克羅格 (KR) 2005 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Kroger Company Third Quarter 2005 earnings conference call.

My name is Ann Marie and I will be your coordinator for today.

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

We will be conducting a question and answer session toward the end of today's conference.

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

I would now like to turn the call over to Ms. Carin Fike.

You may proceed, please.

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 third 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.

Good morning, everyone.

We're pleased you could join us to review Kroger's third 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'd like to begin this morning by briefly reviewing our third quarter performance and some key areas of our business.

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

Total sales for the third quarter increased 9.1% to $14 billion.

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

This growth continues a very good trend.

Identical supermarket sales increased 6.6% with fuel and 3.7% without fuel.

Once again, by either measure, this represents Kroger's highest identical supermarket sales since the merger with Fred Meyer in 1999.

It also is the ninth consecutive quarter of positive identical supermarket sales, excluding fuel.

We're very pleased by this performance.

As we've discussed before, identical sales growth is a key component 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.

To do that, we've taken a page from Kroger's past to build our business for the future.

Some of you may know that back in the 1970s Kroger became the first U.S. grocer to formalize consumer research.

Since late last year, our Company has been surveying thousands of customers around the country each quarter to ask about their shopping experience in our stores.

The great thing about this feedback is that it comes directly from our customers and it clearly identifies areas where we can improve.

We want to know what matters most to them when they choose where to shop.

We also ask customers the same question about their shopping experiences at our competitors so that we can benchmark ourselves and measure our improvement.

Each quarter we share the feedback with our supermarket divisions as one way to help our associates better understand what our customers expect when they visit our stores.

We know that you win one customer at a time and these surveys are a very useful tool.

Kroger's corporate brands continue to be an important competitive advantage.

In the third quarter we added 201 items to the corporate brand line-up.

The market share of Kroger private label grocery items, in terms of dollars, reached nearly 24%, and our share in terms of units was slightly over 31%.

Now turning to southern California, sales and operating profits at Ralphs and Food 4 Less improved during the third quarter as compared to last year.

Identical supermarket sales, without fuel at both divisions, on a combined basis increased 2.9% over the prior period.

The pace of our recovery is proceeding slower than we would like.

We see additional opportunities for growth and our teams at Ralphs and Food 4 Less are clearly focused on seizing those.

We continue to be bullish on southern California.

As we're now in the final quarter of our fiscal year, I'd like to remind investors about our earnings guidance for fiscal 2005.

In March, we forecasted that our 2005 earnings would exceed $1.21 per diluted share.

In June, on the strength of our first quarter financial performance, we raised our earnings estimate to exceed $1.24 per diluted share.

Now, based on our year-to-date performance through the third quarter, we are confident we will exceed earnings of $1.24 per diluted share as a result of improved results in southern California and the balance of the Company, lower interest expense, and fewer shares outstanding as a result of our stock buybacks.

Now I'll ask Rodney to provide some additional perspective on Kroger's third 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 of the country and across all major categories.

All but one of our divisions experienced another quarter of an increased identical supermarket sales.

The strongest categories included produce, grocery, and drug general merchandise across the Company.

Also at Fred Meyer, in addition to these categories, the home fashion and apparel categories were strong.

We estimate product cost inflation during the quarter was 0.4%, that's 0.4%, excluding fuel and 3.4% including fuel.

Kroger reported net earnings of $185.4 million or $0.25 per diluted share for the third quarter.

Net earnings in a year ago period was 142.7 million or $0.19 per diluted share.

Kroger's results for the quarter reflected a variety of items that together had little effect on fully diluted shares earnings per share.

These items include $0.02 of income resulting from the settlement of a previous class action credit card suit and the reversal of an unrelated tax contingency.

These benefits were offset by a combined $0.03 of expense resulting from the impact of Hurricane Katrina and Rita and an increase in certain legal reserves, some of which are nondeductible for tax purposes.

And a write down to fair market value of assets held for sale.

The biggest item was the increase in certain legal reserves.

Our fuel business had a strong quarter in sales, gallons, and margins.

While fuel margins in the quarter were strong, on a year-to-date basis, they were more normalized.

FIFO gross margin was 24.48% of sales, a decline of 62 basis points compared to the third quarter of 2004.

Excluding the effect of retail fuel operations, FIFO gross margin declined 6 basis points from the prior year.

Improvements in strength, advertising, and warehousing allowed us to fund additional investments in lower prices for our customers on a targeted basis.

OG&A declined 69 basis points to 18.23% of sales.

Excluding retail fuel operations, OG&A declined 3 basis points as Kroger was able to leverage higher sales to offset higher energy prices and investments in better service.

We estimate that the higher energy prices negatively affected gross margin by 8 basis points and OG&A by 9 basis points for a total of 17 basis points.

Our financial performance in the third quarter reflects the consistent approach we have taken to managing our business.

We continue to balance investments in gross margin and improved customer service with operating cost reductions to provide a better shopping experience for our customers.

