克羅格 (KR) 2004 Q4 法說會逐字稿

Good day, ladies and gentlemen, and welcome to The Kroger Company fourth quarter 2004 earnings conference call.

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

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

We will be facilitating a question-and-answer session during today's presentation.

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

I would now like 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 today's discussion 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.

I would also like to remind you that, as previously announced, Kroger will restate prior-year results to correct its accounting for leases.

The preliminary results reported today exclude the effect of the correction.

Both our fourth 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 the call over to Mr. Dillon.

Thanks, Carin, and good morning, everyone.

We appreciate you joining us to review Kroger's fourth 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 would like to begin this morning by briefly reviewing our fourth quarter results, and 2004 market share information.

I will also share some guidance for 2005.

Rodney will provide additional details.

Then we will be happy to take your questions.

Total sales for the fourth quarter increased 5.1 percent to $13.7 billion.

This growth resulted from strong sales at the Company's food stores, including fuel, as well as the convenience and jewelry stores.

Net square footage at the Company's food stores increased 1.2 percent.

The details on our identical and comparable food-store sales are available in our fourth quarter earnings release.

Here are the 2 figures that we believe best illustrate Kroger's progress.

Identical food-store sales, without fuel and without southern California, rose 1.9 percent.

Comparable food-store sales on this same basis rose 2.3 percent.

We are very pleased with our sales progress in the fourth quarter.

Kroger's identical food-store sales, without the effect of fuel and southern California, have shown sequential improvement for 7 of the past 8 quarters.

And for the fiscal 2004, we achieved identical food-store sales, excluding fuel and southern California, of 1.2 percent, extremely close to the target we established at the beginning of the year.

These sales figures are a clear sign that Kroger's strategic focus is on fulfilling the needs of our customers continues to generate positive results.

This momentum has continued in fiscal 2005, with identical food-store sales through the first 5 weeks, running ahead of our fourth quarter results.

In southern California, we are working to rebuild our business.

Ralphs and Food 4 Less have faced one of most challenging periods in their proud history.

They have confronted a variety of obstacles, including promotional battles, store conditions, personnel changes and morale issues.

That would overwhelm many retailers.

Yet Ralphs and Food 4 Less have tackled every issue head-on and I appreciate that.

The recovery in southern California has been slow.

Identical sales as compared to the fourth quarter of 2002 are about the same as in the third quarter of 2004.

We are not back to pre-strike levels.

As a reminder, we are comparing results to 2002 because of the disruption caused by the strike in 2003.

Ralphs is making some progress.

As I said before, Ralphs has a great plan in place and we're executing it.

I have a lot of confidence in both the associates in our southern California region and our business plan for that region.

Both are keys to our success.

Taking a quick look at some other areas of our business, Kroger's corporate brands remain a competitive advantage.

During 2004, we introduced 765 new items across all 3 tiers of our corporate brand lineup.

In the fourth quarter, the market share of Kroger's private label grocery items in terms of dollars increased an estimated 67 basis points to 24.60 percent versus a year ago.

Private label grocery share in terms of units rose an estimated 144 basis points to 31.72 percent.

One other item of note on our corporate brands, customers are increasingly recognizing the quality and value of our private label offering.

In customer taste tests, 50 percent chose our banner brands and 10 percent had no preference when compared to the leading national item.

Turning now to Kroger's performance in major markets in 2004.

We define a major market as one in which we operate 9 or more stores.

The market share figures that we report are based on internal estimates.

We include all retail outlets that sell merchandise comparable to our own, including supercenters, and other nontraditional retail formats.

Most third-party market share data providers do not include the alternative formats.

Thus, the market share figures that I am about to provide will show -- will generally show less favorable results than those you may have seen.

Kroger competes in 52 major markets, including 7 in California.

For 2004, Kroger held the number 1 or number 2 share in 40 of the 52 major markets.

Kroger's share increased in 23 of these 52 major markets in 2004, declined in 27, and remained unchanged in 2. 6 of the 27 markets in which our share declined are in California, including 5 that were significantly affected by the southern California labor dispute.

On a volume-weighted basis, Kroger's overall market share declined slightly in our 52 major markets.

Kroger competes against a total of 1,020 supercenters.

There are 33 major markets where supercenters have achieved at least a number 3 market share position.

In 2004, Kroger's market share increased in 17 of those 33 markets, declined in 15, and remain unchanged in 1.

On a volume-weighted basis, Kroger's market share rose slightly in those 33 markets during 2004.

Kroger competes against 781 Wal-Mart supercenters.

This reflects an increase of 103 stores, compared to a year ago.

Wal-Mart supercenters have achieved at least a number 3 share in 24 of the 33 major markets where we have significant supercenter competition.

Kroger's market share increased in 8 of those markets, declined in 15, and remain unchanged in 1.

On a volume-weighted basis, Kroger's market share declined slightly in those 24 markets during 2004.

So what does all this data mean?

Well, to us, it suggests 3 themes that are currently indicative of our business.

First, as I described earlier, we know the challenges we face in southern California, and have a strong plan in place to address them.

Second, the pace of Wal-Mart's aggressive expansion into the supermarket industry shows no signs of slowing down.

We have factored this reality into our business strategy and we are confident in our ability to compete effectively with Wal-Mart and other operators.

Third, Kroger achieved measurable sales growth last year in the face of substantial supercenter expansion in our industry.

Our market share was about the same.

These statistics are a further indication that the retail supermarket industry has fundamentally changed and will continue to change in the coming years.

We were the first traditional retail grocer to recognize these fundamental shifts, and that's why we began to change our business model in 2001 to meet the competitive challenges.

We have made measurable progress since 2001, and we expect to continue that progress in 2005 and beyond.

With, that I will turn to our expectations for 2005.

Kroger's growth strategy is squarely focused on consistently meeting the needs of our customers by our associates providing improved service, selection, and value.

We have made considerable progress, and in 2005, the successful execution of our strategy will be clearly evident in our financial performance.

Kroger expects 2005 net earnings to increase compared to 2004, excluding the effect of the goodwill impairment charge.

We expect this earnings growth to be fueled by improved results in southern California, growth in the balance of the Company, and lower interest expense.

