克羅格 (KR) 2005 Q2 法說會逐字稿

Good day, ladies and gentlemen and welcome to the Kroger Company second quarter 2005 earnings conference call. [OPERATOR INSTRUCTIONS] I would now like to turn the call over to Ms. Carin Fike.

You may 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.

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

Now, I will turn the call over to Mr. Dillon.

Thanks, Carin.

And good morning, everyone.

We're glad you could join us to review Kroger's second quarter financial results.

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 second quarter performance, and some key areas of our business.

I will also discuss our sales outlook for the second half of the year and our earnings estimate for the full year.

Rodney will share additional detail about our results.

And then we will take your questions.

Total sales for the second quarter increased 6.8% to $13.9 billion.

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

This growth continues a very good trend.

Identical supermarket sales increased 5.1% with fuel, and 3.4% without fuel, by either measure this represents Kroger's highest identical sales since the merger with Fred Meyer in 1999.

It also is the eighth consecutive quarter of positive identical sales excluding fuel.

We're pleased by these results.

As we've said before, identical sales growth is a core part of Kroger's strategy.

Kroger's business strategy is squarely aimed at consistently meeting the needs of our customers through great service, selection, and value.

In the second quarter, our associates continued to focus on improving the shopping experience for our customers.

This commitment to place the customer first helped drive growth in customer traffic and average transaction size.

For some customers, that means offering valuable savings through our loyalty programs, or the Kroger 1-2-3 Rewards MasterCard which allows customers to earn points on all purchases with the card.

Those points can be redeemed for free product in our stores, and by the end of this month, the 1-2-3 Rewards card will be available in approximately 2200 of our stores.

Our focus on putting the customer first also means delivering great service.

Here is an example.

A few days after the hurricane struck, I heard from a customer in Grayson, Georgia.

He had been driving around the area looking for a place to fill his car with gas.

What he found was frustrating.

Lots of long lines and retailers with sky high prices.

He was on his way home to, as he put it, wait out the hysteria, when he decided to stop at our nearby Kroger fuel center.

He was surprised to see that our prices hadn't risen significantly.

But what he saw next was even more appealing.

Several Kroger associates were in the parking lot helping to direct long lines of traffic to the fuel pumps, as they became available, and generally keeping things calm and orderly.

As a result, he said, he was able to get in and out much more quickly.

Your company has earned our gas business and our grocery business away from your competitors, with the thoughtfulness of a handful of managers, he told me.

I wanted to share this example, which is just one of many that we receive on a regular basis.

Because it really strikes at the heart of what we're trying to accomplish across the organization.

Our goal is to make sure that every action our associates take and every decision that we make as a company positively influences the way our customers feel about Kroger.

At a time when competition among food retailers is tougher than ever, great customer service has never been more important.

That's why we're working to reduce the time our customers spend waiting in line at the checkout.

And measuring the results.

It is why we're investing in lower prices.

And offering valuable savings to our very best customers through targeted marketing programs.

These are just a few examples of what we mean by placing the customer first. .

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

In the second quarter we added 114 items to the corporate brand lineup.

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

Our share in terms of dollars declined a bit because of deflation in the dairy category.

Moving now to southern California, business at Ralphs and Food 4 Less continued to improve during the second quarter.

In southern California, identical supermarket sales without fuel at both divisions continued to grow in the second quarter.

On a combined basis they increased 2.9% over the prior year period.

As a reminder, the labor dispute ended in the first quarter of 2004.

Our recovery in southern California remains on track.

We're seeing sustained improvement there as Ralphs and Food 4 Less associates target the areas of our business that our customers have told us are important to them.

On the strength of of Kroger's year to date financial performance, we are affirming our earnings estimate for fiscal 2005.

Kroger expects earnings for the full year to exceed $1.24 per fully diluted share.

We expect this earnings growth to be driven 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 buybacks.

We expect identical supermarket sales for the second half of 2005, including southern California, and excluding fuel, to exceed 3%.

I want to note that these estimates do not include Hurricane Katrina as it is too early to understand fully the effect, whether favorable, or unfavorable, that the storm will have on our results for the balance of the year.

We will provide additional updates as appropriate.

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

Rodney?

Thank you, Dave.

And good morning, everyone.

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

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

Most of our divisions experienced another quarter of increased identical supermarket sales.

The strongest categories were grocery, produce, drug GM, fuel, and apparel at Fred Meyer.

Fuel grew both in dollars and in gallons.

We estimate product cost inflation excluding fuel was 0.7% during the quarter.

Kroger reported net earnings of 196.5 million, or $0.27 per diluted share.

For the second quarter -- net earnings on a year ago period were 142.4 million, or $0.19 per diluted share.

FIFO gross margin was 24.59% of sales, a decline of 59 basis points compared to the second quarter of 2004.

Excluding the effect of fuel, FIFO gross margin increased 10 basis points versus the prior year.

We continued to invest in lower prices for our customers on a targeted basis.

These investments were positively offset by good expense control and shrink improvements in grocery, drug GM.

OG&A declined 52 basis points to 18.23% of sales.

Excluding fuel, OG&A declined 22 basis points.

Strong sales, the recovery in southern California, strong cost controls across the Company, and lower health care costs contributed to this improvement.

We remain on track to improve our operating profit margin for the year.

