克羅格 (KR) 2004 Q3 法說會逐字稿

Good day ladies and gentlemen and welcome to Kroger's third quarter analyst conference call.

My name is Carlo low and I will be your coordinator for today's presentation.

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

And we will be facilitating a question-and-answer session toward the end of this conference.

If at any time it during the call you require assistance, feel free to press star zero and a coordinator will be happy to assist you.

It is now my pleasure to turn the presentation over to your host for today's call, Carin Fike.

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 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 third quarter press release and our prepared remarks from this conference call will be available on our Web site 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 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.

I'd like to begin this morning by briefly reviewing our third quarter results and sharing some perspective on what we're doing to rebuild sales at Ralph's in Southern California.

Rodney will provide some additional details on the quarter and update you on our progress and contract negotiations.

Then we'll take your questions.

Total sales for the third quarter increased 5.9%, to $12.9 billion.

Identical food store sales including fuel, increased 3.2%, and excluding fuel, increased 1.8%.

This improvement was broad-based.

Ralph's and Food 4 Less stores in Southern California together accounted for 10 basis points of the increase.

We are very pleased with our sales performance in the third quarter.

Kroger's identical food store sales showed strong improvement over the second quarter.

Our continued focus on fulfilling our customer's needs is an important part of our strategy to increase earnings through strong sustainable identical food store sales growth.

Our stores are ready for the holiday season and our whole team is working hard to achieve our sales targets for the year.

The improved identical sales performance in the third quarter versus the second quarter continues to move us toward our goal.

But based on year-to-date performance, it will be a challenge to achieve the Company's previously announced identical food store sales target of 1.3% for the full year, which of course excludes fuel and stores affected by the labor disputes.

Kroger's corporate brands continue to be a competitive advantage.

So far, this year, we've introduced 450 new items in our corporate brand lineup.

Our banner brands are the heart and soul of the program.

Our three-tier branding strategy continues to gain momentum.

The market share of Kroger's private label grocery items in terms of dollars increased an estimated 42 basis points to 24% versus a year ago.

Private label grocery share in terms of units rose an estimated 84 basis points, to 31.72%.

When you look at overall corporate brand dollar sales, the third quarter was our best performance of the year.

In Southern California, we still have a lot of work to do.

Our identical sales, as compared to the third quarter of 2002, are down a little less than 1% for the full quarter when you consider Ralph's and Food 4 Less together.

We are comparing results to 2002, because of the disruption caused by the strike last year.

Ralph's continues to be down, offset by sales increases at Food 4 Less.

We continue to emphasize store conditions, associate training, and competitive pricing.

Our identical food store sales trends in the third quarter did improve at both Ralph's and Food 4 Less when compared to the second quarter.

Southern California is an attractive and growing market.

It is important to remember that Kroger does not have any recent experience in dealing with a strike of this magnitude or the challenges presented during the subsequent recovery period, thus making recovery predictions less meaningful at this point.

We continue to make progress and I have confidence in the business plan in Southern California.

We have a long road ahead, and we expect improvement in GAAP earnings at Ralph's in 2005.

One other comment before I turn it over to Rodney.

I'm proud of the work that our associates across the country have done this year to make Kroger more competitive.

The results are showing up in our top line sales.

At the same time, our entire organization recognizes that there is still a lot of work and significant opportunities ahead for us.

We will continue to focus on becoming more competitive in every aspect of our business, so that we can provide a shopping experience that makes our customers want to return.

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

Rodney?

Thank you, Dave.

And good morning, everyone.

As you probably noticed in our press release, we have stopped reporting a strike effect number for Southern California.

The reason is two-fold.

First, as we move further away from the strike, the calculation becomes less precise.

And second, as Dave said, we expect a significant increase in GAAP earnings at Ralph's in 2005, but not to the pre-strike levels.

As we complete our business plan for 2005, we will evaluate whether projected future cash flows for Southern California require an impairment charge for goodwill.

Kroger's net earnings in the third quarter were $142.7 million, or 19 cents per diluted share.

We estimate that product cost inflation, including fuel, was 2.6%, and excluding fuel, was 1.4%.

Meat and deli were the biggest drivers of inflation during the quarter, and a little bit in pharmacy.

FIFO gross margin was 25.16%, a decrease of 67 basis points from the third quarter of 2003.

FIFO gross margin at the supermarket divisions not affected by the labor stop, the work stoppages, and excluding the effect of fuel, declined by 31 basis points.

This is about half of the decline of the second quarter as compared to the prior year, and it's consistent with what we expected.

We continue to see improvement in shrink in some areas as a result of the increased focus the entire organization has devoted to this part of our business.

Operating, general, and administration costs declined 52 basis points to 18.98%.

OG&A, excluding the effect of fuel, decreased 19 basis points.

OG&A at the supermarket divisions not affected by the work stoppages, and excluding the effect of fuel, increased 23 basis points.

Incentive plan and employee benefit 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.

It is also important to note that in last year's third quarter, there was a smaller accrual for potential incentive plan payments.

Interest expense for the third quarter declined by $30.9 million.

Approximately $18.3 million of this decline is due to premiums paid on debt that was repurchased last year during the quarter.

The remaining $12.6 million reduction reflects lower debt and the lower average interest rate on Kroger's debt.

Total debt was $7.8 billion, a decrease of 607 million, as compared to the third quarter of 2003.

We are pleased with our level of free cash flow.

As you know, Kroger's strategy is to use one-third of cash flow for debt reduction, and two-thirds for stock repurchase, or the payment of a cash dividend.

