克羅格 (KR) 2004 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the second quarter Kroger Company earnings conference call.

My name is Ann Marie, and I'll be your coordinator for today.

At this time, all participants are in listen-only mode.

We will be conducting a question-and-answer session towards the end of this conference.

If at any time during the call you require assistance, please press star, 0 and a coordinator will be happy to assist you.

I would now like to turn the presentation over to Ms. Carin Chabut.

Please proceed.

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 that you that such statements are predictions and actual events or results can differ materially.

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

Both our second quarter press release and our prepared remarks from this conference call, will be available on our website at www.kroger.com.

Now, I will turn it over to Mr. Dillon.

Thanks, Carin, and good morning everyone.

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

With me today are Rodney McMullen, Kroger's Vice Chairman and Don McGeorge, Kroger's President and Chief Operating Officer and Mike Schlotman, Senior Vice President and Chief Financial Officer.

I'd like to begin this morning by briefly reviewing our second quarter results and our expectations for identical food store sales for the remainder of the year.

I'll also share some perspective on the post-strike environment in Southern California.

Rodney will then add some additional detail on the quarter and update you on our progress and contract negotiations.

Then will take your questions.

Total sales for the second quarter increased 5.1% to $13 billion.

Total food store sales, excluding fuel, rose 2.5%.

This is a favorable result, considering our 1.5% square-footage growth.

Identical food store sales, including fuel, increased 2.1% and excluding fuel increased .6%.

Excluding Ralph's and Food 4 Less stores, affected by an earlier labor dispute, identical food store sales, including fuel, increased 2.8% and excluding fuel increased 1.1%.

We estimate that product cost inflation, including fuel, was 3.6% and excluding fuel was 2.4%.

Commodity prices in areas such as meat, dairy, and deli drove most of that inflation.

We are pleased with the 60 basis point improvement in Kroger's identical food store sales results over the first quarter, excluding the Ralph's and Food 4 Less stores affected by the labor dispute, and excluding fuel.

12 of our divisions had improving trends in identical food store sales growth, excluding fuel when compared to the first quarter.

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

We expect improved identical food store sales for the remainder of the year, as compared to the 1.1% growth in the second quarter.

This excludes fuel and stores affected by the labor disputes.

We expect the third quarter to be stronger than the fourth quarter because of the strength of Kroger's identical food store sales in the fourth quarter of 2003.

Based on year-to-date performance, it will be challenging to go achieve the Company's previously announced identical food store sales target of 1.3% for the full fiscal year, excluding fuel and stores affected by labor disputes, but our whole team is working hard to achieve our sales targets for both the second half and full year.

Our corporate brands continues to be a competitive strength.

In the second quarter we introduced 142 new items in our corporate brand lineup.

The market share of Kroger's private label grocery items, in terms of dollars, increased 67 basis points to approximately 24.47%, versus a year ago.

Private label grocery sales or grocery share, in terms of units, declined 48 basis points to approximately 31.34%.

This decline is due, in large part, to the tonnage decreases in dairy categories, such as milk, cheese, butter, and ice cream, where we experienced significant price increases.

Now a few comments about Southern California.

The marketplace remains very competitive.

Ralph's is focused on improving identical food store sales to pre-strike levels.

Based on current conditions in the market, we believe our efforts to return sales and earnings to pre-strike levels will continue for the foreseeable future.

Ralph's is executing the plan to rebuild its business.

The strike had a devastating effect on the lives of our associates and, of course, they will never recover the income that they lost during the141-day dispute.

The employers in Southern California achieved significant change in their labor contract, but as we have always said, no one wins in a strike.

Since that time, we have made necessary contract reforms, under settlements, in places like Arizona, Seattle, Detroit, Louisville and Nashville.

We have balanced those changes with our associates need for excellent pay and benefits.

We continue to make progress towards our goal of labor cost competitiveness.

We have important negotiations ahead of us in Las Vegas, Denver and Cincinnati, and we remain absolutely committed to this goal be and every contract.

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

Rodney?

Thank you, Dave, and morning, everyone.

Kroger's net income for the first quarter was $142.4 million, or 19 cents per diluted share.

Net earnings -- net earnings were reduced by $15.3 million, or 2 cents per diluted share, as a result of the premium paid on the early redemption of Kroger's $750 million 7-3/8% note, due March 2005.

The redemption is expected to reduce the Kroger's interest expense by approximately 2 cents per diluted share during the remaining of 2004 fiscal year.

Net earnings in the Southern California stores affected by the labor dispute were $23.4 million, or 3 cents per diluted share, lower than what Kroger expected had the strike had not occurred.

Dave already provided some perspective on what we're seeing in those -- in those markets, including our efforts to return sales and earnings to pre-strike levels.

We will provide additional information after we complete our business plan for 2005.

The $23.4 million is $37.7 million pre-tax.

That's composed of lower gross profits of $55.6 million and lower OG&A of 17.9 million.

The lower OG&A is due to the new contract that is in place, and the lower expenses from lower sales volume.

FIFO gross margin was 25.21%, a decrease of 118 basis points from the second quarter of 2003.

FIFO gross margin at the supermarkets divisions not affected by the post-strike recovery and excluding the effect of fuel declined by 60 basis points.

We continue to see improvement in shrink in some areas as a result of the use of technology and the increased attention that we have devoted to this area.

As we have discussed in the past, our divisions have been working hard to target various opportunities for shrink reduction.

Part of that is helping our associates understand what shrink is, and how we can tackle the problem together.

We are pleased with the progress Kroger is beginning to make.

This continues to be a focus of our entire organization.

Operating, general and administrative costs declined 48 basis points to 18.87%.

The items detailed in Table 2 of the press release positively affected the OG&A comparison by 55 basis points, as compared to the second quarter of 2003.

OG&A at the supermarket divisions not affected by the post-strike recovery and excluding the effect of fuel and the items shown on Table 2 increased 28 basis points.

Health care and incentive plan costs accounted for most of the increase.

Consistent with our strategic plan, our incentive plan this year is more heavily weighted towards sales growth and other factors.

Res expense declined almost $5 million in the quarter and interest expense, after backing out the premium paid on the early retirement of debt, declined approximately $10 million for the quarter.

Total debt was $7.6 billion, a decrease of $615 million, as compared to the second quarter of 2003.

