克羅格 (KR) 2007 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Q3 2007 The Kroger Co.

earnings conference call.

My name is Lisa, and I will be your coordinator for today.

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

We will be conducting a question-and-answer session towards the end of this conference.

(OPERATOR INSTRUCTIONS) I would now like to turn the call over to Ms.

Carin Fike.

Please proceed, ma'am.

Good morning.

And thank you for joining us.

Before we begin, I want to remind you that today's discussion will include forward-looking statements.

We want to caution you that such statements are predictions and actual events or results can differ materially.

A detailed discussion of the many factors that we believe may have a material effect on our business on an ongoing basis is contained in our SEC filings.

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 would like to introduce Mr.

David Dillon, Chairman and Chief Executive Officer of Kroger.

Thank you, Carin, and good morning, everyone.

We're pleased you could join us to review Kroger's third quarter 2007 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.

Let me begin by saying we are very pleased with our results this quarter.

Our business is robust and our strategy is working.

Our performance this quarter is consistent with our customer first approach, and is yet another example of Kroger's ability to continue to deliver financial results in the near term, while maintaining our focus on investing for the future.

I'll begin with a recap of the third quarter, year-to-date results and guidance.

Rodney will then provide additional details on the third quarter results, and after that we'll be happy to take your questions.

Kroger delivered another quarter of strong sales performance, total sales for the third quarter increased 9.8% to $16.1 billion.

An identical supermarket sales increased 7.7% with fuel and 5.7% without fuel.

This is the 10th consecutive quarter Kroger has reported identical supermarket sales increases, excluding fuel in excess of 3%.

Our strong identical sales growth continues to be broad-based across the company's geographic regions and merchandise departments.

All of our supermarket divisions and department experienced positive identical sales, and in addition, our convenience stores turned in another strong quarter of identical sales growth.

Net earnings in the third quarter totaled $253.8 million or $0.37 per diluted share.

These results include a benefit of approximately $40 million from the resolution of certain tax issues during the quarter.

Most of this benefit was offset by lower margins from retail fuel operations and the company's decision to accelerate certain initiatives that are part of Kroger's customer first strategy.

Net earnings in the same period last year were $214.7 million or $0.30 per diluted share.

Our earnings performance this quarter was solid.

Our strategy continues to deliver earnings growth in a variety of economic and competitive conditions, which underscores the core strength of Kroger's business model.

Kroger's strong sales performance in the third quarter is the direct result of our associates' efforts to focus on our customers.

Our business model positions us well to serve the diverse needs of our customers.

While fuel margins in the third quarter were weaker when compared to the prior year, on a year-to-year, year-to-date basis, they were more normalized.

As we have said before, in the fuel business it is not uncommon to see variations from quarter-to-quarter.

It is important to consider a longer view when analyzing fuel margins to account for these fluctuations, because over time our return on assets in the fuel business is well above our cost to capital.

Turning to year-to-date results, total sales increased 7.6% to $53 billion during the first three quarters of fiscal 2007.

For the same period identical supermarket sales excluding fuel increased 5.3%.

Net earnings for the first three quarters of fiscal 2007 were $857.6 million or $1.22 per diluted share.

Net earnings for the same period last year were $730.1 million or $1.01 per diluted share.

Based on year-to-date financial results and current trends, Kroger now expects identical supermarket sales growth of approximately 5% for the full year, excluding fuel sales.

The company expects earnings per share to slightly exceed the range previously given of $1.64 to $1.67 per diluted share.

This earnings guidance includes the lower tax rate due to the resolution of certain tax issues this quarter and a higher estimated LIFO charge of $130 million which is $80 million more than the company originally anticipated for fiscal 2007.

In addition, Kroger's dividend currently adds slightly over 1% to shareholder return.

As a reminder, the fourth quarter of fiscal 2006 included an extra week that we estimate benefited our earnings per share by $0.07 per diluted share.

Our year-to-date performance positions us to deliver a slightly expanding operating margin, low double-digit earnings per share growth, and strong identical sales growth in fiscal 2007.

Our associates focus on building customer loyalty through service, product and value initiatives remains key to Kroger's future earnings growth.

Looking beyond 2007, we expect identical supermarket growth in the 3% to 5% range, with a slightly improving operating margin, excluding the effect of retail fuel operations.

Now I would like to turn the call over to Rodney for some additional detail on our third quarter results.

Rodney?

Thank you, Dave, and good morning, everyone.

As Dave mentioned, we were -- are very pleased with Kroger's results this quarter.

And they are in line with our business plan.

Our associates continue to do a great job at executing our customer first strategy and we appreciate their efforts in helping us deliver another good quarter.

I will now discuss some of the income statement components that produced our earnings per share growth in the quarter.

On a GAAP basis, Kroger's third quarter FIFO gross margin decreased 110 basis points to 23.38% of sales, primarily due to the lower margins associated with fuel sales.

Fuel margins fluctuate from quarter-to-quarter and that is why we take a longer view to evaluate fuel.

In keeping with our strategy, we continue to focus on reducing operating expenses and reinvesting those savings back into customer service, product selection and pricing.

Investments in pricing are reflected in Kroger's supermarket selling gross margin on nonfuel, sales which declined 45 basis points during the quarter.

Reductions in warehousing, advertising and shrink expenses funded a portion of these pricing investments, as our FIFO gross margin on nonfuel sales declined 34 basis points from the prior year.

During recent quarters we have discussed product cost inflation and the impact it has had on our business.

We estimate that our product cost inflation during the quarter was 3%.

This figure excludes fuel and utilizes CPI to estimate inflation for products in our pharmacy department.

We continue to experience inflation across many core grocery and perishable categories at a level not seen in several years.

