克羅格 (KR) 2009 Q1 法說會逐字稿

Good day, ladies and gentlemen and welcome to the Kroger Company first quarter 2009 earnings conference call.

My name is Katina, and I'm be your coordinator for today.

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

We will conduct a question-and-answer session towards the end of this presentation.

(Operator Instructions).

As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today's call, Ms.

Carin Fike, Director of Investor Relations.

Please proceed.

Good morning, and thank you for joining us.

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

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

A detailed discussion of the many factors that we believe may have a material affect on our business on an ongoing basis is contained in our SEC filings, but Kroger assumes no obligation to update that information.

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

Now I will turn the call over to David Dillon, Chairman and Chief Executive Officer of Kroger.

Thank you, Carin and good morning everyone.

Thank you for joining us today.

With me today to review Kroger's first quarter 2009 financial results 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.

Today, we're pleased the to report very solid results for the first quarter of fiscal 2009.

We're off to a good start for the year, particularly considering the environment in which we are operating.

Our Customer First strategy continues to serve Kroger's customers and shareholders well.

By paying close attention to the changing needs of today's shoppers, Kroger continues to refine the value proposition that we offer to our customers through a combination of better service, improved product variety and quality, a shopping experience that is appealing and convenient, and lower prices.

This approach allows us to report the first quarter sales and earnings results that we are discussing with you today.

Let's begin with sales.

Total sales for the first quarter were $22.8 billion, compared with $23.1 billion for the same period last year.

That comparison may look a bit unusual, and it reflects the year-over-year decline in retail fuel prices.

As a point of reference, during the first quarter of the current year, the average retail price for a gallon of gas sold at Kroger's fuel outlets was 41% lower than it was during the corresponding quarter last year.

When you exclude fuel sales, Kroger's total sales for the first quarter increased 3.9% over the prior year.

Identical supermarket sales without fuel increased 3.1%.

Several departments posted identical sales growth above the Company average, including meat, pharmacy, deli/bakery and grocery.

Strong sales in these areas were tempered by continued slowness in sales of discretionary general merchandise as well as deflation in produce.

Even so, all but one of our supermarket divisions posted positive identical results.

As you know, we believe that identical sales growth, excluding fuel, is a very important metric for evaluating Kroger's business.

Internally, we also look at a few other measures, and I thought sharing color on some of these measures would give you better insight into our first quarter sales trends.

Some of the other metrics we look at include customer traffic, unit sales growth or perhaps tonnage, and corporate brand share.

In each of these areas, we saw positive trends in the quarter.

Our corporate brands enjoyed another quarter of double-digit growth in both dollar and unit sales.

In the grocery department, the corporate brands represented 26% of sales dollars and 35% of units sold.

As in the third and fourth quarter last year, our overall tonnage growth in grocery was driven by corporate brands.

National brand grocery unit sales declined slightly, but at a slower rate of decline than we saw in the third and fourth quarters last year.

Based on these results, it's clear to us that the customers continued to look to our own high quality store brands and the value that they offer, and while this shift affects Kroger's identical sales results, since our store brands typically carry retail prices significantly lower than the national brand equivalent, some as much as 50% lower, it is a tradeoff we're happy to make for the long-term growth of our business.

Our identical sales growth is also affected by product cost changes.

But the impact can carry considerably across different product categories.

So take a deflationary category like milk, for example.

While we sold more units, retail price for milk pressured our first quarter sales results.

On the flip side, higher inflation in tobacco helped our sales growth but depressed unit sales on these products.

Naturally, product cost changes have always been a factor in our retail pricing decisions.

But in the current environment, we're seeing much greater variability and we expect it to continue throughout the year.

This adds even more complexity to our business as we manage through this environment.

This morning, we confirmed our guidance for fiscal 2009.

We are forecasting full year identical supermarket sales growth of 3 to 4% without fuel.

This guidance reflects our outlook for product cost inflation of 1 to 2%.

Our full year earnings expectation for fiscal 2009 remains $2 to $2.05 per diluted share.

Our first quarter performance was a strong start to the year, but it's still early.

While our earnings per share results were well ahead of the consensus estimate, they were only slightly ahead of our own internal budget.

Looking forward, there are several variables that will likely influence Kroger's financial results for the balance of the year.

These key trends include commodity costs, our manufacturing plants enjoyed an outstanding quarter, as we benefited from strong volume and lower commodity costs.

However, based on rising costs of many commodities today, we do not expect that to continue for the rest of the year.

Diesel fuel costs.

Our logistics operation benefited from lower diesel fuel cost during the quarter.

Again, based on a number of variables from a global perspective, we do not expect to have the benefit of lower diesel cost for the remainder of the year.

Consumer behavior.

Shoppers remain cautious in this economy and we do not anticipate that changing any time soon.

We expect customer spending patterns to continue to reflect their uncertainty.

As you think about Kroger's outlook for the full year, recall that as we described last March when we shared our 2009 expectations with you, margins for our retail fuel business are expected to be much lower in 2009 than they were in 2008.

The toughest comparisons will be in the second and third quarters this year.

This headwind will be offset somewhat by lower LIFO expenses.

Excluding the benefit of the lower LIFO expense we anticipate a slight increase in Kroger's non-fuel operating margin.

This operating margin expansion, plus the 3 to 4% identical sales growth, creates the earnings growth reflected in our earnings per share guidance for fiscal 2009.

This guidance reflects our commitment to delivering solid near term financial results, even in a tough operating environment, while investing in the future growth of our business.

On top of that earnings growth, Kroger's dividend adds over 1% to shareholder return.

That kind of return should look attractive to investors in this market.

Now I'll turn it over to Rodney for additional detail on the quarter.

Rodney?

Thanks, Dave, and good morning everyone.

As our first quarter performance indicates, our associates understand the importance of our Customer First strategy and its focus on people, products, lower prices, and the overall shopping experience in our family of stores.

The strength of our Customer First strategy and the flexibility of our business model enable us to continue to deliver value for both our customers and you, our shareholders, in this difficult environment.

At the same time, we are investing in Kroger's long-term growth as we work to emerge in an even stronger position once the economy recovers.

Let's take a closer look at our performance during the quarter.

Kroger's first quarter net earnings were $435.1 million, or $0.66 per diluted share.