Capital investments totaled 336.9 million in the third quarter compared to 429.1 million a year ago.

For 2005, we now expect capital investment to come in to the closer to the low-end of our range of 1.4 to 1.6 billion, excluding acquisitions.

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

During the third quarter, Kroger repurchased 590,000 shares of stock at an average price of $19.97 for a total investment of $11.8 million.

At the end of the third quarter, there was approximately 158 million remaining under the $500 million stock buyback announced in September, 2004.

Since January, 2000, Kroger has invested $2.9 billion to repurchase 153.1 million shares at an average price of $19.14 per share.

Kroger continues to buyback stock.

Net total debt was $7.2 billion, a reduction of 660 million from a year ago.

Net interest expense totaled 114.2 million, a decrease of $2.5 million from last year.

We have reduced net total debt by $1.6 billion since January, 2000.

Over the past four quarters, Kroger's strong cash flow continued to enable us to achieve our financial triple play by reducing net total debt by 660 million, repurchasing 272 million in stock, and making $1.3 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 a cash dividend.

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

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

Our investment grade rating is important to us and we're focused on improving our coverages.

Our net total debt to EBITDA ratio in the third quarter was 2.22.

Our best historical performance since the merger with Fred Meyer came in the second quarter of 2002 when our ratio was 2.16.

Our third quarter tax rate was 38.2% for the current year compared to 35% for the prior year.

The third quarter, 2004 rate was favorably affected by the settlement of open items with various taxing authorities and the retroactive passage of the work opportunity tax credit legislation.

The third quarter 2005 rate was also favorably affected by the settlement of open items offset by the impact of certain legal expenses that were not deductible for tax purposes.

We expect that our tax rate for fiscal 2005 will be 37.5%.

This is consistent with our prior estimate.

Now a quick update on labor negotiations.

Since our last investor call in September, Kroger has reached new agreements with the UFCW in Atlanta, Roanoke, Columbus, Dallas, and Dayton.

Teamster locals in southern California also ratified new contracts.

With these agreements, we have now completed every major UFCW contract identified for 2005.

Kroger generally was able to work with the Unions to craft a balanced agreement that met our objectives for cost reductions or containments while fulfilling our commitment to provide our associates with solid wages and benefits.

We'll be back at the bargaining table in 2006 with a number of contracts covering smaller groups of associates but nothing of the magnitude we faced this year.

Labor negotiations will continue to be a challenge in the face of competitive pressures and rising pension and healthcare costs.

One final note.

We are currently in the process of completing Kroger's business plan for 2006.

As in the past, we will expect to share details of Kroger's business plan when we release fourth quarter results in March, but our strategic focus will remain the same.

We will continue to focus on driving sales growth and balancing investments and gross margin and improved customer service with operating cost reductions to provide a better shopping experience for our customers.

We expect operating margins in southern California to improve slightly to continued recovery in that market, although the incremental improvement in 2006 will be less than in 2005.

We expect operating margins in the balance of the Company to hold steady.

One thing to keep in mind is that fiscal 2006 will be 53 weeks.

Also we will begin expensing stock options in 2006, which we expect will affect fiscal 2006 earnings by $0.04 to $0.06 per diluted share.

Now we'll turn it back to Dave for some concluding remarks.

Thanks, Rodney.

Thanks to the hard work and outstanding contributions of the entire organization, Kroger has made tremendous progress in several key areas this year.

Our associates are offering improved shopping experiences to our customers in a variety of ways.

And Kroger has been able to fund these improvements by taking costs out of our business and improving productivity.

Holiday sales are off to a strong start.

We are focused on becoming more competitive in every aspect of our business so that we can take advantage of growth opportunities and generate value for our shareholders.

During this holiday season, it's important to thank our associates and customers for their generous response throughout the year to help those in need.

2005 has been a difficult year for so many, including those affected by the hurricanes in the Gulf coast.

I'm tremendously proud of the way our customers and our associates at our stores, our manufacturing plants, offices, and distribution centers rallied to help.

Together we raised more than $7 million for the American Red Cross hurricane relief efforts.

Kroger has long understood the importance of giving back to the communities where our customers and associates live and work.

Now others appear to be taking note, too.

Last month, Business Week magazine recognized Kroger was one of the most generous companies in America for our work with schools, food banks, youth groups, and other charitable organizations.

We're proud of that honor and will continue to look for new ways to partner with these organizations in 2006.

We now will be happy to take your questions.

Thank you, sir.

Ladies and gentlemen, if you wish to ask a question, please press star followed by one on your touchtone phone.

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

Again, it is star one if you wish to ask a question, and we'll pause for a moment as questions queue up.

And your first question will come from Mr. John Heinbockel with Goldman Sachs.

You may proceed, please.

Dave, a couple of things.

With respect to your consumer research, what has that told you with regard to the differentiation of your franchise?

Meaning, in this business it's tough to get recognized unless you're at the extremes.

Wal-Mart gets recognized.

