克羅格 (KR) 2003 Q3 法說會逐字稿

Good morning, ladies and gentlemen.

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

At this time, I would like to welcome everyone to the Kroger third quarter 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 number one on your telephone key pad.

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

Thank you.

I will now turn the conference over to Ms. Kathy Kelly.

Ma'am, you may proceed.

Thank you.

Good morning and thank you for joining us.

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

We want to caution you that such statements are predictions and actual events or results can differ materially.

A detailed discussion of the many factors that we believe can have a material effect on our business on an ongoing basis is contained in our SEC filing, but Kroger assumes no obligation to update that information.

Our third quarter press release, which includes additional details on many of the items you'll hear about on today's call is available on our Web site at www.kroger.com.

One other note before we get started.

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

Thank you.

Thanks, Kathy.

Good morning, everyone.

We appreciate you joining us today to review Kroger's third quarter earnings.

With me today are Rodney McMullen, Kroger's Vice Chairman;

Don McGeorge, Kroger's President and Chief Operating Officer; and Mike Schlotman, Senior Vice President and Chief Financial Officer.

Before we get started, I want to outline some of the areas we intend to cover today.

We'll share information to help you better understand the effects of the labor disputes on our business in the third quarter.

We also believe it's important to provide you with some insights and highlights of our continuing operations so that you can get a flavor for what's happening in other areas of our business that are not directly affected by the strikes.

First, some important news on West Virginia.

Through the Offices of Federal Mediation, the parties have reached an understanding concerning issues there that will be presented to the employees on Thursday for their vote.

Now, turning to the third quarter, total sales for the third quarter of fiscal 2003 increased 3.8% to $12.1 billion including stores affected by the labor disputes.

On this basis, identical food-store sales, including fuel, increased .2%.

And excluding fuel decreased .6%.

Comparable food-store sales, which include relocations and expansions, increased .8% with fuel and fell .1% without fuel.

Excluding stores affected by labor disputes, identical food-store sales, including fuel, increased 1.3%.

On this basis, identical food-store sales excluding fuel increased .4%.

And comparable food-store sales increased 1.9% with fuel and increased .9% without fuel.

We estimate that product cost inflation including fuel was 1.7% and excluding fuel 1.5%.

15 of our 17 divisions had improving trends in identical food-store sales excluding fuel and excluding the stores affected by the labor disputes.

We are pleased with the relative, although not absolute trend, in sales during the third quarter.

While this division performance figure is not something that we plan to share each quarter, we believe that in light of the current operating environment, it provides a useful glimpse of our operating trends.

In the fourth quarter to date, our identical food-store sales excluding fuel and also excluding the effects of the labor disputes are running slightly ahead of our results in the third quarter.

Our corporate branch, which continued to be a competitive strength turned in another solid performance.

The market share of Kroger's private label grocery items in terms of units, increased .4% to approximately 30.9% versus a year ago.

Private label grocery share in terms of dollars grew .6% to approximately 23.6%.

Our convenience store divisions had a great quarter and in fact are having an outstanding year.

They are performing very well and deserve to be recognized.

Also, a brief update on cost savings.

Our entire organization continues to pursue cost savings that we outlined in the plan announced in December of 2001.

Through the end of the third quarter, we had achieved $490 million in cost savings.

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

We believe there are additional savings opportunities available in 2004, which we will discuss in more detail during our year-end conference call in March.

Turning to expectations for the year.

Kroger is not able to determine when the ongoing labor disputes will be resolved or estimate the investment that will be required to rebuild our business in affected markets.

Based on earnings results in the third quarter, and the company's continued investment in pricing programs, Kroger's 2003 earnings, excluding the affect of labor disputes, likely would fall below the $1.45 per diluted share described in our past guidance.

As a result of all of these factors, the Company has withdrawn all guidance for fiscal 2003.

Now, I will ask Rodney to provide some additional perspective on Kroger's third quarter financial results.

Rodney?

Thank you, Dave.

Good morning, everyone.

Net earnings for the third quarter were $110.2 million or 15 cents per diluted share.

We estimate the ongoing labor disputes affecting stores in Southern California and the West Virginia area, reduced earnings by 12 cents per diluted share during the quarter.

The company also made open-market purchases of $100 million of debt, which reduced earnings by 1 cent per diluted share.

We were able to refinance the debt at lower rates in order to reduce future interest expense.

Our 12 cent estimate of the cost of the labor disputes is based on a number of assumptions and estimates.

