克羅格 (KR) 2005 Q1 法說會逐字稿

Good day, ladies and gentlemen, thank for you for standing by and welcome to the Kroger Company. first quarter earnings conference call. [OPERATOR INSTRUCTIONS].

I'd like to turn the presentation over to your host, Miss Carin Fike, Manager of Investor Relations.

Please proceed, ma'am.

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 bases is contained in our SEC filings, but Kroger assumes no obligation to update that information.

Both our first 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're glad you could join us to review Kroger's first quarter financial results.

With me here 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 first quarter performance in some key areas of our business.

I will also share our updated earnings guidance for 2005.

Rodney will provide additional details about our results, then we'll take your questions.

Total sales for the first quarter increased 6.2% to $17.9 billion.

This growth was broad-based across the organization, driven by strong sales at the Company's food stores and fuel centers, improvement in Southern California, and a very good performance at our convenience stores and jewelry stores.

This growth continues a good trend.

Identical supermarket sales increased 3.8% with fuel and 2.4% without fuel.

Identical supermarket sales, excluding fuel and strike-effective stores, grew 2.7%.

On this basis, Kroger's identical supermarket sales have shown sequential improvement for eight of the past nine quarters.

In the first quarter our associates delivered Kroger's strategy of providing our customers with high levels of service, selection, and value.

This was the key to Kroger's performance.

We're targeting the areas of our business that our customers have told us are most important to them.

For example, we're working on ways to speed up the checkout process.

That includes taking steps to reduce the time our customers spend waiting in line before they get to the cashier.

It also involves making sure our cashiers have the tools necessary to process the order quickly and accurately and that we have enough baggers available to serve our customers, especially during peak hours.

Our measurements in this area clearly show progress.

Another way we're working to provide an improved shopping experience is through our customer loyalty program.

Over several years, we have accumulated a substantial volume of consumer data through our loyalty cards, and, in fact, with 40% of all U.S. households holding one of our shopper cards, Kroger, today, boasts one of the largest retail customer databases in America.

Our partnership with Dunnhumby, the data analysis firm from the United Kingdom, allows us to segment our customer base and design customized offerings for individual customers.

It also gives us the tools to target our promotional dollars and pricing investments toward our most profitable customers.

The common thread running through all of the examples is our commitment to making sure that every decision we make positively influences the way our customers feel about Kroger.

Our emphasis on placing the customer first generated increased customer traffic and higher average transaction size in identical supermarkets in the first quarter.

In Southern California we continue to rebuild our business.

Both supermarket sales, without fuel, at Ralphs -- identical supermarket without fuel at Ralphs and Food4Less were both positive in the first quarter and on a combined basis increased 1.3% from a year ago.

EBITDA at Ralphs and Food4Less were in line with our expectations.

It's important to remember when evaluating our sales results in Southern California that our stores were not picketed in the first four weeks of 2004 during the labor dispute while competitors' stores were a target.

We're pleased with the progress in Southern California, particularly in light of the significant challenges we have faced.

Our Ralphs and Food4Less associates are embracing the plan and are delivering against our strategy.

I'm very pleased with how our entire team, from the associates in our stores and manufacturing facilities to the distribution centers and division office in Compton, is working together.

We appreciate their hard work, their enthusiasm is making a difference with our customers and in our business and we're grateful for their continued commitment.

Taking a quick look at other areas of our business, Kroger's corporate brands are an important competitive advantage.

In the first quarter, we added 157 items to the corporate brand lineup.

The market share of Kroger's private label grocery items, in terms of dollars and units, continued to increase.

While our banner (ph) brands are the heart and soul of our industry-leading program, our three-tier branding strategy continues to gain momentum.

A great example is Disney's Old Yeller brand dog food, which is exclusive to Kroger.

We introduced this item a few months ago, and the initial sales have been very strong.

Another example is our FMV (ph) brand, which is aimed at the value-conscious shopper.

Our FMV brand posted double-digit sales growth in grocery in the first quarter.

We have a full pipeline of great corporate brand items in development to appeal to a wide range of customers, and we look forward to sharing more information with you throughout the year.

With that, I'll turn to our revised expectations for 2005.

On the strength of our first quarter financial performance, we are raising our earnings estimate for the fiscal year 2005.

We now expect earnings for the full year to exceed $1.24 per fully-diluted share, an increase of $0.03 per share from the guidance we provided in March.

We expect our 2005 earnings per share growth to be fueled by continued progress in Southern California, improved results from the balance of the company, lower interest expense, and fewer shares outstanding as a result of stock buyback.

As a reminder, Kroger expects to begin expensing stock options in the first quarter of 2006.

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

Rodney?

Thank you, Dave and good morning, everyone.

As Dave said, our sales growth during the quarter was very broad-based.

We had growth across all regions of the country and across all categories.

The strongest were grocery, drug jam (ph), pharmacy, produce, and fuel.

Kroger reported net earnings of $294.3 million, or $0.40 per diluted share for the first quarter.

Net earnings in the year-ago period were $262.8 million, or $0.35 per diluted share.

You'll recall that last year's first quarter results were affected by the labor dispute in Southern California.

Operating margins declined slightly compared to the first quarter of 2004.

This was modestly better than our expectations.

We continue to invest in lower prices for our customers.

These investments are being offset in part by strong expense control and improved shrink (ph) improvements.

In addition, OG&A declined as a rate of sales despite increased pension expense.

Strong sales, strong cost controls across the company, and lower healthcare costs contributed to this improvement.