Product cost inflation has prompted questions in recent quarters regarding our position on passing inflation costs on to customers.

Generally, we do pass along product cost inflation over the long term, but there could be short-term lags created by competitive situations.

During the quarter, we did pass along product cost increases.

In our view, periods of modest inflation is a positive for our business, because inflation tends to improve sales, increase margin dollars and create greater leverage of fixed costs.

Inflation also creates the LIFO charge that we recognize quarterly.

The current inflationary environment has caused us to re -- increase the projected LIFO charge for the second quarter in a row.

Kroger has 98% of our product inventory on the LIFO method of valuation.

This is a higher percent than many of our competitors.

When companies elect to use the LIFO method for taxes, they are required to use it for financial reporting as well.

While a LIFO charge is a noncash expense, it creates cash tax savings.

Kroger's estimated fiscal 2007 LIFO charge will reduce our cash taxes by approximately $50 million.

Now turning to OG&A.

Operating, general and administrative costs declined 78 basis points to 17.49% of sales.

Excluding the effect of retail fuel operations, OG&A declined 49 basis points.

This decline was driven by strong identical sales leverage, increased productivity, and progress we have made in controlling our utility, healthcare and pension expenses.

These improvements were reduced by higher credit card fees.

Rent and depreciation expense as a percent of sales without fuel were comparable to last year.

Kroger's operating margin on a year-to-date basis increased 3 basis points.

It increased 7 basis points excluding fuel, charges for labor unrest in the first quarter of 2007, and certain legal expenses in 2006.

As we have said before, we do not believe that a single quarter's operating margin is the best gauge of the success of our business strategy.

This is due to the timing of operating cost savings and investments in our business.

For the full year and fiscal 2007, we continue to anticipate a slight increase in Kroger's nonfuel operating margin, which will enable us to deliver low double-digit earnings per share growth.

This is a little better than the objectives we outlined at the start of the year.

Kroger's earnings per share growth this year is also driven by fewer shares outstanding.

We continued our aggressive stock buyback program during the quarter, reflecting our judgment that Kroger's shares represent a compelling investment.

Kroger repurchased 16.5 million shares of stock in the third quarter at an average price of $26.77, for a total investment of $442.1 million.

At the end of the quarter, $201.6 million remained under the $1 billion stock repurchase program we announced in June 2007.

Our share repurchase and dividend programs deliver substantial value to shareholders.

Over the past four quarters, Kroger has returned $1.5 billion to shareholders in the form of share repurchases and dividends.

Moving now to debt, Kroger's net total debt to EBITDA ratio was 1.97, compared to 2.03 during the same period last year.

Net total debt was $7.5 billion, an increase of $502 million from a year ago.

Total debt was also $7.5 billion, an increase of $528 million from a year ago.

Our strong EBITDA on a rolling four quarter basis enabled us to improve our leverage ratio, while investing $2.2 billion in capital projects and $1.3 billion to repurchase 47 million shares of stock and pay $197 million in dividends.

This is in line with our long term financial strategy of maintaining a leverage ratio to support a solid investment grade rating.

During the third quarter, Kroger invested $555.3 million in capital projects, compared to $415 million a year ago.

Total capital projects during the quarter included 13 new or expanded stores, and 54 remodels.

During the third quarter, we closed seven locations, five of these were operational closures.

Total supermarket square footage grew 1.8% year-over-year, excluding acquisitions and operational closures.

We continue to anticipate supermarket square footage growth of 2% in fiscal 2007, and we still expect to invest $1.9 billion to $2.1 billion in capital projects this year.

This estimate excludes spending on acquisitions.

In terms of capital allocation, our emphasis remains on store remodels.

And we are very satisfied with their performance.

Our customers tell us they appreciate them as well, both in terms of their comments and the sales performance.

We have completed 155 remodels year-to-date through the end of the third quarter.

That compares to 112 remodels during the same period last year.

As you know, improving our return on assets is important to us.

On a rolling four quarter basis, our return on assets improved 74 basis points pretax, excluding the effect of the 53rd week in fiscal 2006.

This is on the same basis that Kroger has consistently used to calculate return on assets.

Turning to labor relations, we reached agreements in -- during the quarter with unions representing our associates in Cincinnati, West Virginia and in Southern California with Food For Less.

We also reached an agreement with the union representing our associates who work in a warehouse in central Ohio.

In Memphis, we have agreed to a contract extension with the union that represents our store associates as negotiations continue there.

In 2008, we will negotiate contracts covering store associates in Columbus, Indianapolis, Las Vegas, Louisville, Nashville, Phoenix and Portland.

Fair and balanced contract settlements continue to be our objective in all negotiations.

We work to reach balanced agreements that meet our cost efficiency objectives and fulfill our commitment to providing our associates with solid wages and benefits.

Maintaining this balance allows Kroger to invest in our business to provide new job opportunities for existing associates and create new jobs for more people.

Now I'll turn it back to Dave for some closing remarks.

Thanks, Rodney.

Our quarterly and year-to-date performance is a great example of the strategy that we have been discussing with you for some time, a sustainable sales-driven plan that allows us to invest cost savings into initiatives that are meaningful to our customers.

We continue to execute our strategy well in every area of our business to create value for our shareholders as evidenced by the results we shared with you today.

Now we'd like to take a few minutes to answer your questions.

(OPERATOR INSTRUCTIONS) Questions will be taken in the order received.

(OPERATOR INSTRUCTIONS) Our first question comes from John Heinbockel from Goldman Sachs.

Please proceed.

Dave, a couple of questions that will tie into your accelerated investment in pricing.

Obviously, can you talk to the degree that that tied into the tax benefit, I assume that was fairly planned.

Was it more shelf pricing adjustments or promotional activity?