As a result, we expect net earnings in 2005 to exceed $1.16 per diluted share.

Also included in this guidance for 2005, Kroger expects to achieve in excess of 2 percent identical food-store sales growth.

This figure includes southern California, and excludes fuel sales, and to generate cost savings and productivity improvements, which will be invested in improving our customers' shopping experiences.

I would like to clarify a few points with regard to our 2005 guidance.

First, we included southern California in our identical sales target because we expect those results to mirror the balance of the Company.

Second, although we do not give specific quarterly guidance, we do want to provide you with some color as to how to see the quarters playing out, -- how we see the quarters playing out during the year.

We expect the first quarter to be the most challenging in terms of sales and earnings comparisons, to prior year.

Comparisons for the second, third, and fourth quarters should be easier.

We believe that the first quarter will be a little better than our fourth quarter trend, and expect continuing improvement from there in the following quarters.

Certainly, there could be some variability on our individual quarter basis, particularly in our southern California operations, because of the comparisons to last year's recovery period.

Now, I will ask Rodney to provide some additional perspective on Kroger's fourth quarter, and fiscal 2004 results, as well as some additional guidance for 2005.

Rodney?

Thank you, Dave.

And good morning, everyone.

As Carin mentioned at the beginning of the call, the preliminary results that I will be discussing today exclude the effect of the correction that Kroger intends to make related to our accounting for operating leases.

Because we are restating our financials, a final income statement, balance sheet, and cash flow statement will be provided when we file our 10-K.

Kroger reported a net loss of $675.9 million, or $0.93 per diluted share for the fourth quarter.

These results include a noncash goodwill impairment charge of $884 million after tax, or $1.21 per diluted share.

This relates -- this is related to the Ralphs and Food 4 Less operation.

Basic and diluted shares are the same due to the loss.

Otherwise, diluted shares would have been 732.4 million.

The impairment charge was the outcome of our annual evaluation of goodwill as required by the accounting rules.

You might recall during our third quarter earnings call, I indicated that we were reviewing the projected cash flows for our southern California business to evaluate whether an impairment charge for goodwill would be necessary during the fourth quarter.

The charge adjusts the carrying value of the impaired goodwill to its implied fair value.

Most of the impairment charge is not tax deductible.

So the pre-tax and after-tax amounts are only minimally different.

Now, turning to gross margin and OG&A.

FIFO gross margin was 25.08 percent, a decrease of 135 basis points from the fourth quarter of 2003.

FIFO gross margin, excluding Ralphs and excluding the effect of fuel, declined by 91 basis points.

While directionally, a decline was expected, frankly, we were more aggressive on pricing than we had planned.

We are not happy with these results.

In 2005, Kroger is determined to maintain its sales momentum while improving earnings.

Our strategy contains many non-price elements and our incentive plan for 2005 strongly motivates us to execute broadly on these non-price elements.

One aspect of our gross margin that does please us is the continued progress we are making on shrink reduction.

Particularly in grocery and drug GM.

Thanks to our associates’ focused efforts in these areas.

We expect to deliver additional shrink savings in 2005.

Operating, general, and administrative costs declined 131 basis points to 18.38 percent.

OG&A, excluding the effect of fuel, decreased 103 basis points.

OG&A at the supermarket divisions, excluding Ralphs and excluding the effect of fuel, decreased 2 basis points.

This reduction in OG&A rate in the fourth quarter resulted from our ongoing cost containment efforts and the leverage from our sales growth.

Even health care costs declined slightly as a percent of sales.

This is the result of progress we have made during labor contract negotiations.

Benefit costs in several of our markets still need to be addressed.

We expect additional improvement in our OG&A rate in 2005, particularly as we leverage increasing sales and cost reductions in key areas of our business.

Kroger also continued our share repurchase and achieving our financial triple play.

During the fourth quarter of 2004, Kroger repurchased approximately 4.2 million shares of stock at an average price of $16.52 per share, for a total investment of $69.2 million.

There are approximately $353 million remaining under the new $500 million stock buyback announced in September.

Since January of 2000, Kroger has invested $2.7 billion to repurchase $140.8 million shares.

The Company continues to buy back stock.

In 2004, Kroger's cash flow enabled the Company to continue its financial triple play of first, reducing total debt by nearly $400 million, to about $8 billion.

Net interest expense for 2004 decreased approximately 8 percent as compared to the prior year.

This is a direct result of our lowering -- lower borrowing and a lower average borrowing rate.

Second, we repurchased $318.7 million worth of stock.

And third, we invested $1.6 billion in capital projects.

Kroger continues to tighten capital investment which has slowed the growth in our depreciation expense.

An additional note on capital investment, last year, Kroger opened, expanded, relocated or acquired 111 food stores, remodeled 135 stores, closed 79 stores, including 56 operational closings.

Turning now to labor negotiations.

During the fourth quarter, labor contracts covering 3,200 associates in Las Vegas and the San Francisco Bay area were ratified without a work stoppage.

And just this past weekend, King Soopers and City Markets completed a new labor contract that will help us contain health care costs and improve our competitive position.

This contract provides excellent wages and benefits to our Colorado associates.

Major UFCW contracts that will expire this year include Roanoke, where negotiations have already recently begun, Atlanta, Portland nonfoods, Columbus, and Dallas.

We also have various teamster contracts expiring, including southern California, and one that covers several facilities in the Midwest.

We are hopeful that we can reach new agreements in these markets without a work stoppage.

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

The changes that have been part of the recently-ratified contracts have helped Kroger to manage its labor costs more effectively, including health care and pension.

But opportunities remain in this area.

We will continue to address those issues during contract negotiations on a market-by-market basis.

In terms of additional guidance, as Dave mentioned, Dave provided some information on sales and earnings guidance for 2005.

Here are other expectations that are incorporated into our guidance for the year.

Capital investment will range from $1.6 to $1.8 billion excluding acquisitions.

As in 2004, Kroger will increase its focus on remodels, merchandising, and productivity improvements, and decrease its focus on new-store projects.

This will produce total food-store square footage growth of 2 to 3 percent before acquisitions and operational closings.