This compares with net earnings of $386 million or $0.58 per diluted share in the same period last year.

We are pleased to report strong earnings results for the quarter.

Yet, these results are only slightly above our internal expectations, as Dave mentioned before.

There is extreme volatility in many of our input costs and it is still early in the year.

We encourage analysts to keep that in mind as you think about our guidance for the year.

Turning now to Kroger's gross margin performance, FIFO gross margin, excluding Kroger's retail fuel operations, rose 5 basis points on a year-over-year basis.

We continue to make investments and lower prices for customers, as reflected by our supermarket selling gross margin, which declined 48 basis points compared to the same period last year.

Improvements in shrink, advertising, and warehousing costs, rate of sales, as well as lower diesel fuel costs, funded Kroger's investments and lower prices.

As Dave mentioned, we do not expect the benefit of lower diesel fuel prices to be significant for the rest of the year.

On LIFO, we recorded a $23.1 million LIFO charge during the quarter, a decrease of $16.9 million from the prior year.

This decline benefited Kroger's non-fuel operating margin by 9 basis points as a percent of sales, compared to the prior year.

Our estimated product cost inflation for the quarter, excluding fuel, was 3.6%.

Cost inflation across several store departments, including grocery, drug, general merchandise, nutrition and deli/bakery, was tempered slightly by deflation in produce and dairy.

For the full year, we continue to expect a $75 million LIFO charge, which would be $121 million lower than the prior year.

Kroger's first quarter OG&A rate, excluding the Company's retail fuel operation, was flat compared to the prior year.

I believe the Company's OG&A performance was actually better than that comparison suggests, so I'll take a moment to explain why.

Kroger has three non-wholly owned investments, dunnhumby USA, The Little Clinic, and iWireless.

Excluding both our retail fuel operations, as well as the effect of these investments have on OG&A, Kroger's first quarter OG&A rate declined 14 basis points as a percent of sales.

This decline reflects strong cost controls, as well as our ongoing efforts to control utility costs through several efficiency initiatives that we have implemented.

We do see continued opportunities in these areas, which will help offset ongoing cost pressures Kroger faces in pension, healthcare expenses and credit card fees.

Kroger's first quarter operating margin, excluding our retail fuel operations, expanded 20 basis points.

As you may recall, our 2009 guidance indicates that we expect a slight expansion of Kroger's non-fuel operating margin, excluding the benefit of an expected lower LIFO charge.

On this basis, and excluding the effect of the three non-wholly owned investments I mentioned earlier, Kroger's first quarter operating margin expanded 18 basis points.

This expansion is significantly higher than the slight non-fuel operating margin expansion incorporated in our 2009 guidance, and our long-term business model.

The outperformance was driven primarily by the benefit of lower diesel fuel costs, which we don't expect to continue for the balance of the year.

Several of you, I know, are interested in the performance of our retail fuel operations.

In the first quarter, we sold more fuel gallons compared to the prior year on both an absolute and identical basis.

Which reflects our customer's strong interest in this part of our retail offering.

While gallons were up, cents per gallon fuel margins were down year-over-year.

The cents per gallon fuel margin for our convenience stores and supermarket fuel centers was $0.082 in the first quarter, compared to $0.092 in the same period last year.

Our retail fuel operations did not materially impact total Company earnings or year-over-year EPS growth.

Because of the margin volatility inherent in selling large volumes of fuel, we always encourage investors to take a longer view of this part of our business.

On a rolling four quarter basis, the cents per gallon fuel margin was $0.143 this year, compared to $0.114 for the same period a year ago.

Please keep in mind that the fuel margins we realized in 2008, particularly in the second and third quarters, were exceptionally strong.

Our expectations for the current fiscal year are based on more normalized fuel margin of $0.11 per gallon.

Now, I'd like to spend a few minutes talking about our financial strategy.

As you know, Kroger's Customer First strategy is supported by the disciplined and balanced approach we take regarding our long-term financial strategy.

We believe it is important to allocate cash flow, to keep our store base current, reduce Kroger's leverage, and provide a solid return for shareholders.

Capital investments excluding acquisitions totaled $654 million for the first quarter, compared to $637 million in the prior year.

We did not invest in acquisitions in the first quarter of this year, compared to $80 million invested in the same period last year.

Capital projects during the quarter included 10 new, relocated or expanded stores, and 37 remodels.

Our return on assets measures improved year-over-year.

We continue to project fiscal 2009 capital spending of 1.9 to $2.1 billion, excluding acquisitions.

Net total debt was $7.4 billion, a decrease of $243 million from a year ago.

On a rolling four quarter basis, Kroger's net total debt to EBITDA ratio was 1.78, compared with 1.95 during the same period last year.

This compares favorably to the 1.77 ratio we reported in the second quarter of 2007, which was the lowest ratio since our levered recap in 1988.

We expect to continue to improve Kroger's debt coverages on a year-over-year basis.

Kroger's bias toward debt reduction and away from share buybacks remain.

We believe that this is the right approach in the current environment to maintain an appropriate level of liquidity and allow financial flexibility to take advantage of any opportunities.

On the labor front, we have some progress to report.

Earlier this year, we successfully completed contract negotiations in Roanoke, Virginia and Las Vegas.

Last week, our Smiths' associates in New Mexico ratified a new agreement.

We are currently in some tough negotiations in Denver, and have contract extensions in Arizona, Dayton and Portland.

Later this year, we will negotiate agreements for our store associates in Atlanta and Dallas.

In addition to the normal pressures on our business, the twin challenges of rising healthcare costs and underfunded pension plans will have to play out at the bargaining table.

Before I turn it back over to Dave, I want to thank our associates for their efforts during the quarter.

We delivered value to our customers and our shareholders in an environment that's incredibly trying.

We are able to do this because of your commitment to our Customer First strategy.

Listening to customers and responding to their needs is a critical part of our strategy to earn customers' loyalty for life.

It is also an important part of our objective to create a sustainable business model that rewards shareholders with long-term value creation.

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

Thanks, Rodney.

As you can see from the results we reported this morning, and the information we shared with you today, Kroger established good momentum in the first quarter.

We are focused on maintaining this momentum throughout the year by investing in what we offer customers and adapting along the way to meet their changing needs.

We expect to emerge on the other side of this recession as an even stronger player.

Now we'd be happy to take a few moments to answer your questions.