And then how do you measure the -- or have you been able to measure the return on that investment during the quarter in terms of comp lift, etc.?

The -- some of the acceleration of our strategies included some pricing plans, for instance, that we have been using in some markets but not all markets.

We elected to extend those to some additional markets that we had been planning to do, but we had actually planned to do it just a little bit later.

We decided to do it when we did because, as we've said before, we're going to look at the affordability of the choices we make in some of these strategies.

I think it's important to recognize that it wasn't just some promotional strategy that we did sort of on a whim because we had money available to spend, but rather it was part of a plan where we actually had these strategies worked out in our minds and over time, and we're trying to pick the best time and best circumstance and best competitive situation in which to introduce them.

And so that's really all it was.

And that's how we tried to approach it this last quarter and that's actually how we've been approaching it for some time.

Both of the two or three strategies I'm thinking about mostly relate to shelf pricing or to pricing strategies as opposed to a short promotion.

The other thing that, Dave, that I would add on top of that, in some markets there were some non price initiatives too, and if you look at one example would be products where you -- ready to heat type products.

Certainly we continue to accelerate the roll-out of that in different markets, but when you look at when you first put that product in place, obviously, you have a very high shrink on that product until the customers get accustomed to buying it.

So there are some initiatives such as that and some service initiatives that were also part of the acceleration.

Was it driven more by timing any way, by the fact that you had the tax benefit or you saw something in terms of the macro or the competitive environment that caused you to move them forward?

Well, it's really all of the things you described and a whole lot more.

At the beginning of the year we have a specific plan in mind and we have a number of strategies, some service strategies, some product strategies, some pricing strategies and we have an implementation schedule.

But in the last several years, we have varied that implementation schedule a little bit by how much we could afford in terms of the situation.

But we have also varied it by the opportunity that we saw.

And some markets it's a competitive situation we think could benefit from the introduction of something we may have moved it ahead of the schedule and vice versa.

So competitive openings can have an effect on that.

But it really is all of those factors.

Now, the tax amount, of course, the beginning of the year we didn't know what the tax amount would be.

It's not uncommon to have adjustments.

But this is a little larger than -- I don't know if it's larger than normal, but larger than usual tax adjustment, and as a result when we saw what that was and when we saw how the gas margins were faring in the quarter, the two we thought would balance out sufficiently well that we could move ahead on some of these other initiatives, so we chose to.

Then just finally, if you take out the investments, would it be fair to say that food gross margin, your selling gross margin, would have been down modestly, or no?

To try to separate those out, because obviously these investments are not necessarily -- they're not one-time but they're not necessarily going to get this hit every quarter either.

Some of the investment in the quarter was the ongoing investment from the last three quarters.

In other words, you get some rolling effect there.

So our margin would have been down irrespective of these additional investments that we chose to make.

However, we also are, as we have said all along, trying to match up at least on an annual basis and even to a certain extent on a quarterly basis, what our savings are in OG&A, or our savings in shrink, or logistics, or advertising.

And take those savings and see what we then have available to reinvest in appropriate ways, in ways that we think would benefit the customers, grow the sales, and then therefore produce an improved result for the shareholders.

So it would have been down anyway.

This was not a case of we invested all of the down gross margin.

The selling gross I think we identified was 45 basis points.

That decline was not all driven, in fact, it was only a small part driven by these new initiatives.

It would be more driven by the overall plan and our overall picture on OG&A.

Okay.

Thank you.

Does that help, John?

Yes.

That's great.

Thank you.

Our next question comes from Jason Whitmer from Cleveland Research Company.

Please proceed.

Good morning.

Dave, can you talk a little bit about the price promotional landscape that you might see structurally changing, whether at Kroger or in the channel at large, such as involving a high/low or EDLP blend or getting -- even using fuel for that matter as a price vehicle, and maybe some pricing software.

What's the overall impact of the changing landscapes on the competitive environment and really overall in the margin outlook?

I don't see it much different than I have for the last several quarters.

I do not see it getting more competitive.

But I also don't see it getting less competitive.

I assume the pricing softwares you're talking about are some of the price optimization software packages out there, and a number of people use those and use them effectively.

I think they help you think about your pricing strategy, but, overall, pricing strategies are chosen by what gross margins they produce, and the gross margin that you require as a company is predicated on the return you're trying to achieve and your cost structure.

As you know here, we have tried to drive our sales.

We've tried to improve on our cost structure, therefore allowing us room to invest in other things that are meaningful.

Some of it's been price, but much of it has been on additional service, which of course then goes back into OG&A cost, training and other product areas which often will end up in the gross, sometimes affects the shrink as Rodney described earlier.

So I don't think the current environment is much different than what we've seen for the last several quarters.

There is a change, of course, going on in the overall economy.

Inflation has picked up a bit.

Mike will probably talk a little bit more about inflation if you have questions.

But inflation was the highest in the third quarter that we had seen in a long time.

And I say highest, but I say that carefully because it's still pretty darn moderate, and moderate inflation, as Rodney points out, we view as generally helpful to us, and so I think that's the environment we see in the economy, and as a result, I don't think that's changing anybody's behavior, at least not that I've seen.

The other thing as you know, we would work with [Don Humby] a lot , our merchandising teams, in terms of how to approach pricing, both everyday pricing, promotional and special offers too.

And that's one of the things that Don Humby's been especially helpful for

I guess that leads right into my follow-up then.

Is it fair to say, I don't know how you would characterize this, but how much more effective or profitable have your programs and deals been either in the impact to drive -- drive the business is very evident, but the overall flow-through of that in a vacuum, has that improved substantially over the last couple of years?

I think we have improved the effectiveness of our spend, and we have improved that through the intersection of several things, one of which is done looking at data, but also I think it's just within Kroger, the desire to be more data driven.