Rent, as measured in real dollars, declined 4.4%, and as a percent of sales declined by 13 basis points.

This resulted from our focus over the past several years of owning real estate.

Depreciation declined as a rate of sales, reflecting our reduced capital expenditures.

This is the result, in part, from our increased focus on remodels versus new stores, plus we also continue to find ways to reduce the cost to remodel and construct our stores.

We are on track to improve our operating margin for the year, primarily as a result of improvements in Southern California.

Capital investments totalled $400.6 million in the first quarter, compared to $456.7 million a year ago.

For 2005, we expect capital investments to range from $1.6 to $1.8 billion, excluding acquisitions.

As we have said before, we continue to focus on improving the productivity of our assets.

Over the past four quarters we have closed 59 underperforming stores.

Now, I'd like to give you a short update on our stock repurchase activities.

During the first quarter, Kroger repurchased 9.5 million shares of stock at an average price of $16.06 per share for a total investment of $153 million.

There is approximately $208 million remaining under our $500 million stock buy-back announced last September.

Since January 2000, Kroger has invested $2.9 billion to repurchase 150.3 million shares of stock at an average price of $19.16.

We have repurchased the equivalent of 17% of the company.

Kroger continues to buy back shares.

Total debt was $7.5 billion, a reduction of $508.7 million from a year ago.

Net interest expense totalled $159.1 million, a decrease of $13.1 million. or 7.6%. from a year ago.

This declined resulted from debt reductions and lower average borrowing rates.

Kroger's strong, free cash flow enabled us to reduce debt by $509 million, repurchase $315 million in stock and make $1.6 billion in capital investments over the past four quarters.

We have the financial resources to continue building our business for the future, which is a critical, competitive advantage in today's operating environment.

Our strategy remains focused on using one-third of cash flow for debt reduction and two-third for stock repurchase or payment of a cash dividend.

Now, turning to labor negotiations.

We recently breeched a ratified agreement in our Smiths stores in Albuquerque, New Mexico.

We are currently negotiating, under contract extensions, in Roanoke and Atlanta.

Other major contracts that will expire this year are Portland Non Foods (ph), 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 work stoppages.

We remain 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.

Now, I'd like to turn it back to Dave for some concluding remarks.

Thank you, Rodney.

We're off to a good start in 2005.

Across the organization, from our stores and division offices to our manufacturing facilities, distribution centers and general office, our associates are working together to deliver the best possible shopping experience to our customers every day.

I'm proud of everything our associates have been able to achieve in the face of tough competition.

At the same time, we recognize that a lot of work remains.

We must do an even better job of providing superior shopping experiences to our customers and managing our costs more effectively.

We are confident that this will drive profitable sales growth and create the value that our shareholders expect from their investments.

We'll now be happy to take your questions.

[OPERATOR INSTRUCTIONS].

And our first question is from the line of Filippe Grossman (ph) with Credit Suisse First Boston.

Good morning and congratulations on a good quarter here.

My question is actually for Michael.

Michael, earlier in the year you indicated that Metropol B (ph), in terms of your credit rating, is kind of the sweet spot that you're targeting.

And actually, last year you deviate a little bit from your rule of two-thirds going to share buybacks and one-third towards debt reduction as you paid down about $418 million of debt.

In the first quarter, although it's probably somewhat seasonal, but you also retired, or paid down more debt, than you bought back shares.

Should we read into that, Michael, that you're willing, at least in the short-term, to go the extra mile in order to protect your current rating with S&P?

As you know, they're currently reviewing yourselves as well as Albertson's and Safeway.

Filippe, I agree that mid-triple B is a rating that we want to maintain.

It's important to us.

We want to strengthen any financial positions.

As Rodney said in his prepared remarks, our financial strength is something that we rely on to allow us to continue to execute our plan.

Our one-thirds/two-thirds strategy is not something we try to balance every quarter.

We try to be rational about our stock buyback program and be disciplined.

We obviously have plenty of debt that we can apply excess cash flow to in the near-term and then have the ability to buy stock on a ratable basis over time.

If you look at since January of 2000, we are almost dead on our one-third debt buydown and two-thirds stock buyback, if you adjust the debt paydown for the effect of the [inaudible] lease that we brought back on the balance sheet.

So if you look at our behavior over time, we continue to track on that, which is what our goal is, and any one quarter, short period of time to deviate from that, depending on market conditions.

With that said, obviously, with the rating agencies, the mid-triple B rating is very important to us, and we'll work on everything we can to make sure that the rate agencies understand that that's important to us.

Great, thanks very much, gentlemen.

Thank you.

And sir, our next question is from the line of Steve Chick with JPMorgan Chase.

Hi, thanks.

Good quarter.

I haven't been able to say that for a while.

I guess my question relates to your comments on sales trends and the improvement you said was broad-based.

And I guess I was wondering if you could speak to basically the competitive environment and , specifically, as it may relate to Wal-Mart.

There's a theory that maybe Wal-Mart isn't quite as incrementally as harmful to the group, and I was wondering if you could speak to that, if that might be helping your sales trends a bit?

Steve, we are very pleased with the sales we achieved in the quarter, and it certainly puts us on target for our objectives this year.

In terms of the competitive environment, we don't think it has changed much, and in fact, in a number of markets we've had additional Wal-Mart supercenter openings and expect for that to continue throughout the year.

And so I wouldn't characterize their impact as any different than they had been.

What I would characterize as different -- at Kroger at least -- is the focus that we've had on our sales objectives, both using price, but maybe even more importantly, using some of our non-price initiatives to push sales.