Whole Foods.

You guys are kind of in the middle.

What has it told you with regard to what your franchise is built on and how recognizable is it to your customers?

I won't answer very specifically, because I don't plan to give that kind of information out broadly, but I will tell you that the research that we've looked at essentially says about our franchise what we would intuitively think.

For instance, those stores, individual types of stores, pockets of stores, and even brands of stores that would be viewed more as either upscale or positioned differently than just a mainstream store, do tend to come across that way in the research.

Those that are more price oriented similarly come across that way.

And the combo store, much like what we would expect, seems to attract a very broad audience and appeal to a wide variety of different kinds of customers in that it seems to address those customers on their terms.

And we often refer to the fact that you win one customer at a time.

And I think that's real important in thinking about store formats, how they address customers, because rarely do you get the same customers coming into any one store.

You've got to address multiple different kinds.

So the combo store really works quite well for that and the research certainly confirms it.

The value for us in the research, though, as I pointed out, is that it really helps us identify areas where we can improve better, where we can differentiate ourselves better, and then some areas where we have been successful.

I don't plan to identify those particulars, but I think it is responsive to what you were asking.

So I take it that you're able to benchmark the strength of your franchise against competitors and, I assume, you're coming out above average in the strength of your franchise versus your competition or is that not right?

I don't plan to discuss where we come out on the research.

We're using it for our own internal purposes.

And for competitive reasons, I don't see any reason to describe that.

John, the other thing it does, this is Rodney, as we make changes, it identifies whether the customer sees those changes and whether it's something that's important to the customer or not.

Right.

The second thing, you talked about balancing and you've done a good job this year balancing investments in the business and bottom-line return.

How do you think about the appropriate total return to shareholders over whatever timeframe you want to think about?

Do you think about a total return?

Do you think about it over two years, three years?

How do you think about that in terms of what you want to deliver to your investor base?

I think we've described how we see the business and how we see our long-term success will be driven by an overall strategy that addresses the customers on their terms and works hard to reflect that in showing our improved sales.

We believe, at the starting base, that our sales really will drive all of the future results and that earnings growth comes from that.

And I think, in terms of our future projections on earnings and our expectations there, about as far as we're going to be willing to go today is -- are the elements that Rodney described which is much the same picture that we've described really all of this year as to what our focus has been.

We'll give you a little bit more specifics come March when we wrap up the year, but I think we're going to leave our future earnings just at the portions that Rodney covered.

Rodney, you want to add anything?

I was just going to say, certainly, from looking at shareholder value, we would look at it at a one year perspective, a three year and a five year and really focus on all three of those, trying to make sure that we keep them all in balance.

Obviously we haven't given specific objectives publicly, but we do understand we have a responsibility to improve shareholder value.

Absolutely.

Okay.

Thanks.

John, thank you.

Thank you, sir.

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

You may proceed, please.

Two questions.

The first one is in general terms, we haven't had a lot of experience about this recently, but how do you think the FTC is going to treat potential combinations of supermarket chains in market going forward?

I mean, obviously, there's a number of properties up for sale right now and we're trying to think about what happens to consolidation in markets like, say, Phoenix or Dallas or whatever.

What do you think the FTC thinks about competition like Wal-Mart, for instance, and whether they're really including those in thinking about market share limits.

Over the years, we've had a variety of conversations with the FTC and they shift their view time.

I can't actually tell you right now what they're thinking.

And so I can't offer any guidance as to what they would suggest in those markets.

I think in, was it Puerto Rico they started to really include super centers in calculating market share?

I actually don't know.

Okay.

Might have been, but I don't know.

Okay.

I'll move on to a more fertile area hopefully.

Okay.

One that I'm willing to talk about.

Maybe you can talk about the depreciation charge and the share count as well.

Considering there was a share buyback, I was surprised the share count was a little bit lower.

The second thing was depreciation.

You're managing to leverage the depreciation charge quite well here, but I'm surprised again that it really wasn't bigger than it was.

Are you writing off assets in the depreciable base?

Is that why it's not going up?

I mean, the depreciation would be -- the write-off periods would be the same now as what they would have been previous quarters in previous years.

Obviously, if you go back, you really have to go back over the last five or six years on the level of capital spending.

And until we have a steady level of capital spending you would expect to see some increase in depreciation.

I'm just surprised it wasn't more.

That's all.

The capital spending has been trending down as well.

Yes, over the last year and a half.

And the share count?

Is there any sort of guidance as to where the share count is now?

Not anything additional from what we provided at the beginning of the year.

What was it at the end of the quarter?

Average for the quarter.

Average for the quarter was 731.

And the end of the quarter?

731.4

0.9.

And finally on gas stations, we've seen some super gas margins in the convenience stores and presumably your margin expanded quite significantly in the quarter.

Would that have a meaningful effect on the gross margin?

And also maybe you mention manufacturing.

Sometimes you talk about how well they're performing, too.

On fuel, what we said was that we had a good fuel quarter.

