克羅格 (KR) 2009 Q3 法說會逐字稿

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

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

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

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

(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 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.

We recognize that the third quarter results we reported earlier today differ significantly from the outlook we shared with you when we reported Kroger's second quarter results in September.

For that reason, we are modifying the structure of today's call from our typical format.

Today, our prepared remarks will address the factors that caused our third quarter results to differ from our internal projections.

We aim to provide you with a better understanding of our current business environment and our plans going forward.

We do not plan to use this time to repeat financial information provided in Kroger's third quarter earnings release.

Finally, our prepared remarks will be shorter, in order to allow more time to address investors' questions.

I will now 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 third quarter 2009 financial results are Rodney McMullen, Kroger's President and Chief Operating Officer, and Mike Schlotman, Senior Vice President and Chief Financial Officer.

The operating environment has proven to be more difficult than we expected and our performance during the quarter clearly reflects it.

We came up short in several aspects of our performance.

We have deflation in sales, making expense leverage difficult, a sharply more competitive environment that is now widespread, and cautious consumers.

These factors led us to results below our expectations.

However, our short-term results obscured some otherwise strong fundamentals in our performance, such as exceptional tonnage growth, market share gains in key segments, increases in loyal household count and good cost control.

These fundamentals are important to our long-term success and creating shareholder value.

For the second consecutive quarter, deflation accelerated in most grocery categories.

Last year at this time we had estimated inflation of 6%.

This year, we estimate deflation to be minus 0.8%, or nearly 700 basis points swing year-over-year.

More importantly, deflation was particularly acute in categories like milk, produce, meat and grocery.

We certainly sold more units, as any associate who stocked dairy or produce departments can attest, but at much lower retail prices.

Based solely on our tonnage, we had a solid quarter.

In fact, our tonnage during the quarter would have generated identical supermarket sales above our original annual guidance were it not for the continued deflation.

As a result of continuing deflation affecting our sales, and higher tonnage and customer count, which increases work flows throughout the organization, it's been more difficult to leverage expenses.

In addition, the current economy has slowed employee turnover rates, increasing average hourly wages and healthcare benefit costs.

But overall, as demonstrated by a lower OG&A rate, excluding fuel, we did a good job of managing expenses.

We also saw competition increase.

Continuing the trend we saw last quarter, pricing and promotional activity increased to include more of our competitors expanding to more of the markets we serve.

Even so, we continue to gain market share which is critical to Kroger's long-term success.

Compounding matters is the economy.

The environment continues to create cautious consumers.

Some are choosing to be more disciplined in their spending and are buying down.

While others are holding back altogether on purchases because they simply don't have the money to spend.

As a result of all these factors, we have revised our guidance for both full year identical supermarket sales, and earnings per share growth.

We now expect the full year identical supermarket sales growth of 2% to 2.5%, without fuel, for fiscal 2009.

This guidance assumes that third quarter deflationary trends continue for the remainder of the fiscal year.

So far, identical supermarket sales for the fourth quarter after four weeks are running about the same as the third quarter.

We've also revised our 2009 earnings per share guidance.

We now expect full year fiscal 2009 earnings of $1.60 to $1.70 per diluted share.

This guidance excludes the Southern California impairment charges recorded in the third quarter.

While these revised forecasts are below what we had expected to deliver for the year, we believe they appropriately reflect the challenges of the current environment which continues to be characterized by significant deflation, cautious consumer spending, and more aggressive competition.

Kroger's continued growth in tonnage and loyal households, and our competitive advantages position Kroger and our shareholders to benefit once operating conditions improve.

Looking ahead to fiscal 2010, we expect current operating conditions to extend at least through the first half of the year.

Deflation is expected to moderate throughout the year, and we will be cycling many of the price investments we put in place during the first half of 2009.

We expect the combination of these factors will produce identical sales growth, excluding fuel, and earnings per share growth, both above forecasted 2009 full year results.

Of course, excluding the Southern California impairment charges.

Now, Rodney will offer you additional perspective on the quarter.

Rodney?

Thank you, Dave, and good morning everyone.

Customer traffic in our stores continued to improve and growth in loyal households continued to be strong.

Loyal households represent our very best customers.

Our data shows these customers are making more trips to our stores and buying the same number of items per visit they did during the same period last year.

So over the course of a month, these households are buying more items from Kroger than they were a year ago, which indicates they are consolidating more of their spend with us.

In addition, visits from all households we track rose in the third quarter.

This is driving outstanding unit growth for our business.