We will use one-third of cash flow for debt reduction, and two-thirds stock repurchase for payment of a cash dividend.

We expect to make a cash contribution of $120 million to the Company pension plan.

This represents an $85 million increase over 2004.

Kroger will be adopting expensing of stock options during the year.

Kroger currently estimates the effect of this adoption will be $0.04 to $0.05 per diluted share.

As Dave mentioned in his comments earlier, this is reflected in the earnings guidance provided.

We expect our tax rate will be 37.5 percent.

More than ever, Kroger's financial strength is an important competitive advantage.

Our free cash flow permits us to operate and expand our asset base so that we can offer our customers clean, modern stores that enhance their shopping experience.

It also enables Kroger to continue reducing debt and buying back stock.

I am confident that we have the right financial resources and the right team in place to build Kroger's business for the future.

As mentioned earlier, we have an incentive plan in place for 2005 that will reward all of us for driving sales and earnings growth, achieving our capital investment goals, and improving our customers' shopping experience.

Now I would like to turn it back to Dave.

Thanks, Rodney.

Reflecting on 2004, we are pleased with our strong sales gains throughout the year, as well as our improving trends in OG&A, especially health care.

In 2005, we will better balance our gross profit investment, and we will also deliver substantial improvement in southern California.

I am delighted with the progress we have made and the plan we have in place for 2005.

Kroger enters this year with the strongest sales momentum in several years and a clear strategic vision.

Our identical food-store sales are growing faster than many of our traditional supermarket competitors, an indication that we are improving our customer service, selection, and value experiences in our stores.

As a result, Kroger will drive sustainable, profitable sales growth and create value for our shareholders in 2005 and beyond.

We will now be happy to take your questions.

Thank you, sir. (Operator Instructions).

We have a question from the line of Steve Chick with J.P.

Morgan Chase.

Hi, thanks.

I guess first off, just with the intricacies of the guidance you provided, can you clarify the $85 million incremental contribution to pension plan, that is a full P&L expense?

That would -- Steve, that would not be a P&L impact.

That's a cash impact only.

The accounting for pension would be completely separate and that is reflected in the guidance we provided what the accounting expense would be.

Mike, did you want to provide any additional comment?

There will probably be more about that in our 10-K when we file it as far as what we expect the expense to be this year versus last year.

I honestly don't know off the top of my head what it is as I sit here right now, but as Rodney said, the increase of $85 million is the cash contribution, not the expense.

Okay.

And can you clarify, when is the next 53rd or extra week year?

I guess it is not '05.

Is it '06 or -- I thought that '05 might have been a 53rd week.

'06.

Did you hear that, Steve?

No, sorry.

2006.

It is '06.

Okay.

And then second thing, maybe for Mike, you guys, in terms of cash flow have had the benefit of a pretty big deferred income tax benefit over the years.

Is that sustainable?

And can you just speak to what has been driving that?

The biggest thing that has been driving the lower tax rate from a cash perspective was the accelerated depreciation that was permitted, I think starting 2 -- I guess it was 3 years ago with the President's capital investment plan.

So we've been able to depreciate assets off faster than what historically had been the case.

That's the biggest thing that is driving that.

Obviously, if the Congress doesn't renew that, then we would go back to having a more normal tax depreciation.

Okay.

But beyond that, I mean should we still think about going forward, you guys -- beyond any change, you guys getting a pretty good -- the same cash flow benefit with cash going forward from here?

If Congress does not extend the current accelerated depreciation that's in the tax law, our cash taxes in 2005 will be higher than 2004.

Okay.

And it will be -- and it always lags a little bit, but it will be a lot closer to our accounting taxes also.

Right.

Okay.

And then just the last thing.

With your allocation of free cash flow, and given some of the margin pressure that the industry is seeing, have you thought about maybe not buying back or dedicating two-thirds of your free cash to stock buyback and maybe focus more on paying debt down?

Or -- can you just speak to that a little bit?

In terms of just where we are, we feel very comfortable with the allocation of one-third reducing debt, and two-thirds buying back stock.

It is really, if you look at the current value of our stock, we feel that it represents a very good value, and over time, we think a gradual reduction in debt is good, but we don't think anything more aggressive would be really needed or necessary.

Okay.

Thank you.

Thanks, Steve.

Our next question is from the line of Mark Husson with NSBC.

Yes, it's HSBC.

A question about the gross margin.

Just to sort of review the way that you go through your achieving gross margin, you have got coordinated buying, you've got coordinated distribution, private brands going in the right direction, shrinkage is better, which means that the area that looks like it lost all the gross margin was the divisional Presidents going out and spending it on price.

And sales did respond, but I mean it sounds like were you surprised and this isn't the first quarter this year you were surprised by that gross margin hole.

What are you going to put in place to stop the divisional Presidents spending the gross margin like sailors on shore leave?

Mark, I appreciate your point of view, and I want to maybe elaborate a little bit on gross margin.

About half of the decline compared to a year ago, in the fourth quarter, was expected, planned, and really embedded in a lot of the things we were doing.

But the other half really was not.

And as I look at it, there were 3 or 4 contributors.

One of which you've identified, I don't think I would characterize it quite that way, but I would characterize it more as division and local decisions on pricing, both promotional pricing and even some shelf pricing, but I look at the 3 or 4 primary causes that caused the gross decline in the fourth quarter to be greater than I had expected it to be, to be these.

First, there were some selected commodity areas that had experienced inflation, that we did not fully recover those price increases in our pricing.

Examples for instance, cheese, I think in the glass juice category, we experienced something along those lines and selected meat categories, and that's particularly important in the holiday time, some of the selected categories that were hit, all had some cases where we did not recover fully some of the cost increases that we experienced.

Second is, I didn't feel, and this is more a personal editorial, I think, I didn't feel that we merchandised through the holidays as well as we're capable of doing.

I thought Christmas was pretty good, but the predictability of some of the weeks was off, and our New Year's presentation wasn't as good as it might have been and in combination that can clearly impact our gross.

And then finally, is the area I would get to, that you described, and I wouldn't characterize it as just local decisions, some of it has to do with decisions we made in a coordinated fashion, and either didn't recognize what the cost would be, or didn't properly plan for it.