Our associates, as we've said -- and this isn't just language we're using, it's in fact what we're trying to do -- is our associates really have concentrated hard on trying to understand how we can better serve what our customers come to us for and by serving those needs better, we actually produce better results, rather than trying to chase after what some individual competitor's doing.

Wal-Mart is a formidable competitor.

They do a nice job.

They keep adding new stores.

But I think the message for us is: what are we doing? what are the actions and steps that we're taking?

And I'm pleased with those steps.

But beyond Wal-Mart adding new stores, being price competitive, it's pretty much the same in terms of what's coming out of them?

I don't see it much different, no.

Okay.

The second thing, I guess, relates to your guidance for the year.

Rodney, you mentioned that you expect EBIT margins to be up for the year, and that's I think really a factor of Southern California.

But you faced, I think, your easiest comparison in the quarter you just reported, in terms of the costs in Southern California in the prior year, so can you speak to that?

If you just look at margin outside of California, we would expect it to be pretty consistent with where we've been in the past.

As you may recall at the end of the fourth quarter, that's similar to what we indicated then.

Almost pretty much all of the margin improvements will be Southern California-based.

We continue to work, as Dave I think mentioned, balancing our investment in price and service along with taking costs out of the business, and we would expect to continue to do that.

Okay.

So I guess even though the $0.10 a share of Southern California costs that you highlighted a year ago, this quarter those costs abate dramatically as the year goes on.

In terms of the comparison, you still expect margins to be able to compare favorably against that?

Correct.

Okay.

Two other things quickly.

Safeway's got a pretty big lifestyle campaign out there for remodels and I was wondering if you compete against any of those and if you could speak to how your stores are faring against those remodels?

Well, I've been in a number of the Safeway, both new stores and remodels, and they do a nice job.

We compete with a number of those as well.

I don't think we've talked specifically about how any one of those matches up.

But generally speaking, when a competitor remodels or builds new stores around us, it obviously has some impact.

And also generally speaking, whenever that occurs, both before and after, we set plans in those particular markets to try to address that in that particular place.

And in most cases, we're pleased with the results.

Our sales are strong, including in those markets where we have those overlaps.

They all contributed to the overall results that we achieved in the quarter.

So I'd have to say we're pleased with our sales despite the description you just gave.

Okay.

And then last thing, Mike, you've mentioned, in terms of the question that comes up about a dividend, you've mentioned in the past that you'd wait to have results come in that are healthy and be able to at least reiterate or maybe even raise earnings guidance.

How many quarters do we need to see of those types of results before you might entertain that?

Let me answer that.

Our Board periodically reviews the question of whether a dividend is appropriate.

And we have felt -- particularly at the stock prices we've been seeing in the last several months -- that the shareholders are far better off if we would buy back stocks than entertain a dividend.

But as we've said before, the Board will keep reviewing that and when they reach a conclusion different than that, we'll let you know.

But at this point, we still see the issues are the same as where the shareholder is better off, and how do we want to balance that out over time.

Rodney, do you want to add anything to that?

No, no.

Okay.

Thanks.

You're welcome.

Thanks, Steve.

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

Yes, good morning.

You indicated that SG&A, ex-gasoline and ex-Southern California, was still slightly down.

Can you give us an indication for what gross margin would be ex-gasoline, ex-Southern California?

Let's see.

Well, in OG&A, we did say it was down about 9 basis points when you take all of that out.

On gross margin, we actually didn't break it out, and the reason we didn't was I don't think it had a material effect; is that correct, Mike?

It was actually up pretty strong, a little better than the 40-basis points GAAP number, if you take ex-fuel, ex-Southern California.

So it was up?

It was up -- I think it was -- I don't think it was material.

It would have been down.

I was going to say, up would have been a surprise.

No, no, we looking at Mike the same way.

It was down, but it was only a few more basis points --

Than the GAAP number.

Yeah, than the GAAP number.

So that's why, we actually asked ourselves, do we want to break that number out, and had we thought it was of material interest or material value we would have, but it wasn't and so we chose not to.

The incremental impact is about 6 basis points, so it's pretty modest.

Okay.

And if you look at for instance Costco during the quarter had -- some of the quarter period they had a pretty lousy gas margin and you saw a lot of gasoline.

Was the cents per gallon up or down year-over-year in the quarter?

The margin?

Your cents per gallon?

Down--

Retail price was up, margin was positive, and gallons were positive.

Yes, we had -- we were pleased with the gas quarter we had.

Yes.

And that's both at supermarket fuel locations and the same-store growth both.

We noted earlier in the comments I made that C-stores were a big contributor to our overall total sales.

Of course, they're not embedded in our supermarket sales, but in our total sales, and they had a fine quarter.

Okay.

You don't mention C-stores very often as usually something exceptional is happening.

You don't mention jewelry stores very often, and I was surprised to hear you talking about them, really, in the first quarter, which I would have thought was a quiet time of year.

What was going on there?

It is a quiet time of the year but they had an exceptional quarter, like you said, that we don't mention them too often except when they have an exceptional quarter and they did, so we brought them to your attention.

I really think it's both of their teams just doing a marvelous job with all the store folks just focusing on the customer and improving the customer's shopping experience, and just doing the basics really well.

Keep in mind for the jewelry stores, you do have Valentine Day and Mother's Day in our first quarter.

Those are things I always seem to forget.

Mark, would you let us help you remember those?

You can go to fredmeyerjewelers.com.

Thank you.

We'll send you a reminder.

One final question.