Kroger's cash-flow enabled the Company to the continue executing our financial triple-play of debt reduction, stock repurchase, and strong capital investment.

As you know, Kroger's strategy is to use 1/3 of cash-flow for debt reduction and 2/3 for stock repurchase or the payment of a cash dividend.

In accordance with this policy, we expect cash-flow for the year to support, at a minimum, the $168 million in stock repurchases made year-to-date, and allow for debt reduction.

Diluted shares outstanding for the quarter equaled 744.4 million shares, a decrease of 11.4 million shares from a year ago.

Kroger bought back approximately 1.1 million shares of stock during the second quarter, at an average price of $16.66, for a total investment of $18.7 million.

We have approximately $21 million remaining under the $500 million stock buyback announced in December of 2005.

Since January, 2000, Kroger has invested $2.6 billion to repurchase 131.3 million shares.

Kroger opened, expanded, relocated, or acquired 24 food stores and closed 21 stores during the quarter. 17 of those closing were operational closings including, 14 Ralph's stores, as previously announced.

The Company continues to evaluate underperforming stores, and additional closings are expected during the balance of the year.

The total food store square footage increased 1-1/2% over the prior year.

Capital expenditures for the second quarter totaled $416.3 million.

During the quarter we purchased 8 Thriftway stores in Greater Cincinnati from Winn-Dixie and 3 Albertson’s stores in Omaha.

We are currently remodeling those stores, and look forward to reopening them under the Kroger and Baker's banner, respectively.

Also during the quarter, we completed the remodel of 5 former Fred Meyer stores in Utah that have been converted to the new Smith's Marketplace banner.

We are pleased with the initial performance of these stores.

The continued roll-out of our Marketplace strategy would not be possible without the general merchandise expertise of the great team at Fred Meyer that knows which categories and products to sell.

For 2004, we continue to expect capital investments, excluding acquisitions to total 1.8 to $2 billion.

We continue to emphasize the tightening of capital.

At this point, we expect capital investment to be at the low to midpoint of that range, excluding acquisitions.

Now turning to the labor front.

As Dave mentioned, we continue to make progress in negotiations with the UFCW around the country.

During the quarter Kroger reached major new agreements in Arizona, Detroit, Nashville, Louisville and Seattle.

Each contract has been the result of hard bargaining, compromise, creativity, open communication.

Everyone involved has worked together to craft contracts that manage costs, reward associates, and make Kroger's labor costs more competitive.

Our recently ratified labor agreements have included a variety of measures to bring our labor costs more in line with the competition.

Those measures include a mixture of wage increases and lump-sum bonuses, modest cost sharing by our associates for health care benefits, new higher provisions for pay and benefits, and caps on cost increases in health care plans.

But there's still a lot of work ahead of us.

We currently have contract extensions with the UFCW at King Sooper's in Denver, Smith's and Food 4 Less in Las Vegas, and Food 4 Less in Southern California.

Negotiations are also underway in Cincinnati, where our contract expires October 9th.

We continue to work toward new agreements that meet our objectives in those markets, and we remain hopeful that we can do so without work stoppages.

Our Dave said earlier, our goal in every negotiation is to achieve a balance -- balanced solution that provides our associates with quality health care and fair wages they need, at a cost that is fair to everyone involved, including Kroger customers.

Now I'd like to turn it back to Dave.

Thanks, Rodney.

As we described over the past several quarters, our business model is driven by improving our customer shopping experiences and growing top-line sales.

Our strategy is producing these results in a sluggish retail environment, as shown by our identical sales trend.

During the quarter, we made incremental investments in pricing and promotion to stimulate sales.

We continue to seek the proper balance between gross margin investments, sales and earnings.

We remain squarely focused on offering our customers the service, variety, and product quality they expect in order to drive sustainable and profitable sales growth for the Company.

We will now been happy to take your questions .

Ladies and gentlemen, if you wish to ask a question, please press star, 1 on your touch-tone phone.

If your question has been answered, or you wish to withdraw your question, please press star, 2.

Again, to ask a question, the command is star, 1, and we'll pause for a moment as questions queue up.

And your first question comes from Mark Husson of SHBC.

Please proceed.

HSBC.

A question really for Rodney, when you look at capital, I know you're tightening up capital now, but when you're thinking about returns on that capital, what do you use as normal?

And every time we talk to you there seems to be some gross margin issue and further investments in gross margin, which we've seen again today.

I mean, how much of that was abnormal, because of commodity price inflation?

How much of it is part of the ongoing environment?

If you look at capital, we continue to use for our hurdle rate 11.3% after-tax return.

And we believe our cost to capital is in the 8-1/2% range.

If you look at the stores that we built over the last couple of years, we didn't do as good a job as we would have liked, in terms of estimating the gross margins for those projects.

But if you look at the projects going forward, we're certainly incorporating the current gross margin trend in those projects as we justified those.

So did you clear your weighted average cost of capital on the last couple of years?

Well, as you know, we think we will.

We've just gone through that process.

Now the thing that's, you know, always hard to answer that definitely is our stores mature for about 5 years.

So, we would expect, you know, if didn't have any additional maturity, I wouldn't be able to answer yes.

But if our maturity pattern is consistent with what we've had in the past, overall we would be able to continue to answer yes to that question.

Okay.

Just backtracking on 1 element of the -- of the previous question.

How much of the gross margin investment was competitive, and how much of it was just simply an inability to pass on commodity spikes?

Let me -- Mark, let me answer that on gross margins.

That's a hard one to dissect, but -- but because you raised the issue of how much of inflation are we able to pass through and what happens in the competitive environments.

Well, there's probably at least 3 different themes going on.

The first of which is, it is a competitive environment.

The second of which is, that we have said before that part of our strategy is to be more competitive on price, and that our gross margins would trend downward, somewhat.

And that's also consistent with this.

And then the third, of course, is what's happening with inflation.

And on inflation, we -- we look at that a lot of different ways, but I think it's helpful to separate the items that are increasing in our inflation cost mix, those that are commodity items and those that are branded.

Most of the increase in this last quarter were commodity-like items: milk, cheese, beef, those kind of things.

And when those kind of items are increasing, sometimes you're able to pass them through, and sometimes not and you'll have significant fluctuation.

And then over time, those tend to come back down again.