We assume that the Ralphs stores in Southern California and the Kroger stores primarily in West Virginia that were adversely affected by the labor disputes, as well as the Food4Less stores that were favorably affected, would have maintained their prestrike operating trends for the balance of the quarter.

This resulted in an estimate of the effect on gross profit and OG&A.

In addition to these estimates, there were costs directly associated to the labor disputes including prestrike expenses, incremental shrink, costs associated with hiring training replacement workers in Southern California, costs associated with bringing employees from other Kroger divisions to work in the Ralphs stores and expenses associated with the agreement among the three employers in Southern California.

It's worth noting that the costs of the labor disputes during the third quarter are consistent with what we had anticipated.

Also during the quarter, Kroger repurchased 3.4 million shares common stock at an average price of $18.72 per share for a total investment of $62.8 million.

At the end of the third quarter, we had $160 million remaining under the $500 million repurchase program authorized in the fourth quarter of 2002.

Consistent with our strategy of using one-third of free cash flow for debt reduction and two-thirds for stock repurchase for the payment of a cash dividend, Kroger has not repurchased shares since October 13.

Over the past four quarters, Kroger's cash flow has enabled the company to reduce total debt by $194 million, repurchase $382 million in stock and invest $2.2 billion in capital projects including the buyout of a synthetic lease for $200 million.

Looking back a bit further, the numbers are even more impressive.

Since January of 2000, Kroger has reduced total debt by $586 million and repurchased $2.4 billion in stock.

The reduction in debt does not include an additional $470 million in debt that previously had been financed off balance sheet through a synthetic lease.

Kroger's financial strength is an important competitive advantage, particularly at this time.

We have the financial resources necessary to continue building Kroger's business for the future.

During the third quarter of 2003, Kroger opened, acquired, expanded or relocated 30 food stores.

Total food store square footage increased 3.6% over the prior year.

Capital expenditures for the quarter totaled $575 million.

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

For the first three quarters of fiscal 2003, sales increased 3.7% to $40.8 billion.

Net earnings were $652 million or 86 cents per diluted share. these results include the effect of the labor dispute, premiums paid on debt repurchases and other items.

For the first three quarters of fiscal 2002, net earnings were $823.9 million or $1.03 per diluted share.

I've already talked about the labor disputes with the USCW and Southern California and West Virginia.

I want to add that we are currently at indefinite contract extensions in a portion of Indiana, Arizona and the Memphis area.

Those extensions are subject to termination by either party following notice.

We are actively pursuing negotiation of new agreements in those areas and are hopeful that we can reach a satisfactory agreement without work stoppages in those markets.

In 2004, Kroger has major USCW contracts, expiring in Houston, Food4Less in Southern California, two contracts in Seattle, Louisville, Nashville, Detroit, Denver, Las Vegas and Cincinnati.

In addition, there was a Teamster contract expiring in Portland, Oregon.

Every year, Kroger has major union contracts expiring in 2004 will be no different.

Now, I'd like to turn it back over to Dave for some final comments.

Dave?

Thanks, Rodney.

A few final thoughts before we open it up for questions.

In the Southern California market, the unions representing our employees have taken them out on strike despite a fair and generous offer that we've made for wages and benefits.

We look forward to the day when we welcome back to work our employees in Southern California and in West Virginia.

And as we announced today, we have every reason to be hopeful that it will be soon in West Virginia.

However, I do believe Kroger can no longer fund 100% of the uncontrolled growth of health care and pension costs if we are to remain competitive with lower-cost operators.

We will not have any further comment on the negotiations in Southern California or West Virginia.

I want to take a moment to thank our customers in Southern California for their support and patience during this challenging time.

We appreciate your business and we are working hard to ensure that you find what you need when you visit our stores.

I also want to thank employees throughout our organization for their incredible work, especially over the past nine weeks.

Your commitment and devotion to our customers continue to define Kroger and our family of companies.

We will now be happy to answer your questions, ask that you limit you question to one per person so that we can accommodate as many as possible in the allotted time.

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

Please hold for your first question.

Your first question comes from John Heinbockel with Goldman Sachs.

Yeah, hi.

This is Eric Wiseman sitting in for John.

My question is related to pricing and gross margin.

There seem to be a fairly noticeable step up in the level of gross margin investment this quarter.

Can you discuss a little bit about the rationale behind the increased promotional activity and whether this represents a strategic shift to kind of a more aggressive stance or something that's more short term and tactical?

Thanks.

Eric, good morning and thank you for the question.