Primarily as a result of improvements in southern California.

This is consistent with our original expectations.

We plan to continue our strategy of investing cost savings to provide better value, service, and selection to our customers.

A quick comment about fuel.

Higher fuel costs have added an estimated $12.6 million to our operating costs year to date.

These higher costs are factored into the guidance Dave provided.

Capital investments totaled $272 million in the second quarter, compared to 416 million a year ago.

For 2005, we now expect capital investment to range from 1.4 to 1.6 billion, excluding acquisitions.

We continue to emphasize a tightening of capital.

Our focus continues to be on interior remodels versus new store projects.

One other item to note is our performance to budget on major capital projects continues to improve.

Now, I would like to give you a short update on our share repurchase activities.

During the second quarter, Kroger repurchased 2.2 million shares of stock at an average price of $17.53 per share for a total investment of 38 million.

At the end of the second quarter, there was approximately $169.8 million remaining under the $500 million stock buyback announced last September.

Since January, 2000 Kroger has invested $2.9 billion to repurchase 152.5 million shares at an average price of $19.13 per share.

Kroger continues to buy back stock.

Net total debt was $7 billion, a reduction of 583.5 million from a year ago.

Net interest expense totaled $120.6 million, a decrease of 31.9 million from a year ago quarter.

About 24.7 million of that decrease is a result of the premium we paid last year for the early retirement of debt.

We have reduced net total debt by $1.8 billion since January, 2000.

Over the past four quarters, Kroger's strong free cash flow has continued to enable us to achieve our financial triple play by reducing net total debt by 584 million, repurchasing 342 million in stock, and making $1.4 billion in capital investments.

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

As you can see, since 2000, Kroger is pretty much in line with that target.

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

Our net total debt to EBITDA ratio, a key covenant in our bank agreement, was 2.23.

This is approaching the 2.16 ratio achieved in the second quarter of 2002.

And remember here, a low number is good.

The latter number was the best that we had achieved prior to the labor dispute in southern California.

Now, a quick update on labor negotiations.

A new nonfoods contract in Portland was ratified in the second quarter.

We continue to negotiate under contract extensions in Roanoke and Atlanta.

Other major retail contracts that expire this year are Columbus and Dallas.

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

As we've said before, Kroger is 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 would like to turn it back to Dave for some concluding remarks.

Rodney, thank you.

Our performance through the first half of 2005 is a clear sign that Kroger's strategic focus on fulfilling the needs of our customers is generating positive results, and helping to set Kroger apart from our competitors.

We have been able to use cost reductions and productivity improvements to reinvest in our business and improve our customer shopping experiences.

We are making good progress.

But we recognize that a lot of opportunities remain for growing our business.

We believe that our associates sharpened focus on placing the customer first is the key to our future success.

Before we take your questions, I would like to share a few brief comments about the devastation caused by Hurricane Katrina and the incredible relief effort taking place.

A number of of communities where Kroger operates are struggling to provide food, shelter, and other basic necessities to many thousands who have been displaced from their homes.

Kroger expects to raise -- help raise more than $5 million for hurricane relief efforts.

This support includes cash contributions from our customers and our associates, it includes $2 million from the Kroger Company and our charitable foundations including an employee match, truckloads of of food, water, and personal care items.

Pharmacy assistance for displaced families.

And loaned equipment and facilities to food banks and shelters.

Our team -- our division teams in Memphis and Houston deserve special recognition.

For they have worked around the clock to support relief efforts and take care of the customers at the same time.

I'm very proud of the way our customers and associates across the country have responded to this tragedy.

Their generosity, compassion, and willingness to help those in need continue to grow day by day.

In McPherson Kansas, our store associates chose to use money that they had earned for superior safety performance to purchase food for the relief effort.

In Russellville, Arkansas, a Kroger store has adopted a displaced family and is working to help them find and furnish an apartment.

In Phoenix, pharmacy associates at Fry's volunteered to work over a weekend to fill over 1000 prescriptions for evacuees and local shelters.

These are just a few of the everyday heroes across our company who are making a difference in the lives of our customers and our communities.

We salute you all and say thank you.

We'll now be happy to take your questions.

[OPERATOR INSTRUCTIONS] And your first question will come from John Heinbockel with Goldman Sachs.

Please proceed.

Dave can you hear me?

Yes, John.

Two questions.

First, can you give us an update on marketplace and then more particularly the evolution of nonfood into the traditional supermarkets, how is it going, what are you learning, and is there going to come a point where that is meaningful to the comp number?

And then I have one other.

Okay.

Well, marketplace first, as you know, we have marketplace stores in Phoenix, Salt Lake, and in Columbus.

We've opened several of those from the ground up now, three in Phoenix, two up in Columbus.

And the results in each of those markets, we're watching those closely, we're pleased with what we see in terms of the type of store.

I love the store in fact to shop, as a place to shop.

It is too early to say how we will roll that out elsewhere.

Our concentration right now is in those three markets that are being served.

But the broader question that you're asking is the way in which our nonfood business will improve over time, and for that, I would just comment that the team out of Fred Meyer led by Travis and others out there have done a terrific job of helping our team here at our general office put together plans that cover really all of our divisions.

And it is at different stages, in most stores we have a strong seasonal program that is provided through that process.