Kroger continues to repurchase stock.

Diluted shares outstanding for the quarter equaled 742 million, a decrease of 11.5 million shares from a year ago.

Kroger bought back approximately 5.4 million shares of stock during the third quarter at an average price of $15.18 per share, for a total investment of $82.6 million.

At the end of the third quarter, we had approximately $422.1 million remaining under the new $500 million stock buy back announced in September.

Since January of 2000, Kroger has invested $2.7 billion to repurchase 136.7 million shares.

That's equal to more than 15% of the outstanding shares of the Company.

Kroger opened, expanded, relocated, or acquired 30 food stores, remodeled 33 stores, and closed 20 stores in the quarter. 14 of those were operational closings, including six Ralph's stores as previously announced.

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

Total food store square footage increased 1.9% over the prior year.

Our square footage growth continues to decline as a result of the lower capital investment for new stores, and our continued focus on selling, or closing underperforming stores.

Year-to-date, we have had 47 operational closings.

Capital investments for the third quarter totaled $429 million.

We continue to emphasize the tightening of capital.

For 2004, we now expect capital investments, excluding acquisitions, to total 1.7 to 1.8 billion.

This represents a decline of 200 to 300 million from the upper end of Kroger's original estimate for the year.

Capital investments year-to-date, excluding acquisitions, totaled 1.3 billion, down $168 million from 2003.

The year-ago figures exclude acquisitions and the synthetic lease.

Now I'd like to just give a brief update on format expansion.

Earlier this fall, we completed the remodel of five former Fred Myer stores in Utah that have been converted to the new Smith's marketplace banner.

We're pleased with the initial performance of these stores.

In addition, last month, we opened the first Kroger marketplace store in Columbus, Ohio.

We plan to build three additional marketplace stores in that area in 2005.

The continued rollout of our marketplace strategy would not be possible without the general merchandise expertise of the great team at Fred Myer that knows which categories and products to sell, and how to sell those products.

Now, turning to labor negotiations.

During the third quarter, major labor contracts covering nearly 20,000 associates in Seattle, Cincinnati, and at Food 4 Less in Southern California, were ratified without a work stoppage.

In each case, we continue to make progress toward our goal of labor cost competitiveness.

These new agreements have included a variety of measures to bring our labor costs more in line with the competition, including modest cost-sharing by our associates for health care benefits, and caps on cost increases in health care plans.

Negotiations with the UFCW continues at King Soopers in Denver and Smith's and Food 4 Less in Las Vegas.

We remain hopeful that we can reach new agreements in those markets without work stoppages.

Also, negotiations continue in Northern California.

As you know, Kroger has a very limited presence in that market.

Looking ahead to 2005, Kroger has major UFCW contracts expiring in Roanoke, the Atlanta area, Portland, Oregon non-foods, Columbus, and Dallas clerks.

We also have various teamster contracts expiring including one in Southern California, and a separate one that covers several facilitates in the midwest.

We continue to be committed to achieving a cost structure that enables us to grow our business and create more good jobs while providing our associates with competitive wages and benefits.

One final note.

We are currently in the process of completing Kroger's business plan for 2005.

As in the past, we expect to share details of Kroger's business plan including guidance on some key financial metrics, on our year-end conference call in March.

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

Thanks, Rodney.

As we near the end of 2004, Kroger continues to focus on better understanding the needs of our customers and employees.

Our identical food store sales have improved each quarter, our merchandising programs and industry-leading corporate brands are gaining momentum.

We are becoming more competitive on labor costs, and our operators have done a good job of controlling overall costs and improving productivity.

And we have the financial resources to continue building our business for the future.

As I said earlier, we are ready for the holidays, come shop with us, so that you will be too.

We'll now be happy to take your questions.

Carlo, would you like to take the questions?

Yes, sir.

Ladies and gentlemen, at this time if you wish to ask a question, please press star one on your touch-tone telephone.

If that question has been answered or you wish to withdraw your registration, press star two.

Again star one for any questions at this time.

One moment please.

The first question is from the line of Meredith Adler with Lehman Brothers.

Good morning.

I was wondering if you could talk about first just whether you see any increase in rationalization in the markets where you operate given that the economic environment is so challenging, and consumers are really being very careful about how they spend money?

Rationalization of competitive capacity, I guess is my question.

Meredith, I think that's a question of course it comes up each quarter, and I don't know that we've seen anything different than in the past with the current environment.

I think what you're suggesting is that sales are not coming easily for everyone.

And as a result, since it's that kind of environment, it might lead to more stores closing shop and I don't think we'd have any data that would suggest that's either true or not true.

Rodney, do you have anything to add to that?

I would just say it's pretty consistent with what we've seen in the past and it's weaker players where they don't have the higher market shares.

And it's, I wouldn't say it's any faster or slower than what we've been seeing in the past.

Yeah, but it's certainly clearly the trend.

I mean there's no doubt at all about that.

And would you say that you are seeing changes in consumer behavior, you know, during the really weak economy we saw a lot of trading down behavior.

Are you seeing a repeat of that kind of behavior as home heating prices are going up and as you continue to have very high gasoline prices?

I don't think we're seeing necessarily trading down, but I do think it's pretty clear that the sales are harder to get.

Now, I'm speculating but it seems logical to assume that the things you just described are some of the reasons that that's true.

And certainly, what we hear from other retailers, as we hear them describe their sales and their performance, they seem to be describing the same kind of picture.