But those really are just explanations.

And I recognize that that's not very helpful to you.

Really, the issue for me and I think for you, based on your question, Mark, is what does this mean for 2005?

What are we doing about it?

And how might we expect it to be different?

So let me describe these few things.

First is, we have taken a number of internal steps to improve the balance of our gross profit investments.

Second, we have focused our incentive plan for 2005 to direct at some of the issues related to this, particularly the balancing of sales and earnings together as opposed to totally separate.

We've added also in this past year, several non-price initiatives that should help sales, but not impact gross, and these should get stronger traction in '05 than what we experienced in '04.

Just to illustrate, as an example, and the examples I'm going to give are rather generic for a reason, but things like better in-stock condition on the shelf can clearly help your sales without hurting your gross.

Maybe actually even helping your gross.

And picking the right items to be on the shelf.

Not only being in stock on them, but actually picking the items for the right combination of items on the shelf, for the particular customers in the store, are examples of broad initiatives that we have specifics on, that can contribute to improved sales without impacting the gross.

We are committed to making this outcome different.

It is 1 of the 2 very difficult issues in my opinion of the fourth quarter, and we are not happy about it, as we have described in our comments.

And so we're focused very closely and sharply on having the results in 2005 be different.

Just on the sales line on the gross margin, do you think if that's done some of the things you just outlined, the divisional level, and spent the gross margin more wisely, that the sales would have been meaningfully worse than that?

Or were these empty gross profit dollars that were spent?

I think it is somewhere in between.

We obviously achieved sales benefits for the price of investment, but the cost of that investment was higher than it should be or needs to be.

And we should have been able to achieve near or maybe even the same sales growth, without that kind of a gross investment, and our intent this year is to prove that point out.

We are -- we are really focused hard on non-price initiatives to improve sales, to take some of that pressure off of the margins.

Okay.

Final question, your guidance of $1.16 is going to be above $1.16, well $1.17 is above $1.16 and $1.40 is.

When are you going to close in the top end of that range?

We don't actually plan to do that, Mark.

But I will tell you that, to get from where we ended up, which was -- if I do the math, I guess I'm not supposed to do the math for you, but if I did the math to get to the --.

If you add the impairment charge.

Yes, if I add the impairment charge back, where I go from there to get to the $1.16, I look at the things we described, improvement in southern California, improvement in the balance of the Company, improvement in interest expense, and the related stock buybacks, and also decline -- decrease it for the expense of adopting the stock option expense program.

And that gets me up in that vicinity.

Anything past that I think will be a function of and the benefit of the competitive environment, the Ralphs recovery perhaps being better than what we've currently planned, or the economy.

So that's how I would position that $1.16 and think about it.

Okay.

Thank you.

And also, our bonus ties into obviously --.

Well, that's true.

It rewards us for doing better than that.

We are clearly, I meant to mention that, we are clearly incentified to exceed that kind of target.

Thanks very much.

You're welcome.

Our next question is from the line of Filippe Goossens with Credit Suisse First Boston.

Yes, good morning.

A housekeeping question before I have a couple of questions.

Michael, can you provide any preliminary global debt and cash figures for us, please?

Any preliminary debt, as we said in the prepared comments, debt was at about $8 billion.

That's total debt.

And it is down about $400 million from last year.

And in terms of cash, Michael?

Cash from operations?

No, just the cash on the balance sheet at the end of the year.

It would be pretty similar to where we were in the third quarter.

Very similar.

And the year ago.

Yes.

Okay.

Good.

Then I have a couple of questions.

The first one, can you perhaps comment on your initial impression of the lifestyle store concept that is being rolled out by Safeway?

Do you see any need to adjust your own presentation to compete with those new stores?

Well, I've obviously seen the stores.

I don't plan to comment on that.

Okay.

My second question, can you give us a just little bit more color in terms of same-store sales in terms of traffic and average ticket, please?

If you look in the fourth quarter, it was driven more by average ticket.

The number of -- the customer count for identical stores were basically flat with prior year.

Okay.

And then the final question I have for today, with the exception of the Shaw's acquisition by Albertson's last year we have not seen a lot of M&A activity in this sector.

Now with the Chapter 11 filing of Winn-Dixie, do you see any attractive kind of sites that would make sense for you in some of their markets or are you pretty much going to be -- remain focused on organic growth for '05?

We never comment on specific acquisition opportunities.

However, I will say essentially what we've said before, and I think this is still true, we always look at opportunities, there are plenty of opportunities out there.

We've had more success recently with the smaller acquisitions that are infield.

And those are a handful of stores here and there.

And we continue to look at that kind of a thing.

It would take something pretty special for us to do something on a big scale.

Okay.

You want to add anything?

I was just going to say, the ones that Dave mentioned, the infield, those are in existing markets where we're focused there.

Yes.

Okay.

One more final question.

Sorry about that.

Michael, you still have quite a bit of higher coupon debt outstanding, given that interest rates are slowly going to start rising, any intention to refinance perhaps some of that higher coupon debt?

I don't think it would be appropriate to speculate on our financing activities that we may embark on at any point in time.

Great.

Thanks very much, Michael.

One thing I would just add to that, obviously any debt that we have outstanding, we're always looking at evaluating whether it makes sense to refinance it and what are the prepayment penalties and how all the economics work out.

We would do that on a daily basis.

Right, Mike?

All right.

Thank you.

Okay.

Thank you.

We have a question from the line of Meredith Alder [ph] with Lehman Brothers.

It is Meredith Adler.

I would like to go back, Dave, you made some comments about southern California.

But I don't know if my pen wasn't working fast enough or I wasn't quite understanding what were you saying, what I did catch was you're not back at pre-strike levels, but you said some other things about comps and how they compared I think to the third quarter, could you just repeat that?

And then talk a little bit about kind of how you see southern California playing out in the next year.

Let me comment a little bit more on that.

We're talking about when we discussed the sales in southern California, we talked about identicals, not comps.

Okay.

But when we talked about identicals, what we said was that when you take Ralphs and Food 4 Less together in the fourth quarter, compare them to 2002, that we are down from 2002, about the same as what we were down in the third quarter on that same measure.