That is, what are the results of the choices we made, and then be willing to re-evaluate choices we made and modify as we think appropriate, given the facts.

And I think those elements have created a more effective approach to spending, more effective in what we spend our pricing on, more effective in everyday pricing, more effective in what we spend our promotional money on, and frankly more effective on our investments in product and in the shopping experience in the stores and in service metrics.

All of those I think have been improved by our focus on what do the facts show us, what does the data show us.

And is there anything to garner from the data as it relates to fuel this quarter?

Is it all just kind of the delta from what you pay and what you buy it for?

Or relative to what you're giving it away for at the pump on discounts?

I don't know how you take a look at it but certainly it's one of the bigger pinches you've had in a long time if not ever on fuel margins.

Well, it's one of the bigger swings we've had from last year to this year in the quarter and from second quarter to third quarter this year.

Those were bigger swings than I think we typically would have seen.

And so it sort of focuses or magnifies the effect.

Fuel margins typically end up being what they are.

In other words, we don't control those very much.

We can control them a little bit but the cost of the commodity is what it is and the retail price is reflect I've of exactly the retail community that we serve.

It's a little bit like we discussed on milk, for instance, that you can't just simply set a retail at whatever you want it to be because in gas line, when you do, your volume drops off substantially.

So for fuel for us, we look at the results over a longer period of time.

We look at -- well, the other three quarters, for instance is a reasonable period of time.

But I even like a full year or longer to understand what the margins are doing.

And on a three quarter-to-date basis, our fuel margins a little below where they were last year, but more normalized, we think, much more normalized.

And so we had a benefit in the second quarter which we identified as higher than normal and we had an impact this quarter which was clearly lower than normal.

And Jason, I do want to remind you of one thing.

In your question I thought I heard you reference the effect of promotions on lower fuel margins.

I do want to remind you that our fuel rewards program that discounts fuel for purchases inside the grocery store are charged against grocery store [idents].

So the 5.7% identicals we announced excluding fuel are reduced for the cost of that program.

They are not charged against fuel operations.

Okay.

That's helpful.

Thank you very much.

That's a good point.

Because as you look at our gross profit investment in a quarter, to the extent that we spent more money on fuel promotions, it would show up in the nonfuel gross profit investment.

Great.

Thank you.

Our next question comes from Meredith Adler from Lehman Brothers.

Please proceed.

As long as we're talking about fuel, I want to go back, Dave, to your question about your -- your comment about the return on assets being higher than your cost of capital for fuel.

It's also clearly a very volatile business.

And I don't know if you perceive that volatility as risk, but when -- if you were to see it as risk and make a risk adjustment, would you still say that the return is acceptable?

Because I think that's what we see more as more volatility.

Yes, Meredith, I absolutely would.

Volatility in this sense, you could take an individual quarter and make a case to say, well, fuel wasn't a good deal.

But if you take any year that I've looked at it or longer periods than a year too, I think you would always come to the same conclusion.

I don't remember any single year where I thought it was not a good investment, and as a result, the volatility is really simply the volatility of the commodities and represents, when you see high volatility, sometimes we can actually make more margin when the cost is more volatile, but just because, for instance, just because the cost of fuel is going up, if it's going up steadily and predictably, we don't make more money in that situation, or if it's going down predictably and subtly, it may be the same thing.

But when there's some volatility there, that tends to improve the margins because we don't have quite as much volatility in our retail as we do in our costs.

I don't know if you want to add to that.

I was just going to say, if you look at it over an annual basis, the volatility is not that high.

Maybe that's the best way to think of it.

If you look at it over a two-year basis, rolling basis, it's almost nonexistent.

The shorter period of time you get, the more volatility there is.

And if you look at fuel margins for the year in terms of where we budget them for the year and where we are and where we think we'll be, we think we're going to be pretty darn close to what the estimates were.

But if you look at it in the quarter, as you know the second quarter as Dave mentioned and we did on the call, second quarter was a little higher than normal.

Third quarter is a little lower than normal.

But when you look at it cumulatively, it looks like it's going to be pretty darn close to where we thought it would be.

Of course, it's a bit of a strain for the market to think of in the two year time frame.

Another question about fuel --

That's fine.

Another question about fuel.

You haven't --

Meredith, let me come back to what you just said.

You don't have to look at two years to get a clear picture.

Keep in mind what Rodney just said and that is we expect to be very close to what we expected fuel to driver deliver for this year.

It's not a two-year look, we're saying, all Rodney was trying to do was the longer time frame you look at, the less volatile it is.

But typically within a -- within one of our fiscal years, we've been fairly close to what we expect fuel to deliver to the bottom line on an annual basis.

There's obviously some variations on your expectations, but what we see today, we're going to wind up pretty close for this fiscal year.

I might be a cynic and say the market has trouble looking at even a whole year time frame.

Just talking about sales -- the benefit, fuel clearly is something that helps you drive food sales.

You didn't talk about it so much this time.

But you are very effective in using your pricing on fuel as a way to drive food sales.

Do you have any numbers where you can sort of quantify that?

Actually, we don't.

We have internally some sense of the numbers, but nothing that we would want to share.

Suffice it to say, though, is that we do believe that there is some benefit to our grocery store business by having fuel stations out front.

The convenience of those, the tie-in with fuel promotions, all of that helps.

Okay.

The other thing, Meredith, and we've talked about it on previous calls, overall we believe that higher fuel costs is a positive for our type of business overall, our industry.

And it's one less trip that somebody has to make, and our stores, our typical customer only has to drive a mile or two to get to one of our stores, and we think all those things tied together is really what helps drive our identical sales.

Okay.