Our convenience stores had a wonderful quarter.

And for a variety of reasons, one of which is that their gallon sales were up strongly, not just the retail price or just the margins.

And the same's true in the supermarket fuel area is the gallons there also were up strongly.

And we made it a point to indicate that over the course of the year, year-to-date, that our gas margins are more normalized because it illustrates that with gasoline margins at retail, you tend to have times when you make a little margin and times when you don't make much margin.

And they do tend to offset over a little bit of time.

This quarter happened to catch the one period of time where the margins were a little higher than other times in the year and so you saw a little blip up.

But it got smoothed a lot when you look at the full year effect.

So we would say that there was good impact for the quarter, for the shareholders, for all of us in our return from gasoline.

We identified in gross margin for you our gross margin with and without fuel, which helps you illustrate what that impact was.

And I'll leave that math, I think, to you.

Mike or Rodney, you want to add anything to that?

Okay.

Manufacturing?

Mark, anything else?

Manufacturing.

Oh, manufacturing.

Manufacturing had a good quarter, although we had a couple of moments where we had some supply cost issues.

In fact, if you look at the whole Company, embedded in our OG&A numbers, we saw some supply issues in terms of costs mostly related to energy costs one way or another.

Sometimes petroleum, sometimes just general energy costs.

And so manufacturing did have some of those issues.

But generally speaking, manufacturing is a strong tool for us and contributes real well.

Through the course of the year, we're quite pleased with their results.

I would just add on top of that, as Dave mentioned, we were very pleased with manufacturing given some of the opportunities they had.

Obviously the opportunities were more difficulties this quarter because of the hurricanes and the effect on some of the supply.

They just did a marvelous job managing their way through that and keeping our stores in stock and everything else on key products.

So when you look at the hand they had dealt, they just did a marvelous job.

Great.

Thanks very much.

Thank you, Mark.

Thank you, sir.

Your next question will come from Filippe Goossens of Credit Suisse First Boston.

You may proceed, please.

Good morning, everybody.

Question for Michael.

Michael, obviously, I think bondholders will be very pleased about the comments you made this morning with regard to your desire to maintain investment grade trading.

Many thanks for retrading that stance.

One quick follow-up if you don't mind, Michael.

If you were to do something with regard to, let's say, a medium or larger size acquisition, is it typically the practice of Kroger to first clear that with the rating agencies?

A little bit more color on that I think would be greatly appreciated.

Thank you.

I don't think I'll speculate on any type of an acquisition and won't go any further than reiterating Rodney's comments that our investment grade rating is important to us.

We continue to paydown debt and focus on increasing our coverage ratios.

It's just something that we think is fundamentally important is to have the investment grade rating.

Great.

Thanks so much, Michael, for those comments.

Thank you, sir.

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

You may proceed, please.

Hi, guys.

Couple of questions for you.

This Wilson housekeeping, could you repeat what you said about fuel?

Did it positively impact the operating margin or negatively?

It negatively affected operating margin by about 17 basis points.

It negatively affected the rate, the percentage, but it of course improved the overall dollars.

Right.

Meredith, before I -- Dave and I are answering different questions.

Repeat your question.

Are you talking about it from the retail standpoint or from the cost standpoint in terms of the effect on the business?

The minus 17 was what I was interested in.

Okay, yes.

The operating margin, we estimate it, and obviously this is an estimate given the information that we have, but we think in total it's about 17 basis points. 8 basis points of that showed up in gross margin, primarily transportation costs, and 9 basis points was in OG&A.

And that would be related to supplies and the flow through effect on supplies and a few other items.

That's not just your business of selling fuel.

No.

No.

That's a cost of doing business.

Yes.

The business of selling fuel was what I was trying to answer.

That's a totally separate question.

And we look at them separately here.

What Rodney was describing is the fact that energy costs, in particular gasoline and diesel, but also just -- .

Natural gas, too.

Natural gas and utilities and other related costs, some supply product, supply packaging, other products that are related to the energy field, those increases, as best we can capture them, are in that general range that Rodney described.

That has really nothing to do with our retail selling of fuel.

Our retail selling of fuel was a real plus for us in the quarter.

And could you quantify how much of that was a plus?

The retail fuel?

Yes.

Well, the two items that we've identified, which we'll leave to you to look at how important that is, we identified the identical sales growth with and without fuel.

We've indicated to you that our gallons were up strongly in both supermarkets and convenience stores.

And we've shown you what the impact on our gross margin was with and without fuel.

So you can see essentially what fuel represented as you do that math.

Okay.

And then moving on --

I think Mike has --

Meredith, just one other thing, just so everybody's clear on the 17 basis points.

That 17 basis points is the effect on our operating margin without fuel sales and fuel gross and fuel OG&A in the numbers.

That's how much operating margin was affected negatively by the higher energy costs we incurred, be it in fueling trucks, higher utility costs or higher bag costs or other related supplies.

Good point.

Got it.

Could you talk a little bit about southern California?