Just on -- you talk about some sort of service initiatives, and I think we saw in 2001, 2002, 2003 that you could have bent over backwards for the customer, they still wouldn't have paid you for the service initiative and you still wouldn't have showed up in the stores.

Is there something about the tone of either consumer confidence or the employment numbers or increasing disposal income that you're seeing where people are feeling just a bit more confident in your areas?

Actually, what I think it is is the combination of the price initiatives and the service initiatives that we've put together, because we felt there was enough resistance to the price that they weren't giving us the opportunity on the service side.

But now, with some better prices from compared to several years ago, we're in a position where they don't have as much resistance and they give to service the opportunity to do its work.

So we're quite pleased with the combination of the two.

Imagine that.

Thank you very much.

Thank you.

And sir, our next question is from the line of Neil Curry with UBS.

Good morning, thank you.

Just two questions, one a very quick one.

What was the inflation rate during the quarter, maybe including and excluding gasoline?

The inflation rate during the quarter was one that was really kind of tricky.

When you look at it in total, without fuel it was about 1.8%, but you have to step back from that number and not just look at that on its face value given where we were on our sales.

If you look at grocery category, for example, inflation in the grocery category was very high at the beginning of the quarter and declined throughout the quarter as milk and milk-related products, price pressures, subsided.

As you recall from our fourth quarter conference call, we had taken a stance not to pass those kinds of price increases on because we did view them as temporary and we wanted to keep a certain price point in our stores.

So while it was high in the first quarter, it did subside during the quarter.

There was fluctuations during the quarter on our -- on more of the commodity-based items and not much difference on what we can and can't pass along.

If you look at it with fuel, fuel in the first quarter, all by itself, was about 2 point -- or about, yes, right at 1.82% inflationary during the quarter, so you had a bit of inflation in the fuel.

Inflation on fuel was double-digit.

So that was the proportion added to the overall sales line then?

The 1.82 is actually --

I think the inflation's 6%, I'm sorry--

Yes, we had 18% inflation in fuel and it had a big be impact, but our inflation without it was--

With fuel blended in we were about 2.7 in total inflationary.

And just to-- I don't know if have this number in front of you -- but the 1.8 ex-fuel, how does that compare to the fourth quarter?

Slightly higher.

Fourth quarter was about 1.3.

It's important to note, though, that it was higher in grocery in the first part of this quarter and was gradually subsiding some.

So we saw by the end of the quarter that inflation had declined a little bit from where it looked like earlier in the quarter.

Now, I don't know that our measuring system is precise enough to nail that exactly, but in a four period quarter, I would think it would be generally true.

At end of the quarter, grocery's back near where it was, on average, for the fourth quarter.

Just on sales, any read-through since the quarter's ended?

Do you think that you continue to be happy with the direction of the trends, i.e. either maintained or upwards?

We don't actually plan to give any additional information on the second quarter sales until the second quarter's actually over, so I don't think we'll be commenting on that today.

I know.

I just thought I'd try again.

The final question --

Well, no harm in trying.

The last question I was going to ask is we've talked in the past about price gaps between the supermarkets and Wal-Mart.

What do you think about your -- the price of the sort of blended price basket of your sales against your supermarket competitors?

It seems given the investments that you've made over the past couple of years, certainly, your gross margin is below many of your competitors.

How do you think that translates in terms of price advantage and is that something that you're happy with or you would like to extend that further?

Well, it varies by market completely, but I think the thing that I would say about it is that our future expectation -- and we've said this before -- that our objective is for additional price investments to be fueled by or thundered by or driven by primarily by a reduction in costs, including strength costs.

And so the extent of which we think we should push harder, that's the primary source where it's going to come from.

There is always room for improvement on price, but we have to balance that and we intend to balance that, and I think the first quarter actually was a good example of having balanced gross profit with our cost reductions and with what our customers need.

In terms of how happy we are with our price difference, right now, I think our sales speak to that point.

It is, of course, one of the reasons our sales have improved.

But as I also earlier commented, some of the non-price initiatives I think are equally important, and we don't want to lose sight of that because this is not just about price.

Thanks very much.

Thank you.

And sir, our next question's from the line of Bob Summers with Bear Stearns.

Good morning, guys.

So clearly Southern California's improving from a comp perspective, but can you drill into margin trends?

And then I guess within that, I believe that heading into the strike there was the need for some price investment.

So what I'm really curious about is what portion or what percentage of the margin erosion that we've seen in the market is actually recoverable over some amount of time?

That's going to be hard to describe.

Let me give you a description of Ralphs and maybe it will get close to answering your question.

First of all looking at the sales, if we look at the divisions of Ralphs and Food4Less together, and if we look at compared to not last year but to two years ago, 2003, when you combine those two divisions, our I.D.'s for the two divisions were -- together, were slightly positive.

Now, we also described in our earlier remarks that compared to 2004, compared to last year, our I.D.'s for both of these two divisions were individually positive and when combined were a positive 1.3% I.D.'s.

We also pointed out that remember in the first four weeks of the quarter we did not have pickets when our competitors did, so our sales were particularly high during that period last year.

On EBITDA, the EBITDA in both divisions were slightly better than what we had expected and better than budget.

We still have -- and I want to make sure we paint this picture clearly -- we still have a lot of work to do in that market but we are pleased with the progress and particularly pleased with our associate commitment to get us to this particular point.

When we compare it to last year, you referenced, really, the amount of -- in effect cost or strike impact that we had last year, which was the $0.10 that had been identified last year, that was identified -- remember how we calculated that.

We tried to calculate that to what we viewed at the time as a normal environment.