During the first half of the year, we initiated several pricing programs to attract and retain cautious customers.

These programs have cost us more than we originally anticipated.

They have also resulted in tonnage increases much higher than we anticipated, an excellent trend in the long term.

But in the current environment, more intense and pervasive competitive activity, coupled with deflation that is yet to moderate as we anticipated, led to results below our expectations.

We are seeing more sales at promotional levels as customers in all segments have become more conservative in their spending.

At the same time, we have noticed a market change in pricing programs at many competitors, as retailers compete aggressively for every dollar.

We have revised our plans in order to respond effectively.

As I mentioned before, strong overall tonnage growth was driven by corporate brand and national brand sales.

Our value brands are clearly winning with customers, who in previous downturns shopped elsewhere for this value proposition.

National brand grocery tonnage was also up for the quarter.

Tonnage growth was particularly strong in dairy, meat, produce and grocery, as customers responded positively to lower prices.

As this positive trend in tonnage growth continues, our associates are doing a phenomenal job keeping up with the increased volume.

Our plant, warehouse and store teams are keeping up with what is quickly becoming a new norm for our business.

Each month, customers are putting more items in their baskets because they're getting more for their money in our family of stores.

We are encouraged by what the shift means for the long-term growth of our business.

On the whole, the grocery team did a good job controlling expenses during the quarter, particularly considering the deflated sales.

The growth in our tonnage and loyal households, coupled with a deflationary environment, makes for a difficult environment to manage labor.

Fortunately, our staffing models are based on tonnage, not sales.

If not for that, our stores could be understaffed for the amount of business we are doing.

But our customer focus strategy and the labor management philosophy that supports it helps us keep our checkout lanes short and stores in excellent condition so that our customers will want to return.

Now turning to labor relations.

We reached a tentative agreement last month with the union representing our associates in Arizona.

We also delivered a final offer to the union representing our Colorado associates.

In both cases, associates will be voting on those new contracts during the next few weeks and we are hopeful they will be ratified.

Negotiations in Atlanta and Portland continue and are now underway in Dallas.

We have contract extensions in those markets.

Rising healthcare costs and underfunded pension plans continue to be important issues in our labor discussions in addition to the increased pressures on our business that we are now experiencing.

Next, Mike will give you some perspective on the elements of the quarter including the impairment charge related to our business in California.

Before he does that, I want to emphasize how pleased we are with our team at Ralph's.

They continue to do a terrific job in one of the most difficult operating environments in the country right now.

High unemployment and real estate values that continue to deteriorate have clearly affected consumer behavior there.

We remain confident on the ability of all our associates at Ralph's to strengthen our position there.

Mike?

Thanks, Rodney, and good morning everyone.

As you saw in our release, we have taken a non-cash asset impairment charge in the quarter that reduced Kroger's earnings by $1.62 per diluted share.

The impairment charge was the result of several factors.

First, the economy in California is as weak as any in the country.

Unemployment in California is at record levels at 12.5%, well above the national average.

Over two-thirds of those who are unemployed live in Southern California where Ralph's operates.

High unemployment and population declines have caused us to revise our near term profit projections for Ralph's.

Finally, valuations for businesses are at historic lows.

Due to all of these factors, we were required to write off the goodwill.

Let me spend a minute on fuel.

As a result, as expected, lower fuel margins also pressured Kroger's quarterly earnings.

As you may recall, in last year's third quarter our retail fuel business experienced exceptionally strong margins of $0.239 per gallon of fuel sold.

This year we earned on average $0.119 per gallon of fuel sold at our convenience stores and supermarket fuel centers during the quarter.

Lower fuel margins account for approximately $0.08 of the year-over-year decline in Kroger's earnings per diluted share for the quarter.

On a rolling four quarters basis, the cents per gallon fuel margin was $0.107 this year compared to $0.156 for the same period a year ago.

A normalized margin for this business is approximately $0.11 per gallon, and that is incorporated into our full year earnings forecast for fiscal 2009.

We continue to see positive identical gallon growth, and expanding our convenient fuel centers is an important part of our one stop shopping value proposition for our customers.

Turning now to the use of free cash flow, in light of the current environment, we have reduced our internal plans by approximately $1 million over the next three years.

Our original plans did call for continued capital expenditure growth.

We now expect capital expenditures to average under $2 billion a year over the next three years, based on current conditions.

We plan to focus our capital expenditures on store remodels, infrastructure projects, and expense reduction initiatives.

This will strengthen Kroger's free cash flow.