So you can see, particularly given that kind of a climate, why we are so pleased with the sales that we've achieved, because while we had hoped to achieve higher sales this year than what we've achieved so far, that was our, at least our goal and our hope.

Nonetheless, I think in this climate, we're quite pleased.

And you don't, as I've said before, you don't hear me say I'm pleased with sales very often.

Because that's a target we want to keep pushing ourselves on.

Okay.

Great.

Thank you.

Sir, our next question is from the line of John Heinbockel with Goldman Sachs.

Dave, a couple of things.

If you look at the ex-Southern California ex fuel I.D. how would that break down in terms of traffic improvement and transaction size improvement?

I mean did you see kind of a consistent uptick, you know, through the, during the quarter, continuing through to quarter end?

We, I don't think we plan to give out traffic counts or average sale in Southern California.

No, ex-Southern California.

Oh, without Southern California.

Well we probably won't give that, either.

So I don't know if it matters.

So you were looking without Southern California.

I was thinking you were talking strictly Southern California.

I'm saying that 17.

Is that mostly traffic or even --

I think both are up.

I was just going to say average size per transaction and transaction count both increased during the quarter.

We think our business is coming from both combinations of driving more traffic in our stores and selling more to the people who are there already.

And certainly, our plan and our strategy revolves around doing both those things, not just doing one or the other.

And what about, what was the consistency of improvement during the quarter?

Oh, through the quarter, it really varied through the quarter.

I don't think that there was a crystal clear pattern.

Part of that was the calendar was a little unusual this year.

When you have a leap year, as we do or a leap day in the year, as we did, now you have a calendar shift by two days.

And so whenever you get around to the end of the month or the first of the month, you see a significant swing, and so we saw a pattern that is predictable, but it doesn't make it easy to answer that question.

I guess I'm wondering, of the 17 how representative of that, is that kind of a clean number and representative of, you know, where you are, or is it, you know --

Oh, I see.

Okay.

I would say it's a solid number.

I see it as a clean number for the quarter.

We didn't -- the bouncing around wasn't that significant.

And I felt really solid about the sales in the quarter.

If you look at a rolling average type number, it continued to improve during the quarter.

You know, the 17 or 18 if you include Southern California, is a great all-around performance.

Yeah.

At what point, at what point are you satisfied enough with the sales where the gross margin investments can moderate, you know, back closer to zero?

When do we ever get there?

That's a harder one to answer.

I think as we've said in the past, it is going to have to be, and we intend for it to be, a balancing routine over time.

And that as we find ways to save additional costs, we plan to reinvest in ways that will be beneficial to our customers.

Sometimes that reinvestment will be in the form of pricing as some of it has been up until now but sometimes it will be in other things.

And service and in variety and assortment and what we're doing in our products, what we're doing in some of our perishable departments, all of those are elements that we plan to reinvest in and to improve our performance in.

So we're continually asking ourselves what is that balance need to look like, and certainly, the last few quarters you've seen it taking more on the chin in gross profit, and our expectation going forward though, is that we've got to find ways to save enough money to reinvest further in gross margin profit if we need to do that.

And so we're working hard on the cost improvement side of things and we see lots of opportunity.

In fact I think we've had lots of success in the quarter but we see a lot of opportunity in that area going forward, too.

And one final thing.

If you took the incentive accruals out, what would the expense ratio have been up?

And I guess the harder question, you know, what do we need in I.Ds to get some expense leverage?

You know, you had a good number here, expenses were still up, and do we need a number much higher than 2 perhaps or no?

I want to comment on the latter part and then I want Rodney to comment on the incentive portion of the cost.

I think you can see in our OG&A rate in the quarter, particularly, that we did get leverage from sales.

Yup.

Strongly.

And a lot of that of course was held by fuel.

But once you take fuel out, we still had good leverage with our sales improvement.

And in fact, if I were listening to things that went right on expense control, of course I would list what our operators did, and that our wage costs actually did improve in terms of our overall result there.

I think our operators did a terrific job.

I couldn't compliment them more.

But the most important think that I think improved our OG&A position was our sales growth.

And so we are already getting some leverage with that.

Now, Rodney, you may want to comment on the incentive question.

Yeah, I was just going to.

On the incentive, that negatively hurt OG&A by 16 basis points.

So if you look at the 23 basis points, 16 of it was the incentive.

The other thing, just to follow-up on Dave's comment on the expense leverage, if you look at the supermarket divisions not affected by the work stoppages, and excluding the effect of fuel, the OG&A increased 23 basis points.

That same increase in the second quarter was 28 basis points.

So it did improve on a trend basis by 5 basis points.

And incentive pay was actually a little bit worse as compared to prior year in the third quarter as compared to the second quarter.

So that was even more so.

It sounds like 2% may do it down the road for, you know, for getting an expense ratio decline going forward.

Or that's kind of close.

Is that fair?

Well, those are your words and I'm not going to answer it that same way but I will tell you this year I think we would have seen that already accomplished had it not been for a high health and welfare cost year.

Okay.

Thanks.

Sir, our next question is from the line of Mark Husson with HSBC.

Good morning.

I was looking at my notes for the second quarter and at the top of the page as the conference call started I wrote good sales, lousy gross margins, and were you unhappy with gross margins in the second quarter and thought you over invested.

In the third quarter, it sounds like you are more happy with your gross margin level but we're still a bit baffled at least I am anyway, you're good [own-label], good generics, shrinkage was good, presumably fresh was better.

Can you just talk about the things that were negative on the gross margin, perhaps in order of magnitude?

The biggest order of magnitude effect on gross margin was gasoline margins.