In fact, we are seeing some moderation forecasted, at least some of the things I read, suggest some of those areas will be moderating in the last half of the year.

But take milk just as an example.

Milk, we are absolutely certain, we were able to recoup our margin as we had costs go up on that product.

But we had a tonnage decline, and that's the mix change that we've often talked about.

When you have increases in costs that sometimes happens.

So, in commodity areas, it is a mixed bag, although in this particular quarter, we think we were able to pass along, at least the big areas, like the milk.

In branded goods, which is a different question on inflation, we did not experience very much cost inflation in branded goods.

But those areas where we did experience some inflation in branded goods, generally speaking, we were able to pass that through in higher retails.

There are some exceptions, but I've looked at a number of examples, and in most cases we did pass those through.

I don't know if that fairly answers your question, Mark.

It does.

So what you're saying is that most of the additional gross margin investment was to keep your growth plan and sales plan on track?

It was a combination of -- of competitive environment in markets and to -- and, what you said, to keep our sales on track.

Now we have said, in fact, I said in my closing about trying to make sure we've properly balanced the sales and earnings combination.

We do think we over-invested just a little bit in the quarter.

And if you look back at the first quarter, we said that that margin was a little higher than what we had expected, because we were a little slower to get our plans in place than we had initially planned, anyway.

In the second quarter, I think it's fair to say, that our margins were a little bit lower than what we had expected.

So if you want to look forward to the last half of the year, I think it's fair to say that we expect the last half of this year to not decline in gross margin as much as the second quarter had declined, when compared to last year.

But individual market competitiveness will ultimately determine that.

Thanks, very much.

Next question?

And your next question comes from Steve Chick of J.P.

Morgan Chase.

Please proceed.

Hi.

Thanks.

You know, I guess, Rodney, the -- the labor cost dispute savings that you guys in OG&A, that you highlight in, I guess it's Table 2, I was actually surprised that there was a benefit to SG&A.

Can you go through that again?

And I want to know if I heard you right in saying that you actually had labor savings that were as a result of the new contract.

Is that correct?

Yes.

As I said, the biggest part of that -- that savings that would be on Table 2 is because of the lower sales volumes, so it takes less cost to have because of the lower volume.

But in addition to that, we did have some benefits from the labor contract.

Now as we go through time, we would, obviously, expect that to be more.

And we continue to have a lot of training costs with new hires, because we continue to hire a lot of new associates in Southern California.

But that's correct but it's, -- it's -- the majority of it would be because of the lower sales, but some of it would be because of the new labor contract.

Is that, you know, the piece that might be because of the new labor contract, is that because a portion of the employees are now in the tier-2 category?

I mean, is it in the wage?

Is it from a wage standpoint or health care or pension or all of the above?

It would be all of the above, Steve.

And we can expect that those savings will -- I mean, net of training costs will continue to go up?

We would certainly expect, going forward, that we would continue to enjoy those savings.

Now, obviously, at the end of the day, we've got to have stronger sales to really take the savings to the bottom line.

Right.

I know you guys don't want to get too detailed about it, but when you say most of it came from lower sales and lower expenses, and a piece came from the labor savings, can you just give us some type of proportion?

No, other than just saying the comment I made before that most of it was because of the lower savings, as Joe Pichler always explained to me, most meant over 51%.

All right.

Okay.

Separate question.

Where do you guys stand with the multi-department store format?

It seems like a format that could be pretty compelling.

You know, I know you've done some conversions, but how much -- how many do you expect to open this year?

And, I guess, why aren't you being more aggressive with opening that format within your capital spending budget?

We -- I assume you're referring to our Marketplace stores.

Yeah, Fred Meyer and Fry's, yes.

Well, what we -- what we've done is, we took the Fred Meyer stores and we've, we have a variant on that theme with our Marketplace store, which is now in Arizona and in, Smith's has some stores in Salt Lake that would be under that banner.

And we have announced our plans to go to Columbus, Ohio, with the same thing.

The reason -- the reason, if you want to think about going at a faster pace is we'd like to make sure it's successful and know -- and know for sure what we're doing and organizationally have our plan together.

And these things that aren't just automatic that you have one store, we're ready to go.

So that's the reason we're not going at a faster pace.

We are actually quite pleased at the working relationship that we have with the Fred Meyer organization.

And I was with Travis yesterday, who really heads up that effort at Fred Meyer, and we're working hard on making sure we have built the bridge well with that organization and the rest of the Kroger divisions in order to make that Marketplace organization work well.

The other thing that was -- that's a critical part of each one of these is making sure that the labor is tied in as part of the strategy.

And if you look in Columbus, our division president there was able to work with the local labor union to get a cost structure in place that allowed that format to be competitive.

And that's one of the critical parts, as we roll it out, is to make sure that we have competitive costs, so that we have competitive pricing.

Do you have the store count number, Rodney?

We have 5 in Salt Lake City.

We have 7 in Phoenix -- 17, excuse me, in Phoenix.

And what's the Columbus schedule that we've announced?

And 3 that we've announced in Columbus, but we're working on some additional sites.

And are the -- generally and broadly speaking, are the economics of these types of stores better than the Company average?

If you look at our return on assets, it's pretty similar to the Company average.

The difference is customers recognize the format and actually tell us they like shopping the store better.

Okay.

Thanks.

Thanks, Steve.

And your next question comes from Chuck Cerankosky of Key McDonald.

Please proceed.

Good morning, everyone.

Start off with, Rodney, did I hear you say you only had, like, $21 million of share repo authorization left?

Correct.

Why -- why are you letting it get so low?

Well, obviously, you know, we want to use up all of an authorization before we do anything else, and at the end of the day, it's left up to the Board what we do.

Obviously, that's an ongoing dialogue that we have with the Board.

But why -- why run it down?

I mean, it sounds to me like would constrain your flexibility to use cash for share repo, and that's always been one of your options.

Certainly from our perspective, it hasn't constrained us in any way at this point.

I think, but, you know, year-to-date, you've done, I guess year-to-date is right up to the moment, 168 million, because that's more than what it says in the cash flow statement?

Correct.

So, you know, you're going at a pace considerably faster than $21 million per quarter.

Does that suggest that you're going to go to the next Board meeting and request an authorization?

Chuck, I don't know that I can really answer that one way or the other.

That will be up to our Board, Chuck.