In both third and fourth quarter, that number is less than 1 percent down from 2002.

I will add a little bit more color on the operations, though.

Ralphs in the fourth quarter on that same measure did improve their sales trends.

That is, they were down less, compared to 2002, on an identical-store basis, in the fourth quarter than they were down on an identical-store basis in the third quarter compared to '02.

Now, obviously, if Ralphs is improved, Food 4 Less would have gone backwards a little, which is not really a surprise, because Food 4 Less last year picked up a lot of business during the strike.

And so that's not at all unexpected.

But Ralphs as a result did show improvement in the fourth quarter sales trend from where they were running in the third quarter as well.

You had another part to that question I may have missed.

Well, I just want to talk about how you see this coming year playing out in terms of southern California?

Do you think that the price investments are going to moderate a little bit?

Do you think that there will be some rationalization in the market?

Is there excess capacity amongst the conventionals at this point?

I think that there was a lot of unsettled time this past year.

I won't speak for anyone other than Ralphs and Food 4 Less but settling into what this new market looked like, what the competitive market felt like, what we needed to do in our ads, working through a number of internal issues, many of which I listed, things like morale issues and personnel changes, and those kinds of issues, some of which, frankly, were particular and specific to Ralphs or Food 4 Less that would not have been experienced at our competitors.

As they work through those, in the year, it was an unsettling year, and this is, as I mentioned, gross profit was the first area of concern for me in the fourth quarter.

Southern California is the second.

Southern California's performance, our results, were not good in the fourth quarter.

And we think, though, that we're getting past that unsettled time.

We believe southern California is a great market for us.

We have a very strong franchise there.

We're proud to have the Ralphs and Food 4 Less folks associates and organization as part of the Kroger family, and we know that 2005 will be better than 2004 was for us in that market.

But no sense about how that plays out?

I don't think I can predict that.

We haven't predicted -- we've tried not to predict because we thought it was too unpredictable as markets go.

Last year, that was especially true.

And while it is less true this year, I think we're better off not trying to predict where that is going to be.

Okay.

And then I have another question.

You talk about rightly wanting to manage the gross margin investments better, but I was wondering if you could just talk a little bit about what is happening external to you in some of these markets.

I mean what I'm hearing is Wal-Mart supercenters are -- the big push in the mountain states right now, pretty much every city that you operate in, you've see seen a lot of Wal-Mart supercenter openings.

What is happening in terms of the response of the other players in the market, how much flexibility are you going to have to manage your gross margin investment given in the face of that?

Well, let's go back to some of the market data that we shared and talk maybe something about that.

We described the major markets that we had the number 1 or number 2 position in.

And it dropped from 43 last year to 40 this year.

So we dropped 3 markets.

Those 3 markets, one of them is Augusta, Georgia and one of them is Riverside, and one of them was San Diego.

Riverside and San Diego I think are understandable given what was going on in southern California.

But Augusta was addressed because we think it occurred because Wal-Mart opened 2 additional supercenters, and we didn't have any change in our store count.

Well, the data we showed showed about 103 new Wal-Mart supercenters this year that we didn't have last year.

That is a fairly large count.

Now, I don't know whether -- I didn't go back to see if that is the highest we've had in any given year, but it ought to be darn close if it is not.

For many years it ran around 50 or 60 and so 103 is a very large increment.

Even with that very large increment, we barely felt the change in market share.

So if you go to the markets where Wal-Mart had achieved as strong a market share as at least number 3, there were 24 markets, that's an increase of 2 markets, and if you look at our stats last year, in '03, we said that in those same markets where we competed with Wal-Mart, where they're at least number 3, our market share declined 30 basis points.

This year, in '04, that same measure, we said it declined slightly, it actually declined 10 basis points.

So it really was essentially flat.

Why I'm describing these numbers is to illustrate to you that even in the face of this sharp increase in number of Wal-Mart supercenters, we did very well on sales.

And in many cases, we did very well even on margins.

Although this kind of situation is certainly part of what creates the unpredictable margin position and creates the more competitive and more promotional market environment.

But I think it is inevitable that when a new competitor, whether it is Wal-Mart or anyone else opens in some of the mountain towns as you described, some of the western communities, they will take some business from someone.

And our market share illustrates, I think, that typically the business they take is not very much from us.

It is somewhat from us, clearly that's the case, but it is less from us than it would appear to be from others.

Okay.

Great.

And then I have a couple more questions.

You did talk about benefits cost, health care benefits costs being down in the fourth quarter.

I was wondering if you look at all-in labor costs on a dollar basis, because we don't know exactly what sales are going to do, do you expect labor costs to be down in '05?

Well, on a dollar basis, we know the dollars are going to go up because our sales are going to go up.

Right.

And as we add stores, obviously, that adds labor costs.

We would expect as a percent of -- to sales that it would decline, but on a dollar basis, we would expect it to increase.

But the increase is being driven more by store sales growth.

We thought all -- not just all year long last year, but even before that, to get health care costs even remotely under control, the fourth quarter was the first sign of some real progress there, where we actually had a decline in OG&A, granted it is only 2 basis points, but heck, I will take a decline any time I get one.

And part of that decline was driven by health and welfare, it was about 6 basis points, I believe.

And that's when you exclude southern California.

So we took that as good news and our forecast for '05 includes declining health care costs.

And as Rodney pointed out, we are actually forecasting for ourselves as a percent of sales for containment and decline, a slight decline, it would be, in the labor area.

I just have one other quick question.

I was talking to somebody who is in one of these western markets, who said that there are some neighborhood markets being built and that the pricing in the neighborhood markets is actually not as low as the pricing in the supercenters.

I was just wondering whether you are have observed that anywhere?

First time I had ever heard it.

I have a lot of opinions on that subject.

But I think, again, like in the Safeway store, I don't think I'm going to comment on our competitor.

Yes.

Are you going to? [ Laughter ] Okay, Rodney will.

No, I'm not going to -- I'll just -- I haven't seen in any of the price checks that we do where there is a price difference in neighborhood stores and supercenters.

That doesn't mean there isn't somewhere they're trying it, but I haven't seen it yet.

I hope they do.

Thank you very much, guys.