And then I just want to kind of go back to -- I think this is the question John Heinbockel was giving you.

I think the market has a tendency to see tax as being completely independent of operations, but it sounds like you don't think about it that way, that you think about tax as an expense that's being managed and you look at how that impacts the bottom line, and then you manage your business to some extent around that.

Is that fair to say?

It's fair to say that we look at it actually from lots of different vantage points.

The first vantage point is that it is part of our cash flow, and so if you look at our overall results as we look at them, we look at our overall cash flow and all of the things that affect it.

We do tend to separate tax swings like this, but also gasoline swings like this from our day-to-day operations for us to get a sense of how our business model is working.

And when you take those two elements out of our quarter, our quarter looks just peachy.

And as a result, I think you could look at it from either of those vantage points and come out feeling as optimistic as I do about where the quarter was.

Would it be fair to say that you earned $0.37, or that you beat, if you took out both the fuel and the tax benefit, that you were better in this quarter?

I'm not sure how to answer that.

Mike, do you want to try to piece together the math, or Rodney, do you have a picture?

We would have been -- if you take out -- if you were to take out the tax and the fuel, we would have been very happy with the growth we posted this quarter.

Okay.

Great.

That's a fair way to characterize it, yes.

Okay.

Thanks very much.

Our next question comes from Chuck Cerankosky from FTN Midwest.

Please proceed.

Hello.

Good morning, everyone.

Good morning, Chuck.

Good morning.

I'm out of the office, actually.

Have you specified what the tax benefit amount was?

It's $40 million.

Four, zero.

Yes, four, zero, that's correct.

What would you say the gas amount was that Meredith was just referencing as being an unusual point of pressure on the gross margin?

We didn't give the specific number other than saying that when you look at the fuel margin and the other initiatives that we invested in, used up, covered most of that $40 million.

And obviously some of it did fall to the bottom line, because we did post $0.37.

Got you.

All right.

And looking at your guidance for the full year of 5%, that's a little less than year-to-date.

Are we simply looking at the effect of the extra week last year?

No, we actually left a tiny bit of an element of conservatism in case the economy in some way impacts us that we can't see it.

It's not trying to signal anything other than we were happy with our sales last quarter and we expect to be happy with our quarter sales this quarter.

All right.

Do you anticipate a second half of this year, Dave, similar to the first half where there's a little bit more inflation catch-up as the half went by, inflation catch-up in terms of shelf pricing?

We, in the quarter, we recovered the cost -- product cost increases that we experienced, and we would expect that that would be true, barring some unusual situation, we would expect that would be would be true in the fourth quarter too.

The rate of inflation in the quarter we already described as being the highest really this year and for some time, but still moderate, and we expect, based an what we've seen so far, that the fourth quarter will be very similar to what the third quarter was on inflation.

So I would expect whatever benefits were derived in the third quarter, I would think you would see the same kind of a picture in the fourth quarter.

All right.

And all that $40 million tax benefit is hard cash?

What it is, Chuck, is it's a reduction of expected payments.

We would have expected to be paying $40 million we ultimately are going to pay.

It wouldn't be necessarily cash this quarter.

The payment may or may not have been due this quarter, but ultimately it will be a reduction of $40 million in cash taxes.

Exactly what month I would have had to write that check, I couldn't really zero in on that.

But pretty much a fiscal '07 event?

Yes.

Got you.

Thank you.

Our next question comes from Neil Currie from UBS.

Please proceed.

Thank you.

Good morning, everybody.

Good morning.

I don't think it's a surprise that you are investing cost savings into price and other initiatives to drive sales because that's what you've been doing for the last number of years.

I think just the timing was a little bit of a shock to the street after what happened in the second quarter, and I think you indicated the third quarter might have similar characteristics.

You indicated that it wasn't due to any sort of increase or decrease in competitive environment, but you did talk about looking for the best competitive situation to reinvest.

So what is the best competitive situation?

Is it when customers aren't expecting it and you can surprise them with lower prices, and that's when you get the best return on the investment?

Or is it purely that you felt that with the economy weakening, that you just wanted to support your value message?

The answer is actually, yes, on both of those.

For me, as an operator, I like to see both extremes as places you would invest, places where you feel you need to because of defensive moves, but also places that you invest because you want to, because you sense that it will improve your sales.

The time you don't want to invest is when you think putting additional money won't produce additional sales and won't have a desired effect with the customer, and there are times when that happens.

If the customers are behaving in a sense that says they don't want to spend money, you can sense that often and where your sales are and that's not a particularly good time to spend money.

But we're not sensing that situation right now.

Neil, the other thing, and I'm confirming my numbers here quickly, but you talked about the second quarter.

But if you remember, year-to-date at the second quarter, our operating margin had increased five basis points and that increase in our operating margin now, and that excludes fuel, is up to seven basis points.

So I think on a year-to-date basis, we are executing what we told you we were going to execute.

Sure.

I think it was just the gross margin strength in the second quarter and maybe we misinterpreted the comments on inflation continuing in the third quarter, meaning that the gross margin growth would continue in the third quarter.

That's just our problem, not yours.

But as we tried to tell everybody for the last two or three years, we are clearly focused on our operating margin because when we do have savings, we do expect to invest them while growing our operating margin slightly on a year-on-year basis.

No.

That's a great strategy.

No problem with that.

Just another question.

I just wondered if you had any early comments on Tesco's fresh and easy format?

Looks as if they're going to quickly saturate at least the Phoenix and Vegas markets over the next year or so with sort of stores every couple of miles and obviously clearly low prices.

I wondered what your early take was on what impact the prices, not necessarily market share, but the prices could have on your offer in those markets?

Well, I won't specifically address their pricing but I will comment.

I have been to several of the Tesco stores and a couple of different markets.