In some stores, we have an expanded drug GM offering that is better focused with better quality products, as a a result of what we've learned both in marketplace stores and from Fred Meyer.

And all of that is continuing as we -- as we had originally planned.

I don't know, Don, if there is anything you want to add about what we've learned in general merchandise along those lines?

Well, I think Fred Meyer's expertise has been the biggest growing -- for the balance of the Company, they have demonstrated over and over their ability to help share their best practices with the balance of the Company.

Our seasonal business continues to be a key component of that.

But as Dave mentioned, there are other components that we're beginning to lay into some of stores throughout the Company.

Thank you.

John, you had a second question?

Yes, well, actually, just as a follow-up to that.

Do you see any SKU rationalization in grocery that would allow you to dedicate more space to nonfood?

And then my final question was given how well you guys are doing fundamentally, how attractive are acquisitions in new markets to you, not in market, but actually going to new geographies?

Does that now work for you?

Well, let me take the SKU rationalization first.

I think we're -- I think I would have to just say we're constantly evaluating SKU rationalization.

Not only having the right SKUs but also having the right amount of space dedicated to various categories.

And I don't think that we're going to see some moment in time where we say okay, we now understand nonfoods, so let's strip back 100 feet of grocery, and put nonfoods in more stores.

I think what instead is likely to happen, and in fact has already happened, is in a number of of categories, we see better opportunity, we expand that through more stores, we contract a little bit in a few grocery categories, and that SKU rationalization literally happens every day.

Don, anything more on that?

The only other thing I would add is this traditionally has been very difficult for all of us to make decisions on the basis of which items to eliminate, and one thing we are learning and in the very early stages of learning is trying to associate the items to the customer that are most valuable to them.

So we're working hard with our dunnhumby partnerships to try to understand which items are most meaningful, which items maybe do deserve shelf space.

So over time, we will get better at that.

Good.

Thank you.

The second question you asked then is moving into new markets, acquisitions in new markets.

I think what we've said before is still true, is that we think we've had best results over time in those markets where we have had in-fill and so a lot of our focus has been on that, where we have the opportunity to pick up a handful of stores that are the natural extension of an existing market.

We have of of course some new markets that we've worked with in particular, the Chicago market, where we have moved Food 4 Less stores over the last several years, but I think on new markets, when we enter that way, either by individual acquisitions in a new market, or by choosing to go in from scratch, as we did in Chicago, we want to be careful to watch those, because when you go into a new market like that, if you're an unknown quantity, as a retailer in that area, it is a lot harder to get started.

So we want to be I think cautious about not trying to bite off more than we can chew.

But other than that, the acquisitions are just as we have described before.

We evaluate things as they come up.

We consider them based upon what we think are our strengths and abilities to perform, and past that, there is not much more to add I don't suppose on those.

Okay.

Thanks.

You're welcome.

And your next question will come from Tom O'Neill with Barclay's Capital.

Please proceed.

Thank you.

Can you update us on the promotional environment in southern California?

Are we back to pre-strike levels in terms of the level of promotions there?

In southern California, I would say that competitive environment hasn't changed much.

In fact I would say that's probably true about the competitive environment all across the U.S.

You have some markets that pop up and others that maybe retract a little bit.

But on the whole the competitive environment hasn't changed very much.

If you look just at southern California just for a second, maybe I will dive a little bit more into our results, we do see improvement and we're pleased with that improvement.

We described the 2.9% I.D.s which are I.D.s without fuel for Ralphs and Food 4 Less combined for just southern California.

And those are compared to last year for the same time period.

But if you go back to the 2003 time period, which is the quarter actually before the strike began, which would have been second quarter of '03, and compare there, RIDs when you look at Ralphs and Food 4 Less again combined and again looking just at southern California, our RIDs now as a combined two divisions are a positive, where they were not before.

Those are broken out, though, Ralphs is still negative.

And Food 4 Less is positive.

But when you add the two together, it is a positive number.

Now, that would not be true for total sales in that market, because we've closed, as we've identified, we've closed a couple of handfuls of stores in those markets, and that would cause our total sales actually to be less than what we had at that time.

Second quarter.

Second quarter trend is better than the first.

When we look at the second quarter this year and look at the first quarter this year, and then look at the trends compared to '03, the second quarter trend on that metric is improved.

And then finally, EBITDA, while our EBITDA in southern California was in line with our expectations, we do feel we have a ways to go to get back to the 2003 numbers, which won't come as any big surprise.

Okay.

Thanks for that.

Another quick follow-up on the M&A strategy you gave an answer to this on your last question, but I just wanted you to expand.

Since Fred Meyer, you largely have been focused on small piecemeal acquisitions.

Would you consider doing something larger, given the overall improvement in performance?

I don't think we're going to talk about acquisitions going forward.

I don't think we'd have anything to add to that.

Sure.

In terms of your rating, you are an investment grade mid BBB by Moody's and low by S&P.

How important is that investment grade rating in light of potential acquisitions out there?

Rodney you want to talk about our investment grade?

Nothing beyond -- we've always said investment grade is important, regardless of what environment that we're in, we think it is an important competitive advantage and we wouldn't see that changing.

Okay.

Great.

Thanks for that.

Thanks, Tom.

And your next question will come from Mark Husson with HSBC.

Please proceed.

Yes, good morning.

A couple of questions.

Could we just talk a little bit more about traffic and where your comparable store sales came from?