Thank you, Meredith.

The next question is from the line of Chuck Cerankosky with Key McDonald.

Good morning, everyone.

Hi, Chuck.

Hi, Chuck.

A couple of questions here.

First off, just a kind of a technical thing, looking at table 2, where you are talking about items affecting interest in the fourth quarter of '04, a $9.1 million item, what is that exactly?

If you remember in the second quarter, we paid off $750 million of high coupon debt that was due this March.

And that cost us about $25 million in a premium.

We said at that time -- that was $0.02.

We said at that time we expected the back half of the year interest expense to be lower as a result of that.

We frankly didn't think it appropriate to not reflect that benefit when we showed the charge in here in the second quarter as an unusual expense.

Okay.

So that's due to -- it is a cash interest decrement due to paying off the debt early.

It is the benefit in the fourth quarter of having the same amount of debt with a lower interest rate on it.

Got you.

All right.

Thank you.

You guys do a thorough job of breaking out fuel comps from the ID's and the same-store sales.

Can you give us any indication what fuel contributes to profitability?

If you look on the supermarket side, I mean it is a reasonably modest number, and obviously that is driven because of the low margin of that business.

If you look at the convenience store side of the business for that part of the business, it is very important, but it is relatively small when you look at it as a percent of the total Company.

We should compliment our convenience store operators this past year.

They had a terrific year.

And any time you have fuel costs, fuel retails as high as they had been, to grow gallonage the way they have, I have just been real impressed with what they've done.

We have done the same thing in the supermarket fuel, but we're, of course, newer in that business and as that matures that will be a different issue.

But I'm very pleased in what we've done in fuel overall.

Can you give us, Rodney, some idea what you mean by "modest" in terms of fuel’s contribution in the supermarkets?

It will show up -- it will influence the rounding.

Okay.

Okay.

What would you say at this point, Dave, is your contribution of labor cost savings where you've restructured contracts into pricing in those same markets?

I'm not sure I'm following exactly what you're asking.

How much the labor has contributed to our ability to lower margins?

Well, I mean when you look at a market where you've had a contract renegotiated in the past year, you've taken some labor cost savings, as a result of that, how much of that is typically going into more aggressive pricing and promotion in such a market?

Oh, I see.

Our intent is to take the savings that we achieve, whether it is from labor contracts, whether it is from productivity improvements, whether it is shrink improvements, whether it is many of the other lines that we're working on to reduce costs, and look for ways to reinvest that in ways that changes the customer shopping experience in our stores, which then drives better sales.

Another way to put that is we, years ago, we would have looked at those savings and looked at them dropping directly to the bottom line.

We are not looking at it that way.

I will comment, though, on the labor contracts, too, because that's an area that is worth some pause on.

With Denver, we've now completed all of the major contracts that we identified in 2004.

And in each one of those contracts, we addressed issues relevant to that -- to that particular market.

We said before, every market is different and every contract is different, and so we have really looked at each market individually and tried to be relevant to that market.

But in every case, we have addressed pension and health and welfare in appropriate ways for that market.

So we're pleased with that kind of progress.

And believe that that actually enables us to take some of the positions that we have taken with our pricing, and also with other investments in our stores that will produce a better shopping experience.

The only other thing I would add to that, it also affects how we allocate capital and markets where we put capital in, and if you look at like in Columbus, one of the reasons that we are willing to build marketplace stores in Columbus was the ability to work with the Union to have a cost structure as that's competitive in the market.

So it also affects how we allocate capital.

And, Chuck, I probably ought to also be quick to add, that as we've looked at individual markets, there are still quite a few contracts out there that we have before us, and in many cases still need to address health and welfare and pension.

I don't want to imply that just because we have the major contracts to go forward on, that we think that that battle is done.

It is a major issue for the industry, and a particular issue for Kroger.

We are most pleased, though, in the progress that we have made, the results we've achieved so far, and that which we expect to achieve in the future.

Dave, are you saying that ahead of the Columbus labor negotiations, you've worked with the Union to change some of the job classifications for the marketplaces?

We did, yes.

Okay.

And finally, you talked about the incentive plan being adjusted for this year, to focus on a better balance between profit, growth and sales growth.

Sort of how has the needle swung in terms of the weightings from fiscal '04 into fiscal '05?

If you look at sales and earnings, they would be equally weighted, including -- and also on top of that, would be some dimensions on our customer shopping experiences and feedback from that, so all 3 of those pieces are critical parts.

The other part is, as you know in the past, our performance to budget on capital projects were part of the overall number, we've separated that out as a separate component, where specifically performance to budget is part of our bonus directly.

And how is the weighting between earnings and sales in fiscal '04?

The way they worked out, it was -- you were influenced to go after sales more than earnings a little bit.

Thank you.

Thank you, Chuck.

Our next question is from the line of John Heinbockel with Goldman Sachs.

Great.

A couple of things.

Dave, you talked about the first quarter being better than the fourth.

Is that relative to the 0.8 including all stores, the 1.9 or both?

I believe both.

And we were referencing just through 5 weeks, which is through last Saturday.

Was there any -- has there been any change yet in level of pricing or promotional intensity in the first 5 weeks or that is yet to be peared back as we go forward?

It is hard to look at any one period and know that for sure, but the statements I've made before about what we believe will occur in '05, we don't see anything at this point in time through 5 weeks that caused us to feel differently.

I'm just wondering if the sales have continued to improve even while you've become less promotional, is that the case?

Or that would be obviously more encouraging than the other way around.

Well, I think -- I think I probably answered it as best I can, because we don't release period results.

But let me put it this way.

What I've seen through 5 weeks gives me confidence, additional confidence that what I said about our ability to achieve this is true.

What is the progression of nonfood impact going to be throughout this year and on into next in terms of moving the comp dial and doing anything for gross?

How impactful is that going to be and how much of that is in your budget?

We've had a lot of help in the last several years, not just in '05, with our seasonal and holiday nonfood business, particularly from the help from the fine folks at Fred Meyer.

We've improved the quality and the pricing on what we offer in those periods of time.

We also have looked at other nonfood areas of our business on an ongoing basis and see some improvement there as well.

But I don't think there is anything I would want to quantify.