We expect to use free cash flow to maintain our current debt coverage ratios and reward our shareholders.

Now I will turn it back to Dave.

Thanks, Mike.

We hope our comments today give you a better understanding of what is happening in the current environment and our plans and priorities going forward.

It should be clear that our strategy is based on customers and volume.

In periods of deflation, this strategy helps us build market share and strengthen our long-term market share position.

But clearly the short-term financial results suffer.

Conversely, in periods of inflation, sales rise more significantly but tonnage movement is not as strong.

We are confident that with the adjustments that we are making and as the inflationary picture improves, Kroger will be better positioned than many of our competitors.

There are other changes we could have implemented that would have improved short-term results.

But in our judgment it would have hampered our ability to grow market share, provide a good shopping experience for our customers, and create value for our shareholders and opportunity for our associates.

We'd now be happy to take your questions.

Thank you.

(Operator Instructions) You have a question from the line of Deborah Weinswig of Citi.

Please proceed.

Good morning, thanks for all the details on the quarter.

Digging a bit more into how things played out by month, can you go through either by detail or even just at a higher level, how month by month sales played out?

Can you talk a little bit about the paycheck cycle and is there any impact on your business by more consumers being on food stamps or the impact of EBT?

Let me start with food stamps.

Food stamps continued even just this last month of November, continued the last three months at as high a level as we've ever experienced at least as far back as we've looked.

And the last three months were a little bit higher than the months preceding.

So if you looked at our third quarter that means the first month of the third quarter would have been a little bit less food stamps and then it increased from there a little bit, not a lot, because it was already at a pretty high level.

It affects the sales cycle in every state differently because each state has a different process how they pay out the food stamps.

Sometimes it's the first of the month.

Sometimes it's scattered between the first and the tenth.

Sometimes it's stretched all through the whole month.

But on the whole we have seen an exaggeration of what's happened at the beginning of the month and the end of the month.

The end of the month for us has been poorer than we are used to seeing.

The beginning of the month, a little bit stronger than we have been used to seeing.

And certainly the electronic benefits have increased dramatically when you compare, say, to three years ago.

You go back to three or four years ago, the food stamp volume we're currently running is not quite double but it's a lot higher.

So it's very significant.

Now, as to the trends through the third quarter, Mike may want to check my facts on this but generally speaking, at the time of our earnings announcement for the second quarter release, would have been about four weeks into the third quarter.

At that time we gave you a sense of where sales were and from that point forward they gently dropped in dollar sales but our tonnage continued reasonably strong.

And so it became a different quarter for us, I'd say almost from the moment we hung up the phone but it wasn't quite that dramatic.

But clearly it became more deflationary and it became more competitive from that point to the present time.

Does that give you a sense of what you're asking, Deborah?

Yes, that's incredibly helpful.

And if you had to go back and obviously you've been in this business for a very long time, as has the management team as a whole, if you were to go back, could you describe another environment in the past 20 or 25 years that was like this one?

And did the competition react similarly to how they have you now or is this a new game?

The environment itself, I would characterize as a new game.

I've not ever seen anything like this or if I have, my ability to understand what was going on around me was so long ago that I maybe didn't perceive what was happening.

But put that aside and I think just use conventional knowledge of what typically happens, and I think what we saw from a competitive point of view is pretty simple.

Is that sales as you've seen, many of our competitors, in fact most of our competitors, have reported negative sales, negative IDs.

And when you're in that position it is pretty normal to try to reach out and say what can I do to change that.

That automatically makes a market a little bit more promotional and a little more focused on price.

So we shouldn't have been really surprised that that occurred, but it did occur clearly differently and a little more pronounced in the last half of the third quarter than what we had experienced earlier in the year.

So I think that the behavior you're seeing is actually pretty consistent with patterns in past cycles.

But I think the environment is a clearly different environment than what we have experienced before.

Okay.

And I just want to close it out with it sounds like you are gaining share with I think a very important customer base which is your most loyal households.

Is there anything that you're doing different in terms of communicating with them to drive the additional footsteps or is it that you think that they're just more aware in terms of some of the values that you're offering to them?

Remember, put this in context.

Remember, we've been on this journey now for multiple years and while it has a lot to do with price, it has an awful lot to do with other things.

We talk about our four keys.

Price is one of the four keys but the other three keys are petty important to our customers too.

And I think Rodney said it pretty well.

If you were to put a piece of masking tape over our sales dollars and look at all of our other data inputs, you would go away saying this is a pretty good quarter.

Our cost control was good.