And anything in specific about why you guys are not making the progress you want?

You talked about opportunities.

What exactly does that mean?

Well, let me describe it this way.

Our sales were up over last year on an identical basis.

When you Ralphs and Food 4 Less together, 2.9%.

That's the same that we were up last quarter from the year before.

So we actually see that as good progress, because we continue to be up.

We continue to have decent sales.

But the disappointment, if you felt any in what I said, was that we believe that there are more sales and operating profit opportunities and that there's more available than what we have achieved.

So that's why we used the phrase we would have liked to have had more.

But we have made progress because both our sales and operating profit at both Food 4 Less and Ralphs are improved versus last year's third quarter.

So on that basis, we actually are quite pleased at the progress.

It's just that we thought it would be a little quicker and we're pushing ourselves really to make that happen.

And the division is, the divisions, plural, are very focused on making that true.

We highlighted it because southern California, of course, is a major part of our business, and we just felt that the additional insight would be helpful to you.

But I guess I'm wondering is it external or internal factors that you think have held back the progress maybe a little bit versus what you had hoped?

Well, the single biggest impact on holding back our growth in operating profit in that market was gross margin.

And that gross margin was, in our view, primarily because of mix and some things that we're addressing, but it was a gross margin question more than it was expenses or other issues.

Great.

That's helpful.

And maybe you could just comment real quickly on the competitive environment more generally.

Have you seen any -- on average any big change in the competitive environment, better or worse?

Actually, no.

I don't think we've seen much change.

Now, that's not true, in some individual markets you will see some changes.

But I think the answer I'm giving now is essentially the same answer I've given for several quarters in a row that, while we see some markets better and some worse, on the whole it's a very competitive business and it gets stirred in a variety of ways.

Some of it is traditional competitive openings.

A lot of it has to do with the additional growth that Wal-Mart is adding with their super centers.

As you know, they've increased the rate by which they open those.

And roughly half of whatever they open we compete with and so there have been a lot of openings there.

And it just makes for a very competitive market.

And in the face of that competitive market, we are very pleased at the results we achieved.

They thought our sales were good.

We thought our earnings were good.

And overall felt that we positioned ourselves quite well, particularly in this kind of environment.

Great.

Thank you very much.

Thank you, Meredith.

Thank you.

Your next question will come from Steve Chick with J.P. Morgan.

You may proceed, please.

Couple of questions.

Obviously your sales have been very good.

You've really pulled away from your peers with your non-fuel IDs.

I know you'll speak to next year in March, but how do you feel about how you're going to do -- you've built up this momentum.

What are your thoughts in terms as you start to comp the comps, so to speak, what level do you think ends up being sustainable.

And do you think you'll be doing a year from now non-fuel identical store sales that are quite at these levels?

I was wondering if you could speak to that a little bit.

Yes, Steve.

We continue to see opportunity.

And as a result keep focusing ourselves and realizing that identical sales really are the core of our strategy.

And we have repeatedly said it's not sales at any cost.

It's sales at profitable long-term growth and sales that can produce a profit in the long-term.

But those identical sales are the core and we are focused on making sure that we get what we can get and improve where we can improve.

We base what we think that objective is for us in part on what we feel our customers can and will respond to.

So it's really evaluating what we think is the opportunity, comparing that with what we think is our capability and asking ourselves what can we achieve.

And so we have set targets.

Of course we set targets for this year, we've set targets for next year.

We don't plan to announce those targets at this point.

But our objectives really do focus around what can we do to improve our position and acceptance of our franchise in each of our markets to our customers.

We still do see opportunity out there and I want to make sure you sense that, because we think we've had a good quarter, but we also think that there's more opportunity out there for us to get.

The only other comment I would add, the comment that Dave and I both made was that growth was broad-based.

If you look in some of our markets where it was broad-based, those are on top of strong results a year ago.

So we really do think it's all of the things that our associates are offering our customers in terms of improving their shopping experience that's causing the customer to enjoy shopping with us more.

Yes.

Good point, Rodney.

That's helpful.

Just on the share math if you look into next year, on a three-year stat basis, technically those identical store sales could be in the 1.5% and 2% range and not the 3.7 maybe that you reported this quarter.

I guess that type of range, from your standpoint now, that type of range would disappoint you.

You're cutting in and out a little bit, Steve, so I'm not sure I heard the whole statement.

But I think what you're doing is hypothesizing what our idents may be next year and we're not going to be able to address that.

I think what we've said on that subject is probably as much as we're going to be able to say.

Separate question on, I guess, the buyback.

And hopefully you can hear me all right.

The last two quarters your buyback has dipped down to pretty low levels in terms of share repurchases.

Is that -- in fact, this quarter I think was the lowest it's been in a while.

Is that is a function of the stock price being where it is, now that it's higher than it has been previously?

What's your mind-set with some of your share repurchase activity?

Mike will answer that.

Steve, as Rodney said, we continue to buyback shares.