And if you could break it down on sales to core customer, sales to noncore customers, average basket and then traffic and how affected that was by your gas promotions.

You want us just to give you our spread sheet?

I will give you my e-mail address.

Well, Rodney -- I will have Rodney just comment on the average sale and the traffic.

I think that is the only part of that that we will probably give you.

Yes, when you look at overall, about two-thirds of the increase is from transaction size and about one-third is increase in count.

To be able to assign a specific activity that caused that, I just don't think anybody is that -- our systems aren't that sophisticated be able to point directly to what it is.

Obviously, this -- by showing the mix of numbers, it is showing a mix of increasing our current customers spending more and getting some new customers coming into our stores, both.

So I think that really shows where we're actually addressing both pieces and customers are reacting accordingly.

And as far as gasoline is concerned, obviously this is a huge gas comp store sales numbers for you, you said gallons have gone up as well.

Can you talk about whether that was just in the supermarkets, or whether the convenience stores also saw gallon increases?

And I know you won't give me the cents per gallon but was cents per gallon up or down versus a year ago?

If you look at identical gallons, we're both up, both at supermarkets and C stores.

Very nicely.

If you look at margin per gallon was actually down quite a bit, and that's very typical as gas prices increase, typically margins decline as a cents per gallon.

And that actually considering you do several hundred million gallons that is a significant number for you in terms of gross margin impact?

I wouldn't -- it is a meaningful number.

I don't know that I would say significant.

We will discuss what the difference between meaningful and significant it is after the call.

But you can see how pleased we are with our gasoline business, and I also think you can see clearly because it is an important part of our business, why it is important, to look at our sales with and without gasoline, and to look at our gross margin and our OG&A with and without gasoline, because the gasoline dollars will SKU that quite a little bit.

Just on SG&A, I think if there was a disappointing part of the release today, for me anyway it was that you didn't get a bit more SG&A leverage ex-gasoline.

Can you just talk about what you need to get further leverage on SG&A, and what the cost base is looking like post the southern California strike in southern California?

I respectfully disagree with you.

I'm actually pleased at the leverage we were able to get on OG&A.

Some of that leverage was clearly the direct result of our sales improvement.

And that obviously drives some of that.

Southern California recovery has helped us there.

Cost controls, things like improved labor productivity has helped us there.

And lower health care costs.

Now, there are obviously some areas that have cost us additional dollars but all of those areas that cost us additional dollars were offset by these things I just described, and so I'm very pleased at the results of the organization on cost containment.

We also by the way, some of the costs that are embedded in our gross margin improved as well in particular, the shrink in the drug, grocery, drug GM area.

We had improvement there as well.

Mark, it is also important to keep in mind that not all the investments we're making are in price.

As we save dollars, some of the dollars we save we turn around and invest in additional hours in the store to provide a better service or shopping experience to our customers.

So we aren't taking all the leverage and all the savings to the bottom line, some we invest in price and some we invest in service.

That is an important point that Mike added.

Because the way we talk about this with our divisions, is to literally separate it into those two piles.

On one hand, where are you saving in expenses, and then on the other hand, how are you spending that.

And some of of that spending is in the form of additional service, front end and other places in our delis for instance, other places in our stores and so that will have the effect of looking at the total numbers, will have the effect of increasing some of our costs as well.

Good point.

That's helpful.

Thanks very much.

One other -- a couple of other comments.

On the 22 basis point point decline in OG&A without fuel, less than half of that was because of southern California improvement.

And when you look at it on a sequential basis, this is the third quarter in a row that we've him proving OG&A rate.

In the second quarter, we were down just a couple -- or fourth quarter we were down a couple of basis points.

First quarter was about 9 basis points and this quarter is 22 basis points.

So it continues to get better.

And more than half of the improvement are from the areas other than southern California.

Great.

Thanks very much.

You're welcome.

And your next question will come from Filippe Goossens with CSFB.

You may proceed.

Yes, good morning.

A couple of questions if I may this morning.

Again from a fixed income perspective.

Probably towards Michael.

Michael, the first one, if you let's say purchase one store site, does the labor agreement typically come with that acquisition, and can you differentiate between the situation in California as well as in the rest of the country, please?

So if I purchased a particular store site, does the labor contract come with it?

Correct, yes.

I would have to read every labor contract associated with any store site I bought.

And I would say that they are as varied as the number of stores that could be out there.

Yes, it varies widely.

I was under the understanding that in California, typically if you buy a store, you have to take always the labor agreement with it.

Basically meaning that there is very little interest perhaps from Wal-Mart entering that market if certain of the assets from Albertson's were to become available.

So that is not necessarily your understanding then?

Like I said, it varies by every contract, and I don't have the specifics of all 250 or 300 contracts in front of me.

I don't know specifically what southern California is.

Okay.

Then my second question, if I may, just to follow up on Neil's question, on the ratings, as you can well appreciate, I mean many bond holders in Albertson's have kind of lost their shirts over the last couple of weeks, despite the fact that management had indicated on the first quarter earnings call that they fully remained committed to their credit ratings at the time and would continue to pay down debt so it is is very good to hear from you Michael that you remain committed to the investment grade rating given that it gives you a competitive advantage, so can bond holders sleep on both ears that Kroger under no circumstance will use kind of the concept of a once in a lifetime opportunity to take advantage of certain -- let's say divisions of Albertson's if they were indeed to become available to let go of its investment grade rating if that is what's required.