Our growth in loyal households -- our growth in households, not looking just at loyal but households on the whole grew.

In fact, all of the dimensions of the way we typically look at customer reaction has been strong.

And so I would say that we believe it's the accumulated effect of all of the things that we've done that came before.

One of the mistakes that we made in not just this quarter but earlier in the year is we committed a whole lot of our plan to some pricing strategies that we put in place, most of which was put in place early in the year.

Didn't leave ourselves a lot of gunpowder for later in the year if the market got more competitive, which it ended up doing.

But we think some of the price positions that we took earlier in the year and other things we did helped generate what we're seeing today.

These things have a long tail and they don't produce results immediately but as a result of things we've done earlier in the cycle I think gave us the good results we achieved with customers.

Rodney, do you want to add anything?

I was just going to add a couple of comments on a couple of Deborah's questions.

One, when you look at the cycle, if you go back and look at certainly from a recession standpoint, generally the supermarket industry lags by about six to 12 months on a cycle.

And certainly if you look at where we are in the process right now, it certainly would suggest that that would be a similar type lag this time.

Obviously, the economy appears it has stabilized and is starting to get a little bit better in some spots.

So if our historical trend is similar this time, it would be a similar type lag I would expect.

The other thing in terms of what it looks like different today than before is our decline in average selling price per unit would be more this time than before.

We think a lot of that is because before customers that we would lose in a recession, today we're keeping them and we think some of that decline is because of that.

But certainly if you look at our average selling price per item, the decline is more this time than it would have been before.

And we would have not had deflation to the degree that we have today.

Okay.

Thanks for all the color and best of luck.

You have a question from the line of Karen Short of BMO Capital Markets.

Please proceed.

Hey, everyone.

Just a couple housekeeping first and then some questions on your unit volumes.

You normally give your product cost deflation and also private label as a percent of units and a percent of sales in the quarter.

Do you have those handy?

Yes.

The private label units were 35%.

And the percent of sales were -- I don't have it right in front of me -- 26%.

So basically, the same as the last quarter but still a growth over last year's third quarter.

Not as big a growth but --

It's a slight growth from third quarter last year.

We've now had I think four quarters in a row -- five quarters in a row of almost 35% or in the range of 35% of the units in grocery have been in Kroger corporate brands.

If you look at our corporate brand unit growth, it's basically double-digit range, very low.

And that would have been on top of double-digit growth a year ago in the same quarter.

So it actually stacked two quarters on top.

Okay.

And your product cost deflation?

Be a negative 0.8%, based on the way we estimate it.

I tried to emphasize in my comments, that doesn't really give you a good, clear picture, because that number, while a big swing from last year, seems like a small one.

But when you look at where the deflation occurred, it was in meat and produce and dairy and grocery are the biggest areas.

And those are really important areas and so that's really why I would emphasize that point.

We had some inflation in as I recall in general merchandise and in pharmacy and that tended to offset a little bit of the percentage that we would report as a total number so I think it's important to look at some of the categories that it occurred in.

Most of that inflation is driven by tax increases on cigarettes.

Yes, the GM is mostly -- don't draw any other conclusion other than the fact that cigarettes went up.

When taxes go up, 25% or 30%.

And are you seeing deflation in grocery as in the center store excluding dairy now?

Yes.

If you take dairy out, it's not quite as deflationary as it is with dairy but it is still deflationary, more than 1% deflationary.

Last quarter was inflation.

That's a good point.

Mike looked at last quarter for us and last quarter grocery without dairy was actually an inflation number, slightly, and this quarter grocery without dairy was deflationary.

So that's a big change.

And in fact, I think that's the primary change I'm describing when I talk about the more deflationary environment than we experienced in the quarter before.

On your tonnage, you gave that 8.5% unit volume in the Q for the second quarter.

I just had one clarification on that.

First of all, was that unit volume at your stores or from your warehouse?

And then the second question is can you provide us with that number for the third quarter, because it would seem that it is higher this quarter than it was in the second.

It was at the stores and it's just a little bit better than what was in the Q last quarter.

Okay.

And then just turning to your BBB rating, you had said that you needed -- if EBITDA declined by 2% for this full year you would still maintain your BBB rating.

With your new guidance, even at the high end of the range on earnings, I get an EBITDA that is declining by about 4%.

I know you also reduced your CapEx so I'm just wondering where that situation may shake out in terms of maintaining your BBB rating?

Yes, that 2% estimate on that was actually the rating agencies when they put out their press release when we went to BBB flat.