Thank you.

(Operator Instructions).

Your first question comes from the line of Deborah Weinswig representing Citi.

Please proceed.

Hi, this is actually Susan Anderson for Deborah Weinswig.

Good job on the quarter, guys.

First, can you talk a little bit about Kroger's tuck-in strategy and the strategy for gaining market share?

Do you expect any real estate opportunities to open up as a result of the weak economy and some consolidation we're seeing?

I think the last quarter you mentioned that valuations were still too high.

Have you seen them come down yet?

I didn't hear the first part of your sentence, but if I understood you right, you wanted to talk a little bit about how we see the market in terms of acquisitions.

Correct.

Yes.

I'd say we see it pretty much the same as what we've described before.

We of course have lots of good opportunities we've seen in some of the end market acquisitions that we've made and those are episodic as they become available.

Always interested in those.

Bigger ones of course are certainly available out there.

There's lots of opportunity.

But prices are still a little steep and we tend to be cautious in wanting to be careful to pick something that's a good fit for us.

Rodney, you want to add anything?

I completely agree.

We continue to look at several things, but from a pricing standpoint, we haven't found anything that really makes sense.

Okay.

Great.

And then also can you talk a little bit about the competitive environment?

Seems like it's still pretty stiff out there.

Seems like a number of grocers are doing things in term of price cut promotions to drive traffic.

Maybe talk about what you guys are doing and also what you're doing with your loyalty card, any new initiatives there?

Sure.

We're -- well, the competitive environment, as always, I think, as probably our standard description is, it's a very competitive environment out there.

And you're right, in a number of markets, people are reaching out for sales.

We feel pretty good about our situation.

In fact, if you think about -- let's think about sales we just reported, the identical sales growth without fuel of 3.1%.

Sometimes that number is a great indication of where we are.

Sometimes it's actually too good of an indication of where we are, that is, it overstates the fact, and other times it's the reverse.

In this case, I think there are a number of factors that suggest that the 3.1 actually is not as good an indicator of where we are, that we actually did better than what that number shows.

We talked about some of those, but if you think about the competitive environment, and how that plays out, our tonnage and units was up.

Our pharmacy scripts are up.

Our gasoline gallons are up.

Our Kroger brand sales were up strongly.

We're seeing some wild numbers that will tend to cause these numbers to get a little skewed like the inflation and deflation we described, particularly in milk, where our units were up strongly but the dollars are down because of the deflation in milk as an example.

We of course are seeing the impact of discretionary GM, but from the customer point of view, we're seeing behavior that based on the economy that is pretty similar to what we've seen in the past.

And one of the reasons we're comfortable in describing this continuing is if you look at our second quarter so far through four weeks, we're about the same level of identical sales without fuel as what we were running in the quarter we just finished.

That continues to give us confidence that while the consumer is uncertain and that uncertainty seems to be continuing, it does not seem to be getting worse, but at the same time it doesn't look like it's materially improving.

Now, I realize that doesn't get exactly to the competitive question, but to me, the way for us to answer that is how are we doing and how are we feeling we're connecting with our customers, and what are we seeing in our sales.

And as you can tell, I'm actually more bullish even than the 3.1% ought to imply, and in these circumstances, 3.1 is pretty darn good.

The only other thing I would add, in terms of use of the loyalty card, that's something that dunnhumby and working with Don McGeorge and Don Becker over an extended period of time, we continue to modify the offering, modify the way we interact with customers, and you can continue to see improving engagements measured by redemption rates and customers that are actually engaged, using mailings that we send.

So we see continued progress.

I don't think there's anything that we would want to talk about that's a huge new initiative until we actually do something.

Great.

Thanks a lot.

Good job on the quarter.

Thanks, Susan.

The next question comes from the line of John Heinbockel, representing Goldman Sachs.

Please proceed.

Dave, a couple of things.

How would you describe the balance sheet that you had this quarter between price investment and comp?

I know you guys are always struggling for the right balance.

Hard to get that every quarter.

But how do you think the balance was this quarter?

Actually, I felt pretty good about it.

Some of the numbers you think about, our gross margin that we showed was up 5 basis points, but as you know, I actually look at the selling gross margin a lot more -- selling gross a lot more closely, because that's more reflective of whether we invested in lower pricing or not.

That was down 48 basis points.

Now, that was all offset, plus a little, actually, by the shrink in advertising and warehousing improvement and of course diesel fuel.

And if you combine then our OG&A, and as Rodney pointed out, I look at the OG&A as actually improving by 14 basis points.

If I wanted to look at a flow of our business and whether or not it improved or not, I'd take those variable entities out and look instead at the 14 basis points, and if you combine the decline of 14 basis points of OG&A and you combine that with our improvements in shrink advertising and warehouse improvement, even taking out the diesel fuel, we still had good progress on saving money to be reinvested on behalf of the customer.

And, we selectively did reinvest it as the selling gross decline illustrates.

Actually, I feel pretty good about it.

If there's anything in this market that I'm encouraging us to keep looking at, it's keep pushing for sales, because we believe sales are available.

We're proud and pleased with where we are, but we are pushing ourselves to do even a little bit better because sales are really our future and our strategy, and as we invest in those sales, we expect to have even more savings that then can be plowed back in.

That, which then produces the earnings growth that we forecasted in our guidance.

Do you think the rate of reinvestment increases as we go through the year or stays about the same?

I think we read it as we go, John.

I don't think that we can necessarily answer that.

What we're targeted at is the sales guidance we indicated, between the 3 and 4%, we're pushing ourselves to be squarely there.

And we're pushing ourselves to be self at the earnings at the $2 to $2.05 a share.

As we do that, we measure ourselves as we go.

Of course, if sales don't pan out, then we push ourselves a little harder to get those sales.

Because we think our earnings are the direct result of the sales.

So that's why we're going to push that point.

So I don't know that I can predict it, except that I would say the whole year is going to look pretty much like we've described.

Now, we had a lot of tail wind in the first quarter, diesel fuel is maybe the best example, but there were other illustrations, the commodity costs we talked about and some other things.

But if you take those into account, we of course think the rest of the year's going to be a little bit harder if you just look at a comparison to the previous year.

But I think it's going to be the same plan that we played out in the first quarter on the whole.