As we have said before, we have always assumed that Tesco would come to the U.S.

We're the biggest market around the world, and they would need to come here for their growth.

And we're quite comfortable in our strategy.

In fact, our strategy was designed knowing that someone like Tesco would be here.

As I have looked at their stores, I see a lot of positive things about their stores.

Actually, more positive things than even have been written about.

I think they've done a nice job.

But one thing, though, that is clear, and that's more clear about Kroger, is first, is we take Tesco and other competitors like that very seriously.

And second is that at Kroger, we will improve as a result of this new competition.

Those are the important messages from our vantage point.

What individual effect they may have in individual markets, what the pricing strategy may affect, I don't want to speculate at this point.

Okay.

And just finally, on the economy and the consumer, how do you think your consumers feel right now?

Do you see any early evidence of trading down to private label products or that sort of thing?

We do not see any big swings in customer behavior.

Now, obviously smaller, more subtle changes might not be as evident.

We have said before, and I still think it's true, two things about this.

One is that as customers feel pinched, one of their reactions that often occurs is going to restaurants less often and instead going to supermarkets, where it's less expensive to prepare a meal for a family or even for an individual person.

And we do think we've been seeing some of that for some time now, not just in the last quarter, but for a long time.

And second is that we don't refer, especially now in the last quarter or so, we don't refer to buying our Kroger brand as trading down.

We actually see that as trading up, because the customers are learning that the product quality in our Kroger brand is not only as good as, but often better than, the leading national brands and it costs less money.

So what's not to like about that?

But we're not seeing a changed behavior as the bottom line of your question.

We're not seeing a changed behavior, certainly not in the third quarter, anything that we saw in the data there.

No.

I didn't mean to be disrespectful about your private brand.

And I didn't take it that way.

I used it as an opportunity for a commercial.

And would that be consistent on the nonfood side of the business as well as some of the larger stores?

Nonfood is a little harder to read because of seasonal impact and weather impact.

And so we have seen a little more softness in the drug GM side of our business than we've seen the other parts of our business.

But as we've identified, it's a positive department.

And at least I believe I'm correct in my statement.

I'm looking over to be sure the numbers are right.

But I don't -- I'm not reading anything into that right now about consumer behavior because we're not a real large nonfood merchant, like a department store might be or some of the other mass merchants.

And we also have one extra day between now and Christmas, so -- and until you get through the complete cycle, you don't know exactly where you are relative to that.

Yes.

That does make it a little bit hard to read as the shifting of shopping patterns with Christmas falling as it does.

Thank you very much.

Sure.

Thanks, Neil.

Our next question comes from Mark Husson from HSBC.

Please proceed.

Yes.

I guess the first question is just a plea, given your steady [Eddie] kind of company, you're not doing [a full costing] credibility any good at all the way you come out with quarterly earnings.

So perhaps you could give us advance warnings on big things like tax charge changes to make this whole thing seem like you're not making it up as you go along.

To that end, what is the tax rate going to be for the fourth quarter and the year?

If you look at it for the fourth quarter, we expect it to be about 38%, which is what we estimated for the year starting out for the full year estimate.

Okay.

And then the other thing, when you're looking at your individual reporting companies, they have to make bonus somehow.

If you could just refresh everybody on how the individual reporting companies make bonus and how you make bonus.

And is it fair to them to get them to pay or to invest back in in [EBITD], if you like, a tax benefit, which may not have impacted their bonus?

How do you get around that?

I have to think about the way that would impact.

I think in the -- first of all, the bonus, I don't think it would have any effect.

The bonus is based upon -- that portion of the bonus is based on EBITDA for our divisions and for our officer group, for general office here.

And I don't think that would affect EBITDA in any way that I could think of.

To the extent that you had a tax benefit and you spent the tax benefit back in, reduced EBITDA, haven't you, because you got some tax money --

If we spent it all and had nothing to show for the spending, then it would have hurt bonuses.

But if you look at our view -- my view is that the money we spent on things like we have described improves our sales and ultimately improves our earnings and our EBITDA.

And develops a more -- I think a more positive outlook for our shareholders and certainly more positive for us.

I think the way the bonus is set up for individual divisions or for general office or for me, it is pretty clearly in alignment with the shareholder benefits in the short run and the shareholder benefits in the long run, because we take elements based on identical sales growth, EBITDA, performance on our overall strategy in terms of how we're producing on things like our customer first tracker that we've described before, things like that, and then a portion on capital spending and the effective use of capital spending and hitting our targets on capital spending.

Those are the elements and those are very aligned with shareholder objectives too.

Sure.

Longer term, absolutely.

I'm just wondering, given what the performance has been recently, whether you've made any changes to the accruals you've been making for bonuses for this year.

No.

I mean, other than being consistent, pretty consistent throughout the year.

Okay.

Great.

And then just one sort of bigger picture question.

When you look at sort of Tesco's format of 10,000 care feet, it's about four times the size of your average convenience store and quarter the size of your average supermarket.

When you think about formats, I know you've spent some time investing in larger formats and discount formats, when you think about capital dollars, how do you think about allocating those dollars going forward in format sense.

If you look as you know, and one of the comments we continue to focus quite a bit of capital on remodeling existing stores.

If you look at in terms of relative to formats, what we believe works the best is having a complement of several different formats in a market.

So if you look at a market like Phoenix, or a market like Wichita, Kansas, might be a better example, where you'll see marketplace stores, regular supermarkets and also convenience stores tied together.

So from a customer standpoint, we really are trying to have where a customer can engage with us with multiple formats and we believe that that's most effective.

So we're really looking at all of them together rather than each one individually.

Is the marketplace format now performing at group averages in terms of return on capital?

At least.

Oh, okay.