Sorry for the question but it is one that pops up almost on a daily basis.

I think to answer that question it would probably come a little too close to commenting on acquisition strategy so I probably ought to steer clear from it and just reiterate that we think having an investment grade rating is a competitive advantage, and not go anywhere near anything related to any acquisition strategies.

Okay.

Fair enough.

Thank you very much.

And your next question will come from Chuck Cerankosky with Key McDonald.

Please proceed.

Good morning, everyone.

Good morning, Chuck.

Just a quick question to start off with.

Where is the second marketplace in the Columbus area?

It is a shopping center called Graceland -- no, tha's the first one.

The first one is Graceland.

Great Southern and it's on the southern part of the city just inside the loop, just north of the loop.

Close enough you could drive down there.

That's right.

All right.

Thank you on that.

You could drop Vicky an e-mail and she could give you the specific address, Chuck.

Excellent.

I have a little bit of a variation on John's question but I was more interested in looking at additional space, if you see there is a need, Dave, for fresh furries, and natural, organic categories.

Can you talk about that a little bit, please?

You cut for part of your sentence, but you wanted to talk about the organic and natural food categories?

And fresh as well.

Looking at space as a -- as something you need to manage within the store but I was thinking more in terms of perhaps increasing the space available for fresh, natural, and organic categories.

Well, we're seeing in organic areas now, we're seeing still some good improvement, particularly in produce.

We still see some growth in our natural food areas, although some of the ways we've tracked that in the past, the low carb craze that has gone down quite a little bit is embedded in some of of those numbers but if you take that picture out, we're still seeing some strong results in those areas, and we have continued to carve out space to make sure that we have room for those products.

On the fresh side, that actually is a pretty broad -- it is not a category.

It is multiple categories.

And we have concentrated more energy on a lot of the fresh areas.

Sometimes it is more space.

Sometimes it is just better presentation.

Sometimes it is better products.

But that would be true in produce, it would be true in meat.

It would be true in our delis, our bakeries.

In all the categories that would sell fresh products, you would see some different products today, than you would have seen a month ago or six months ago or a year ago.

So I would have to say you're right to target those areas, those are an area that is being emphasized, within our stores, whether or not you will see us add appreciably more space to that, I'm not sure.

I think we will probably be working more within the footprint we have in a store, but I think you can get more products in and a better presentation in on those products without necessarily adding space.

And I don't mean adding space to the store, Dave, but taking away from say dry grocery.

No, our dry grocery results in the quarter, Rodney identified some of the departments, we had good results there.

We are not trying to suggest we're shifting gears out of dry grocery and into fresh.

What we're really trying to do is emphasize all the areas that the customers are currently real interested in.

And based on our sales, anyway, we would say dry grocery is one of of those categories.

Okay.

Looking at some of your targeted promotions, and what you're doing with dunnhumby, can you give us an update on that?

We commented in my own remarks, we commented about some of the targeted promotions, we continue to target some of our best customers with marketing pieces that -- in large part are driven by data from dunnhumby.

We also use dunnhumby to help us focus on the actual selection of products in the stores.

We use dunnhumby help to help us sort through and segment our stores, to decide which stores belong in which segments, and then of course, marketing and figuring out the marketing plan for each of those segments.

It is -- those areas are all progressing, as we have been describing.

I don't think there is anything, any new revelation in them.

Only I would say we are further developed than we were last quarter or the quarter before.

We continue to learn how to use dunnhumby but that is something that we would expect will take forever, because every time you learn how to do something, you learn how to do something a little bit better.

So there is just, from our perspective a lot of additional work to do and a lot of opportunity to continue to get better with partnering with dunnhumby.

And finally, can you talk about what might be the plus or minus factors that are related to hurricane Katrina?

Yes, I would be happy to do that.

Let me describe it this way.

The effects of hurricane Katrina really are unknown.

And for that reason, we identified it.

There are pluses and there are minuses both.

On the plus side, have seen in those markets more impacted than other parts of the country, we've seen a good increase in sales.

Second, on the plus side, we've certainly seen an engagement of our associates that has been absolutely remarkable, not just in the business sense of getting our stores, keeping our stores open and functioning but also serving the needs in the community at the same time and that is a pretty hard task.

On the negative side, some of our costs will go up.

We've cited diesel fuel, for instance, the impact of that cost so far this year, well that cost went up suddenly with this hurricane.

There has been and will likely continue to be some supply disruptions of products and packaging and supplies.

Things like just as an example, bananas, we received some of our bananas through the port of New Orleans, and we've had to divert those loads to other ports, which has increased our cost a little.

We have had to spend some money to keep our stores open.

Although I wouldn't put a whole lot of emphasis on that.

It is still in those store, if you're in one of those store, it is a big deal.

We had a couple of handful of stores that were -- food stores that were one-time closed.

Those are all back open and were for the most part back open rather quickly because of the work of our associates.

We had more than that, stores, convenience stores that were closed at one time, and those have mostly rebounded, I believe.

We have three stores I think it is in Gulfport that were not our -- they were our stores originally, we're on the leases there, they have been sublet one is vacant and the other two were operating.