We agree with you that gross profit obviously is the issue in this quarter.

Frankly, it is lower than we had expected.

Although, part of it, obviously, was what we had expected.

Our gross profit for the quarter was affected by a number of things.

First, by a trend change in inflation and a competitive market.

Those combinations when you have those occur tend to keep your gross from being able to grow, particularly in a cost inflation environment.

Also, I personally think that we had internally, not externally, but internally overprojected our own gross profit expectations for the third quarter based upon the increase in third quarter gross profit we experienced last year.

We did experience a little bit worse shrink in the quarter than what we had expected.

By the way, on shrink, we do believe that it's still a big opportunity for us next year, and it's on our list of big opportunities that will be explored with you more in the fourth quarter conference call.

But the most important really in the fourth quarter that impacted gross profit was our sales effect.

Our third quarter, yes, I'm sorry.

The biggest thing that affected our third quarter on gross profit was the sales that we pushed for and that is the result of promotions and it's the result of investment strategies on sales that we've developed over time.

And it has produced, frankly, the best identical sales growth we have achieved without fuel since we started this process in December of '01.

We're very pleased with the sales results.

And realize that the investment was important to make, and it did throw us a bit off track, though, in the quarter as you can see.

Okay, thank you.

Your next question comes from Phillipe Gusen with Credit Suisse First Boston.

Good morning. [Inaudible] fixed-income research.

Question for Mike.

Mike, in light of the current review for a possible upgrade by Moody's, if pressure on cash flows were to remain due to the strike lasting a little bit longer than you would all hope, is there any chance that you might change the allocation of two-thirds free cash flow going towards share repurchases in order to kind of mitigate some of the concerns perhaps from Moody's and still get that upgrade?

I mean, obviously, as you said, we're under review for the upgrade and are hopeful that would happen in the near term.

As you know, we already have been upgraded by the other two agencies and that is certainly helping our borrowing costs under our working capital facility with the commercial paper we're issuing.

We're doing that at a very favorable rate today.

As far as changing the balance of the one-thirds, two-thirds, I think we're very comfortable with that.

I think we've demonstrated to all of the rating agencies our commitment to that balance, if you look at the numbers of what we've done over the past four quarters and if you look at what we've done since January of 2000 and take into account the effect on those numbers of having brought the syn lease back onto the balance sheet, that's really a strategy of use of cash flow we've executed since January of 2000 and have been very close to those percentages.

As we said in both the earnings release and in the comments, we stopped using any cash to buy in stock beginning October 13th so we can properly balance the use of our free cash flow for the rest of the year.

And would expect to stay on that strategy of keeping that balance.

Thanks very much.

Your next question comes from Lisa Cartwright with Smith Barney.

Good morning.

I want to make sure I'm looking at the gross margin in the correct way.

If you look at the strike impact, which you isolate at on the gross margin line at I think $96.5 million, if you back that out, and then you look at the gross margin change, is it correct to see that that change is the price reduction which I estimate would be about an 80 to 85 basis point reduction?

Is that the right way to look at it?

Lisa, first, it is close to right.

The first part, of course, is correct, and in fact, I want to go back to Eric's question just to point this out as I made a big assumption when we started this when he asked a question.

I mentally took the roughly one-third of the impact on our gross margin decline from the year ago and set it aside because it was strike-related just as you pointed out, Lisa, as shown on our tables.

The remainder, though, isn't simply price reductions.

Okay.

It is a number of things.

It includes additional promotions and it includes strategic investment in our sales plans, but it also includes a little higher shrink impact particularly in the nonfoods and the perishable areas.

We had some good successes in shrink work in grocery, but we had some increases in those other categories.

It also includes some additional costs of product, when you experience cost inflation, particularly when you have a trend change like occurred between the second and third quarter, what you'll have is costs rising at a little faster clip.

I realize that this rate of inflation isn't exactly enormous, but on lots of billions of dollars of sales, it is a pretty big swing.

And when that happens, you end up with some costs going up more rapidly than, say, the retailers are able to catch up.

And in that environment, you do end up, not so much with price reductions creating a squeeze on your gross profit, but rather cost of product going up gives you the squeeze.

So I'd say that's the more full picture.

So would you say that it's fair to say heading into next year if you get some improvements in shrink and if the inflation picture stabilizes somewhat that we would not be seeing that reduction in gross margin as necessarily a run rate?

We're not going to give any guidance for next year just yet, but I will tell you that gross profit rates is not so much the driver to us here as is sales growth and gross profit dollars.