Just on dairy and produce deflation, how much do you think the combination hurt the comp by?

Could it have been 100 basis points or not that big?

And then when does that start to flatten out year-over-year?

Well, I don't think we have a number to give you.

I would be surprised if it was 100 basis points.

That strikes me as too high.

But both of those were important areas that you're describing and in terms of flattening that out, I don't know.

Rodney, do you have an opinion on that?

If you look at dairy, we expect it to go up from where it is today, but throughout the year we still expect it to be lower this year than it was last year for the equivalent period of time.

The item that probably affected the identicals the most and really was some of the background on Dave's comment about he feels more confident about the number than what the 3.1% would show, is that if you look at the switch from national brand to corporate brands, this is a rough estimate and there's several different ways can you calculate it, but we think that hurt identicals by about 0.7% just by itself, and that would actually be more than the dairy and produce deflation.

All right.

And then finally, I think you said in the fourth quarter that non-food hurt the comp by 40 basis points or so.

Was that similar in the first quarter or different?

I don't have that number.

We're looking to see if we have that.

That 40 basis points was Fred Meyer only, John, not total non-food.

In the fourth quarter that would have been a bigger impact than in the first quarter.

Holiday season.

About 20 basis points or so in the first quarter versus 40 in the fourth quarter, because of what Dave said.

About half the impact.

The holiday selling.

Okay.

Okay.

Thanks.

Thanks, John.

Your next question comes from the line of Simeon Gutman, representing Canaccord Adams.

Please proceed.

Hey, guys.

First, can you just touch on a basket versus traffic and then I have a follow-on to that.

If we look at the basket that consumers are purchasing today, can the number of units actually continue to go down?

And I'm just asking you to base that on history and where I'm going is if you get a little bit of reinflation in the back half of the year, could that be a good thing or if basket size were to go down further, could you see more sensitivity from the customer?

Well, interesting question.

Thank you.

Average sale actually was down a little bit in the quarter and transaction count, if you look just purely at transaction count, it was up strongly.

If you look at our own customer loyalty data, what we see happening is customers are coming in more often, but they're buying less in the individual trip than they were buying before.

But the combination of the two produces -- generally has produced increases.

Certainly, there's some households that are buying fewer items over the course of the month, but there are many households that are actually buying more items throughout the course of the month.

It's just that they're visiting us more often.

What we believe is happening is customers are buying what they need when they need it, closer to when they need it, to make sure that their dollars stretch further to the end of the month, or the end of the pay period.

I think we've seen that now actually for several quarters.

And to me, it's actually pretty clear what they're doing in that regard, but the net result for us, though, is it gives you a misleading feeling that we're selling less to people, but in fact I think customers are consolidating more of their purchases at Kroger, and I think we're actually selling more items to many households than we were before.

So that actually bodes well.

Now, at the end of the year if we end up with a little bit more inflation and we've commented on some of the commodity costs that we think could sort of reverse themselves and create a little bit higher issue for those items, at least, you could see resistance on those items, but I think you may find people shifting to other items.

And as a result, I'm fairly bullish about what the rest of this year is going to look like.

Is it possible that -- yes, sorry.

You had also mentioned in your question, can units keep going down?

I don't -- just specifically on the units going down, we continue to see very strong unit sales growth.

It's the national brand that's down a little bit.

It's way more than offset by the strength of our corporate brands.

Corporate brands is double digits.

I put that in proper perspective because first I don't see units as really going down.

They may be going down on an individual shop basis and most stores would measure that on a per transaction basis.

We measure it on a household basis, and when you look at it the way we're looking at it, it's actually not really declining.

Generally.

Now, certainly some households, but on the whole it's not, and that double-digit growth in our own Kroger brand is just gigantic, and in grocery it was 35% of the unit sales so you can just do the math yourself how important that was to us.

The national brands were down in tonnage but only slightly down, and down at less of a declining rate than they were in the fourth quarter.

So that's actually an improved position.

Is it possible that maybe the decline in retail fuel prices, not the -- I guess what you sell and then to customers, is helping the number of visits people are coming around, and I guess at the same time, with the competitive environment, I guess you described it as not getting materially changing that much, maybe is there more of a cherry-picking mentality that you think that your customer has now versus before?

No, I don't see a greater cherry-picking mentality at all.

In fact, the way we're trying to do our program is based upon winning households over a long period of time and winning their loyalty and that kind of approach doesn't really target the cherry-pickers.

It's possible that the increased frequency of visits might have some relationship to gas prices, but I actually think it has a lot more to do with how people are feeling about their money and how they stretch their money over a longer period of time.

And I also do think that lower gas prices tends to put, and in fact it does put more money in people's pockets which of course helps us, helps every retailer for that matter.

But if you look at recently, fuel prices have been going back up, and you can hear increasing concern from customers about the price of fuel.

Yes.

Okay.

And then lastly, just on the pace of IDs through the quarter, I forget if you comment on this, but curious where you ended the quarter.

I heard your comments that you were relatively flat with where you left off in the current quarter.

We didn't give any dimension on how it went through the quarter.

I think it's probably enough to make sure you knew that in the first four weeks of this second quarter that we're about the same as where we were last quarter, which we take as a positive note that things are steady as they were.

Okay.

Thanks.

Thank you.

Your next question comes from the line of Ed Kelly, representing Credit Suisse.

Please proceed.

Hi, good morning and nice quarter in a tough environment.

Thank you, Ed.

Thank you, Ed.

My question for you is on your ID sales and the fact that your ID sales so far in the first four weeks of this quarter are up similar to last quarter, to me it would seem encouraging because you're beginning to cycle the stimulus promotion that you had last year.

Do you view that as a headwind?

Does it make it tougher to cycle that?

And then I'd just be curious as to whether you would view the underlying comp as a little bit better because you are cycling a tougher comparison?

I would really agree with just about everything you said except that I don't think I would play up too much the headwind from last year's tax rebate promotion.

It was a good promotion, and based on what we know about which customers it targeted, I don't really feel like we're going to have as much headwind as maybe what you described, even though I liked having the promotion that we had.

And I do feel good about the sales trend in this current second quarter.

I do take it as a positive picture and I think it's worth remembering that.

And so I think you probably sized it up just right.

On the gross margin side, you saw a pretty big benefit it looks like from shrink, advertising, lower warehouse expense.