As you saw in the quarter, we did reduce debt and our net total debt to EBITDA ratio did improve over the same quarter last year.

It went from 195 to 193.

We would expect to be able to maintain our coverage ratio in the range that we need to to maintain our credit ratings.

And the reduction in capital over the next three years is to help us to satisfy that and reward shareholders.

Okay.

And then my last question is just on Ralph's in general, could you address whether or not part of the situation with the write-down was your specific positioning in the market because that would be the one market where you're viewed more as the quality operator, as opposed to price.

So could you maybe talk about that a little bit?

I actually think the write-down came as a result of the change in values of businesses in that market, as hard hit as that area has been hit by the economy, and because of the impact of the economy on our customers on our current and future forecast for cash flow from that division based on the consumer.

We're quite bullish on Ralph's, in particular.

In fact, we believe in the last six months that our market share has actually grown slightly and that's based on looking at AC Nielsen tracking data.

We think that the market itself has shrunk a little and that's actually what creates a lot of the problems.

So I wouldn't read anything into that write-down having to do with how pleased we are with Ralph's except that we're pleased with that team and their strategy.

And we believe in the long run that that's going to be a good market for us.

As to positioning, actually, we're in lots of markets there, so it's not just upscale.

What you're describing I think maybe it's hurt more proportionately because of upscale features but I don't think that's the case.

Thanks very much.

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

Please proceed.

Yes, thanks for answering my question.

Actually, could I just confirm what you said about tonnage growth because I missed part of the answer.

I'm sorry about that.

Did you say tonnage growth was higher in the third quarter than the second quarter and did you put a figure around that?

We didn't give a specific figure.

In the Q last year or in the last quarter, we disclosed it was 8.5% and it was slightly stronger than that in the third quarter.

That's private brand.

No, that's total.

That's total tonnage.

I want to make sure I was using the right number.

So total tonnage is up more than 8.5% in the third quarter.

So you must be very satisfied with that and for the long term that sets you up very well.

Really what I wanted to ask about was the cost of achieving that and whether you think that getting your gross margins down at these levels is a price worth paying for that tonnage growth.

That's a great question.

And I alluded to that earlier when I said that the strategies we put in place earlier in the year spent pretty much what we had projected to spend.

In fact, actually as I think we earlier indicated, spent a little bit more than we originally planned because they were more successful than we had originally planned.

And as a result then, when the markets got a little more competitive, we needed to react to that situation, requiring that we invest additional dollars.

So we would have to say for the quarter we're disappointed in where our earnings ended up being but very pleased at where the tonnage was and how our customers reacted to our plan.

So I think you could argue that in the quarter maybe it was too much investment.

But we couldn't roll the clock back very easily on what we had committed earlier in the year.

And we believed, as I closed the discussion with, we believe that we didn't want to make short-term changes that we thought would cause us bigger penalties in the long run.

So that's why we maintained the course.

I would agree with that statement.

I'm just wondering more about the reactionary investment that you've made.

Considering that your tonnage growth was so strong and you're happy with the planned investments, do you feel the need to respond to everything that competitors do?

Wouldn't 7% tonnage growth be great?

Actually, yes it would and I agree with your point.

We do not need to respond to everything competitors do.

We make a judgment call in each case, whether or not what the competitor's doing and how the consumers are responding is an important situation or not.

And we are responding to those that we think are important in protecting our franchise with the customer, but we did not in the third quarter and do not plan in the future to respond to every little thing that happens.

We make judgment calls on each of those.

And I didn't really specifically comment on Thanksgiving.

We gave you the sales so far, good indication of the sales so far this quarter and Thanksgiving of course is in the fourth quarter, but Thanksgiving and sales and results were softer than we would have liked and it was a pretty competitively contested holiday.

And so it fits the characterization you have, except that at holiday times we found with customers it's real important to make sure you protect your franchise.

And so that's actually one of the elements that is in our minds as we give you the new guidance for the rest of this year.

Okay.

Because my next question was going to be obviously you missed by $0.10 in the third quarter but the fourth quarter you've taken guidance down by another $0.20.

So that wouldn't imply that you're going to take your foot off the pedal in terms of reactionary investments or are you just being over-cautious here?

I wouldn't say we're being over-cautious but I will indicate that we felt that we did not properly read the market in the second quarter release when we were telling you where the third quarter and the rest of the year would come out, and I fault myself.

As we looked at that, we did not read the market right.

And we're trying to stand back from it now and read it more accurately for you and to try to describe all the factors that we know about.