And since that time, though, the environment, really, is clearly -- when we look back with hindsight and look at present -- the environment is clearly tougher and recovery is more difficult.

An example of the tougher environment, you gave the example of our margins maybe needed a little work even before the strike.

And given that particular picture, that made our environment that much tougher.

And so it proved to be more difficult than we had assumed a year ago and as a result, beginning last year, roughly in the second quarter, we again modified our strategy in that market and changed our plans to address the market as it was then.

And we continue to follow that same plan; we continue to see progress.

It's slow, but it's progress.

And we're proud of what the associates have been able to accomplish.

I don't know that I'll be able to color the margins any further than that, unless Mike or Rodney you want to add to that.

I think that's probably it.

Okay.

And then just looking at OG&A trends, the dollar increase on a year-over-year percentage basis was the lowest we've seen in quite some time.

I mean, is this essentially a new run rate or were there some items in the quarter that we shouldn't expect to see again?

Let me talk generally and then I'll have maybe Mike or Rodney comment about any particulars.

But we identified, for instance, that our pension costs were up; that's no big surprise.

Our health/welfare/medical costs were down; that maybe is a little bit of a surprise; that's the result of lots of things, including the results of some of the contracts that we've recently negotiated.

Of course, our OG&A decline is the result of stronger sales and we've talked about that on previous calls and that has a big impact.

And remember. that even though what we showed was a 29-basis point decline in OG&A, a lot of that was driven by Southern California.

So if you take Ralphs out, it was a decline of about 9-basis points for the quarter.

And so we're pleased with that and we do actually expect a trend something along those kinds of lines.

We really have to control our OG&A and actually bring some of our costs down in order for our strategy to work as well as we intend for it to.

And so that's our intention, that's how we're working to make that happen.

Mike or Rodney, you want to comment on any of this?

We continue to focus on the basics and we see a lot of opportunity, improved OG&A from where we are, but it takes a lot of people working really hard together to get it done.

That's the thing that maybe is hard to recognize is that every time we stand back and look at a set of expenses, we see additional opportunities to improve.

We go after that improvement, we accomplish those improvements, and then we look around some more and we're constantly surprised that there's additional opportunities.

What it really says is we can always do better and we intend to do better.

Okay.

Great.

Thank you.

Thank you.

Sir, our next question is from the line of Meredith Adler with Lehman Brothers.

Hey, guys.

Hey, Meredith.

Couple of questions.

First, I was wondering, given that you are clearly taking share from others, are you seeing any pick-up in the opportunity to make in-market acquisitions?

You did a lot of it, really, two years ago, and there wasn't so much last year.

Are the opportunities are still there and are you still focused on that as a strategy?

Rodney, want to comment on that?

I was just going to say we continue to see opportunities, it continues to be important.

Now, obviously, as you know, we're very disciplined, making sure we don't overpay, and it really is market-by-market, looking at specific sites, trying to make sure we find the right locations that fit in with our store network.

So it continues to be important.

We continue to focus on it, but we haven't been able to find-- you know, if you look in the first quarter, we really weren't able to find anybody that was willing to sell the right stores at the right price.

But there's no shortage of opportunities.

And then, I guess, I don't think anybody has ever asked you this question -- at least I don't think I have when I'm with you -- all the acquisitions you did, these small, fill-in acquisitions, have they met your expectations?

Very much so.

When you look at them as a group -- you can always find individual stores that didn't, but when you look at them as a group, they very much have.

Great.

And then on a follow-up question.

There was a good discussion on inflation on the call, but I was just wondering if you can talk about packaged goods inflation?

Are you seeing a pick-up there and what is your ability to pass that along?

Well, the inflation of packaged goods, first of all, remember that Mike said -- which would primarily be grocery -- that grocery was a little bit bigger, inflation early in the quarter than late.

Second is I should tell you that I think it's our -- it is certainly my opinion, that overall we are able to pass through cost increases that we receive.

We did a little analysis just to take a look at this -- actually we do this analysis lots but I asked this to specifically look at it because I wanted to get a better sense of it -- and just to give you a few examples, when I look at what happens in retail price, the three factors that I think impact it, first is the cost, of course, which is what you're talking about as the inflation; second is, is it a competitive item and what's the competitive market doing; and then third is what's the price elasticity on that item?

And some packaged good items would cause us to be a little slower to raise prices than others, but on the whole, we do feel confident we are able to pass it through.

Now, the two examples I wanted to give you, one is in tuna, as an illustration, the cost of tuna this year is higher than the cost of tuna was last year.

And I went through and looked at average retail and our average retail was not quite-- was up, but was not up quite as much as the cost was.

So there's an example of where we did not pass it through fully; we passed through some, but not all.

I suspect that had a lot to do with Lent season, I think it had a lot to do with the competitive nature of tuna during that time of the year, and I think that that's the likely reason that our retail prices were where they were.

Contrast that with coffee, where coffee also had a price increase, and yet we were able to pass it through and recoup our costs there and we're pleased with that result, of course.

But on the whole, we recognize that it's the margins that pay the bill, and so when we have cost increases, it is our intent to pass those through on the whole and on average.

And we think we successfully did that in the first quarter and expect to do that in future quarters.

Great.

And I had just a couple of other questions.

Safeway announced that they're doing a buyout in Northern California and I just want to confirm that you guys -- at one time I think you said you don't like to do buyouts.

Is that still your view or is there anything else you can do to accelerate the benefits of the new labor contracts or do you not feel that's necessary?

A buyout is certainly a way to, on paper, do that.