There are a few factors involved in that.

One is we've continued to lower our CapEx goal or target or expectations for the year.

So we wound up with a little more cash than we had originally expected for the year.

We also have continued to try to balance our one-thirds, two-thirds over the long-term.

And if you look at the accumulation of what we've done so far this year in stock buyback and what we've done in debt reductions, the combination of those two with this year, when you track it back to January of 2000, puts us right on the one-third, two-thirds target.

And that continues to be something we monitor over the long haul and make adjustments to our plan going forward.

Rodney also mentioned that our investment grade rating is important to us, so we have continued to paydown debt as we've gone this year.

One last one, maybe for Mike.

Your operating cash flow for three quarters has been growing at a lower rate than EBITDA and it looks like some of this has to do with the lower benefit that you're getting in deferred taxes.

And that's been pretty beneficial on a gross basis in the past.

Can you speak to what that benefit might look like into the end of the year and what the sustainable rate might be maybe going forward?

Well, certainly our cash taxes are up this year if you look at the supplemental information we've disclosed.

We paid cash taxes of 112 million so far this year and just under 4 million last year.

Actually a bigger driver of use of cash, when you look at cash provided by operating activities, is we've contributed $247 million to our Company pension plan this year compared to 35 million last year.

We have used some of our strong operating cash flow this year to contribute to our pension plan to keep it in the properly funded position so we don't run into any reporting requirements with the RISA and other issues that could be out there in a Company plan.

So I think, if you look at it purely in this year from an operating cash flow and the growth of that, those contributions have as much to do with taxes.

We have said over the last couple years that the tax provisions that were out there that have since expired for the accelerated depreciation, we enjoyed that the last couple of years.

And we told everybody at the beginning of this year that those would turn around beginning this year and you can start to see that in the increase in the cash taxes we paid.

If you may recall, after 9/11, Congress passed a bill trying to get companies to spend more on capital.

You could accelerate the tax depreciation of your assets.

And with a significant amount of capital during that period of time, we were able to take advantage of that.

As Mike mentioned, we did mention at the beginning of the year that cash taxes would be a lot higher in 2005 and 2006 because of being on the other side of that.

Yes.

I think that's what I was speaking to.

But I think once we see the effect in '05, it doesn't get worse in '06.

This is kind of the run rate.

Wouldn't expect it to significantly get worse, but it will continue in '06.

Okay.

And then it starts getting smaller after that.

And then it'll be driven by whatever capital we've spent over the last couple of years.

All right, that's helpful.

Thank you.

Steve, thank you.

Thank you, sir.

Your next question will come from Chuck Cerankosky of Key McDonald.

You may proceed, please.

Good morning, everyone.

Dave, you mentioned here that you see holiday sales off to a strong start.

Can you elaborate on that to some extent?

Well, we are pleased with how we've started so far out in the quarter.

We just used the word "strong" to try to give you some degree of emphasis.

We have a number of programs going that I think have produced some of those results already and will likely produce, I believe, a good holiday selling season.

We have, for instance -- and I just spoke with [Ciconia Madlinger], who's in charge of our general merchandise and seasonal areas among other responsibilities, today and I see a good holiday selling season, at least started.

And pleased with the work we've done and the role that -- our GO staff here has tried to make some improvements on an already good program.

One of the things we've talked about in our organization over time is the expanded space we've provided for general merchandise -- seasonal general merchandise.

More and more we've allowed space in the stores so that we can display this product and sell it better than in the past.

And I think we each holiday season seem to get some better emphasis from that.

So I think that's somewhat contributing, but "strong" is really the word I'd use so far for the start that we've seen in the quarter to date.

That includes food sales over the Thanksgiving weekend and what you're seeing at Fred Meyer, as well, plus the seasonal general merchandise you already addressed.

Yes, it does.

And Rodney reminds me, if you wanted me to try to quantify the word "strong," I probably should.

It's a nice word that could mean a lot of different things.

I would use last quarter, third quarter, our idents there, I view those as strong.

So that's another maybe reference point that I use as a reference to strong.

And I've got a couple more specific questions, but, Dave, I'd also like you to comment on industry consolidation in light of three smaller deals or perhaps deals being recently announced.

Just today we had Fresh Brands make an announcement and Food-A-Rama last week and Marsh looking at strategic alternatives.

What do you think?

Why the coincidental timing in your view?

I don't think it's so much coincidental.

I think it's just a sign of the times.

I think it's just a continuation in a long stream of announcements like this.

Sometimes they get publicity.

Sometimes they don't.

This has been going on actually longer than all of us have even talked about it, but it's a consolidating industry.

It becomes harder and harder for the smaller operators to make it work unless they have a particular niche that is unique for them, for their markets, for their location and can make that win.

And certainly I'm not forecasting that every smaller operator is going to disappear.

I don't mean that at all.

But I do mean that many of them have decided that market and landscape that made them successful has changed.

And their ability to continue to be as successful as they once were has changed and as a result they have decided their better alternative is to sell.