And we said back in December of '01 that our objective was to increase sales at a better clip than we have been able to achieve.

Now, we didn't expect to go through the economic times we did or the deflation we did, but putting that aside, we are seeking better sales and do believe that with better sales you get leverage of your gross margin and you don't have to have quite the same gross margin percentage to accomplish that.

Rodney, do you want to add anything?

The other thing I would add on top of that is if you just look at the gross profit rate for the third quarter versus the second quarter, the change is very similar.

And, as Dave mentioned before, if you go back a year ago, we had a substantial increase in gross profit rate third quarter versus second quarter.

Yeah.

We were probably too optimistic this year that we would have a similar type situation happen.

So I think a part of that decline is just due to that.

And if you look at the run rate quarter, the quarter, that change I think would probably be more what you should expect going forward.

Okay.

Well, the sales certainly look good.

Thanks a lot.

Thanks, Lisa.

Your next question comes from Meredith Adler with Lehman Brothers.

Yeah, I'm going to follow onto this just a little bit if we could talk about sort of the geographic spread of the investments that you're making.

And trying to understand, are there particular markets, and you don't have to name the markets, but there are particular markets where the environment has gotten substantially more competitive and that there is a hope that by you being this aggressive, you will put some people out of business?

I know markets like Detroit are markets where a competitor has decided to be more aggressive.

We know Winn-Dixie is more aggressive and you compete with them.

Maybe they are a small player but you compete with them in a bunch of markets.

Are we talking about that or talking about something that is more across the board?

I'd like to along with that is what are the ROI or what is the payoff for these investments?

Meredith, first on the geographic spread of the investments, it varies all the time.

Every one of our markets has individual characteristics and what you described as the environment certainly is true that we do see markets, some markets more competitive than others.

And now there are some others that are more competitive today that weren't maybe that way last year.

We're always seeking additional business.

We're always seeking to grow our market share.

We are not particularly targeting someone that can go out of business as you described.

So that's really not a very descriptive way for to us think about this.

We really look at the investment we're making in gross profit as being targeted to some individual categories, some individual departments and some selected divisions based upon the particular characteristics in that local division in terms of our ability to gross sales or the competitive environment in that particular market.

So I'd say it is more by market, though, than some overall global deep investment in gross.

But I think the characteristics that we've described by our gross have affected all of our divisions this past quarter.

As to the ROI on gross profit investment, we believe it's a prudent investment.

I've recognized that it was a little bit deeper in the quarter than we expected, but still nonetheless, we believe it was prudent.

We think the ultimate proof in whether or not we're right about that is future sales growth, future profitable sales growth.

Gross profit percent, as I mentioned, really is not the driver here but rather the leverage you get both with your expenses and with the gross margin dollars when you achieve better sales.

Yeah, and the market's not very good at seeing the future, so thank you very much.

Thanks, Meredith.

Your next question comes from Mark Hudson with Merrill Lynch.

Good morning.

The first is actually not a question, a clarification.

The $1.45 that you talk about being the low for the year, that's really the $1.50 number, is it, for the $1.45 must include Dynegy and Black Hats and all that kind of stuff?

If you remember from last quarter, the guidance that we talked about was $1.50 but we also said we could be as much as a nickel below that in certain situations.

And that the $1.50 would be the $1.50 minus the nickel that we talked about before that we could be as much as that below the previous guidance.

In other words, you're cheating a little bit in saying you are going to be below the low range of your previous guidance?

Is that what you are saying?

That's what we're saying but we specifically wanted to put that number in so there was no doubt that somebody could see what we were trying to say.

Okay.

And could you just talk about -- well, that implies -- does that include the strike?

I mean, it says in the text, I guess x the strike, I mean, x the strike you just said that your gross margin investment was a bit heavier than you expected.

It sounds like you are contemplating an even heavier gross margin in the fourth quarter in order to miss the bottom end of the bottom of your range.

And if it's heavier than expected, can't you correct it?

Mark, that's a good question and one that I feel pretty strongly about.

We have sales momentum going right now.

And I think part of it is the result of the investments that we've made.

And in the past, in retail companies and in ours, if we make a sharp right turn to correct for what we think may be a spot of overinvestment of gross margin, we can end up turning the sales the other direction.

So we're going to be very careful about that.

It's true we are going to try to recoup the gross margin that was not spent in an effective way to produce better sales, but we are still after improved sales.

It will still require making sure that our gross margin investment is appropriate and strategic.

So we will be careful about that.