And in some markets and in some situations a buyout actually works quite well.

And so I wouldn't suggest that we wouldn't consider a buyout; in fact, we have considered them numerous times and occasionally done them.

And so we wouldn't rule it out at all.

We do think, though, the contracts that are in place also have the ability to have substantial savings with or without a buyout.

And so we're not going to use this call to announce, one way or the other, any particular plans there.

And, of course, any plans on a buyout we would be discussing and would expect to discuss with the unions that represent our associates and work with our associates to understand it, but we haven't addressed that with anything recently.

Okay.

And then, just my final question is you mentioned that Wal-Mart was opening more stores in some of your markets.

Is there anything -- any markets in particular you want to highlight?

I mean, I've been hearing that the mountain states, markets like Phoenix and Denver and Las Vegas, maybe Salt lake, have been seeing much more Wal-Mart than they had before.

Any comment at all on where, particularly, you see Wal-Mart?

Well, I think where we're seeing the biggest growth -- and I'm going more by my gut feel from what I've seen in past reports -- is in markets that did not have high concentration of Wal-Mart supercenters before.

Now, there's still plenty of times when they add fill-in stores.

And so I don't want to leave those out, but take a market like Cincinnati just as an example, which is not in the geography you described, but previously had no Wal-Mart supercenters and has now got Wal-Mart supercenters open and several under construction and lots more to come.

And so there are plenty of places where we're seeing a rise in that count and it's in many of the new markets that had not previously experienced at least big numbers of Wal-Mart supercenters.

Okay, great.

Thank you very much.

Thank you, Meredith.

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

Good morning, everyone.

Hi, Chuck.

Good morning.

Mike, I have a question for you to start off with.

Can you talk about working capital as a source of cash this year given the pretty good sales rate?

Mike?

Thanks, Chuck.

You zeroed right in on the one thing that wasn't very stellar in the quarter and it's squarely my responsibility.

We were disappointed with our working capital results from the first quarter because we actually invested cash in working capital and our intent for the year is to free up cash.

I am still targeting the position that we're going to free up some cash for working capital this year.

In fact, within the week I'm having a rather large, cross-functional meeting to renew our effort to reduce working capital because it's -- the CFO could get the working capital out within a couple of months but the merchandisers wouldn't be too happy when they didn't have stuff to sell in stores.

And it's going to take a cross-functional effort to get this done, not just me getting it done, and we still are targeting internally and, I guess , externally now, the goal of freeing up working cash from working capital on the year.

And that onus is squarely on yours truly.

Can you provide what the target range might be?

I won't go that far.

Okay.

I just felt a sigh of relief in the room.

Well, Chuck, we are glad you asked the question. for a lot of reasons.

It is important to us and we did not do a good job in the quarter on that.

But I want to add, too, that we are going to do it carefully.

And Mike has been particularly conscious, more than others even about this, of making sure we don't hurt our sales trend as we do.

But this objective is real important for us to make headway on because it's an opportunity for us to fund some of our cash flow.

We need to figure out what our customers want in our stores by what they're buying, and the stuff that they don't want, stop having that and give them more of what they want.

I can tell you that we are not going to improve our working capital by not paying our vendors.

That is not a solution to having a high investment in working capital.

Understand.

Dave, can you talk about some of the highlights of the loyalty marketing, things that would illustrate how you're rewarding, especially , your best shoppers?

For competitive reasons, I won't tell you very much, but I will tell you two themes that are important that we've -- I don't know if I've discussed them with you before, but I know I've discussed them before -- one is that the loyalty data helps us understand the individual customer better.

As a result, it helps us customize things for individual customers and to see them and to make sure something we give them is responsive to what they're interesting in rather than just some global market offering that everybody might be interested in.

Second, it also helps us understand our stores better because our stores are made up, of course, of a complex group of customers.

And we can see the various types -- and there are multiple types in any store, no store is single-type -- but we'll see multiple types in stores and we can better -- in those stores -- address the particular needs of those types of customer groups in the stores.

So it helps us run our stores better.

It helps us with our advertising campaign better.

It helps us change our intuition about merchandising -- as I know I've told you this before -- that I learned merchandising in this business well over -- well, about 30 years ago, 25 to 30 years ago -- and a lot of my view of it is dated but it's still my intuition.

And Dunnhumby data has actually help me re-set my understanding of what the customer is after and it helps replace intuition with actual data and actual facts.

And it's those facts that are driving our decision-making, and we are very early in the process but I'm quite pleased with what we see.

Last question for Rodney.

When we're looking at this somewhat improved guidance Kroger management has provided for the rest of the year, what kind of -- what are the variables that really improved your confidence in the outlook?

Obviously, on the first quarter we were very pleased with the balance between growth in OG&A and that tie-in, and we were also pleased with the improvement that we had in depreciation, rent expense, and the share count was a little bit lower.

We were able to buy back a little bit more stock than what we had planned.

So it's really a combination of all four of those items together that gave us, together, confidence in raising the estimates by the $0.03.

All right.

Thanks a lot, gentlemen.

Thank you, Chuck.

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

Good morning and great quarter.

Thank you, Jason.

Good morning.

Dave, I wanted to address market share from a little bit different angle.

I know you really kind of crunch these numbers just once a year, but are you seeing different dynamics?

I'm on the top line and I guess more -- my question is on the margin side of things where markets are starting to settle in a little more.

And I know rationalization and consolidation are still big buzz words in this industry, but I'm more curious where it's basically now Kroger and maybe one other or two other guys in the market, versus a lot of noise still with the big three supermarkets and other formats entering those markets.