How sustainable are those items?

And I don't know if you could maybe break out diesel impact so we know what doesn't continue.

Well, let's see if Rodney and Mike want to give some numbers on that specifically, but I'll tell you on shrink, advertising and warehousing expenses, I'm very pleased with the teams that work on those, both in those particular disciplines, but also in our operating divisions who work with those two.

Our results were very good and in my opinion, those results are pretty sustainable.

We're trying to do the kind of things -- we talked about shrink often enough where we've said, we tried some things and it hurts our sales because we went too far.

I think we're very balanced.

We're trying to apply better thinking to the way in which we could shrink, and I think our organization has responded well and produced great numbers, very pleased with that, and I believe it can continue.

Do you want to comment on that?

If you just look at diesel, on a rough basis it's about 40% of the total improvement, it's because of that.

So 60% we would view as more sustainable.

You can see, it's pretty important, though.

And the diesel fuel comment is not necessarily the absolute cost of diesel fuel this year versus last year.

It's more relevant to what our expectations and our guidance of 2 to 205 was, so it's more comparison of what our internal expectations were for diesel fuel, the actual prices in the first quarter were below our expectations and they appear to be trending at or slightly above our internal expectations.

I just don't want people to think that we're doing something magical and buying diesel fuel differently or last year versus this year.

Yes, yes.

Lastly for you, on SG&A, could you provide a little bit more color on those three wholly owned investments that you talked about and why we're sort of hearing about them this quarter?

I mean, it seems like it could be a few cents a share impact based on the numbers you gave and just how that variable sort of plays out the rest of the year.

Is it really just a one-time issue?

It's really not anywhere near that size of an effect.

You can see the portion of the entities that we don't own on the very bottom line.

If you notice, we don't have net earnings anymore.

We have net earnings attributable to Kroger and that line right above there represents the amount that's not attributable to Kroger backing out, so it's a relatively small effect because that's the portion that we don't own and they're pretty much not entirely 50/50, but close enough for conversation.

The impact is that on the individual lines of the income statement, we have to put all those entities in on every individual line on the income statement now, and that's a result of FASB 160 and two of those are actually entities that are you appearing for the first time in that manner because they're new investments as compared to this time last year.

That being wireless and the little clinic.

My hope is that as we cycle this, this time next year, the effect on our OG&A and gross lines won't be dramatic and we won't have to talk about them but putting things in for the first time, because these are start-up entities, by and large, so they have fairly high expense rates relatively low revenue, so when you consolidate them, it can make your comparisons look kind of strange and that's why we called it out.

Okay.

And was there anything else sort of non-operating or non-recurring in SG&A?

I mean, because you had about 4% growth excluding that.

I would have thought that maybe it could have been a little bit better, given the environment.

And can it get better than that the rest of the year?

You're looking at the total OG&A as reported.

Yes, as a growth rate year-over-year.

I'm looking up what it was without some of the -- because you can't see it.

You can't see it with the entities pulled out.

It wasn't as high as that when you pull out fuel and you pull out the one-time entity.

So if you look at the absolute growth in dollars, without that, it would have been -- it would not have been a 4% growth rate.

Okay.

Well, to decline 14 basis points, it couldn't have been.

Right.

Okay.

Thank you.

Thanks.

Your next question comes from the line of Karen Short, representing FBR Capital Markets.

Please proceed.

Hey, everyone.

Good quarter.

Thanks, Karen.

Sorry, not to beat a dead horse here, just on your guidance, if I had to paraphrase, it looks like you obviously maintain your guidance for the year on sales and earnings.

Your sales currently are still in the 3 to 4 -- they're still at 3.1% range but you definitely sound more cautious.

I guess the only thing that I can gather that would be -- that would have changed since your prior guidance is really your diesel expectations or is there something else?

Well, let me take you through a little bit of the thinking.

I'm not more cautious when it comes to thinking about the strength of our business.

I'm actually feeling pretty good about where we are on sales and where the sales can be and the organization's work there.

So first of all, take that as a really confident statement on my part.

But when we look at the earnings, we looked at our own internal forecast.

That's one of the reasons we told you that our first quarter was only slightly better than our own internal forecast and plans.

We thought that was important.

We had some tail wind items in the quarter that we do not expect to continue later in the year and we think they're important enough that you shouldn't get so bullish, based on the earnings in the first quarter, to extrapolate that out for the rest of the year and just to give you some of those examples

Diesel fuel you already commented on, that you saw that, but look at retail fuel margins.

We talked specifically about that and in the second and third quarter, retail fuel margins will be less this year by quite a little bit than they were last year in our opinion.

Commodity costs.

We think that there will be some swing back in those that takes some of the tail wind out of the first quarter into the remainder of the year.

And then on the economy and the customer uncertainty, we see that actually as continuing through the year.

I don't see that getting worse.

I'm not sure I see it getting better.

We don't see any particular signs of it getting better.

But that's sort of steady as it goes and then of course LIFO which we've already talked about.

Certainly on the economy, we're seeing things stabilize and in a few areas, seeing a little bit better but not much.

When we say a little, I mean, it really is a little.

Karen, I think Dave's comments about relative to our internal expectations is one of the important factors here as well.

When you look at our internal expectations, compared to the consensus estimates for the year by the quarter, really what we're saying is the first quarter consensus was well below our internal expectations, although the year for the consensus was within our range, and if you're wondering where we think you're too high, I would point to the fourth quarter.

Okay.

Actually, so I mean I got -- I had the list that you just gave make sense.

You already knew that fuel margins were unusually high last year, and so you factored a normalized fuel margin into your guidance for the current year so I guess I don't count that necessarily as unusual.

But looking at fuel margins a little bit, I guess I'm curious, I think on one call, you had kind of given some directional impact on the impact on earnings from a change in margins and I can't remember what quarter it was, but I kind of got that about $0.01 change in gas margins year over year was about $0.006 in earnings.

So I guess the first question is, can you tell me if that's kind of directionally right?

And then the second question is, with margins very unpredictable, I guess I'm curious how quickly you can react to strong or weak gas margins as it relates to the rest of your promotional programs, meaning if you're suddenly seeing really strong gas margins, can you accelerate a promotional program within that period so there's kind of a neutralizing effect, or do the reverse if margins are much weaker?