And given that the two major holidays in the fourth quarter, one of them has already passed, we already know the data.

And we can share with you that it was a soft holiday for us in sales and the earnings results were softer than what we would have liked to have.

And so when we take those things into account, and look at how unpredictable this environment has been, we had to leave a lot more room than we might ordinarily have left with only one quarter left in the year.

Okay.

And then on 2010, historically you have really focused on the top line and your stated policy is really to hold operating margins relatively flat but given the investment that you have seen this year, would you maybe in the second half of 2010 and beyond be now looking to recover some of this over-invested margin?

I think what we're going to see next year, we'll have to see it as we go, but we would expect things to improve particularly in the second half from what we've experienced this year.

But as we've indicated, we think that first quarter or two could be rough for a lot of reasons, one of which is that we don't know when deflation actually will turn.

We also haven't rounded fully the year when we had the price investments that we've made.

Those are just some examples and we can't predict where competition's going to be yet in the year either.

So ordinarily we give the full year guidance for 2010 in March, which we still plan to do.

We did, though, want to give you an indication of what we saw ahead so that you would have some way at least to bracket where the world is.

And that's why we indicated that both our sales and earnings per share we expect to be higher in 2010 than what we are projecting for 2009.

And the CapEx cuts over the next three years, will you look to give that back to shareholders?

As I said, our use of free cash flow -- that obviously will strengthen it and will strike an appropriate balance between maintaining our BBB rating which we think is important in this environment, as well as returning to shareholders.

Thanks, well done on the tonnage and unlucky on the margin.

You have a question from the line of Andrew Wolf of BB&T Capital Markets.

Please proceed.

Hi, thanks.

Just on the increase in tonnage and you tied it into variable cost and that's how you run the business.

Is it one for one?

I assume it isn't but could you give us a sense of how much hours or store labor hours you have to add for every increase in tonnage so we can do some sensitivity analysis around that?

Every department is obviously different but if you look at it overall, it's usually about 60% of our hours would be variable, 40% would be fixed.

Now, that would depend on where you start out on a volume of a store and the department of the store.

But as a rough rule of thumb that's going to be pretty close.

Okay.

So we're talking tens of millions of dollars per quarter with this kind of tonnage run rate of increased variable cost against department contributions because the unit profits are down, they aren't that great.

Is that how the department P&Ls shake out?

Yes, it would certainly be tens of millions.

The other thing that would mitigate that to some extent is we continue to make process changes in our stores to improve productivity.

And I said stores but we're doing the same thing in our manufacturing and our warehouses, continually looking at ways to do the same work more efficiently and effectively.

And that would mitigate some of that increase in our needs.

Got it.

And the other thing I wanted to ask about was, as you looked at -- as the third quarter, I think you indicated, got tougher towards the end particularly versus where you set guidance, was it more being forced by the consumer in how they're behaving and maybe more unexpected markdowns to clear out perishables and things like that?

Or is it more out of the competitive environment when you've gone back and done your post mortem on where things are and how the quarter shook out?

The post mortem for me says that deflation was more pronounced from when we had the last call to the present.

Deflation was more pronounced than what we had expected it to be.

I actually thought it was going to begin turning but I guess I was looking through rose-colored glasses.

So that's the first item.

Second is I think based on where the industry was seeing its sales, you saw a lot more reactions throughout the industry, more competitors and more geography with competitive reaction.

I wasn't surprised to see some of it but it was more widespread than I had expected.

And those are the two biggest areas that I think we just didn't see properly.

With hindsight we can see a little bit more clearly.

With deflated sales, particularly when we weren't able to get a higher margin for it and in fact had clearly lower margin for it, that doesn't leave a lot of dollars to pay the bills.

And our bills came in in regular bills because the labor we have to spend is for the tonnage, not for the dollars.

Okay.

And I just want to really follow up on Neil's question on the guidance.

Particularly when you add back the $0.08 swing, the quarter clearly wasn't nearly as bad as it looked.

As the reported number on the core business, ex fuel.

And I just look back and I think Q4 was pretty neutral on fuel last year, which really makes your numbers -- your Q4 look pretty scary or pretty conservative.

Can you just give us a sense of that?

Are you saying what you're seeing lately and with Thanksgiving is just making you that cautious or are you trying to build in some kind of conservatism so you don't surprise investors?

I'm probably not going to -- in fact, I won't call it conservative as an estimate because I don't think it is.

I don't think that's an accurate description.

I will tell you that it is more conservative relative to where we see our current forecasts, than it was when we gave it in the second quarter in September.