Okay.

Dave, if you look at, say, your top, 50% of your more customers, say your more loyal customers, and trying to look at them on a monthly sales basis, what's it telling you about their purchase behavior?

Are they trading up in your stores?

Are they spending a greater proportion of their food dollars in your stores?

Are you capturing a greater share of wallet from your more loyal customers?

We don't normally release that kind of data, but I can tell you a longer term picture, which is part of what's driving our strategy, is if you look over a several year time frame, we believe that that number would have trended down.

That is, the behavior of the customers, that they would have shopped more elsewhere than we would like them to do, and then, than they had done in the past.

The 2 big moves that have happened in retail that have created difficulties for the supermarket industry, the first is the whole pricing issue as created by the discount operators like Wal-Mart, but others, too.

But also, the fragmenting of where people shop.

And if you take one of our loyal shoppers today, versus one of our loyal shoppers, say, 5 or 10 years ago, and look at where all they buy goods, it is surprising how many other places they go besides Kroger, and how many other dollars they spend besides at Kroger.

And we're trying to address that to where they see greater reason to shop with us and spend more of those dollars with us.

And it's that trend over the long pull, that over the last couple of years that we've seen that has created the need, I think, for to us move in this general direction.

I don't think we are in a position, though, to report that kind of statistic on an ongoing basis, or at least at the present time.

You don't want to talk about how it's behaved, say, since the beginning of the year versus that trend in the past 2 years?

No, I don't think I have any data that would be helpful there.

I also think one of the things about data like that, we're getting used to using it, but it's still in its infancy stage.

One thing I've learned is that you really need to get long looks at data.

That is, long, meaning time.

Short time frames really don't tell you an awful lot about data like that, because you can have aberrations and we've had lots of aberrations during this year.

We've seen lots of things that, statistically, might be noise, versus meaningful.

And I think the longer time frames you look at, the more likely you are to get to something that is statistically significant.

But, so I don't have anything that I think is statistically significant that I want to report to you this morning.

Okay.

Rodney, I think you mentioned about the bonus package this year, focusing more on sales growth.

What are you looking at, Dave, as well, in terms of making sure there is some balance with regard to cash flow at the store level and operating profit performance at the store level?

Chuck, the incentive plan this year while, as well, as Rodney pointed out, does emphasize sales and other accomplishments related to our strategy.

It is still has a major component that's based on EBITDA.

And that, by itself, if you look just at the incentive plan, certainly provides some balance, itself.

It's just that compared to past years, it has a little bit more focus on the sales and the strategy than in the past.

But actually, the real issue is it relates a lot to our overall business model.

We relate the capital we have to spend in any division to the kind of free cash flow that they're able to generate or not generate.

And so divisions actually are quite focused on the same balance that I described, and that that we are interested in as a Company.

I think that the, one other thing we've learned, actually, over the last several years is that to have a, a sort of a market pressure balance within a company is really a very positive thing to have.

And the market forces we have aren't just the incentives, but include, really, how they get capital, how they spend capital, how we look at the returns, what kinds of raises people get.

Overall, our evaluation of how someone runs a division or how a management team runs a division or how a group of store managers operate a group of stores is based, ultimately, on a variety of factors, all of which include and require balance.

The only other thing, Dave, I'd add to that, just so that everybody knows, you look at our bonus, 1/3 of our bonus is based on sales, 1/3 is on EBITDA, so those 2 components are exactly equal, and then 1/3 would be the other components that we mentioned.

There is an overall limitation that the percent can't go over a certain amount, if with don't achieve certain earnings targets and sales targets.

So that is a limitation on the total.

That, obviously, probably wouldn't apply for the total Company, but it does apply to specific divisions.

One other reason you saw such a big difference in the incentive plan, by the way, was that last year's bonus accrual year-to-date, compared to this year's bonus accrual year-to-date was very, very low last year.

And so in contrast, even a moderate bonus would have shown some big increases.

Anything else, Chuck?

That's all.

That's all for now.

Thank you.

Thank you.

And your next question comes from Meredith Adler of Lehman Brothers.

Please proceed.

Yeah, first I want to go back to the question, I think it was Steve's question, about expanding the Fred Meyer Marketplace stores.

I was surprised you didn't mention distribution as being part of, sort of, a constraint on expanding this.

Is that no longer an issue?

Meredith, it actually in some ways is an issue.

There are some products that we carry in the Marketplace store that we have in regular distribution through our Company, or at least can get them pretty easily.

There are others that are a little harder to do.

But we actually believe and feel that that's going to -- that it will solve itself over time, and we're working in the direction of solving that over time.

So while it's a constraint to the cost side, it's really not a major constraint to being able to go forward.

The biggest constraint is just making sure that we have the economic model figured out in markets where it hasn't -- where the customer -- where it's new for the customer, and making sure that we have a cost structure that supports that.

Once we are comfortable with that, the distribution system will be able to get modified very easily to support that roll-out.

So that includes the labor, that's what you're talking about before.

Correct.

Yes.

And that's a critical -- you know, that's, in terms of being critical, that's one of the most important components.

Got it.

Switching gears, I think I've heard you guys say that sales really are a very high focus, and that if you can get the right volume through your stores, you really start to leverage your expenses well.

You've made some progress, I think, on your price positioning in some market.

Are you seeing, in those places, that the volume and the leverage of fixed costs is doing what you want it to do?

Meredith, in selected markets, we clearly are seeing that.

And even if you look at our total numbers, while our health care costs, for instance, still increased as a percent of sales, and that's even when you take out the, I think, that's -- well I'm sure that's taking out the Southern California divisions.

And even if in that situation, though, we've talked about earlier during the year that health care costs were going to be a big issue this year, because they were rising at a fairly fast clip and we weren't sure that we could recoup it at that kind of pace.

In fact, our sales proved that we could not.

But I believe one of the reasons that OG&A was not up higher, particularly in health care was because we were able, through our sales growth, to leverage some of those expenses.

As our new contracts add additional benefit over time, and as additional contracts that are yet to be negotiated add additional benefit over time, we do expect that even to be more true than it is true today.

Rodney, do you want to add anything?

No.

Okay.

And I have heard you say that you will take those labor savings and continue to invest them in everything from training to competitive pricing and promotion to continue to drive sales.

Is that fair?