I'm sort of thinking of the learnings from Marketplace, which is different than what you've been doing with nonfood before, particularly Kitchen Place and some toy categories and probably not furniture as much.

Clearly, that is certainly true.

What we learn in the Marketplace stores does have some benefit to other stores that are smaller.

It allows us to take items or categories and focus on them in a more strategic way in other stores that are not large enough to be a super -- to be a Marketplace and those learnings come directly from that store, and we are replicating that in numerous places.

That would be correct.

Then finally, what -- have either of you kind of rethought what comp you need ex-fuel, to get some leverage on expenses, and consistently improve EBIT margin?

Is -- are we getting close to it?

Is it much higher than the 2?

You would sort of think that we're getting to a point here where the sales have paid off, the bottom line hasn't yet, and you ought to be close to at least some leverage on expenses.

Is that the case?

Are we still fairly --?

I will let Rodney comment on that.

I should tell you though in advance that we had, of course, improvement in the fourth quarter, and the sales improvement was only 20 basis points the way we look at it, from third to fourth, so that's not a big increase.

But I am sure there was at least some leverage there.

And there is certainly was some leverage by the absolute level of those sales.

We're certainly pleased with that.

But let me have Rodney answer your specific question.

Well, part of it, exactly what Dave said, we are beginning to see some of the leverage already.

Now, as Dave mentioned in his prepared remarks, some of those savings we will also invest in services, both service in the stores, and some price initiatives, which we've already done.

So, our basic business model is driven by growing sales, and having the earnings growth coming from that, and deleveraging and buying back stock.

So it is not so much focused on operating margin improvement as it is growing our sales stronger than where we've been.

All right.

And one final thing.

If the recovery in southern California ends up being a little bit better than you think or the sales are better, if you get a positive surprise, is there more of an inclination to put back to the bottom line in '05 or to reinvest that?

If that is the case, what do you do with the benefit let's say?

Well, let me answer it this way.

We were not pleased with the results we achieved in southern California.

Right.

That was true in sales and that was true in profits.

As a result, as we see the year progressing, we think that actually both can be improved together.

Our plan is for both to be improved.

My expectation is that it actually won't be a question of having to say well, we can get great sales so let's reinvest that and grow even more.

I think in southern California, it will -- the disruptions that we saw this past year when it starts to smooth out, it will become a smoother-running business and we will see better overall results.

That could have the possibility of improving further than what we have budgeted or estimated.

Which is one of the elements that we indicated would be important to this next year, is how strong that recovery is.

Do you want to add, Rodney?

No.

Okay.

Thanks.

Thanks, John.

Our next question is from the line of Jason Whitmer with FTN Midwest Research.

Good morning.

Dave, I want to get a firmer grip around operating margins.

I know you've clearly outlined gross margins and your disappointment on that line item.

But when do you see -- maybe you can provide some more color on the magnitude or timing of cost savings here to facilitate an operating margin rebound?

What are your long-term goals for operating margins?

Where do you want to settle in?

And what's your sustainable long-term earnings growth based upon that?

By operating margins, I assume you mean basically operating profit?

Yes.

And what we've tried to describe is that that may not grow as a percent.

But will grow more in terms of dollars because of sales growth.

And that's really why we describe the reinvestment of some of the savings we've achieved and will achieve into areas that will improve our shoppers' experience.

But that's a pretty broad statement.

I wouldn't try to nail that down to the specific tenth of a percent, but generally speaking, what we're targeting is to not grow the operating margin percentage, but rather grow the operating margin dollars through improved sales.

I'm not sure if I fully follow you on that, considering you're in a recovery period and you expect some better GAAP earnings out of southern California and the like.

You're saying your operating -- your EBIT margins have been down about 200 basis points the last couple of years.

Are you saying you're now going to run a sustainable model at 3 percent or would you expect that to get back up to 4 or 5 percent some day?

We would expect a little bit of improvement just from southern California, but beyond that, we would not expect continued improvement from an operating margin basis.

I think that's fair.

Okay.

Now, the one -- one other thing to remember is that we do get leverage from the free cash flow and the use of that in terms of buying back stock and paying down debt.

And that would improve margins on a total basis when you look at net income margin or however you want to look at that.

Let me just ask one other question.

In terms of your experience versus these "nontraditional" competitors in the marketplace, you've been -- you have multiple years now, of data points and anecdotes.

What are you seeing in some of the earlier markets versus some of the newer markets, within a market shakeout or rationalization or competitive environment?

How you would define your progress in some of those markets on the top line and on margins?

In some of the more mature markets where we have experienced supercenter competition over time, but haven't been adding supercenter stores, so in other words we haven't added additional stores, I feel quite comfortable with the results we've achieved in those markets.

The Augusta example I gave earlier, I illustrated because we had 2 additional supercenters, and it could have been 2 other large combo stores for that matter and we would have achieved kind of the same effect.

Any time you add new square footage in small markets, it has a big impact.

But I think your point is a good one, is that a lot of the impact that we're seeing is because of new markets, or because of additional stores being added to existing markets that have been the issue.

Where we have more stability, we've had good results.

I was just going to say, one thing that I would add to that, and obviously, we have experience with Meijer out of Grand Rapids, Michigan, longer than Wal-Mart in terms of when you go back 20 or 30 years on competing against them, but what happens is generally the competitive fallout is slower than you would expect for whatever reason, but if you look at today, versus 5 years ago on some of those markets, our sales are in excess of where they were before the competitor came in, earnings are above, and return on assets are above.

But it usually takes a pretty long period of time and it is always longer than you would think.

And I always joke about, it seems like it is chapter 33, I always think of Little Rock, Arkansas, where the 1 division there, the group of stores went through a Chapter 11 3 times before it was finally liquidated.

But if you look at our return on assets today, it is actually higher than when supercenters came in.

Great.

Thanks.

Thank you, Jason.

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

Good morning.

I just want to explore pricing a little bit more if I could.

To the extent that your lower prices and I guess your positive ID's have stimulated some competitive responses recently, do these responses mean that you have more pricing to put into your markets or do you see yourself in 2005 of more of a price adjustment phase instead of a price investment phase?