Gasoline margins were down in both the supermarkets and the C-stores and so that's I assume we'll always give you numbers without fuel just because it can cause such high fluctuation and that's one of the reasons we do that.

So you think gasoline margins it's not just the effect of gas prices on the mix, it's the actual cents per gallon margin which was worse?

Both.

Both of those.

The dollar impact and because of high dollars and growth, and because the actual cents per gallon was less, that's true.

Right.

Because we had some rising gas prices.

So if we see falling gas prices in this quarter, typically, you see cents per gallon is obviously you can't generalize, but typically you see cents a gallon expand a bit in the falling cost price environment on gasoline.

That happens I think more often than not.

Okay.

So the biggest one was gas.

Okay.

And then after that?

I don't know that we'd comment after that.

Do you have anything you want to add to that?

It is, you know, we obviously did do some prices, some investment in prices because we talked about that often enough.

Right.

That's price getting accelerating, or is it about the same as it was?

If you look at the second quarter, the investment was about half, or third quarter versus the second quarter, about half what it was in second quarter.

Okay.

The other thing that was a smaller number was obviously as fuel cost price increases, you know, warehouse and transportation costs show up in gross and as transportation costs increase, because of fuel price increases, that also negatively affects the gross rate.

Now there's all kinds of things that we're doing trying to minimize that impact but that is another piece of the puzzle.

Great.

That's much more helpful.

And just on the, you made a comment that you may have to take a goodwill write-off for Ralph's in the future, if cash flows don't improve.

Does that not suggest to you that the strike was a failure?

Presumably, before the strike, you weren't thinking of writing off goodwill on Ralph's, or else you would have done it.

But subsequent to the strike, now you're having to do it.

Doesn't that suggest it was a failure?

Well, we are first not going to comment any further than we what we said on the goodwill part because that won't be determined until we've completed our review and our business plan.

But as to the reflection on whether or not the strike was a strike that should have happened, well, that's a difficult thing to answer, because we've said often before that no one wins in strikes.

We don't like strikes.

We don't want strikes.

We try to avoid them.

It's terrible on our employees.

It's terrible on the Company.

It's terrible on the shareholders.

But having said all of that, Southern California and other markets, too, have gotten in a position in the past where something had to change.

And if that change didn't occur then business as we know it today, anyway, was not going to continue over the foreseeable future.

And so I believe that Southern California was one of those markets and I believe that the changes that had to occur had to occur.

I wish they had not had to occur with the strike.

I wish they had occurred through the negotiation process.

And as you've seen, in negotiations that have occurred since that time, they have.

In fact many of the same kind of changes we made in Southern California have been made in a negotiated fashion in each of the contracts that have been concluded since that time.

Okay.

So a successful failure really stands and falls not on Ralph's but on the entire negotiating environment.

I think it stands and falls on everything and I think the thing really to remember on Ralph's is, is there is a lot more to this story to be written, and I think the time to look back at Southern California is going to be years down the road, and look back and say what does that market look like and the fact that we will be there and we'll be strong and we'll be vibrant in a strong market that we're pleased with, will suggest I think at that point in time that the cost changes did have to occur, and that it was regrettably with the strike, but that they did have to occur and they occurred for a reason, because the economy in terms of our business had gotten out of balance.

And that's what forces those kinds of issues.

They are not easy issues but that's what happens.

One final question.

One other thing to add on Dave's point is we are seeing savings within the contract.

When you look at Southern California, with the new contract, you are seeing savings on the new hires that we're hiring in terms of labor savings, and health care and pension savings, both for existing and new hires.

So we are beginning to see that.

Now, it's hard to see that in the numbers overall, because the strike happened a year ago, and, you know, things get pretty cloudy, but when you look at the absolutely number, there are benefits there.

The final question was just are you prepared to let us know how much of your employees in Southern California are now on the new post-strike rate?

I don't believe, Mark, we're going to answer that.

That I do happen to know, but I can tell you just simply this.

Rodney said that we've started getting some benefits of the savings there.

Clearly, we have.

And the way in which we've gotten that in part has been because we have a significant number of people who are hired under the new portion of the agreement.

And that allows us some savings.

Now, naturally, and you need to remember too, that those are typically the entry level positions, and there is a little higher turnover in those ranks.

So in that particular environment, it's not going to come quickly.

But we are seeing a good strong solid noticeable savings occurring in Southern California as a result of that.

Thanks very much.

Hey, Mark?

Yeah.

One other thing on the goodwill calculation, keep in mind that when you do that calculation, you have to sit here and look out for 15 years and project free cash flows and ultimately present value those back to today's dollars and it's obviously from what we've talked about that cash flow now is below where it was at pre-strike, and although we expect significant improvements next year, it will still be below pre-strike.

So you have the phenomenon that in the early years your cash flows are lower and obviously they get discounted less.

So whatever point, if we ever project something and I don't it to make one way or the other recovery above pre-strike levels, that would be in future years that are more heavily discounted than they would have been prior to the strike.

So part of it, the reason for write-down is purely the way the calculation works.

And I would agree with Dave, any inference of a goodwill write-down would not be any kind of a reflection on whether the strike was a success or a failure because we wouldn't characterize it that anyway.

Right.

Thank you very much.

Yes, thank you, Mark.

Sir, our next question is from the line of Bob Summers with Banc of America Securities.

Good morning.

So it seems that right now, the Achilles heel to the P&L is Southern California investments so I guess, and I know it's a tough question, you know, how do you expect that to moderate over time?