And I think that's all you're seeing in those three cases.

I think that's what you've seen in numerous other cases.

Every time we've had this call, there have always been stores available and always been stores that are out trying to be sold.

And I think it's nothing more than the continuation of that same stream.

Capital questions now perhaps for Mr. Schlotman.

Looking at a big cash increase or source of cash from store deposits in transit, income tax payables and receivables were up quite a bit, and then a mention in the text of the release about construction and progress payables.

I was wondering, Mike, if you could sort of clarify and balance all of those.

And what's ongoing and what's sort of just part of normal operations.

I think just about everything in there is an ongoing phenomenon.

The deferred taxes is a number that, depending on settlement of cases and new cases or new issues that a taxing authority could raise could affect that, but when you look at our store deposits and transits and the like, I don't really see anything in our run rates that would alter those.

We did end the quarter with about $100 million in temporary cash investments.

That's primarily because there was really no other debt to paydown.

And that's just the sign of our strong cash flow as we've gone throughout the year.

We actually made a little improvement on our internal definition of working capital from the second quarter to the third quarter, which was encouraging.

We continually make sure we balance any focus on that with what a knee-jerk reaction to that could be as it would affect sales.

The last thing we want to do is to get a bunch of working capital out and not have stuff to sell to customers who have become used to having nice product and having some surprises in our stores.

So we'll continue to balance that as we go forward.

Thank you.

Thank you, sir.

Your next question will come from Jason Whitmer with FTN Midwest Research.

Please proceed.

Good morning.

Dave, could you give us a progress report on where you stand on some of your cost cutting opportunities?

Certainly sounds like you're still looking for opportunities to be more competitive.

I'd love to get any color on that specifically and maybe some actionable items you can see in front of you over the next six to 12 months on that.

Thanks.

There's a couple areas I might highlight, Jason.

First is that even though our OG&A was basically flat in the quarter, when you take fuel out we were very pleased with that.

As you know, the first couple of quarters this year, we were able to pull some costs out in actual basis points, but in the third quarter we faced a number of increases, in particular the 9 basis points that Rodney described in OG&A that were the fuel related and energy related cost increases.

But we were able to offset all of that and still end up actually slightly down.

So we see that as good news.

And we think that was helped of course by sales, but it was also helped by good cost control and a number of steps that our divisions and our group here at general office have taken.

So we're pleased with that direction.

We do see additional opportunity out there.

And I think we've described this before, that every time we think we have nailed down an opportunity and we pull our heads up and look around, we see additional opportunities out there again.

And so I do not yet see, and I don't know that I'll ever see, but I sure don't now see an end to the opportunities for us to bring our costs down and to leverage the sales growth with that as well.

We have seen -- in one particular area we have seen some modest decline in health and welfare costs in the quarter.

Those were partially offset, though, by increases in pension.

We do think that some of the changes we've had and some of that of course is the result of changes we've made in labor agreements.

Some of the changes in the labor agreements will, over time as we grow our business, will produce improved results too or at least give us the opportunity to have improved cost results.

They're predicated in large part on us growing our business, because often they require us to be hiring new employees and so forth.

But we see that as an opportunity.

And then there are a variety of other individual opportunities that I don't think we'll plan to identify.

And then just a short following question on a separate subject.

You mentioned product inflation was fairly minimal this quarter.

What do you see in terms of package food companies giving you some price increases here over the near-term and immediate-term based upon some higher fuel costs, transportation costs et cetera?

How do you plan to deal with those?

What is the current view within the end market, within the competitive side as well on that?

Thanks.

You saw what our inflation was.

At least what we estimate it to be as best we can.

The grocery component of that, which is where most of the packaged goods would reside, in the quarter it was the lowest quarter for inflation in grocery in the last nine -- not the lowest, second lowest in the last nine quarters.

So fairly low.

I mean, it's not -- we haven't had that much of a range in the last nine quarters, but it's still quite low.

We've read about the kind of increases that you're describing.

We certainly have gotten notice on a few.

The thing you need to keep in mind, though, is a couple of things.

First is that increasing list price to us doesn't necessarily mean that the price goes up.

It depends on what they do with promotional allowances.

And that remains to be seen, because that will be more dictated by the competitive marketplace than it will be by any particular announcement.

But you can clearly see, at least in the third quarter, that we did not experience any noticeable inflation in those areas.

And then maybe finally, the main thing I want to point out is that our best defense in the long run is that if prices are raised to us, costs on products are raised to us, and the corresponding underlying economics, the cost to operate, the cost to manufacture the product, did not also go up, it gives us a good opportunity for our Kroger brands, because it will increase that price spread between where the national brands are and where our own Kroger brands are, either out of our own manufacturing plants or even out of those that we buy.

So we see that as a real opportunity.

And of course Kroger is well-positioned with the Kroger brands that we have to take the best advantage of that.

And we expect to do exactly that.

