.

So thank you very much.

Thank you, Gary.

And thank you to all of you for your time and for your questions.

Thanks.

Ladies and gentlemen, this does conclude today's Kroger second earnings conference call.

You may now disconnect.