At that time, we gave you a forecast that we believed to be accurate but it was pretty much right where we were seeing things.

So we've built in a little bit of room for the fact that we got surprised on the down side and so we're expecting that that could easily happen this quarter, particularly with the very important holiday of Christmas ahead of us.

And given what happened in Thanksgiving, I'm not as bullish about where Christmas is going to come in for the industry.

And as a result, that doesn't mean we're being conservative, that means maybe that we're being realistic about the current environment.

Okay.

Thank you.

You have a question from the line of Meredith Adler of Barclays Capital.

Please proceed.

Thanks for taking my question.

I'd like to talk just a little bit about tonnage.

I have the same sort of question.

When Safeway was talking about tonnage when they reported their third quarter numbers, tonnage always goes up when perishable costs or prices go down.

Are you seeing more tonnage growth than you would have expected given the amount of deflation in those perishable categories?

You're correct, that in categories like produce and certainly parts of -- maybe not all of meat, when you have commodity costs go down, typically tonnage always goes up.

That would be accurate.

I don't think that I felt this was just a reaction to what happened with commodity prices, though.

And I would turn to maybe grocery as a good indication of that, is that our grocery tonnage was solid too.

And while it has some deflation in it, as I pointed out, I think that the tonnage growth that we're seeing is more a reflection of our customers.

So look instead at the data that we get from our loyalty cards.

We are growing the number of loyal households that we serve.

Those loyal households are shopping more often with us, making more visits.

That's known -- that's not new news.

That's old news.

They are buying more items in a month's time.

That's also the same news as we had last time.

The only change that we're seeing in that is a positive change and in this quarter, the one we just finished, we're actually seeing the number of units they buy per visit of the loyal households has become flat.

It's no longer a decline.

It was a decline the last several quarters on a per trip basis, but now on a per trip basis, they're actually buying more items, not more -- the same items as they bought a year ago.

It's a small development but I see it as a positive development and I think it is reflective of our overall program is connecting well and producing the tonnage.

If you had a sharp swing the other direction on inflation, I think you would see some contraction in tonnage.

The best example I can think of is milk.

If milk costs go up and we do expect that they will go up some.

In fact, they already have a little.

As milk costs go up and as retails go up, we do expect some of the gallonage to dissipate that we've gained.

But we still think there's lots of tonnage out there to be had based on the combination of our strategy, connecting with our customers.

The only thing I would add on tonnage is it's pretty broad-based, it's not just the perishable department.

If you look across the whole store, it's pretty strong across the whole store.

The only place there would be weaknesses are more things that are more economic related in terms of discretionary type items.

If you look at seasonal items and some of those kind of things would be where you would see the softer tonnage.

A follow-on question with that, when you look at the frequent shopper data, I know you have more households in general.

Does the data show that people are buying more than just the promoted merchandise, that they're bringing you more of their total purchases, even if they're not what you would consider a really loyal customer?

That's a hard one to answer because the market has gotten a little bit more promotional.

And as a result the items that customers buy, their basket would be a little more promotional too.

So I don't know that I can answer it any different than that.

We think our gains remain solid, even in the face of the promotional side of this, is how I think I would characterize it.

I meant are you just getting people coming in and cherry picking you and that's why households are up?

Households are up but so are loyal households and loyal households require a household to be more than a cherry picking customer.

They actually have to buy with a combination of frequency and dollars over time to qualify for that description.

And that category is clearly growing.

So that would not be a customer who comes in and buys just the featured item and leaves.

Okay.

When you think about the inflation outlook for dry grocery, we have almost nearly an entire year coming up, at least four quarters of inflation to compare against.

Is that right?

Three quarters would have -- if you take dairy out, I think that's right.

Rodney?

I was just going to say in the first quarter wouldn't expect to see much different than where we are today.

In the second quarter, I think we'll start seeing some categories changing.

If you look at dairy, I think it will change sooner rather than later.

If you look at other categories, I think it will probably be a little later, if you look at traditional grocery.

Okay.

And then my final question is about the impairment charge.

I try to remember, I was around a long time ago but I'm not sure my memory is very good but I don't believe that you had goodwill on your books for any other markets besides Southern California.

And so you didn't have to do the impairment test anywhere else, but would it be fair the to say that the impairment doesn't mean that Southern California is necessarily worse than anywhere else?

I'm not sure what you mean by not necessarily worse.

There are a lot of places where we do not have any goodwill.