Well, Bob, we, as I indicated, we don't have a lot of experience with strikes like this, at least not recently, and that makes it a bit hard to predict, at least to predict with any kind of degree of accuracy.

Let me just maybe say this about Southern California.

We see Southern California as a great market.

We really do.

We are fortunate to operate in that market with two great formats, Food 4 less and Ralph's.

And at Ralph's we also have the Ralph's Fresh Fare banner as a subset of Ralph's.

These formats really put us in a strong position in that market going forward.

The sales trend as we indicated at both divisions, Ralph's and Food 4 Less, in the third quarter, the trends in third quarter were better compared to '02 than in the second quarter compared to '02.

So that's good news.

And while the profit was not as good in the third quarter, the market was a little bit more promotional, people reaching for sales, people trying to hold on to sales that they got during the strike, that's all, I think reasonably predictable and you can read that just by picking up the newspaper there.

We did see a lot of variances bouncing around in the sales per week and in fact when I was answering earlier John's question, I thought that's what he was talking about, and that's where we did see some high variance.

But generally speaking, we clearly are seeing improvements made.

And there's still a lot to this story down the road.

I think it will be one that we'll want to look at closely -- well, obviously, each quarter we'll be looking at it, in fact we look at it every week, but you'll want to look at it regularly, because as it develops, it will be an important story.

And while we're not exactly where we expected to be, none of us really had a good basis to judge where that expectation should put us, I'm very pleased at the work that they've done there and pleased with the progress that we've made.

One other point, comment, you know, we mentioned we're in the middle of going through the 2005 business plan, but we would expect GAAP earnings for Southern California to significantly improve in 2005 versus 2004.

Okay.

And then, you know, as you think about the benefit from all the negotiated or renegotiated labor contracts, I mean in aggregate, you know, where is that benefited?

And then, you know, what's the expectation in the acceleration in that?

Where is the benefit meaning the dollars?

Or where do they show up?

I know where they show up but just in terms of size, you know, what was roughly, you know, how much did it help this quarter and where would you expect that to be, you know, four and eight quarters out?

We've calculated that but I don't think we're going to release that information.

Clearly, though, the benefits are there.

And they are significant.

And they will grow over time.

And as we've said before, the reason that this became necessary, not just in Southern California, but as necessary in our industry, is that our costs as an industry are just too high.

And that has forced us over the years to reflect it in too high of retails and not sufficient service in the stores and other ways.

And we plan to take those savings, reinvest them in ways that will better connect us with the customer, producing better growth in sales, which then produces growth in profit.

That in essence is our strategy.

And the growth in sales is obviously the key part of what the ultimate savings are, because all of the new hires are in at the new rates and as we grow sales we will get the leveraged benefit from that.

Yeah.

Okay, and then one last thing.

Any change in the CPG inflation?

You want to comment on that?

If you look at, I wouldn't say globally, but if you just look at for Kroger, because our third quarter inflation was lower than what it was in the second quarter for almost every category we track.

When you look at, you know, grocery, meat, produce, those type of broad categories, it was lower in the third than in the second.

Okay.

Thanks.

Thank you.

Sir, our next question is from the line of Jason Whitmer of FTN Midwest Research.

Good morning.

Dave, if you look we're almost three years effectively removed from--

We couldn't hear you and now sorry, the speaker's not working very well in here.

I'm sorry, can you hear me?

Yes.

Dave, we're effectively three years away from the strategic growth plan being established.

What's different today versus when you set up the plan and what do you think might be different three years from now in either in your business or in the industry?

We established a plan roughly three years ago, and in doing so, at the time, we actually made it a pretty simple plan at the time, which was we needed to reduce our retail prices.

We knew that.

That they had grown more to support a profit desire than to reflect what the customers were willing to pay.

We knew to do that, we had to reduce our costs, and we knew for at least a period that our profits may have to, or at least our growth in profits, and sometimes our actual profits, would need to decline.

And we worked our way through that.

But we also knew, even then, although we didn't talk much about it, and have talked much more about it recently, that this really isn't just about price.

Price is an important component of it, but it is also important to look at our assortment and our quality, and our variety and the service we offer, and everything else that goes into make a store what a customer wants to shop in.

And so in recent years, in the last couple of years, we've been focused more on that.

I think what you'll see over the next three, four, five years, I think you'll see increased emphasis and increased focus in our organization on sort of the non-price elements, those elements of assortment and quality and variety and service and so forth.

I think you'll see more of that.

Now that's not to suggest that we're done with pricing completely.

It's not to suggest that pricing is not important.

It's to suggest that we have come a significant way on the pricing elements.

And we think we need to save our way into doing much more, if there's much more to be done there.

And that we also think that there are other elements that are not price related that will help improve our sales, will help improve our connections with the customer, and that is the primary part of our focus currently.

And has actually been for roughly the last year.

Granted, the strike has distracted a lot of our discussion, because a lot of the discussion focuses around that impact, because the impact was so significant.

But if you boil it down, our strategy really is I think a pretty simple one; is to understand and connect better with our customer, to reflect both the data we get through things like [inaudible] Humvee and otherwise, and to reflect our own retail thinking and to providing the customer with a better shopping experience so that they want to return to Kroger.

How close are we to getting some tangible cost savings that can actually start to offset your margin investments or the margin hits, either in labor other?

Can you give a general time line?

Is this something that could happen next year?

Are we still a couple of years away from actually making material progress on that?

I think it depends on a lot of variables that are hard for me to predict.