Add to the $1.45, when it became likely to us that we would not be able to hit the $1.45, we thought that was, in addition to the strike, an appropriate reason to withdraw the guidance and make sure that you had a fairly clear picture of how we saw the world.

But that was driven as much by what happened in the third quarter as any particular forecast for the fourth.

Okay.

And just on the gross margin and SG&A.

What's the effect of gasoline on those two in the quarter in terms of mix?

Do we have that yet, Mike?

I've got it in here.

On the gross profit rate fuel affected it by about ten basis points.

On OG&A --

It's about 23 basis points, Mark.

Positive impact of fuel on the OG&A rate.

And 10 basis points off the gross.

Okay.

In other words, your gross gallons, your cents per gallon were pretty good in the quarter?

Yes.

Great.

Thank you very much.

Both on a gallon growth basis and a margin basis both.

Yeah.

It really dramatically illustrates why it's important, and we've done this now for quite a while, why it's important to look at some of these numbers without fuel in it because fuel can disguise really the picture of what's happening.

We regularly do that and we try to give you as much information along those lines as we can.

Thanks so much.

Your next question comes from Mia Kirchgaessner with Bernstein.

Good morning.

Given the sales numbers and the progress that we now see on the margin side.

What kind of impact does that have on how you expect to spend CAPEX going into next year?

Does it make you want to be more conservative at all on your CAPEX spending?

I'll let Mike answer that, Mia.

Hi, Mia.

Hi.

At this point, we aren't planning any changes, I will tell you that we're in the middle of doing our business plan process for next year, and as everybody knows, the foundation of our business plan process is our capital allocation plan and it's a three-year rolling allocation for our capital.

So when we do our business plan every year, we look at not just three years out, but we look at '04, '05 and '06 all combined.

And we review where we're spending it, how much we're spending it and are we getting a return?

It will be something we review as we go through our business plan process, but at this point, we wouldn't be planning any dramatic change from the kind of levels we're at today.

Just to follow up, can you comment at all on whether the Food4Less stores are the more discounted oriented formats will get more of the allocation going forward?

If you look at even in the original plan, had Food4Less getting a more than their proportioned share of capital, and we would expect to continue to do that.

Thank you.

Your next question comes from Steve Chick with J.P.

Morgan Chase.

Hi.

I was wondering if I could just clarify something.

In terms of the agreement that you have with Albertson's and Safeway and just how you are accounting for that, if it's, in fact, I guess what would be a revenue sharing agreement, I mean, some of your Ralphs stores look like they are hitting record weeks in sales because of the traffic that's going there and not going to Vaughn's and Albertson's.

If you have a revenue sharing agreement, is there no adjustment to the sales line in your accounting for that in SG&A; is that right?

You are not netting it against sales, in other words?

I'll attempt to describe it and I'll look at the two attorneys in the room that if I get off the beaten path of what we planned to talk about publicly to stop me and it's unusual for us to say that, but it's an issue we want to make sure we describe properly.

While it's described as a revenue sharing agreement, it's based on -- while you described it as a revenue sharing agreement, it's based on changes in sales and then some calculation of what that change in sales shift amongst the retailers mean from a profitability standpoint.

So there is no way in GAAP that if somebody comes in my store and spends a dollar that I reduce my sales by a dollar and give it to Safeway because they didn't spend it in their stores.

My sales are what people came into our stores and spent.

Our sales number wouldn't change.

What I ultimately have is an obligation either to pay or receive money under the terms of the agreement based on our relative changes of sales compared to our historical sales.

Okay.

Gotcha.

That's being accounted for within the adjustment to SG&A, not gross?

Correct.

Okay.

Now, if I look at those adjustments you made relative to the sales loss that you are attributing to the strike, I think I'm coming up with something like $130 million in sales.

The adjustments you have made are at that if not actually a little bit more.

If you look at the gross piece, it implies the gross margin on those lost sales is very high.

I guess the adjustment is a little bit higher than I would have expected.

Is this kind of a high water mark, so to speak and now going forward the costs associated or the adjustments you will be making say into the next quarter will be a lot lower relative to the sales loss?

Steve, there are a number of things included in the numbers that we showed on table two.

First of all, starting with sales, which we did not list in table two, our own estimate, and it is simply an estimate because obviously it didn't happen so you don't know what the sales would have been, are a little bit higher.

Our estimate was $135 million to $145 million in that range in sales.

I believe wasn't that correct?

Yes.

Yes.

So starting with that.

Second, as to the gross margin, the gross margin impact is the result of really two real big things.