Thank you very much.

And one other thing, just FYI, we did open up new marketplace market in Tucson, Arizona, this week, we opened our first marketplace store in Tucson and that is the first market there.

We'll have another one that will open in a couple of weeks there too.

Our next question comes from Todd Duvick from Banc of America.

Please proceed.

Yes.

Good morning.

Thanks for taking my question.

You -- this is on the debt side.

With respect to the debt that is maturing in March of 2008, I believe there are two issues totaling about $950 million.

And given that your policy has changed such that you're no longer focusing on debt pay down, are we to assume that you will refinance that in the capital market?

I wouldn't necessarily be definitive exactly what I'm going to do as that debt matures.

But do keep in mind that we may not be targeting reducing the absolute dollar of debt outstanding, we do continue to expect to manage our leverage ratio at a level that will keep us [triple B] a solid investment grade rating.

So, it's not that we are going to totally ignore what our debt levels are, we do expect to continue to manage it on a ratio basis.

Okay.

And so I guess just depending on market conditions, you'll decide closer to time what you're going to be doing in terms of any refinancing.

I would look at it the way we do some refinancing earlier this year.

We would probably make sure that the market is right and receptive to an offering from Kroger on the right particular day, versus being forced to do it on any particular day.

We would look for the right opportunity, rather than like we have to do something.

Okay.

That's helpful.

Thank you.

And we obviously like the direction of overall rates at the moment too and where they seem to be going.

Even with the higher spreads, the coupons would still wind up being attractive, particularly compared to the debt that is maturing.

Okay.

That's great.

Thank you.

Our next question comes from Bob Summers from Bear, Stearns.

Please proceed.

Hi.

Good morning.

Just in terms of the acquisition market, given overall operating conditions and maybe a pullback in private equity, are you starting to see a loosening up at all either in the availability of assets or price points?

Not -- I wouldn't -- I wouldn't say in terms of if you look at the flow, there's much of a change, and so far I think people still have a pretty pricey assumption on terms of valuation.

And as you know, we kind of have the same approach, whether the market is strong or weak in terms of what's the value that it adds for us.

In existing markets it's really looking at specific real estate opportunities, going into new markets it has to be a good, solid asset with good market share before we would look at it seriously.

But really not seeing much change.

I think people are still expecting that it's a short term rather than long term and valuations still need to come down to make a little bit more sense of it, I think.

Okay.

And then kind of a pointed question.

These unusual items that we have had have become a little probably too usual over the last six or so quarters, and as we continue to manage through this customer first approach, I mean, when we can we start to see maybe a more consistent shareholder friendly approach to managing the business?

Actually I'm not sure I fully understand what it is you're saying, but for us, unusual items are things that we think are important for you to know in order for you to understand what's happening in our business.

And our management team here tries to call out those things that are good for us and those things that are bad for us, so that you would have a clearer picture, the same picture that we would look at, as the business rolls forward.

And as a result, I doubt that you'll find a time when we don't call out some things.

There may be some quarters where nothing happened that's unusual enough that we ought to point it out to you, but we try to play right down the middle by calling out the good and the bad, where we see it and when we think it is important to you.

And we think we have been managing the business now for several years, what we view to be a shareholder-friendly environment.

If you look at the summation of this year, strong identical sales, low double-digit earnings per share growth, a sustainable model going forward, all of our metrics are looking better, our leverage ratio is improved.

Slightly improving operating margins.

The operating margins have slightly improved.

And returned $1.5 billion to shareholders.

If you look at how we spent the cash flow, that's all from a shareholder point of view is a good thing.

We think the ways -- the way the metrics out ought to be viewed are positive, and we think calling out these items are helpful to you, not hurtful to you.

We could have left them all alone this quarter and you wouldn't have known the difference.

Well, you would have known the difference because our stock would have been up $3.

Our tax -- the tax rate would have been obvious too.

I mean, Bob, we don't mind pointed questions whatsoever.

We actually do think so far year-to-date and what we expect to deliver for the year is going to wind up being a shareholder friendly year.

Okay.

And when do you address the buyback?

You've almost completed the June '07 order stub.

That would -- we still have $200 million left as of the end of the quarter.

That will depend on the stock price and the board's desire to give us an additional authorization.

Well, unfortunately you're getting an attractive entry point today.

Thanks.

Our next question comes from Mark Wiltamuth from Morgan Stanley.

Please proceed.

Just wanted to clarify a little bit on the accelerated initiatives under the customer first strategy.

You talked about it, that being a little bit gross margin and OG&A investment.

Could you just talk a little bit more about how much was OG&A and some of the elements under that customer first strategy you were really emphasizing here?

No, I don't think we will try to quantify it.

We were just trying to give you some illustrations, and I don't want to overplay that additional investment.

We did comment earlier that the decline in our selling gross was not primarily driven by accelerating investments, but rather by our original plans and the continuation of our original plans, and so I don't think you should read too much into our gross margin or OG&A, either one, as a result of those accelerated investments.

They were meaningful, but they were not meaningful enough to turn the dial very much.

So I think the bigger issue was the $40 million in tax benefit was much of it was offset by the margins in fuel, and we had a little left over for this additional investment, and we had a little left over to drop to the bottom line.

So you would characterize the margins story as kind of getting back to your normal strategy, in reinvesting gross margin into the business?

I mean, we did invest dollars into gross margin and somebody made -- I forget who it was, made the same comment a second ago.

It might have been Neil.

Relative to you would have expected the second quarter to continue.

When you think about gross margins on a year-to-year comparison, you have to think about what happened in the prior year.

And if you thing about the second quarter of '06 versus the second quarter of '07, one of the things that caused gross margin to expand was we made some pretty big investments in the second quarter of '06.