As I mentioned earlier though, I actually think we would have achieved that this year but for the fact that health and welfare costs generally around the country, not just with us, but anybody who provides health care benefits, saw such significant rises this year and the year before and I think even the year before that.

Those kinds of cost increases are hard to overcome in a period of low inflation or in fact deflation.

And I think the story of the supermarket industry and certainly the story of Kroger in the last couple of years, includes at least one chapter about the periods of deflation in terms of what our retails were doing, and our margins were doing and at the same time overlayed on that some significant cost increases in a sector like health care that were impossible to avoid.

If that starts to swing to change and we think some of our contract work that we've done will help it change, but if that changes much at all, I think you'll see that happen, that our OG&A as a rate of sales will actually decline in the not too distant future.

I think our sales improvement in the quarter clearly helps us in that regard and will clearly help us into next year in the same way.

That's the best thing we can do to improve our OG&A rate in addition to what we've done with contracts and with reflecting the organization to look at all costs.

We've recently done a lot of work on a lot of cost areas, and we see really frankly a lot of opportunity.

The more, it's always amazing but the more you look, the more you find.

And we find some good opportunities ahead, and so I'm very optimistic about our ability to bring costs down over time particularly in an environment where we can grow our sales.

Thanks a lot.

Thank you.

Sir, our next question is from the line of Jack Murphy with CSFB.

Good morning.

Good morning, Jack.

Just like to go back to the Cap Ex reduction for a minute.

And I know you were really only referring to '04, but could you give us a sense of how permanent that 200 to $300 million reduction is going forward?

In terms of giving full detail, obviously we'll do that in March.

But if you look at the run rate, we would expect the run rate for capital going forward to be pretty consistent with what we're talking about.

As we said on the call, you know, we continue to tighten, and we would expect to continue to tighten a little.

Okay.

That's helpful.

And then just a couple of follow-ups, from earlier questions, just to clarify, on a follow-up on an earlier question, in pennies per share, did gas help or hurt earnings in the quarter?

The fuel, I should say.

Well, let's see.

I don't know.

Dollars, did we go up in dollars?

If you look at year-on-year, it would not have helped.

But if you look at it in terms of contributing to earnings, it did.

Now, the number, if you exclude C-stores, if you just look at supermarkets the number is so small, it really doesn't, it affects the rounding and that's about it in terms of the number.

Obviously the sales are a lot bigger than what you make on fuel at the end of the day.

We are pleased with our fuel operations by the way.

Both C-stores and supermarkets and at times like this with high prices, it gets a little strained in terms of margins, and gasoline sales and margins tend to fluctuate around a lot.

As you probably know, we have a long experience with the C-store business, since I think about 1960, and gasoline has long been a part of our history as a result, and you do see those kind of fluctuations from one quarter to another.

In fact you actually see them from one day to another.

And if you look at just gallons on the, like the C-store side as an example, identicals were a positive 4.5% for the quarter, so the gallons or tonnage however you want to look at it improved nicely and the supermarkets also experienced similar type growth.

And that's not often the case in prices like they are now in gasoline.

So we're obviously gaining in our position.

So we're quite pleased with that.

Okay.

And then just a couple of quick ones.

You mentioned guidance on key financial metrics on the next call.

Would that include earnings per share guidance for full-year '05?

We really, Jack, we really haven't decided on that yet.

Obviously, we'll think through it and give it a lot of conversation, but we haven't made a specific decision on that at this point.

Okay.

And last question is on, just on the tax rate for the fourth quarter.

Do you have a sense what we should expect there?

It's probably easier if you just look at for the full year, we would expect the tax rate to be about 38, or I guess for the full year, 37%.

For the full year.

Thank you.

Sir, our next question is from the line of Chuck Cerankosky with Key McDonald.

Good afternoon, everyone.

Or good morning.

In, can you hear me all right?

I can barely hear --

I can hear you Chuck.

It sounds like you're in one of our stores.

I'm in an airport.

Okay.

Well, they're similar traffic.

That's right.

First question.

When you're looking at the OG&A ratio as reported in the consolidated P&L, or pulling out strike-affected divisions, what really matters?

What should we be focusing on here?

Well, to understand our OG&A rate, I think there's two, at least two things, maybe three things that I think really matter and to answer that you got to look at all the numbers.

First is, as I mentioned, fuel helped us and sales growth generally helped us reduce our OG&A as a rate of sales.

So you got to look at the total number to understand that.

Strip out fuel and you can see that even without fuel, but with Southern California, and mid-Atlantic, to West Virginia area included, in that environment, we still made good progress.

Which suggests that depending on what it looks like once you take those out, suggests that the contract did help produce some savings.

And then when you pull those out, and then look at the Company on an ongoing basis, where there wasn't as much significant change as there had been in those other pieces of the business, gasoline and the strike-affected divisions, now you see that OG&A did go up a little, but less than last quarter, and a significant part of that was driven by the incentive plan, which was significantly different than last year's 16 basis points.

So you can see it really was a very modest growth in OG&A.

And it was only in that context.

So that's how I would look at it.

Rodney, you want to add anything?

Okay.

Thanks.

You guys have some feel for the economy, or what you're expecting, and as you look out to next year, Dave, and you're developing your storing plans, which I imagine are pretty well along at this point, are you looking at more of an upscale or downscale flavor for to what you put in place in terms of remodels, relows, new stores, and that is, are we going to see a little bit more weighting towards Food 4 Less or more fresh fare or in the banner combos or are we going to see the merchandising be a little bit more upscale or downscale based on what you think the economy is doing and what the customer expects from a Kroger store?