Because earlier we were talking about benefits you've gotten in Southern California?

Do you anticipate that that will flow to the bottom line, absent the benefit from sales?

I anticipate that it will be imbedded in the business model for any particular division, and as a result, will most likely be in the frame of reference of part of what helps us achieve the sales growth that we're after.

Now some of the sales growth, of course, comes from lower pricing.

Some of the sales growth comes from different sales initiatives, some of which costs money, but aren't necessarily price investments.

As you point out, some of it has to do with training and service.

But all of those components are areas that we -- we need to spend more money on, and plan to.

And one of the reasons we hadn't spent it before was that our labor costs were not competitive in the markets, when you compare to all the other places that people buy the same products we sell.

And as those costs get more competitive, it's our intent that our pricing and other sales initiatives become more competitive, as well.

And I have one more question for you, or it's kind of a 2-part question.

Are you seeing any acceleration in the pace of rationalization by the weakest competitors?

You talk about Winn-Dixie selling stores in Cincinnati and Albertson's getting out of Omaha.

But anything else?

Do you think the pace is going to accelerate?

And then what about you in markets where, maybe, you are not as well positioned?

Well, the pace, I don't know how you measure it, because it's in fits and starts.

I mean, it has -- you know, you see the examples like you just cited, and then there'll be a period of time where there's not much change.

And then a few other changes like that.

But consolidation in our industry has been going on now, actually, for quite awhile.

But we expect it will continue for some bit of time.

And we certainly see those pressures remaining that will keep pushing that theme.

On the subject of Kroger's markets, we regularly review underperforming assets, and that includes not just underperforming individual store assets, but underperforming markets.

And we regularly ask ourselves, do we have a real future here and a real opportunity here?

Or should we evaluate other approaches?

And you've seen us, just in the last quarter or so, closing some of the stores, rationing some of -- rationalizing some of our assets in Southern California.

That process continues into this quarter, and we expect that that's a thought process, at least, that will continue in our organization, really, probably, as a regular theme in our Company forever.

It should be.

It is to evaluate where we are, and what we want to be.

Great.

Thank you, very much.

You want to add something to that, Mike?

There were 30 -- 33 operational closings that we've made so far this year, Meredith.

And operational closing is a store that we close that wasn't closed because we had a replacement store around the corner, but one we just closed that had previously been running.

But no market exit in that 33?

I don't think there were any complete market exits.

Well, define market.

There might have been a one-store town we got out of, but no -- no market.

I can't think of --

There's a couple of smaller markets where it would be, you know, 2 or 3 or 4 stores that would certainly fall into that, where we were in the process of doing that.

Yeah.

Yeah.

That'd be very true.

Okay, great, thanks.

You're welcome.

And your next question comes from Edouard Aubin of Deutsche Bank.

Please proceed.

Morning.

Just to clarify one point, last quarter you had mentioned a negative impact of approximately 20 to 30 basis points on sale in the first quarter from the of [inaudible] this shift.

So, should we assume that it was a positive impact of the same magnitude in the second quarter?

Yes, you should.

I actually looked at this as a sales graph to get some sense of that.

And while we didn't go back and quantify that number, it's probably in that vicinity, maybe 20 basis points.

But I looked at our sales trends through the quarter, though, and while we did get some benefit there, we had plenty of other weeks that had good sales.

So I wouldn't attribute so much to that to say that that was the reason for the trend.

Right.

Great.

You have anything to add to that?

It's just slightly -- the impact is slightly -- I agree with everything that Dave said, but it, mathematically, the impact would be a little bit more in the second quarter because, just recall, that that's, our second quarter is a 12-week quarter, and our first quarter is a 16-week quarter.

So you do need to make a minor modification for that.

Right.

That would be true.

Right.

Great.

And just regarding what you said earlier on inflation, a few manufacturers have announced over the past 3 to 6 months, you know, some significant increase in their list prices.

Do you see them increases simultaneously allowances to mitigate the impact of price increases, and could this indicator lag, in terms of customer package goods inflation?

We -- it's hard to -- it's hard to quantify in terms of all the consumer package goods companies, what they're doing, but generally speaking, what you said is what we're seeing, is that there have been a few cost increases in list cost.

There have been, for short periods of time, promotional money applied that, in effect, offsets that increase.

But at some point there'll be an end to that promotional money, and those particular branded goods, company's, intend, I think, to end up with their list price where it is.

But ultimately, as we have said before, that ends up getting played out in the market, because, as in years in the past, there is some pressure from our Kroger brand product, which is excellent product, well priced, and may not experience, in some cases, may not experience some of those same cost increases.

And when that occurs, you always have the market pressures of, can they sustain the sales that they need at those higher list prices?

And that is, really, yet to be determined.

But what you said is an accurate description of some of the cost increases that we've seen recently.

Great, thank you.

If you look historically over the last, you know, 5 years, easy, usually when the national brand folks raise their price, if it's not driven by commodity price increases, what happens is the Kroger brand pick up significant market share following that, and that's been the experience time and time again.

I can't imagine that this will be any different.

Now, if it's just driven by commodity price changes, then our Kroger brand will have the same cost changes.

Yeah.

And we think we are well-positioned on the Kroger-brand side of things, both with the quality of what we offer and the assortment of what we offer, and that's one of the reasons over years we've been able to improve our share on -- on our Kroger brand.

Great.

Thanks.

And your next question comes from John Heinbockel of Goldman Sachs.

Please proceed.

A couple things, Dave, can you give us color on how your price perception has changed, particularly in some of the markets you've been at this for 2 years, plus, now?

What magnitude of price perception improvement have you seen?

And what's the typical lag between change in perception and change in actual sales?

Well, all of that, and what you're asking is more intuitive than probably anything else.

I don't know that I can give you a price perception that would be -- would be meaningful in any broad-based way.

I think the best measurement, actually, of price perception is what kind of response we get on sales from those -- in those markets where we have changed pricing.

And what kind of response we get on individual items and where those customers move from and to.

And we are in the process of evaluating that, and we regularly evaluate that because it's important for us to understand as were we do our pricing, to pick the right targets.

So to that extent, I think some of our sales improvement, clearly, and we're very pleased with our sales improvement, as you can probably tell, is clearly the result of some of our pricing strategies.

So that's part of it.

Now, the other side of it is how long do these things typically take?