We could have some liability there but it is too early to tell because we haven't seen the stores, we don't really know the condition that they're in.

But those are the kinds of things that are today, unknown to us.

And then one other unknown is what impact would gasoline, retail gasoline prices have on the shopping behavior of customers.

We're not going to speculate on that, but there has certainly been a lot said, and a lot written about that topic and if that became an issue, we thought it was important at least to identify it.

So these are things that are identifiable, but not quantifiable, and that's why we describe them as unknown.

All right.

Thanks a lot, everyone.

You're welcome, thanks Chuck.

Your next question will come from Meredith Adler with Lehman Brothers.

Please proceed.

Great.

A couple of questions.

You talked real briefly about product cost inflation at 0.7% and mentioned deflation in dairy.

Could you just talk a little bit about sort of the puts and takes that you're seeing within the pricing environment?

Well, let me--.

The cost environment.

Okay.

Let me comment on the -- on just the dairy just for a second and then I will see if Mike wants to add anything on the inflation generally.

The reason we noted the dairy area was that in our Kroger brand products, we've seen lower costs and in some cases, in many case, lower retails on cheeses, on fluid milk and I think eggs, as well.

Those three areas.

And those are pretty big dollar items for us.

And that, as a result, caused the Kroger brand in dollars to not increase in terms of market share in the quarter.

Even though in units we continued to rise as we have in the past.

Mike, or Rodney, you want to comment on other categories?

In the grocery categories Dave described, those things are certainly factored in there and it is such a big category for us if somebody reads a headline that vendor X has raised price, people will immediately think there is inflation in our category but typically the dairy category and coffee category and categories like that are a relatively big component of that because not only do we have it at retail at manufacturing so a one-off price increase by somebody really doesn't affect the grocery category too much.

We did see inflation in produce.

We actually saw deflation in the meat and deli category for the first time in a couple of years.

Meats by nowhere back to a couple of years ago level but it does look like at least for now that the tide has turned on meat and it's starting to show some signs of deflation.

Okay, great.

That's helpful.

I was wondering also, I think Rodney you were talking about kind of all the areas where you saved money, you talked about health care being down, but I think the last two quarters you've actually told us how much in terms of basis points.

Can you give us that for the second quarter?

Let's see.

We're going to look it up.

Okay.

Then I will try to ask just one other question.

We've got it right here, I think.

Okay.

Good.

If you look at -- it would be somewhere in the neighborhood of 10 to 15 basis points.

And that's a sequential improvement, right?

Right.

Great.

And then my final question would be you talked about the marketplace stores.

I was just wondering if you could give us a bit of of an update on the Food 4 Less, or Food 4 Less type concepts, how many stores you have in Chicago, and whether you're looking at any other markets outside of sort of California, and the western states for expanding Food 4 Less?

Well, on Food 4 Less, we have, I think we have nine in Chicago now open.

And in the southern California market, and northern California, we continue to add some stores in both of those markets.

And Las Vegas.

And Las Vegas, too, right.

Those are all growing markets.

I'm pretty bullish about the concept of Food 4 Less and what value it can offer.

It connects wonderfully with customers in the value segment of the business.

And if you look at the way customers fall, there is of course a wide range of where they all fall, and the whole middle section which we address quite well with our combo store.

Our combo stores actually do pretty well also with the value segment, but Food 4 Less, I would say is even better yet.

And so that concept in California, Las Vegas, and Chicago, I think, is a good one for us.

And it is good to have it in our arsenal.

I don't know that I would add anything more about our specific plans there.

I mean if you look at Chicago, we're still learning how the economic model works in a market where they don't know your name.

That's true.

And we're pleased with where we are but we still have a lot of work to do.

We are adding stores along the way in Chicago, as we find the appropriate sites.

Great.

And then I have to add one final question about antitrust.

And whether you have any information that tells you that there would be any change in either the fed's or the state's approach to antitrust versus what happened in the late '90s or has there just not been enough happening to have any sense of that?

I don't think I have any sense of how the FTC sees that world today versus what they've seen it in the past.

It has always been a question in our minds as we look at markets particularly in some of these in-fills so we always ask the question, but I don't think we have any information that would lead us to conclude anything's particularly different.

Okay.

Great.

Thank you very much.

You're welcome.

And your next question will come from Jason Whitmer with FTN Research.

Please proceed.

Thanks, good morning.

David, I wanted to revisit just some of your brief near term thoughts on the consumer.

Do you see any sort of trade down effects or mix shifts within products or departments, any trip consolidation and then I have a second second question on the overall pricing promo outlook.

Well, I think if I were to answer any of those questions, it would be more my own conjecture based on things I see out there, because I don't think we have any data proof of what you're saying.

There's certainly some things I've read recently that suggest there could be some trip consolidation that is causing some of our sales to improve.

Mostly because of gasoline.

Or the people are staying close to home and keeping their drives shorter.

Those kinds of things.

Certainly could be one of the things going on.

But we don't have any data proof to suggest that that is the case.

And as a result, I'm not trying to guess, outguess the customer in this sense.

We're just trying to keep our ears open and hear what they tell us and offer the products and services as they tell us they want them.

And whether in that context or you get into the broader, shifting landscape or I guess the evolving pricing in the industry, what do you think,-- where do you think the long term picture is going here?