Well, as is traditionally the case, I think with people thinking about the economy, is I tend to think where we are is where we're going to continue to be.

Not being an economist, I can't see what those change elements are that are going to drive us out of the particular position we're in now.

What we're in now is actually, I think it's a good economy, but there is some restraint on spending.

As was earlier suggested, perhaps it's driven a little bit by gasoline prices and heating costs, and so forth.

But I don't really know that.

I just know there's some constraint on buying patterns.

However, I don't think that the market is necessarily stepping down to just price sensitive kinds of buying.

I think the market is fragmented.

And that's one of the reasons we're best suited I think in this kind of environment.

In fact, that's one of the reasons I pointed out in Southern California that we have not just the Food 4 Less banner which we're very pleased with, but we also have the Ralph's banner and the Ralph's Fresh Fare banner, because we address all of those segments, and so ultimately we don't really have to predict as much as we have to figure out the right neighborhoods to put the stores in that we need to put in.

Our view, I think is, we're trying to address all of those areas, because we think all of them are true in today's consumer.

There are plenty of customers who want to save money on everything they buy.

Very sensitive to the prices.

Our Food 4 Less banner works well there.

We also have some pricing that happens in our regular Kroger stores that actually address that similarly.

But there is plenty of folks in our customer base who like the shopping experience and even if they're tight on money, that's the place they choose to spend what money they have.

We have a saying that everybody saves where they can so they can spend where they want to.

And you'll see people spend in ways that don't, are counter-intuitive to the economy, and I think our stores will be well positioned to serve their needs.

The only other thing I'd add on to that is that we continue to focus more and more on within the wall remodels and expansions and really making sure we understand the trade area and having the store address the trade area.

Yeah, each of our stores we're trying increasingly to make sure it reflects what that store's mission is.

I think that's exactly right, Rodney.

Thank you.

Okay.

What's the early read on the co-branded Master Card with those unique points in the Cinci-Dayton area?

So far, so good.

We're pleased.

Rodney is the chief architect on that program so maybe you want to comment on it.

Other than saying we're very pleased with the initial reaction, we feel thrilled about our partner, Royal Bank of Scotland, and our customer feedback's been good.

So, so far, so good.

But still a lot of work ahead.

Next week, I'll be using my refund or bonus checks back from them in our stores, so that's the beginning of cashing in on the points earned.

If you don't have a Kroger Master Card, you ought to get one because I guarantee you it's the best value out there and you get Kroger gift certificates that you can spend in any of our stores.

Open some stores in Cleveland and I'll get one.

We have jewelry stores there and you can use them in the jewelry stores.

Oh, yeah we do have jewelry up there.

And Chuck, it's the right holiday season for jewelry.

Thank you very much.

Thank you.

Sir, our next question is from the line of Perry Keiko with CIBC World Markets.

Good morning.

On your point about I guess eventually shifting away from the emphasis on pricing to other elements within your stores, I'm wondering if you find right now that different formats that you run require more or less pricing investment?

I'd say definitely yes.

The Food 4 Less kind of an operation is focused on the person, the shopper who is more sensitive about price.

And so the gross margin requires, the requirement is that it be lower.

That's not necessarily in a promotional sense.

It may be in the every day pricing.

But the overall business model of an operation like that requires lower pricing.

And requires ultimately lower gross which then requires of course lower costs to operate.

The same is, or the flip side of that is in a typical combo store, I think you would see the gross margins would vary from one store to another across the whole U.S. for us, and part of that is because of the reflections of the mix that you sell in a store.

And if you have a store that is more focused in a neighborhood where we have very price sensitive kinds of customers, you will see typically that that mix will be a little bit different, and it's not necessarily a bad mix.

It may produce and sometimes will produce a lower gross profit percent, but often in families like that, that do an awful lot of their shopping with us, rather than restaurants and other outlets, and as a result, we end up with better sales from them, and it's a very profitable customer, in that environment.

Similarly, though, we see in a really upscale area, upscale store, we see a lot of upselling there, and gross margin can improve in those settings, particularly in some of the fresh categories, and that's driven more by the percentage of sales of those categories than driven by having higher prices in those areas, it really ends up being the mix of what you sell that produces that more than a radically different price structure or something along those lines.

And as you build out larger stores I guess either under the Kroger or the various marketplace banners, it seems that there's obviously a lot of added place going to general merchandise or just selected dry grocery categories.

What about the fresher perishable departments going forward in stores of that size?

Are they being expanded as well or is your focus in other places?

Of course, you're right about the general merchandise being expanded and that improves our position in two ways.

One is you generally get a little bit higher margin perhaps in that area, but maybe more importantly, is we can expand the products that we sell, and so it's incrementally new business for the store.

When you look at what we're doing in fresh and perishable categories, sometimes we're increasing those and sometimes not.

We just opened a larger store here in Cincinnati and we have additional perishable space there than some of our other stores but we also have additional general merchandise space in it as well.

And it really depends, I think, upon the market and the area we're serving and how well those perishables, markets, and departments are developed in that particular division.

You know, in some areas, you will see a Starbucks, I never know how to define that, whether it's a perishable department or not, but it's something our customers appreciate, In some places you'll see Boarshead deli meats.

And it really is more department, store specific for that trade area.

Yeah, Starbucks would take a little more space, but the Boarshead actually doesn't take additional space as much as it takes a presentation and a commitment.

And my last question is, you look at the future of each of your formats I guess conventional stores, discount marketplace, fresh fare, which ones do you see driving the business going forward?

I could guess related to that which ones are the most differentiated from mass and alternatives, or do you see it as being a blend?