Are you seeing any of this variance -- any variance within those type of markets?

What I'm seeing, Jason, is an array of everything you've just described.

Some markets that are down to essentially us and Wal-Mart and maybe a few other smaller operators, if they've been that way for some time, seem to me a little more stable.

Some markets where that is true, but it's only recently been true are still a little bit unstable.

And so I don't know that there's any way to clearly draw a line and say things have stabilized or they've not stabilized.

It really is driven market-by-market.

And one of the reasons we give annual market share information -- and I believe in this pretty strongly -- is that market share, while it changes a little bit from, say, period to period or quarter to quarter, it doesn't change in a way that we're able to measure it effectively.

Our ability to measure isn't precise enough to get a good read in that short of timeframe.

That's why taking a little longer look is really far better.

I've looked at things like IRI and AC Nielsen (ph);

AC Nielsen, particularly some of their panel data and things, but it bounces around so much you really have to look at a long-term trend and a quarter-by-quarter doesn't help much.

Our best barometer, I think, are our identical sales without fuel.

That's why we push that internally as much as we do and, of course, you hear us talk about it externally, but it is the most important marker that we use internally and we use it regularly.

In fact, we use it daily inside Kroger.

And the only other thing I would add -- and I know everybody understands and realizes this -- but when you look at market share there's still on average in our major markets almost half the market held by people without our economy's of scale.

And when I say without our economies of scale I'm including Safeway and Albertson's and Publix (ph) and Wal-Mart and HPB (ph) and people like that in that calculation, but there's still a tremendous amount of market share available for any of us to go after from people who do not have our economies of scale.

That's a good point and I want to add further on that, too, as we pointed out in January or Feb -- I guess it was March when we gave the data -- when we look at market share, we look at market share for anywhere our customer buys the same products we sell.

We don't look at just traditional food market share, and traditional food market share is what often gets described in trade publications and elsewhere.

But we think it's far more relevant to look at the relevant market, and that is where where do customers buy this product.

And there is a lot of available market not held by the big players that's available to us in our markets, as Rodney points out, and that's really important for us to remember.

Fair enough.

In terms of -- certainly you're getting a much better balance here on sales and margins and, obviously, you're incentivized now a little bit more toward that end -- but can you talk about two factors; one, I'm interested in more specific shrink progress, transportation warehousing, some of these elements that would actually impact your gross line; and then maybe more from a merchandising standpoint, what has improved there, either on promotional elements or seasonal or other general merchandise product?

Well, let's see.

On the trends of some of the expenses within gross, so we've made good progress, continue to make progress on shrink (ph), particularly in the grocery/drug/GM area.

Perishables are a little bit harder to track because of getting an accurate read on it, but we think we are actually about there and being able to track that much better, too.

But we're pleased with our shrink.

We're pleased with our trends in the whole logistics distribution area, although we recognize -- and everybody else has this same problem too -- is that there are increased fuel costs, which impacts our distribution from our warehouses out to our stores.

So that's an important item.

And we actually had improvement in that area versus last year, but not as much as what we had hoped for.

And that was driven because of fuel costs were obviously higher than what we had expected.

Yes.

So we saw good results there.

Any other part of that we want to comment on?

The same thing would be true for advertising.

Yes, that's true.

We had some improvement.

And Dave talked about Dunnhumby before and I think Dunnhumby's one of the things that's helping us understand more in terms of improving the efficiency and effectiveness of our advertising.

And we still have a lot of work to do, but we are making some progress there.

You asked a question about the seasonal merchandise;

I wasn't sure I caught what you were wanting to know, Jason.

Yes, I was looking at merchandising in general because, obviously, y having a better loyalty quotient, if you will, better traffic and better transaction, you were probably doing somewhat better on the merchandising standpoint, whether it be your food or extending into some GM and seasonal.

I wanted to see if you had any color on that?

Oh.

Well, we had -- I think we had good results in a number of those GM areas, and our seasonal programs just keep improving.

The folks out at Fred Meyer have helped us, I think, in remarkable ways to -- every year we've gotten better in what we've done there.

One other thing we did that I think was better is our approach to how we handle seasonal selling and seasonal mark-downs and the discipline around that was improved.

You may remember I commented on that in the fourth quarter, where we weren't as happy as we would have liked to have been.

This quarter, actually, we were happy, and thought the divisions did a nice job of that and the discipline embedded in the organization and in our division to do that was a good improvement.

Thank you.

Thank you.

Sir, our next question is from the line of Andrew Wolf with BB&T Capital Markets.

Good morning, just two follow-ups.

First, you described how product costs overall disinflated in the second half of the quarter.

Could you just tell us a little about how that affected sales and gross margin?

Well, I wouldn't say "disinflated."

That implies it was deflationary, and it actually was not deflationary, it just was back down to similar levels of the fourth quarter by the end of the quarter; ssn't that correct, Mike, for grocery?

Actually, grocery was slightly under -- it was still a slightly inflationary.

Yes, it was still slightly inflationary; it was not a negative number.

And the word "disinflation" implies that it was negative; it just wasn't as high as the first period of the year.

And so it settled back down, I guess, is my point.

There have been some changes.

I think some of that might have been driven by dairy, by milk; maybe primarily driven by milk.

What's the rest of your question?

Basically, did it help gross margin to have lower inflation in the second half and did it hurt sales?

It didn't hurt sales, but I don't know -- I don't think it hurt our margins either.

Because as we said before, we really try to pass it through and we try to maintain the margins based on where those costs are and try to let our margins be more driven by the pricing strategy and by the mix of what we sell.