Rodney and Mike are looking up the comments you want to make on the impact that you're asking initially.

Let me talk about the fuel margins and our other margins.

It would be incorrect to say that we view them as independent of each other, but it would also be incorrect to say that we try to make up or give back any change in gas margins and vice versa.

Gas margins change every day, and that's one of the reasons we say that if you look at gas margins, you need to look at at least a full year run and I even think longer term is even better than that.

Certainly looking at four quarters gives a much better sense of where gas margins can be, and on any way of measuring, last year on a four quarter basis, was much higher than what we have historically experienced and what we expect to experience going forward.

So if we see in a given week or given month or given quarter that gas margins are higher or lower than what our expectations are, certainly it will influence what we do elsewhere in our business.

But we're not going to let it whip saw where we go because we're directionally focused on what our customers want and we don't want to change that model just because of one month or two months of gas margins, one direction or another.

So I don't think I would be too directed by that.

I realize that the gas margins were forecasted for the whole year and it did enter into the guidance we gave for the whole year.

But I think it helps explain why our first quarter internal estimates were about on target for the guidance that we've given you and I think it helps explain why when the Street had a lower expectation for the first quarter, why you shouldn't go add the extrapolation of that performance into the second, third and fourth quarter, because in the second and third quarter, the gas margins aren't going to be there this time.

The other thing I would add, I think your number would be reasonably close.

The thing that we all have to remember is part of it will be a function of what the retail price of gas is.

Because so much of gas is bought on credit card.

If gas is at $3.50 or $4 a gallon, the interchange fee that we're paying for the credit card companies is a lot higher than if gas is at $2 a gallon.

That would be the one thing that would cause your number to be off as much as 20 to 30% either direction depending what the retail price is.

You also have to figure out what gallon growth is doing.

The amount of gallons we sell could affect your calculation relative to the effect on net income.

Right.

Got it.

Okay.

Sorry.

Last question.

Any status on the comment or conversations with the S&P as it relates to your ratings and I guess any progress on how they look at the underfunded multi-employer plans?

I'll let Mike answer that.

There's no net new news out of the rating agencies which in this environment is good news, I would say.

They continue to ask a lot of questions about the underfunded liability.

We continue to help educate them significantly on it.

And as we go throughout the year, hopefully market returns help some.

As we said in the prepared comments, both rising healthcare costs in the country and this underfunded pension liability is going to have to be something that works out at the bargaining table.

Okay.

Thanks very much.

Thank you.

The other thing is we think it's very important to be as transparent as we can on what that potential underfunding could be, and that's one of the reasons why we've shared it for several years.

We continue to have the dialogue with all the rating agencies to make sure they understand that and make sure they understand our plan on working to address too.

Your next question comes from the line of Scott Mushkin, representing Jefferies & Company.

Please proceed.

Hey, guys, this is -- I'm going to -- I'm sorry.

I'm in a car.

I wanted to reclarify Karen's last thought process there.

Her first question.

Is your confidence the same, increased or decreased regarding your $2 to $2.05 number guidance?

I'd say about the same.

I don't know, Mike or Rodney, if you feel any different.

I don't see it -- I certainly don't feel more confident, but I don't feel less confident about it so I'd have to say about the same, yes.

Okay.

That's great.

Second question, getting back to I think it was the first question about acquisitions, can you guys just refresh us if we were going to make some -- we've done a lot of tuck-in in-market acquisitions, but if you were going to do something bigger, kind of what your parameters are for that, and do you think prices for something larger are working their way down or not really?

Rodney, you want to comment on that?

In terms of overall as we have said many times, any time when we look at something merging with somebody that would be a new market, we're looking for somebody that has a high quality asset base, with strong market share, great people and a culture similar to what we have, and we think that is absolutely critical, any time that we merge with somebody on a bigger scale.

If you look at our merger with Fred Meyer, if you look at our merger with JC, any of those companies, they all fit those parameters.

So any time we would go into a new market, those are things that are the first things that we look at and that we would have to check off.

Then we have to make sure we get comfortable in terms of the sustainability of their business model and what they have.

So those are things that we would continue to look at, always have and always will.

And it's a characteristic of every deal that we've participated in.

And we also look to see what does the party bring to us and we think that's what creates a merger.

If you look at what Dillon, when we merged with them many years ago, they brought a lot of things to Kroger.

If you look at Fred Meyer, there's many, many things that Fred Meyer brought to Kroger, if you think about our three tier corporate brand program, you think about our marketplace store, you think about our price impact store, all those are things that Fred Meyer had, that brought to us.

Of course it brought Dave to you guys too; right?

Absolutely.

And Joe Pickler.

Two for one.

That was a two-for.

How about the environment for a large acquisition?

Do you think it's improving?

Do you think prices are becoming more realistic?

Do you think the pressures that are coming to bear on the market is making things more likely or less likely?

I don't think the trend really has changed on that.

As you know, we look at a lot of things but we don't do a whole lot.

We want to make sure that it is the right one.

I don't see that this environment really changing that much.

And one final one, if I could.

Obviously, I think it was 48 basis points of selling gross margin investment, kind of large.

Offset by a lot of great things that were happening.

Where do you think your ability going forward if those things -- this has been asked before, but I mean, what do you think your ability is to continue that type of investment the rest of the year with what you know today?

I think the investment varies a little bit by the -- maybe a lot, actually, by the opportunities that we see.

And but directionally, and I tend to look at this more on an annual basis, directionally, we expect to continue to invest in our selling gross by investing in pricing, but we also expect and have even in this last quarter invested in other things that are not price.

Things that improve the other three keys.

People, the shopping experience and the products keys, we've invested in each of those in the quarter too.

Now, in this environment we've invested a little bit more on price disproportionately than you might have otherwise done in a normal economy, but I think all of them are important.

I expect we will continue that trend through the year and we have number of things in mind.

We have a number of things we put in motion in the first quarter which we think will play out well for the rest of the year.

Thanks for taking my questions.

Thank you.

Your next question comes from the line of Todd Duvick, representing Banc of America-Merrill Lynch.

Please proceed.

Thank you.

Good morning.

Good morning.

Appreciate your comments when you were talking about the bias towards debt reduction and away from share buybacks.

And I guess what I'm wondering is you've got some short-term debt on the balance sheet but you also have a fair bit of cash.