I think it will be a blend.

I also think that you will see our traditional combo stores become different from one another more than in the past.

And so what I think you'll see is clearly a blend.

I think you'll see stores trying to address their particular customer base better than they have in the past, and I don't think, at first you're not going to see some big dramatic change and walk in the store and say oh, that's radically different, but the people who will notice are the customers whose needs are being satisfied better than they were before.

And I think it will show up in sales.

It will show up in our research.

It will show up in a lot of ways.

Thanks.

Thank you.

Sir, our next question is from the line of Monica Aggarwal with Merrill Lynch.

Good morning.

Good morning.

Are there any new initiatives in place in your private label program to see the strong improvement and how much might it have contributed to gross margins?

Well, there's not any radically new change in our Kroger brand strategies.

We are focused on it.

But we have been for a long time.

As you noted in the call, we have added this year I think it was 450 new products, which is pretty significant.

In recent years, we added the private selection products, which are the upside of our branding, and we have also focused on the more cost competitive products.

Those are listed under several brands but usually for maximum value, and all of those I think the combination of those have worked well.

And I think it's the combination of that, over time, that has continued to grow our business.

We're very pleased with our Kroger brand business.

We think it is a competitive advantage, not just because it gives us product that we can sell that no one else carries, that our customers really like and appreciate, but it also helps our mix, because we do it so well.

Okay.

And then one of your competitors has seen sales return to pre-strike levels in Southern California.

What are you doing differently or likely to do differently going forward to get to pre-strike levels?

We keep looking at Southern California and our operators there keep looking at Southern California to focus on how we operate the stores, how we connect with the customers, how we work with our associates, and how we work through our recovery process.

I'm actually very pleased with what they've done.

As we mentioned, we have, if you combine Food 4 Less and Ralph's together, our sales for the third quarter, when compared to two years ago, were down less than 1%.

So that's pretty good recovery when you compare the two.

But obviously, Ralph's is still down and Food 4 Less is still up.

Both of those formats though, not just Ralph's but both of those formats improve those trends in the third quarter, from where they were in the second quarter.

And so I think all of that's going to contribute to our recovery.

We are clearly not yet satisfied and we know we have lots more work yet to do, but I'm very pleased with the position that we find ourselves there in terms of the future prospects, the future opportunities that it presents for us.

Thank you very much.

Thank you, Monica.

We'll take one more call after her.

Sir, our final question comes from the line of Stewart Frio with Hunter Global.

Yeah, Dave, I mean you just mentioned that the sales are back to 2002 levels in California, and I'm guessing given the new labor contracts that your labor costs should be lower, so why do we get a big earnings recovery in Southern California in 2005?

Well, remember that at Ralph's, the business is still down.

Food 4 Less, the business is up strongly.

And the two together is where we're to the 1%.

And as you see, what we're seeing is, each store, think of a store as almost as a fixed asset.

And in the sales that go through there, it is very sensitive to the sales level that goes through those stores.

I was asked, I don't know, some months ago, about a recovery in sales, and whether or not I was, they wanted to have sort of a big view of whether they were, I was concerned about recovering to the 90% level and I said, and I still feel the same way is that the 90% is not what I'm worried about.

It's those last few percentage points that are very expensive because you lose that, it's highly incremental profit to you, and as a result, many of those stores with their sales position, at the Ralph's stores, are not producing the kind of profit that they could produce, and so until we get that productivity in sales up where we need it to be, I don't think we're going to end up happy with what we have achieved there yet.

But I think it's a matter of time.

It's not a matter of whether it will happen, it's a matter of when it will happen.

I mean don't you think that once you get back to that 100% level that those sales will have a structurally lower gross margin than pre-strike?

Yes, I think the sales, well first the sales at Food 4 Less already have a structurally lower gross margin than at Ralph's and so that's problematic.

I'm talking about at Ralph's when Ralph's gets back at 100%.

At Ralph's, I do expect that Ralph's will have a lower gross margin going forward but they'll also have a lower cost structure going forward.

I mean that was the whole idea.

And so it does produce profit and it can produce profit that's pretty significant.

Now, when it will get back to the kinds of margin percentages that we had before, I don't have any idea there.

And in fact, that's not how I'm thinking about the business.

I'm thinking about the business in terms of dollars, and growing the business, growing the sales, and getting the efficiencies of those sales growth to produce profit growth.

The other thing, when you look at 2005 relative to 2004, if you recall in the early part of 2004, we were still on strike, were still in lockout mode.

So we had the expense associated with that.

We the expense associated with the strike assistance agreement, obviously as the strike, or the strike lockout ended, cleaning the stores up and those kinds of things, those expenses we will not have in 2005.

That's also contributing to the increase.

That's true.

Yeah, I guess my concern is that, you know, last year in the third quarter we had a full strike impact, or not a full, but a strike impact in that quarter and now we have a recovery period and your operating profit is only up $13 million.

That's true.

The strike last year was --

19 days or something.

Was it three weeks in the quarter?

Four weeks in the quarter last year.

Roughly it was four weeks.

Okay.

Last year.

I should know that exactly but that's pretty close.

Okay.

Thank you.

Uh-huh.

Thank you.

Well, we want to thank you all of you for joining us.

I really meant what I said, our stores are ready for the holidays.

We hope you'll come shopping with us.

We wish all of you a happy holiday season and we appreciate you tuning in today.

Thank you.

Ladies and gentlemen, we thank you for your participation in today's conference.

This concludes your presentation and you may now disconnect.