I know you've talked a little bit more about shifting your own pricing lower, doing different type of promotional strategy, targeted promotional strategies, certainly the industry is changing on this, do you have any general thoughts on where we're going on this or the overall margin indications for Kroger or for the industry?

Yes, before I go there, I will -- let's go back to your previous question, too.

You actually also asked about trading down, whether customers, and I presume it was because of the dollars being spent on gas, whether they're trading down in their purchases, and I wanted to tell you on that, too, I don't know that we see anything discernible there at all.

Plus I think it is too early to tell, particularly with the higher gas prices, those have only been in the last two weeks.

But moving more to the broader question of where is this industry going.

I don't know so much about the industry.

But I can tell you where Kroger is going rather clearly, is we believe what our customer wants is all of the things that we provide.

We think they want a good price, we're not trying to be the cheapest price but we think they want a good price.

We think they want a collection of products that are clearly the ones that they're after.

And occasionally, like to be surprised at something they would see in the store.

And we think we provide that very well.

And are improving on that every day.

We think they want to see people in the store that engage them and are interested genuinely in serving them and providing them the products and services they want.

And we see that, and the way we measure it, we see that improving at Kroger also.

And then finally, we think the customer is interested in the shopping experience.

But the one thing we've learned about the customer is there are as many customers opinions of what they want as there are customers.

Everybody wants something a little different.

Which suggests that segmenting in small ways and big ways is essential and to the long-term success of individual stores, and of individual retailers with their customers.

We are, as you can tell from my own comments, we are trying to make sure it is real clear that what we're trying to do is identify what our customers want, and provide answers to that, through our associates in our stores.

We think we are on a path to do that.

We think that is where our company is going.

We think that is where success will be for retailing of our type.

And we're absolutely committed to it.

In terms of the promotional environment, I think that will depend.

I think there will be some customers and some segments that will need a bit of promotion.

There may be some other stores that -- or other segments that can have less.

I think every segment that I've ever seen though, likes a little bit of promotion.

And because it keeps things exciting and promotion can be not just with price, it sometimes is with sampling, it sometimes is with demonstrations, it sometimes is with how it is displayed or signed but a little bit of excitement like that causes people to have interest in our stores.

So I think you will see us in varying degrees continue to pursue a strategy that includes all of those components.

Now I don't know whether I've answered your question, but I--.

No that is a really good answer, thank you.

And then in terms of the cost savings to fund all of this, do you see some accelerating movement here whether it is is within supply chain, labor, shrink, health care, the magnitude of the timing of all of that is what I'm most interested in, as we kind of move forward toward that end.

As we've said going forward is is that we expect our operating margins to remain stable, operating profit margins to remain stable improved a bit by southern California's effect.

And that point is intended to drive home the idea, and that we will reinvest as we find savings, we will reinvest in ways to try to improve our sales.

Our objective here and our strategy, a core element of it is our identical sales and we want to keep that strong, because that's what will allow then our earnings to grow, and our operating profit to grow.

And so we will be, as we identify additional savings going forward, finding ways to reinvest that in a very positive way with our customers, and in fact, you saw some of that in the quarter.

Some of our comments were consistent with that in OG&A, and in gross margin, and gross margin, as an example, we were up 10 basis points the way we look at that, and that was a result of some good expense control, and some improvement in this drug GM and grocery shrink but it also helped offset some additional targeted price investment.

And I think you will see a lot of that going forward, where we're looking for where we can save so we can look to where we can spend it, and in a very effective way.

We do see lots of opportunities for cost savings, down the road.

Every time we turn a page on one, we open a page for another.

And think that there is plenty of opportunity for us to keep going forward on that metric.

Great.

And I will just sign off with any -- ask for any concluding thought or updated thoughts on a potential dividend.

I don't think we have any additional comments on a dividend.

We periodically review that.

Our Board periodically reviews that.

We try to identify what we think is in the best interest of our shareholders.

And in fact, we've queried a number of you and a number of our owners to ask their opinions, to get some sense of that, and it is is just a balance of how we see that.

Okay.

Thanks.

You're welcome.

And your next question will come from Carla Casella with J.P. Morgan.

Please proceed.

Carla?

Sorry about that.

Can you hear me?

Yes.

Sorry.

You talked about southern California somewhat but I'm wondering have you -- is your market share data showing that you're actually gaining share in that market or is it just an improved market for everybody?

We don't -- first, we don't give out market share data like that, for that market.

Second is, we really run our concentrated look at market share the way you're describing it in each year, at the end of the year, so I don't have anything there current.

But I think that -- the metric that I think is important for us to recognize is that our second quarter has improved in trend from where the first quarter was.

And that our second quarter was, compared to two years ago, the identical sales have actually now improved for the two businesses combined.

And Rodney, I think, has corrected me, I think I said maybe the first quarter was positive this year, compared to two years ago, too.

I don't think that was the case.

It was positive.

It was positive.

I said it was negative.

It was positive.

That's right.

But we're more positive in the second quarter compared to '03 than we were positive in the first quarter compared to '03.

And so directionally I think the message I want you to see is that we are step by step making improvements, making progress, and we're pleased with that progress on the part of our associates in southern California.

Okay.

Great.

Thank you.

And your next question will come from Mark Wiltamuth with Morgan Stanley.

Please proceed.

There has been a lot of chatter in the marketplace about real estate values.