Well, now I'm switching totally, not to any data source, but my -- my intuition based on having worked in the business for a long time, but price perceptions, if you have a good price perception, and go high and lose it, it doesn't take very long to lose a price perception.

But it takes quite a long time to actually build one.

Because you set it -- I don't know why that is -- but you set a tone in people's minds, and it just stays with them for while.

And the problem is is that we have drive short-term sales pretty easily by being much more promotional.

And if all we wanted to do was just drive some simple sales burst, we can do that starting tomorrow that isn't all that hard to do.

What is hard to do is to do it in a sustainable, profitable way over time.

And that's what we are attempting to do is to get to a price level where we can afford to be, to stay, and to push, and to capture the loyalty of our customers over time and have them recognize, over time, that we're the place to shop.

For all reasons, not just price.

In fact, I can't, maybe overemphasize enough, that it is not just about price, it's about sales initiatives that include price, but also include lots of other sales initiatives that require some investment in training, some investment in capital, some investment in other ways, as well.

And so that's, I think the proof for now, the proof in our -- in our test will be where our sales are tracking, and on that measurement, we can quite pleased.

Where do you think, I know you guys have a number which you've never said publicly, but, maybe, give us a directional sense?

Where do you think -- how much -- how far are you along the path of getting to a price gap with Wal-Mart that you're comfortable with?

You know, 2 years ago, you weren't there, not there today, but you're closer.

You know, where are we on that journey, just maybe, subjectively, where do you think we are?

I think we've come a long way on the journey, but we still have a ways to travel.

And some of the ways to travel in the future, though, I think will come from, and one of the questions earlier, I think, illustrated it, will come from the savings that we find in our markets either on benefits or labor or on other OG&A expenses or on other total costs.

You know, we measure, we look at our total costs, which include advertising and logistics and shrink along with the OG&A costs.

And all of those costs, as those trend down, we see that as the ticket to be able to narrow that gap further and further.

However, we have made the first cut, the first initial cut is a pretty important one, and I think we made good progress in that regard.

And our comparison, we look at our comparison, actually, in 2 ways.

We look, not just at how we would compare to, say, Wal-Mart or other price discounters, but we also look on the other end, is how do we compare to other people we sell products we sell, not just traditional supermarkets, but also the drug chains and so forth.

And on that measure, we clearly have made progress.

When you look more broadly at all of the competitors we deal with.

So I would say we've made good progress, but still have a ways to go.

And I'm not sure I can characterize it any narrower than that.

Rodney, you want to add?

I mean, but it looks to me, based on the studies we've done that your gap with your traditional competitors has never been wider.

How does that influence what you do in terms of the -- you know, that's certain where you want to be versus then, but, you know, that can stall your, you know, your move toward a better pricing position with Wal-Mart.

I mean, it sounds like you'd agree that your price gap with your traditional peers has opened up over the last 2 years.

That's really not in any impact slowed down your rate of investment?

Well, it's -- it's partly because of the rate of investment.

And the reason we get there, the gap from our traditional competitors or from drug chains or from others, and Wal-Mart or other price competitors, when you look at that, if we add more investment on one, we're improving on both measures, actually.

And it hasn't slowed down our investment, but I also want to caution you that in the second quarter, we do recognize that in a few selected cases, we did overinvest a little.

And so I don't want to create some impression that what you saw in the second quarter, take that, you know, lots more of that to come, because that's certainly not my current intent.

I did caveat it with the, you know, ultimately, it's really up to what happens in the competitive markets that we operate in.

That ultimately will determine where we end up, but I think that's just the environment we're in today.

One final thing.

Every few quarters, you guys seem to have a period of overinvestment.

Why is that?

And is there a way to better corral that and manage that so the earnings are a little less volatile?

I would like to say that there is a way.

It is actually hard to do, because we're dealing with individual markets.

And we don't always know before the fact when an investment is going to be a prudent investment and produce value.

The fact that we're saying that there, at least, was some overinvestment in the quarter, at the time we made the investment, we didn't think it was an over investment or we wouldn't have made it.

That part I can tell you for sure.

But it's Monday morning quarterbacking when with look back it, and -- and it's not only me looking back at it, it's the division themselves or individuals things or the parts of the organization or the category management team, wherever the overinvestment may have been made, they look back at it and say, that really wasn't a good use of money.

And so once we do that, we try and share that learning.

We try not to repeat that particular issue, and that particular mistake.

And in this particular quarter we had a couple of markets that -- that were pretty competitive.

And in that competitive environment, we found that we spent some money that didn't -- we didn't have a lot to show for the money spent.

And that sometimes happens.

Sometimes you get in an environment where it doesn't matter how much you spend, you're just not going to get something for it, and as soon as you discover that, as a retailer, generally you back off a little on your spending, and get it back in balance.

And I'd say that's a fair description of what have we saw happen.

I do think that we have actually gotten a little better at the over-investment areas.

You have, you're right, every few quarters, we have a time when we talk about, we had some examples of over investment.

These are different, and I think, to an extent, a little less significant than some of the ones we've had in the past.

In the individual divisions in question, it probably was pretty big to them, but for the Company as a whole, it was not as significant as some others that I've seen us have.

Okay.

Thanks.

Thank you, John.

And your next question comes from Mark Wiltamuth of Morgan Stanley.

Please proceed.

I wanted to get back to the comments Rodney had on the bonus structure with a third focused on sales and third focused on EBITDA progress.

It seems like you've the growth side of the equation mapped out for your managers, in terms of incentives.

But can you talk a little bit about what you're doing in terms of controlling invested capital, inventory management, and capital spending?

If you look at working capital, we would charge interest, or credit interest off of a base, and that interest is added or subtracted from EBITDA.

If you look at from a capital spending standpoint, we keep track of every capital project that we've invested in in the last 5 years and look at the incremental EBITDA that's projected from each project, for, say, 2004, and that is part of what the -- that number is incorporated in our EBITDA when we set the goals for the current year.

And when you look at 2005, we'll do the same process.

But that's how we incorporate both working capital and capital investment into that equation.

So the capital spending decision is more centralized, and then you just aim your managers at the targets?

Allocations are centralized, individual projects are on a division basis while working -- the division working with their senior vice-president.

And the only exception to that would be, like, on a format expansion.

On a marketplace expansion, that would be a coordination of both.