I see closer to the price adjustment phase.

I don't see us as across the board wide scale dropping margins in '05.

I think we're going to earn our way to be able to do that.

In other words we're going to find savings that we can reinvest if we were to reinvest, but actually we're putting a lot more focus on non-price initiatives in '05 than we did in '04.

And as a result, I think it will be -- each division will be different.

Each market will be different on its own individual merits and so it will have to settle out based on what is happening.

Competitive responses vary widely by market and in many markets, we see some, and in many markets we don't see some.

But either way, we -- in the combination of those we've achieved good strong sales improvements and we're pleased with that result.

Okay.

Thanks.

Thank you.

Our next question is from the line of Neil Currie with UBS.

Oh, wow, thanks.

I have 2 questions.

One very quick one, which is you normally give an inflation number with your quarterly results.

Either I overlooked it or you didn't give it this quarter.

Is there any indication of what price inflation was in the fourth quarter?

Rodney will answer that.

Yes, if you look at price inflation in the fourth quarter, it was about 1.37 percent excluding fuel.

Very similar to -- down slightly from the third quarter, but not significantly.

Okay.

And that's without fuel.

Okay.

And the second question is, if you look at your sales performance and Albertson's sales performance, it is sort of a mirror image.

They are doing better in southern California, but coming up with the sort of sales performance outside of southern California, which you probably wouldn't stand for, whereas it is the opposite way around with you, not so good in southern California, but better outside.

In your -- I mean in your target for '05, how do you take into account the potential -- well, 2 questions, the potential for Albertson's to need to readjust that balance?

And secondly, what is your overlap with Albertson's outside of southern California?

We have several markets we overlap with Albertson's, Texas, Colorado, the Northwest --.

Arizona.

Yes, Arizona.

In addition to California.

I don't think I will comment on anything going on at Albertson's, but you can see, and you did correctly describe one of the reasons that we are as concerned as we are with southern California is that Albertson's has apparently recovered better than what we have been able to do.

As I've described, Ralphs and Food 4 Less have had a number of issues this past year, some of which were experienced by all of the competitors, or some of the competitors, some of which were experienced specific just to them.

We think '05 is an opportunity for us to grow back and we expect to be pleased with the results.

Well, put another way, I guess my concern is if outsiders for the California becomes like southern California, whereby you've got retailers struggling to recover a much worse sales performance than yourself, you yourselves are expecting to modify your gross margin investment and then focus more on non-price activity, have you budgeted anything in your '05 number for a sort of -- like a war chest, in order to respond to any increased competitive activity that might be out there?

Let me answer that 2 ways.

First is, as we did our business plans by division, each division took into account what they saw as the competitive situation in their market.

And we looked forward to see what that might look like.

But more importantly, let me clearly distinguish between the southern California markets, and the rest of our organization, whether we overlap with Albertson's or anybody else.

What the southern California market has experienced was significant upheaval and a lot of uncomfortable, unsettling positions.

And it has taken time to work through those.

We don't think that there is another market in this country that has experienced anything even remotely close to what that market went through.

And so I don't really look at what is happening in southern California as being a model of what could happen elsewhere.

It is, I think, totally different.

Okay.

Thank you.

We plan to take 1 last question.

Sir, we have a question from the line of Bob Summers with Banc of America Securities.

Hey, Bob.

Good morning.

You made some comments on changes in morale levels in southern California.

Could you just expand on that?

And I guess within that, were there any key management changes in the southern California market?

Yes, there have been.

Some of the key management changes were from promotions of others.

For instance, the President of Ralphs was promoted in here to cover a number of our divisions.

And his replacement, new President there, Dave Hirz came over from Food 4 Less, so both Ralphs and Food 4 Less have new Presidents.

We're very confident in their work and the plan there and very pleased at the appointments that we made.

Those were announced, of course, some months ago.

In addition to that, we have had some retirements.

Among some senior management at least 1 senior management person there.

And that person was replaced.

In addition, as you know, we have had an ongoing legal inquiry that we don't plan to make public comments about, but there have been some resignations and departures as a result of that.

And then finally, there -- as we review in each division, and this is true in every division, we evaluate what we need in terms of our administrative help there going forward, and we have made some modest changes in the administrative composition of that market, which did cause a few individuals also to leave the Company.

Each -- any one of those can create a little bit of uncertainty.

Because any time you add a new person in a role, there is a little bit of adjustment time.

But that's actually quite a few changes, and as a result, that is what we were referring to when we talked about personnel changes.

Okay.

And then can we just circle back a minute to the compensation structure and aligning interests?

If I remember correctly, you had actually made some changes in '04 that maybe swung the pendulum on a sales side.

Are the '05 changes swinging it back?

Or if you could maybe talk about the sequential change in how you're compensating people.

I wouldn't define it as a swing, but what we're trying to do is take the things we learned from 2004, and put more balance in it, and even move more strongly in the direction that we're going in.

Okay.

And then lastly, it sounds like you're looking for limited EBIT margin recovery here.

I guess 2 thoughts, how does that impact how you evaluate new capital projects, and with that in mind, what are the remaining hurdles to putting a dividend in place?

Well, on the capital projects I will comment and I will let Rodney comment on the dividend.

But in the capital projects, we began last year to tighten capital somewhat and you can see the results in '04 ended up being less capital being spent than what we had originally started the year out expecting.

We expect that same sort of position to continue into this year.

That is not to suggest it is going to get tighter yet, but that the tightening we did last year we plan to continue.

We also mentioned in the prepared comments that we will be emphasizing a number of areas that will put more focus on some remodels and other changes as opposed to lots more money going into new stores.

You want to comment on dividends?

Well, in terms of a dividend, obviously, at the end of the day, it is really left up to the Board what we decide to do.

It is something that we have a regular discussion with our Board on whether to start a dividend or not.

So far, the decision has been not to, because the value of our stock, we think we're much better off using that money to buy back stock than pay a dividend.

At some point, we along with our Board may look at that differently.

But that's currently where we stand.

But it is something that we discuss on a regular basis with our Board.

Okay.

Thank you.

Thank you.

And we appreciate you all joining us today.

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

This concludes your presentation.

You may now disconnect.