If you look at the third quarter of '06 as compared to the third quarter '05, that margin difference was very, very minor.

And so if you look at our margins on that kind of a basis, you have to understand what happened in the prior year when you say we went up or down as compared to the prior year.

The second quarter was frankly a little easier to have expanding margins because we made pretty big investments the prior year.

The third quarter of this year as compared to the prior quarter of last year, it's reasonable to expect when last year's quarter didn't have a lot of investments, that that will happen this year.

Okay.

Is there anything we should be thinking about for the fourth quarter coming up?

Only that we expect the year to wind up with the metrics we had, and I think if we hit those we're going to be pretty happen with what we delivered on a full year basis, certainly compared to what return there will be for the shareholders and in addition to what we expected at the beginning of the year.

It looks like we're on track to have another year where we exceed every promise we made to our shareholders.

Okay.

Thank you.

Thanks.

This will be our last question.

And our last question comes from Ed Kelly from Credit Suisse.

Please proceed.

Hi, good morning.

Good morning, Ed.

I was hoping you guys could help me work through some numbers.

I was just looking at what you presented and it seems to me that core grocery [EBITD], if we were to sort of take out fuel all together, was probably up somewhere in the high-single to maybe even low-double digits, given almost a 6% comp and what looks to be 15 basis points of margin expansion.

Is that a fair statement?

Yes.

Okay.

So I mean, given that your reported [EBITD] was down modestly, it looks like fuel obviously was down significantly and potentially even incurred a loss this quarter.

Would that be right?

It wouldn't be a loss, no.

Okay.

But there's been a lot of questions asked about the volatility of fuel, but can you just maybe help us understand why quarter-to-quarter there's so much volatility in that business?

Well, two things you should think about.

First, if you look at last year versus this year, we think about pennies of margin per gallon.

We didn't -- it wasn't quite half this year versus last year, but darn close.

And the same kind of swing occurred from the second quarter to the third quarter, if you took the second quarter as a number, and then looked at the third quarter, it was almost half in the third quarter.

And what that suggests, and I think is true, is that in the third quarter last year and in the second quarter this year we had unusually high gas margins, and in the third quarter this year we had unusually low gas margins.

So you had sort of a double swing.

When you're comparing to the previous year, that's why you have such wide swings like that.

But when you look at the course of the year, year-to-date this year, we're a little bit under where we were last year but not much on a year-to-date basis through three quarters.

So it tends to smooth itself out over the course of even three quarters, and certainly over the year we think it will have smoothed itself out.

That's, I think, a fair way to describe it.

Is that volatility related to the change in price?

It's related to the interaction between the retail price at the pump and the cost of the commodity that we buy to fill.

I mean, it is -- it's really a cash market, and what you see is cash market in the sense is that you see us buying fuel, several times a week, for each station, replenishing that immediately, but as costs go up, costs go down, the costs on gasoline change not only every day but every minute, and that kind of volatility just produces differences in margin.

It's been true -- we've been in the fuel business, at least I've been involved in the fuel business, even before I was in this business, Dillons was in it since 1960, and through all the time I've watched it it's always been the same.

You can't try to judge what's happening with fuel in any one week or any one quarter.

You have to look at a couple of quarters or three quarters or a year to get a good sense of that, because of all of the volatility of the cost and the volatility at the pump.

It's the most price competitive item that we would sell.

It reacts not daily in price, but every hour, if you were to see a change in the local market, you would change your retail price.

That's just the nature of that business.

Can we generalize and say that you make maybe more or less money as prices -- as cost increases and -- or you make less money as costs go up and more money as --

I'll let Rodney answer that, because we actually have studied that.

Yes, in terms of your comment, it's correct.

As a general rule, it's not always true, but as a general rule, when costs go up, margins contract, when costs come down, margins expand, as a general rule.

Okay.

Great.

And then just last question for you.

Any insight on your CapEx plans for next year, either qualitative or quantitative?

It's been up pretty good the last couple of years.

Do we think about that trend continuing?

In terms of specific numbers, we would do that when we give our fourth quarter, but in terms of intent on where we would spend the money, and I think you'll see us continue with the heavy emphasis on remodels and expansions would be the biggest key focus point.

You also see us continue to aggressively spend on logistics and technology.

Okay.

Great.

Thank you.

Thank you.

And then wrapping up, let me offer these closing comments before we sign off.

I wanted to share a few thoughts with the associates listening in today.

In our business, the holidays are obviously a very exciting time of the year.

And our stores look great, our plants and distribution centers and offices are running well, and as we all work together to create special experiences for our customers, it just is a great time of the year.

This season offers each of us a chance to reflect.

Just before Thanksgiving I had the opportunity to visit our store in Greensburg, Kansas.

You may recall that this past summer a tornado devastated that community and we lost both a Dillon's store and a Kwik Shop convenience store.

As the town went about the difficult task of rebuilding, associates from Dillon's worked together with a group of of our associates from our convenience stores to come up with a solution that works for Greensburg.

Today, that community is served by a combination store, one that is a Dillon's Kwik Shop, which meets the daily grocery and household needs of Greensburg residents and provides the community with much needed fuel center and other conveniences the Kwik Shop offers.

During my visit I spoke with associates who are so proud.

They are so proud of serving the community, and I listened to customer who are so grateful they have a store that meets their needs.

It was a clear reminder to count our blessings every day, and I'm thankful to count each of you, our associates, among mine.

Thank you for all you do for our customers and each other every day.

Have fun this holiday season, and take time to celebrate with your friends and your family.

Thank you all for joining us today.

Merry Christmas and happy holidays.

Thank you for participating in today's conference.

This concludes the presentation.

You may now disconnect.

Have a great day.

Thank you.