Okay.

And can we also just switch and talk a little bit more about the behavior of the consumer during the quarter?

I know we had some of the other grocers talk about a slow down that they saw on the consumer during June, July, and August.

And we've seen that across many of the different consumers groups, as analysts.

If you could talk about the behavior of the consumer, and did you just offset some of that consumer weakness with your price reductions?

We saw through the middle of the summer, what you said, was a sluggish sort of midsummer, 4th of July was not a real exciting time.

Although, part of that, I think, was driven by the way of calendar fell this year versus the year before.

And when we've studied, in the past, like calendars, the 4th of July was not as much a surprise.

But it -- but it was down and was very much like what other retailers did report.

We still, as we have said, we really are quite pleased, especially in the environment you described and I've just described.

We're very pleased with where our sales were through the quarter.

And while we did have some bouncing around from week to week, that's true both in Southern California and also as -- on a whole.

And that has a lot to do with the competitive market, competitive nature of the market.

We just saw a decent sales growth, and we're pleased with it.

Okay.

And do you have any thoughts of doing any significant cuts to capital spending next year, given that we're still having a very sluggish environment right now?

We're in the process now of working on our 2005 business plan, and certainly, that will be part of that discussion.

We have not made a decision one way or the other, yet.

But at some point, when we talk about the 2005 objectives, we'll incorporate that as part of the -- part of that discussion.

But we are actively going through the process right now.

Yeah.

Mark, I want to go back to your question right before this on the customer, and just reiterate what Rodney had already said in his prepared remarks, which was that we have had 12 divisions that had improving trends from the quarter in identical sales.

The reason we included that is to illustrate that it is pretty -- it is broad-based, that a number of divisions experienced sales growth, it wasn't just in selected markets.

We see that as a good theme.

It's important for us to realize.

It's also, we thought, important for you to see that.

And I think that does give you some indication of the customer and their shopping behavior, at least with us.

We also -- we don't have any mathematical way to measure the impact.

We hear others talk about it, and I suspect there's some truth to it, is the impact of higher gasoline prices to what the consumer has available to spend.

Gasoline was a terrific contributor to our quarter, it had very strong sales.

We're very happy.

We also had strong gallons, by the way.

We're very pleased with our fuel strategy.

Our customers, obviously, like it, and it helps us leverage our C-store operation with our supermarket petroleum group.

That's worked quite well.

But even with those dollars, though, we were able, in that environment, still to grow the sales the way we were, which is why we're quite pleased.

Okay.

Thank you.

Thanks, Mark.

And your next question comes from Jason Whitmer of FTN Midwest Research.

Please proceed.

Good morning.

Hi, Jason.

Dave, you've talked numerous times about trying to find this balance between sales and margins.

Is this just a theoretical target, or is there, in all reality, divisions that have already achieved a good balance?

And I presume you know where that is, or know where that target is it.

And is it, you know, turning into more of a science or an art?

That's a good question.

I'd say it is, we can clearly see it from here.

There are some examples of where we think we've struck that balance pretty well.

But it's a little bit back to, like, John's question earlier of every quarter we're going -- we're going to have some examples, I'm sure, or maybe every few quarters, we'll have some examples where we see that we need to balance that better, at least internally, where we look at individual divisions.

Because it's a moving target, it's a fluid, think of our markets as sort of a mass of water where it's flowing and moving.

And all the competitors and all of the customers are all shifting to certain extent within that environment.

So as you balance it, you're always trying to rebalance.

And so if you are standing in that water, you're always trying to move around to keep your balance just properly positioned.

So it's not something we can mathematically compute, and then be able, as a sense of science, to just move in that direct and stay in that groove.

We always are going to have to make some small, modest changes to our balancing position.

Okay.

If we look a little further out, lets talk first, 2005, and then the next 3 to 5 years.

Do you have any visibility yet on the next year and confidence that you can prevent further earnings erosion?

And in the 3 to 5 years, what do you think will be different, what has to be different, and how does Kroger stands taller than it appears?

We -- in 2005, as Rodney said, we are putting together our business plan now, and don't really have any guidance that we can offer for that year, at least that we're ready to give.

But out in the longer term time frame, 3 to 5 years, I think our picture really looks pretty simply like this: that through our approach to connecting better with the customer, both from a price perspective and a non-price perspective, we expect to be able to improve our sales growth as measured, both in total sales and identical sales -- I happen to think that current best measurement of our progress is identical sales growth without fuel.

We would take fuel out, always, because of how much it can create distortion in the numbers.

And with that -- that growth, we expect to be able to leverage our OG&A down.

We are taking steps to keep our overall costs, not just OG&A, but costs of shrink and advertising and logistics, as well.

Keep those costs down and move them down further.

And as we move them down further, we expect to be able to reinvest that in the business model and make it a more effective business model, further driving the sales.

And so I do expect that you'll see a growing earnings, certainly, in the future.

I think it will be driven more as a result of growth in sales and leverage of that growth in sales, than it will be driven by, we got a big savings in labor contract and, by the way, that savings fell to the bottom line.

So that's the difference, really, in our business practice.

But I want to emphasize, we're looking at this as a total retailer from the perspective of the customer.

We are not trying to be just a pricing story.

While pricings an important element, and that's actually where we started a couple of years ago, we have clearly gravitated to add elements to the plan that are non-price initiatives.

Rodney, do you want to add anything to that?

Okay.

Okay.

Last question, here.

You're looking to understand your customer better, are you seeing some inflections there in some of the data that you're gathering, some of your technology initiatives?

And how do you prevent, you know, just someone walking into your store, cherry-picking your ads and walking out, proving to be a unprofitable visit?

Our -- our data from our Kroger loyalty card allows us, today, to get a sense of who the customers are when they come in and cherry-pick our ads.

And what was it about the ad that causes them to do that?

And it helps us modify our approach.

When I was in merchandising years ago, we didn't have that technique, and all we had to go on was our gut instincts.

And some of the things we've learned from our loyalty card data reinforces our gut instincts were right, but some of the things we've learned have said that our gut instincts were not right on some other issues.

And -- and it's important, maybe, as you think about price, too, also to recognize that a lot of what we're doing isn't just promotional pricing.

If it was just promotional pricing, we could be -- we could run into the problem of just cherry-pickers come in and have a surge of business just on those competitive items that were featured for the week.