So with all that, it seems like borrowing costs have really come down lately so I'm wondering if you can talk about your views on potentially tapping the debt capital markets to term out some of that short-term debt.

Some of that short-term debt, if you look at what's there, there was as piece of debt that matured June 1 which would be in the short-term category on our balance sheet.

I think it was about $360 million or so, which if you recall back last fall we did a debt offering and said that that was really prefunding that opportunity.

We have paid that off.

We did not do an incremental borrowing to do that so relative to our overall cash position, that would come out of that.

You also have to keep in mind, if you look at the cash, there was about $460 million on the balance sheet.

So a large chunk of that got used up at the beginning of June when we paid that note off.

Okay.

And if you can talk kind of big picture, if you -- what signs are looking for that will make you a little more comfortable going away from debt reduction to share buybacks?

And I understand that I'm a debt guy, so it may seem odd for me to be asking that, but it seems like your balance sheet is in very good shape, so I'm just kind of wondering what signs you're looking for from the economy or from capital markets to get you a little more comfortable going back to share buybacks?

From a capital market standpoint, I feel comfortable with our ability to access the capital markets when we need to.

Clearly, from -- if you look forward to our bank credit facility maturing in November of 2011, so that means sometime, this time next year we'll be sitting down, renegotiating that facility, it would be great if we were BBB flat with all three agencies so we had broader -- so we had access to the A2P2 commercial paper market versus the unrated commercial paper market.

That would change our view of our ability to get day-to-day liquidity.

While it look like the ability to do a larger bank deal is better today than it was six months ago, it's still uncertain how big it could be, how long it will be, what it will costs, and how many banks there will be so there's still a little bit of caution in our view.

We also think we need to improve our credit metrics.

Keep in mind the net total debt to EBITDA ratio we talk about is the one that's contained in our bank facility, it's not necessarily the one the rating agencies use because it doesn't capitalize the rents and it doesn't contemplate the multi-employer pension funds.

Obviously, the way they do it would have gotten better as well.

So all of those are in the background.

I do think that one of the things we have to keep in mind is absolute debt doesn't necessarily have to go down as EBITDA grows and we reduce debt a little bit.

That obviously, what we're really fixated on more than anything is the absolute leverage ratio, not the absolute dollar amount of debt necessarily, but we do want to have a better ratio.

Okay.

That's helpful.

And just one follow-up.

Mike, it sounds like within the past couple years I've heard some frustration on your part, maybe I've just interpreted it that way, with the rating agencies.

It sounds like you're renewing a commitment to really try and work towards that mid BBB from S&P.

Am I interpreting that correctly?

We think in this environment it would be very helpful for us to be A2 P2 F2 and be able to access that commercial paper market rather than the unrated market.

I think we've had the commitment all along.

Obviously, the think that's been the wild card in this is the amount of the unfunded Taft-Hartley obligation or the estimate of the amount that they're underpinned by, even though it's not a direct obligation, and as Rodney said we do believe in the transparency of putting that number out there, and it's bounced all around the place and the size of it right now is probably the thing that was more of a headwind than we would have estimated two years ago.

Okay.

That's very helpful.

Thank you very much.

Have a good day.

Thank you, Todd.

Thanks, Todd.

Your next question comes from the line of Neil Currie, representing UBS.

Please proceed.

Good morning and thanks for answering my question -- let me me ask my question.

You may not answer it, but -- I just wanted to talk about eating at home trends and how you're benefiting from people eating out at restaurants less.

Obviously, private label tends to move up during tough times and tends to be quite sticky.

Do you think we may be able to see that in eating at home trends, and people eating at restaurants and shopping at supermarkets more, as the economy does level out and maybe shows some improvement that some of this market share growth from restaurants that you might be seeing could be sticky?

I believe that that would be correct.

We are still seeing the trend of families eating a little less at restaurants and a little more from us.

Part of that is driven simply by where they can get the less expensive meal.

And part of it's driven by improvements that we've made in our own deli and meals that are ready to take home and eat.

The combination of which, we've commented that bakery-deli is one of the areas that has improved in sales above our average and that's been true now for some time.

That's a reflection of the better job that we're doing.

On the flip side, restaurants are doing actually a better job in trying to develop more their pick-up meals at the restaurants to take home, trying to get some lower priced point items.

Those I think could get a little bit of traction.

But I still don't expect any big change here, other than the continued trend.

And as the recession ends and the economy improves, because of the improved quality job we've done in our delis, I fully expect to retain some of that, maybe not all, but I certainly expect to retain some and the same would be true of the Kroger brand, just as you described.

The other thing, this was a trend we thought we were seeing even before the economy slowed down, people are starting to eat at home more together as a family and when we do our research, customers certainly tell us they enjoy eating together as a family and there's been quite a bit of research done where people that eat together as a family and Columbia did a great study on this, kids have a much lower rate of being involved in drugs or abusing alcohol and things like that.

So we really think that was a fundamental trend going on even outside of the economy.

Thanks and obviously you're at the bottom end of the ladder when it comes to when people do eat out less or trade down, you're very much a high quality operator.

However, while on one hand you're gaining market share from restaurants, I presume there are some customers who are going to super centers, dollar stores, discounters.

What's your confidence that that trend won't be sticky as the economy recovers and you can get back some of those shoppers who are really struggling financially and going -- compromising some quality and going to lower end retailers?

Actually, it's those trends that give me confidence in our sales going forward because it tells us that there is opportunity and sales available out there that we could still be getting more.

So actually, I feel better about the fact that that data is there and the reason I'm confident about that is I believe based on our own research, that customers prefer to shop with us than in those other types of stores that you've described.

And because they prefer to shop with us, we think that as we give them more and more reason to do so, even in this economy, they will continue to do so and they'll do it in growing numbers.

And when the economy improves, we think that that improves our prospects even more.

So I'm pretty bullish from the perspective of what you were describing.

As you recall, in the first -- year-end earnings call we talked about it, that our market share last year grew by over 60 basis points and if you look at over the last four years it's 225 basis points for the the sum of those years together.

A final one.

I noticed that you called out lower warehousing, cost of warehousing, distribution and that you seem to call out as apart from diesel costs being lower.

In terms of some of the investments you have made in IT in recent years, with regards to warehousing and distribution, are we starting to see that come through in terms of lower costs or is there something else that's causing lower warehousing costs?