On Dave's last point there, we have examples time and time again where CPG companies have tried to push costs through beyond the economic costs.

And usually when you go three or six months down the road, you can see significant improvement in share market by our private label products.

And I would assume the same is true for our competitors.

The same thing happens.

But that just happens time and time again if somebody pushes up their pricing more than what the real costs are changing by.

Thank you, sir.

And your next question will come from Scott Frost with HSBC.

Please proceed.

I wanted to go over a bit, with respect to ratings, what sort of competitive advantage or boost to earnings do you get for having ratings kind of where they are versus, say, high BBB or even A or below investment grade?

And a second question is what is sort of the -- I know that you guys aren't announcing your plans until Q4, but in general is there sort of an optimal level of sales that you're gunning for over time that you think you can manage effectively?

Is it growing a scale of the business?

Is that the idea?

On the rating, we feel like our lowest cost to capital is the BBB flat type rating.

And you can go a little bit on each side of that.

I don't know that it's that precise, but we would believe that's our lowest cost to capital.

And that's the reason why we believe so strongly that that's their optimal place to be from a rating standpoint.

But if you gave -- if you were to go up or down, how much of an effect would that have?

Is it a large effect on your earnings?

Is it a very small effect?

I know it's optimal, but if it were to be given one way or the other, would it be a big deal, I guess?

If it was small changes, it's not.

If it's big changes, it would have a pretty big effect.

I realize that's a little obvious answer, but small changes really don't show up very much.

Bigger changes would.

But we just think it's very important to be investment grade.

We think it gives us the financial flexibility to manage our business appropriate and deal with the competitive environment that we're in.

To answer your question about sales, I did address part of that before when we were talking about long-term sales strategy.

Maybe another way to think about that is we do see it as a balance.

Obviously -- and, in fact, that's the reason I pointed out that it's not sales just for sales sake and it's not sales that are unprofitable sales.

We do realize there's a balance and we still see opportunity or we wouldn't be pursuing it.

If we thought that we had reached the point where we ought to stay where we are and keep our sales level where we are and then see if we can just grow the earnings, that would be a different strategy.

But we see opportunity here, we think it's the better long-term strategy for us.

As a result, we haven't reached that point yet.

We will try to address that a little bit more in the fourth quarter when we talk about 2006.

Thank you.

Scott, thank you.

We'll take one last question.

Your final question will come from Andrew Wolf with BB&T Capital Markets.

Please proceed, please.

Thank you, good morning.

Last quarter you gave us a rough approximation of the core ID sales increase breaking down between customer account and transaction size and I think you said it was about a third count.

Can we use that safely for this quarter or was it a little different than that?

It was a little did different.

It was a little bit stronger on count.

It would be more 50/50 in rough generalization this quarter.

Thanks.

And both were improvements.

Both on a total basis and on an identical basis.

Yes.

I'm talking identicals when I make that comment.

The X gas identical to the 3.7.

Correct.

Yes.

Yes.

Dave, on southern California, you said it mixed out a little, I think, lower than you had expected.

Could you elaborate on the reasons for that?

Well, I'll eliminate one of them for you, but I won't elaborate further.

One of the possibles, Ralphs, is whether or not that market has gotten super hot competitive.

And that of course could lead to that, but I don't believe that that's the reason.

I think it has more to do with our own mix and how we're addressing some things.

There are questions for us to address.

We are addressing them.

And we have insight into how to do that, but I don't plan to further elaborate on this call.

Okay.

And lastly, the rent expense had been trending down year-over-year.

I think in the past you'd said you wanted to own more stores and the store count's down a little bit.

And then this quarter it went up year-over-year and sequentially.

Could you explain why that occurred?

Yes.

Whenever we close stores, we would estimate the net present value of the remaining lease liability versus the recovery.

And that net expense would show up on the rent line.

There was a couple of stores that we did close in the quarter and that's the reason why rent was a little different this quarter than the trend.

Okay, is that it, Andrew?

Okay.

So we could expect the rent to -- ?

Over time, our expectation would be rent expense would continue to decline as we continue to own more of our real estate.

Fair enough.

Thank you.

Andrew, thank you.

And, with that, we'll wrap up.

I have just a few closing thoughts I wanted to share with you.

I am proud of what our associates have achieved so far this year.

We've shown solid progress on the commitments that we've made to our customers and to our investors.

And we look forward to finishing the year on a similar note.

As you can tell, we are ready for the holidays and we invite you to shop with us so that you will be, too.

In addition, we encourage our associates to listen to this earnings call each quarter.

As a result, many of them are on the line right now.

They have been working very hard to get our stores in shape for the busiest time of the year.

I want to thank all of you for taking such good care of our customers every day.

Our improved sales are because of you.

The holiday season is a time when our thoughts turn to family and friends and I hope that each of you take some time to enjoy the holiday spirit with those close to you.

Merry Christmas and Happy Holidays!

Thank you for joining us.

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

This does conclude the presentation and you may now disconnect.

Have a great day.