That's not at all uncommon to happen in a highly promotional environment.

But combine that with some pricing measures that we've taken, both individually for customers, taking them into account from our loyalty process, but also categories and selected items based on what we see as a purchasing pattern among our customers that we think will address the very balance you're talking about.

Our ultimate success in the long run -- back to Chuck's earlier question, I think -- will be based on capturing our loyal customers, those who shop with us routinely; getting them to shop with us more routinely than they even do today; capturing more of their basket of goods than we do today; and converting more customers who are not among our loyal shoppers today, but who become loyal shoppers because of the offering that we -- that we give.

Our success will not come in the long run from having many more customers who cherry-pick us and come in and just buy our ads.

We recognize that, and are trying to be able to measure that carefully.

Thank you.

And your next question comes from Bob Summers of Banc of America Securities.

Please proceed.

Good morning.

You talked about, you know, addressing some expense items.

I was wondering if you were, you know, at a point where you could start to articulate some of the savings buckets, just to help give us a feel for how much leverage is in the model?

Well, I'll give you a couple of examples of some savings that we've had.

We've talked about some, issues in our OG&A.

We talked about health care and incentive. 2 other areas, by the way, that gave us some cost increases were credit card and pension.

Those weren't -- aren't any big surprises.

We've talked about them before.

But they weren't as significant as health care and incentive.

But on the flip side, we had good stories to tell.

We had a couple of areas that I just picked out to remember to tell you as some examples that have worked out well.

We did well in productivity improvement, that is, the work that was achieved for the hour spent.

A lot of that is driven by process change, and some of it's driven by technology improvements.

We also had good improvement in energy.

Energy is one we haven't talked about recently.

But, as you know, energy costs have gone up, and yet our energy costs -- our energy costs, actually, are down in absolute dollars, I believe that's true.

Well on a same store basis, I know they are.

On an absolute basis, total store, they still are.

Yeah.

Yeah.

So our energy dollar costs are actually down.

So that's because of some very significant efforts.

And that's just an example of where, by us working smarter than we had before, we are able to achieve some savings where, before we might not have seen the opportunity for savings.

And there's a host of other places like that that we think we can achieve savings.

All of which has the opportunity to then to be reinvested into this business model that we've described.

And Bob, we have no shortage of finding opportunities.

Obviously, in the retail business, it's all in the execution, and that's where the focus is.

Okay.

I mean, do, in general, you have, kind of, a guideline on, you know, how much of that you will reinvest, and how much you might, you know, let flow through?

Or is it just, you know as the market dictates, you know, you'll spend it accordingly?

Well it obviously will be driven by the balance of the market at the time, and how we see the competitive picture at the time.

But -- but, mostly and primarily, as we've described, we expect these kind of savings, actually, to be driven into producing more sales.

And then the sales driving us to produce the higher profit, not -- not the savings on the particular item itself.

Okay.

Now you talked about the sluggish midsummer.

I mean, does that suggest that the sales performance, you know, over the quarter was generally uneven?

And if that's the case, could you maybe talk about, you know, what you saw over the last 4 weeks of the quarter?

And then maybe what you've seen, you know, heading out?

I don't think there was anything unusual in the last 4 weeks of the quarter from where we ended up.

The only thing really -- we did have some bounces back and forth from week to week, certainly.

But I would -- I would say, roughly the middle of the quarter was a soft spot.

And the beginning of the quarter driven primarily, but not just by, the switch in Memorial Day from one quarter to the next.

Drove that up a little, and then at the last part of the quarter was -- was back on track again.

So it was just a dip in that soft spot is all we saw.

But even with that, we still ended up achieving sales that we were very pleased with.

Okay.

And then, one last question.

Just on the margins or Kroger brand, could you just update us on where those are?

And I'm particularly carries on, you know, the manufactured side, you know, with where product costs have trended.

Actually, I don't have that at my fingertips.

Rodney, do you have that?

You know, the number that we've always used in the past is about 1,000 basis points, when you look at the margin of Kroger brand versus national brand.

There hasn't been anything that changed relative to that, even with the commodity price changes.

Okay.

Thanks.

Bob, thank you.

After Bob, we will take, then, one more question.

Thank you.

And your last question comes from Phillipe Gousins of Credit Suisse First Boston.

Please proceed.

Yes.

Good morning.

Good morning.

A few questions, here.

A couple of question, perhaps for Mike.

The first one: have all payments been made, now, under the profit and loss sharing agreement in Southern California?

And where might we be able to finds those payments on the cash flow statement?

The payments were made, actually, in the first quarter, and the way you can see those is a reduction in accrued liabilities in our first quarter cash flow statement, because at the end of the year, we had expensed our estimate, and had those set up as an accrued liability.

And we paid those in the first quarter.

Okay.

So that's completely finished, then?

Wonderful.

The second question, Mike, if I look at, kind of, your maturity profile, or your capital structure, you still have some debt outstanding with relatively high coupons in the current environment.

Given the success that we've seen from, for example, CVS, last week when they successfully tapped the market, could we see you guys, at all, looking at, perhaps, the refinancing some of that higher coupon debt later this year?

Well, we effectively did that with the early call of the 7-3/8s that were due in March of '05.

And that actually kept us from having cash invested in our balance sheet not earning very much interest, and allows us to use that cash to pay off the coupon that, as I said, was 7-3/8.

That was a $750 million issue due March of '05.

We have a little bit of mortgage debt that's a relatively high coupon that we pay off December 15th of this year, just a couple hundred million dollars, or so.

Right now, we don't have a terrible amount of actual usage under our working capital, our revolving facility with our banks that I would entertain refinancing.

We continually look at using make-hold premiums and/or tenders to call in some of our long-term debt.

The other thing I would caution you on is don't assume that some of that high cost debt is, what we're paying is the coupon on that debt.

Because to keep our fixed to floating ratio where we like it, a good portion of those debt issuances have floating rate swaps put into them.

So we're actually paying a rate lower than that.

And a lot of that information would be in our footnotes in our proxy from year-end, our 10-K.

Okay.

Great.

Thanks very much, Mike.

Good.

Thank you.

And thank you, all, for joining us today.

Thank you for your participation in today's conference.

This does conclude the presentation.

You may now disconnect.

Have a nice day.