It's really a combination of lower costs from the investment and driving that, plus process change in our existing facilities.

It's really both together.

Okay.

Thanks very much.

Thank you, Neil.

Thanks, Neil.

I think we have time for one more question.

Thank you.

Gentlemen.

Your final question will come from the line of Meredith Adler, representing Barclays Capital.

Please proceed.

Thanks for taking my question.

Sure.

Good morning, Meredith.

Good numbers, congratulations.

I'd like to start by talking a little bit about a comment you made about if you see some inflation again, then something that was a tail wind in the first quarter might go away and you weren't talking about fuel, I think you were talking about food inflation.

Is it fair to say that the deflation you saw in some categories was actually beneficial to gross profit dollars?

I think I've asked this question before, but I'll ask it again.

Really depends on the items.

Milk as an example, we do expect the cost of milk to go up a little bit at the end of the year from where it is now and I do not think it's correct to say that that helped our gross margin dollars, but we sold a lot more milk but the dollar sales would have suffered a bit because it was down actually quite a little bit.

So if you -- if we end up with with a little bit of inflation in milk going towards the end of the year, actually we would see the retails go up and I would actually anticipate maybe that makes a little bit more gross margin in that situation but that's always a hard one to read.

It depends completely on the competitive market.

Other areas that we were talking about, we called out manufacturing, had a terrific result in the first quarter and it was partly because of the great job they're doing and the processes they're doing and the increase in tonnage that they were able to sell.

But it also is driven in part by lower commodity costs and we are expecting some of that to change and as that changes, that does depress a little bit the profit that we were producing in manufacturing in the first quarter.

But we still expect outstanding results.

Still expecting a good year from them, yes.

I don't know if that fairly answers your question.

Yes, I think that's helpful.

I was just trying to understand what tail wind exactly you thought would go away.

It was really those lower input costs for our plants.

We called out that and the diesel fuel costs were below our own expectations.

Those were the two major tail winds in the first quarter that at this point are beginning to dissipate.

And then on -- thank you.

Another question I have.

I believe you said that you're putting a big investment program on remodels, where you have one in place, and I just want to confirm that you do look at it as kind of a push to do remodels.

Also, is there a point where you feel that you have done, with the push, obviously you always have to do remodels, but is there a point -- and really I want to know is there a point at which you would see the CapEx come down?

Well, I look at remodels a little bit different than that.

I don't look at it as a one or two or three year push.

I look at it as more of an emphasis.

We're getting good results on our remodels.

We're pleased with what we're achieving with them.

But I actually think the pace with which we're doing it, I don't see it reaching a point for instance at the end of next year where we sort of reduce that.

I think we're going to be pushing remodels for sometime and we've been emphasizing them now for what, the last two or three years as least, and I just see that as -- we're getting better returns on those too, actually, than when you compare it instead to some of our other investments so it's natural that we would emphasize those areas, so I don't think it's going to be something that you'll see wind down in another year or two.

I just think that that's an important area for us to keep building.

And as Dave mentioned, performance to budget continues to be very strong on the remodels.

Obviously, if that changed, that would cause us to look at it differently.

But as long as we're getting strong returns on that investment.

The other thing, if you look at the number per year, you'll see a much more measured pace and you won't -- we haven't tried to do 400 in a year or 500 in a year.

It's really trying to balance it across periods of time.

If you do a couple hundred a year it takes you over 10 years to touch every store and 10 years is probably too long for a lot of stores to go between remodels.

We think it's too long.

This kind of number is the range we need to be in.

Okay.

Got it.

That makes sense.

I warranted to ask you a question about the one market I don't think you mentioned in a long time that any of your markets have negative comps.

This time I think you said there was one market.

Although this is going to be hard to break down, to what extent is that a function to that market of the economic environment or -- and to what extent is it a function of competitive environment and those are related, but -

Well let me offer three comments.

First, it is one division.

It was only slightly negative.

Second, is that it is the result of both the environment, in my opinion, the environment, customer behavior and competitive activity, both of those are playing in that particular situation.

And so I actually wouldn't make too big a deal of it, because it was only slightly negative and that's -- but we thought in fairness we've got to mention there was one.

We mentioned that we had one in the fourth quarter as well.

Yes.

It happened to be different markets between the fourth and the first, though.

Okay.

And then my final was just a housekeeping question.

We underestimated interest expense for the quarter.

Do you have -- can you give us guidance for interest expense for the full year and just maybe just understand a little bit about what would be driving interest expense at the moment.

I won't update the guidance for that now, but we'll step back and look at addressing that when we file our 10-Q and give some clarity to what's driving the interest expense.

Is that fair enough?

That's fair.

That's fine.

Thank you very much.

Thank you, Meredith.

And thank you all.

But before we sign off, I'd like to share some thoughts with our associates who we encouraged to join us on this call today.

Thank you for your individual contributions to our results this quarter.

In our industry, operating successfully in any environment is a challenge.

Performing well in this current economy is remarkable.

It's clear your commitment to customer first strategy continues to differentiate our family of stores from our competitors.

I hear, see and experience great customer service in our stores every week.

It's gratifying when others recognize it too.

Recently, one of our exceptional associates in Nashville, Tennessee, was featured in the local paper for her customer service skills and her commitment to the neighborhood where she works.

Described by her store manager as the heart and soul of the Bellevue store, Jo Hughes has been working for Kroger since 1968.

Everybody knows Mrs.

Jo.

"I just love my customers," Mrs.

Jo says.

"I know some by first name, some by last name, and some I know their faces and they know me.

I see this store as a corner grocery that is involved in the community.

They realize we are here for whatever they need." Earlier this year, I had a chance to meet Mrs.

Jo.

She is a great example of the tone John Hackett, our Mid-South President has set for the whole division.

Mrs.

Jo is Customer First at its best.

Many small, simple acts of kindness practiced every single day that make customers wants to return.

I want to thank Mrs.

Jo, the whole Bellevue store and the entire team at our mid south division for all they do to create a great environment in our stores for our customers.

I also want to thank all of our associates for the extra effort that you make every day on behalf of our customers.

We appreciate all you do.

That completes our call today.

Thank you all for joining us.

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

This concludes your presentation.

You may now disconnect.

Good day.