I wanted to have you talk a little bit about your -- how you approached the decision on leasing versus owning properties and do you see any value to be extracted by doing sale lease back transactions.

Well, let me first comment on the question about the choice of a lease versus owned and then I will ask Rodney to comment generally on this area.

I have long believed and we have followed a strategy for some time that says generally speaking, it is less expensive for us to own the real estate than for us to lease it.

I believe that very strongly.

And we have focused on that whenever possible.

We have done that.

But we always make an evaluation of which is -- which is the right financial choice on this particular deal.

It is not automatic that ownership is always the right answer and it is not automatic that leasing is always the wrong answer.

There are times when it can flip the other way, but generally speaking our cost to finance real estate, even out of our general financing pool, is less expensive than the embedded financing costs of the leaseholders or the lease owners, the property owners, and so a lease by us typically ends up being a more expensive way to own it.

But with that background do you want to add?

There's not really -- yes, I mean.

Sorry, I got carried away.

It's a topic I feel strongly about.

Okay?

Okay.

Thank you.

Thank you.

And your next question will come from Andrew Wolf with BB&T Capital Markets.

Please proceed.

Andy, I think we're going to make yours the last question.

Okay.

I got one, they're all somewhat related.

Do you have the square footage at the end of the quarter and your expectations for the year?

Mike, do you have that?

Well, let's see.

I better ask Mike, because I'm not sure of the number I'm looking at here.

I will get it.

Just a second.

While you're looking that up, I will ask -- these are essentially follow-ons.

On the shrink reduction in perishables, would you attribute that more to programs that you're focusing or just the better sell-through and how that sort of automatically improves?

Actually, the shrink we identified was in grocery, drug GM.

It was not in perishables.

In fact, in perishables, it was not an improvement.

However, in perishables, we're very focused on that, and part of our lack of improvement in perishables is the way in which we're measuring it.

We're trying to flush out, as you might imagine, in order to solve for shrink, you have to first understand what the shrink is.

And the real question for us is, what is real shrink here?

And we've worked now for several years to try to make sure that we have been able to pinpoint that shrink.

A second question on perishable shrink that tends to offset those improvements that we have made is we've made a decision, take the example of the earlier question about organic produce, in order for us to sell more organic produce, we have to be willing to experiment with that product.

Which means we have to have product out there when it is maybe not going to sell, and will increase our shrink.

That is also true in some products in bread, for instance, that we're trying, it is true in some cheese products that we're trying, recently, it is true in a number of fresh products, and unless we're willing to target some additional shrink in those areas, we can't grow those areas.

But we're being very targeted about that, we're trying to identify how much shrink should we expect from that particular decision, and recognizing, quantifying it, and saying that that is an acceptable level, and then trying to improve on the general shrink in our perishable categories as a whole.

We have take an number of steps, some of which we have described on this call in the past, our fresh insights program which is technology and process focused, to help us understand shrink better than we understood it before, and to make some improvements, so I am quite comfortable in saying we have made some clear improvements in our perishable shrink efforts but I am also conscious of the fact that our numbers don't bear that out but I think that is mostly because of the way we measure it, and because of some of the merchandising steps we've taken that will tend to offset those improvements.

So we really did not identify that as an improved area in the quarter because in fact it was not.

Now, do you want to comment on the question about square footage?

Yes.

If you look at square footage in absolute terms it was up a little under 1%.

Our guidance for the year, I believe was 2 to 3% without operational closings and if you take out operational closings, it is up a little over 2%.

And those are as compared to last year's second quarter end.

So that would be a rolling four quarters kind of comparison.

And could you remind me how you define operational closings?

I mean is that when you close--?

Where we shut down and do not have a replacement store open for it.

It is just one we decided for operating reasons to close, versus one that was relocated.

So we've seen a net reduction of 17 stores I think year to date.

Is that essentially the operational closings associated with Ralphs or for the most part, is that what that is?

Operational closings for the year, we've actually had about 36 of them.

It is not all Ralphs.

It is about -- a little less than half of that would be Ralphs, actually.

Got you.

And I just want to follow up, and this is my last question on the product cost area, that various folks were asking about.

Generally speaking, and in this quarter, specifically when have you a deflation and two big categories, dairy and meat, what was the effect on both tonnage, and on gross margin?

You want to answer that, Rodney?

Well, yes, we would not get that specific in terms of giving that level of detail, or at least we never have.

I've always, too, hedged a little by telling you that actually it is often a mixed bag.

Because of the various puts and takes.

Some of it is driven by what seems to be happening with the customers in terms of demand for the product.

At the same time that something else is happening on the supply side.

And so it will vary situationally pretty regularly.

When you look at tonnage overall, our tonnage was up very strongly, to me, I think I agree with Dave, it is always difficult to look at just one specific line but when you look at tonnage overall, it was up nicely.

Good.

Anything else, Andy?

That is it.

Thank you.

Thank you.

And let me just close by saying this.

As we said last quarter, we continue to acknowledge that even as things look good, we see room for improvement.

But we are pleased overall.

I am especially proud of our associates, both for how they have committed to our customers, but also how they have in a very personal way committed to those in our communities, impacted by Katrina.

I am proud of you.

Thank you all for joining us today.

Goodbye.

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

This does conclude the presentation.

You may now disconnect.

Have a great day.