The first is the margin you did not get on the sales that you did not get.

That's certainly part of it, but the other part, and it is a big part when you have labor disputes like this, is you have significant shrink.

That shrink on existing inventory and shrink with existing sales, not shrink on the sales you didn't get, so you have to consider that when you look at the gross margin.

Then the rest of the dollars were in our OG&A and those dollars included the long list that Rodney described as examples of the kinds of expenses that you incur.

And one of those examples is this agreement among the parties.

But there are lots of expenses in there that relate to things like security and paying the temporary help and a number of things that cause us to have higher OG&A costs there because it was associated with the strike.

Rodney, do you want to add anything more to that?

Okay, great, thanks.

One thing if I could.

I've heard, it seems like the strikers who are picketing lose health benefits I think on December 30th.

Do you know that or can you confirm that?

I don't think we'll have any comment on that.

Okay, thank you.

Your next question comes from Mark Wiltamuth with Morgan Stanley.

Hi, good morning.

I wonder if you could give us a general sense for how much of the strike impact was from the West Virginia dispute and how much from Southern California?

And then if you could also give us a little picture of what you think things would look like coming out of the strike?

How do things readjust after a strike ends?

I'll let Rodney comment on that.

I'll answer the first part and Dave can answer the second part.

By far the majority of the costs are related to Southern California.

If you just looked at probably 90%, 10% would be a rough rule number to use that you'll be fine.

It's actually a little bit even stronger than that in Southern California.

Okay.

As to the second part of your question, what to expect coming out of a strike, I'll answer two ways.

First is, we really aren't going to speculate either on when that will happen or actually even how it will occur.

We have put a great deal of thought in both markets into how you approach these things.

In one market, in West Virginia it's a different market than Southern California because it's primarily us and Wal-Mart super centers and a few other competitors.

So it is a different environment than you experience in Southern California.

But my experience is that it's a widely different, that you can't predict very easily or very well, but it's important for us to look at the time period afterwards as a time we're going to regrow our sales and make sure we get things back to normal.

We're taking that into account as we think about our future but that's speculative and hard to predict.

So we won't be giving much guidance on that subject.

Okay.

Do you have any experience in past strikes, how fast things recover?

Yes, we have.

Do you want to add anything to that?

I was going to say as a general rule of thumb, none of us have that many experiences but as a general rule of thumb, when you have a labor dispute at the same time your competitors have the same thing, the recovery is quicker than others.

But that's just on a very limited number of situations.

Okay.

That's true.

Thank you.

Your next question comes from Edouard Aubin with Deutsche Banc.

Good morning.

I have a kind of longer-term question regarding your cost-savings initiative.

In the past, you've talked about how you rationalized your distribution center network, and my question is what type of improvement should we expect in the median term coming from you?

Or are you already happy with where you are today in terms of supply chain and how would you rate your supply chain in the discounters?

Our distribution process, our logistics process is an ever-evolving and, frankly, ever-improving process, and I view the midterm and long-term as having clear and significant opportunities to improve.

I believe today we are operating at a pretty good level.

I think particularly in some of our newer facilities or where we have applied some of our more recent technologies, I would put us up among the best and think that we are rapidly getting to where our whole operation would be similarly described.

So I see that there is additional opportunity there, but I think it is already doing a good job in this past quarter, this past year has been an example of that.

Okay, thanks.

Your next question comes from Michelle Cave [ph] with J.P. Morgan.

Hi, this is Margaret Kannell with J.P. Morgan.

A question related to pricing and competition.

A couple of months ago at the Wal-Mart analyst meeting, they implied if not announced, that they were going to more aggressively roll out their super centers and eventually more aggressively roll out their clubs which have been performing better in recent quarters.

What kind of plans do you have or what changes in plans might you make with regard to their new or more accelerated competitive rollout of the super centers?

Or have we already seen that in terms of some of the pricing changes that you've made in the last quarter?

Margaret, we periodically update the number of Wal-Mart super centers with which we compete.

And I believe after the third quarter, the number is 663 Wal-Mart Super Centers and that's through the third quarter.

Total super centers as a group, including the Wal-Mart Super Centers but also including other super centers, it's 899.

Because of that, though, we've had many, many years now of experience where Wal-Mart Super Centers have grown in our markets, and in some markets like West Virginia have become one of the main competitors.

So our plans, even since December of '01 when we started down the path of our strategic growth plan, even at that point, we were fairly strategic about how we competed against or would compete against a Wal-Mart Super Center and how we've approached that.