To me, that's a good question, but it's always a hard one to answer.

At the end of the day, the best we can tell in our analysis is it really didn't affect the numbers.

Okay.

But certainly in dairy, where you said you were not -- you'd cause, probably, a little sticker shock if you tried to pass it through -- it must have helped in that category to have those prices come back down.

Actually, I didn't study that for the last part of the quarter, but I'm guessing you're probably right on that point.

Although it's a pretty competitive item and so when costs come down, the retails tend to come down rather quickly, too, so I don't know that I'm quite right with that.

And in any particular category, you'll see some unusual occurrences, too, and so dairy could have been different there.

Rodney, you want to add anything?

Well, I was going to say on the couple of items that I have handy here it looks like it's pretty much dollar-for-dollar that we passed it to the customer.

If you remember, in the fourth quarter on dairy, we felt like the inflation in dairy was going to be pretty short-lived, and that's the reason why we didn't raise our retail prices because we've worked awfully hard to have a reasonably consistent message from a milk standpoint and it just didn't make sense because we thought the costs were only going to be up for a short period of time, which obviously turned out to be true.

Okay, got it.

My second follow-up, just back to the competitive environment question where you indicated, really, no changes from Wal-Mart overall.

Could you also discuss that, just versus your large conventional competitors, if you're seeing either on an overall basis or in specific geographies, any changes in their competitive go-to-market?

We don't describe specific geography and as a result, I don't have anything specific there to say.

And I think we just stay with what we said before, is that we don't see that the competitive environment has changed.

It's still hotly competitive, and that's true with not just Wal-Mart, it's true with our conventional supermarket competitors and it's true with the other operators and even the non-traditional kinds of operators.

So it is still plenty warm out there, but I don't think it's gotten any worse or better overall.

Thank you.

You're welcome.

We'll take one last question.

Sir, our final question is from the line of Bryan Hunt with Wachovia Securities.

Thank you.

Let me perhaps try to rephrase the last question.

In Southern California, you feel like this is going to be a major driver of your higher operating margins.

Do you feel like, one, that's a function of cost savings and regaining -- and gaining market share, and/or two, do you feel like since the strike has ended that the competitive environment and rivalry between your competitors trying to re-gain market share has lessened?

Let's see.

In Southern California it will be -- I think our future success will be a function of both cost savings and market share gain.

The cost savings will help us in that battle, and I think it is all about -- ultimately all about sales.

Now, sales have to come with a balance;

I mean, it's not at any cost and that's why we have described this as a very long process to come back and believe it will be a long one.

The competitive environment, I think other than the initial recovery time, which was of course more erratic at first, I'd say now it's been more steady, strong competition.

It's not a changed market in terms of these competitive environments not getting worse, but it's certainly not getting better.

That part's clear.

The only other thing I would add to what Dave was saying is if you look at the improvement in operating margin that we expect this year for the Company, which we've said is primarily driven by Southern California, obviously, a year ago we had the costs related to the labor dispute and getting our stores back up and operating and cleaned up, and those type of expenses in a year-ago numbers, where this year, obviously, we don't have that same expense.

Yes, that's a good point.

And that's part of what's driving the changes, too.

Yes, that will be part of that operating margin improvement, you're right.

Just as a follow-up, one, could you tell us how many stores you've opened or closed in that Southern California region since the strike as well as two, do you feel like profitability within the next, call it year, on a dollar-profit basis in Southern California will eclipse what you were doing prior to the strike?

I'm going to give Mike a chance to look up and see on the store count so we can give you that, if we had that available.

But on profitability, I think what we've said and I think we need to stick with this is that this recovery is going to be a long time coming.

And in fact, I don't actually even look as a reference point where our earnings were prior to the strike.

I look at the market as it is today and say where are we today, how do we improve from that?

And our measurement is improvement from where we have been last quarter, last quarter before that, and the quarter before that.

And that's our road to getting back to something more normal.

When that will be, what timeline that is, I can't predict and won't predict.

It is clearly longer than what we had imagined a year ago at this time, and it's clearly different than what we had imagined a year ago at this time.

That's actually why we stopped trying to give some indication of what the strike costs were because we thought it was no longer really relevant, because the market as we knew it had changed and as a result, we changed our strategy given that market change and we believe in the long-run that we'll end up successful because of that improved sales and improved profitability one quarter after the next after the next.

Rodney, you want to add to that?

I was -- the only other thing would be our associates are focused on serving their customers and getting Ralphs and Food4Less back to where it was from a customer standpoint before the labor dispute.

And when they do that and as we do that for our customers, that will really drive how long it takes us to get from a profitability standpoint back to where we need to be.

Yes.

Yes.

Mike, I don't know whether you have any data you want to talk about on stores.

We have closed a number of stores there, which we've described publicly before.

Ralphs store count is down about 25 since the beginning of 2004.

We've closed about 30 stores and opened about 5 in arriving at that number; that would be all of Ralphs, not just Southern California.

Okay.

Thank you very much, gentlemen.

Thank you, Brian.

Let me just close by saying that we felt this was a well-balanced quarter and we were pleased with the results.

Even when things look good, there is room for improvement but we are pleased overall.

On the fourth quarter call we outlined our 2005 commitments.

I'm confident our first quarter results position us to achieve these commitments for the year.

I'm especially proud of our associates and their commitment to our customer, and I want to thank them for their hard work to get us here to this point.

Thank you all for joining us.

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

This concludes your presentation and you may now disconnect.