We've shared that learning through the organization, have had good experience in some markets.

Obviously, the number of competitive store openings like the Wal-Mart has had has had its impact, but we've also had our successes.

The last time we gave some actual examples was a year ago based on 2002 actual data.

I presume after 2003 ends, we'll put together some similar comparative data and try to give you a feel for that.

The other thing is, we continue to focus on what we're good at and it's not relative to any specific competitor.

But if you look at the combination store format, it's incredibly convenient for our customers to shop, both from an aspect of it's easy to shop from a timeframe, how long it takes to get your groceries, a few nonfood items and all of your perishables plus the distance that a customer has to drive.

The average customer has to drive less than two miles to get to one of our stores.

The other thing is when you look at the perishable side of the business, the produce, meat, seafood, deli, bakery, all of those great departments that we have, in our meat department, you can still get a cut of meat cut just for you if that's what you want and that type of service.

Those are the things we are trying to distinguish ourselves between all competitors, not just just one specific one.

Good example.

Thank you, Margaret.

Thanks very much.

Your next question comes from Jack Murphy with Credit Suisse First Boston.

Good morning.

Good morning, Jack.

I wonder if you can just kind of put parameters around what's at stake, not so much in Southern California but as you look at the labor negotiations over the next 12 months, the contracts that are coming due and the like.

What's the type of dollar savings that you hope for or, if you want to think about it in terms of what percentage of your expense structure?

However you are comfortable talking about it, what's at stake in those negotiations?

Jack, I'm not sure I'm going to be able to answer quite as definitively as you'd like but let me take a stab and I will see if Rodney or Mike want to add anything additional. very year, we have a number of contracts that are up for negotiation and Rodney read the list of the major contracts that are up this next year.

And generally, we have pretty good relationships with the local unions that we work with.

And we expect many future favorable negotiations and favorable contracts, but there's certainly no guarantee of that.

In the future year or years probably, certainly the next year, we believe health and welfare and pension will continue to be primary issues in those discussions, because as I said in our prepared remarks earlier, we do not believe that we can be competitive on one hand and continue to carry the full load, the 100% load of the growth in health and welfare and pension costs over time.

In addition to that, every market has its own local issues.

Sometimes a market is already, the wages are in the right position for to us compete and sometimes they are not.

Sometimes the benefits are already in a reasonable position and sometimes they are not.

So in each market, we have to address those specific needs for that specific market and we intend to do that and we intend to do it hand in hand with the local unions as we have for many, many years.

You want to add anything to that?

Okay.

Thanks, Jack.

Okay, thanks.

Your next question comes from Chuck Cerankosky with McDonald Investments.

Good morning, everyone.

Hi, Chuck.

Just a couple data points really, when you are talking about the sales impact of the labor disruptions, you mentioned $135 to $145 million.

Does that include the West Virginia strike as well?

Yes.

Okay.

And if we also look at the strike costs that impacted the third quarter, did that include any preparatory strikes, strike costs for Phoenix and Indianapolis?

Those numbers did not include anything for those.

We did have some expenses related to that, but those numbers did not include that.

The only free strike costs that were in the numbers we described were those where we actually had a labor dispute in West Virginia or in Southern California.

Can you describe what the costs were in Phoenix and Indianapolis?

Don't want to really give a specific number, but it's not a huge number in terms of moving the whole needle, but, it's --

There was some.

Yes.

And year-to-date, how many stores have you acquired?

Just acquired stores?

We'll look that up here in just a second.

That would be 29, Chuck.

All right.

Thank you.

Thanks, Chuck.

Your next question comes from Neil Currie with UBS.

Yes, good morning.

I'd like to ask another couple of questions about the strike, or at least one main question which is, the strike in Southern California obviously had a lot of publicity ahead of it.

And I imagine there was a slight build up in sales as customers stocked up.

Is that slight build up included in the run rate that you used to assume when you took out the strike impact afterwards?

Neil, when the number I gave, the .4% identical sales growth without fuel and without the stores affected by the labor disputes, in that number we actually took out the stores affected by the labor disputes for several days preceding, and in fact in Southern California it amounted to six days, I think, or seven days that we took out in order to take away that run up in sales.

The run up actually occurred in that particular market Thursday and Friday, we could see it in the sales and then on Saturday, it started to reduce and then, of course Sunday is when the dispute for us began.

We also took out the favorable affect that Food4Less is experiencing while the Safeway and Albertson's have the labor dispute going on.

So we didn't take credit for the positive effect that Food4Less is experiencing in that number, either.

That's a good point.

Then in West Virginia, in that case, we took out, I think it was three or four days roughly a couple of days in advance of the strike in order to eliminate that run up.

But that wasn't material anyway, but we did it in a consistent way so that we'd make sure that the run up was not contained in those numbers.

That's pretty prudent, thanks.

Also, I wondered how many stores will be affected by negotiations next year in terms of the labor contracts coming up for discussion?

A lot.

I don't really know the answer to that.

We'd have to add up those markets and a lot of other contracts.

As we mentioned, we really have hundreds of labor contracts so every year, those typically, the contracts run maybe three to four years generally, some are longer, some are a little shorter but just do the math, you can tell we have lots every year and so I don't know how many stores that would be.

Okay, thanks anyway, that's great.

Thanks, Neil.

Your next question comes from Andrew Wolf with BB&T Capital Markets.

Good morning.

A couple of questions for you.

First just on product cost inflation, can you tell us what the trend was during the quarter and what it's been in the last month, the increase, is it still increasing?

Secondly, when you look at your sequential pickup in sales productivity, can you talk about any progress you might be making in customer count or is that still pretty much a basket size gain?

Let me answer the last part first and then I'll have Mike comment on the trend on inflation.

What we're seeing is more increase in basket size.

Our average sale has been trending up.

In terms of total customer count, we prefer to look at that as transaction count because that's the way the machine measures it.

The number of transactions that we are running through on a total basis is increasing, but on an identical basis, it is slightly decreasing.

But our average sale, that is the purchases made on each transaction clearly has grown.

And that's the picture for the sales.

You want to comment, Mike, on the trends on inflation through the period through the quarter?

It's kind of a mixed bag, Andrew.

Some categories inflation growing throughout the quarter like meat.

Others had some growth and tempered slightly in the tenth period.

So it's really kind of a mixed bag.

I would say overall it looks like the amount for the quarter would have grown as we went throughout the quarter.

At this point, I would not comment on the fourth quarter primarily because our 11th period just ended and I haven't seen 11th period results so I don't really have a number to talk about if I had it, if I could.

Just to follow up on the ID transaction decrease.

What I'm asking is, is that getting less?

Is that decreasing less or is it still pretty much running?

You are breaking up a little.

I'm not sure we understand your question.

Can you hear me now?

Yeah.

Your ID sales, identical store transaction count, is the decrease there getting less or did it stay the same sequentially, so in other words, is all of the pick up from the basket size or is the decrease in ID customer count or transaction counts at least going down a bit?

Are you talking about through the third quarter or are you taking about over a longer period of time than that?

Well, your pickup here was really second to third quarter.

You can both ways, longer term and particularly second and third quarter.

Well, actually, I don't know the answer to that.

Do you know?

I don't know the specific answer, but when you look at transaction count and when you look at basket size, I think one, it's not a perfect size.

There's things that happen in the way we change how we do certain aspects in the business that can change a customer counter or really a transaction count.

The other thing is that if you look at some of the things we're doing in the stores, we are promoting and we are carrying bigger packs of a lot of items.

If you sell one big pack of an item to a customer, that may reduce transaction counts because they write up once now instead of two or three times but it increases that particular basket.

You really have to look and just say transaction counts are down.

You almost have to try to get underneath every one of those transactions and see, they may have toilet tissue in there but instead of a four-pack, it's a 12-pack or 24-pack and they may come to our store less frequently now because they bought a big pack.

That doesn't mean that that's a bad thing, it's just a somewhat change in the dynamic of how customers are shopping.

I want to make sure we don't just look at the numbers in the absolute without understanding some of the things behind it.

I'm not saying that explains everything in our transaction count, but it is certainly a factor.

Andrew, we don't have the specific numbers right here of the trend change from second quarter to third.

I do know that when we answered the question in the second quarter that the answer in the picture was basically the same, that the average sale was going up and the identical transactions were not either going up as much or not maybe weren't going up at all on an identical basis.

Those are transactions that we're counting and as Mike said, it's data that may give you the wrong answer if you look at it as though it's giving you customer count.

Okay.

Thank you.

Thank you.

We have time for one more question, please.

Yes, ma'am.

Your final question comes from Bridget Nigard with Lazard.

Actually, my question was answered.

Thanks, guys.

All right.

Thank you for calling.

Thank you all.

We appreciate your time this morning.

Thank you for participating in today's Kroger third quarter conference call.

You may now disconnect.