We still have over $1 billion of goodwill on our books, as you can see on the balance sheet, and it's spread over a lot of different geographies.

There is no more goodwill on the books for Ralph's.

That has been entirely written off; the combination of what we wrote off in '04 and what we wrote off that we announced today.

I wouldn't characterize it as any worse than anywhere.

You just don't have to do a calculation like you do when you have goodwill for other entities that don't have it.

And it's the combination of factors that we spoke about; the tough economy, cautious consumers, the high unemployment, as well as just general market conditions when you apply a multiple to a revised cash flow based on that environment yields you a value lower for the entity than you would have gotten at this time last year.

And the physical value of the assets, clearly have declined in value in California more so than most places.

Thank you very much for answering my questions.

Thanks, Meredith.

You have a question from the line of Jason Whitmer of Cleveland Research Company.

Please proceed.

Thanks.

Good morning.

Dave, you talked briefly about making some adjustments.

I'm not sure if I picked up on what exactly those adjustments might be, whether they be near term, moving into 2010.

And I think even more broadly, have you thought differently about your business model for the next couple years, assuming that this value emphasis sticks with us for a while or whether the macro or competitive environment remains stickier longer than expected?

Yes, we've given a lot of thought to that actually.

First of all, I did not describe specifically what adjustments.

For your thinking, you should think about as we look at our business, we're looking at adjustments in our gross margin and in our cost structure.

But both of the areas that we're looking at, I would characterize them as not significant changes, not radical changes, not big changes, not the kind of thing that you would see some difference in our numbers next week or next month but would help, in our judgment, would help make the current strategy where we are more affordable.

What we are not doing, if you go back to the closing comments I had right before we came to Q&A.

In fact, let me just read the sentences to you again because I think they're real important.

There are other changes that we could have implemented that would have improved short-term results but in our judgment they would have hampered our ability to grow market share, provide good shopping experience for our customers, and create value for our shareholders and opportunity for our associates.

We did avoid and are continuing to avoid making significant changes; abrupt kind of short-term changes that probably five and ten years ago we would have been more inclined to make.

That doesn't mean though we're going to stick our head in the sand and ignore what the operating environment is.

I think the biggest thing that I'm watching for is the area of inflation and deflation.

If we were to continue with a very deflationary environment, which is what I would think of as the current moment to be.

I think we would have to re-ask ourselves what do we want to do on our pricing strategy, and I think we would have to push ourselves a little bit more on gross margin.

But because we believe it is of more limited duration, we're holding the course a little bit more straight than we might have done if we thought it was a more permanent change in the economy.

I don't know that I can spell it out any clearer than that.

That's helpful.

I was curious, regardless of the competitive environment which obviously has changed in the last three to six months, you think all in for 2009 it's been a year of learning in how to re-establish or define value within your product offerings, within your stores.

Not just private label but opening price points and all in with the basket which seems to be where the greatest amount of pressure has been.

And I don't know if that's baseline or the promo mix or all this noise from all the deals that have shown up in the channel; some supplier driven, some retailer driven.

But is that mix getting re-evaluated all in, is that what you're talking about with gross margin?

I think we've done a really good job of evaluating how to create value for our customers in this environment.

And we started doing that actually a couple years ago but it became very strong in late 2008 and in the beginning of 2009.

And I actually think it's because we've done a good job on that point, I think that's one of the reasons that our identical sales are positive and that our tonnage is strong.

There's not many retailers, food retailers out there who can say that.

And we think we can say it because of the things we did actually some time ago on exactly the points you're making.

That value proposition and the combination of what are the right items, what are the right prices, what's the right promotional strategy.

And it's not a fixed target, it's a moving target as you go through each month and see how the customer is reacting and changing and what the competitive environment is.

But on that I would give us pretty good marks.

I think we've done a good job there.

To follow up on your expense or cost structure comment has that moved up in priority or urgency internally to help find other ways to help offset some of this pressure?

Yes, one of our longer term disappointments right now is that we have not yet found as many process changes that produce large dollars and implemented those changes as we had hoped we would have.

We found a lot of the opportunities but we've not been able to turn it into actual dollars as much as we had expected.

And it is an important part of our strategy going forward.

We are not giving up on that point.

We are pressing ahead and pushing that point even harder.

Because we believe that we can make some permanent reductions in some of our costs through process change in ways the customers won't feel abandoned and it won't be short-term and it will make more affordable the strategies that we have in mind.

And that is a disappointment for this year but it's a long-term disappointment.

It's not something that I can say today we're going to change and you'll see a difference next week or next month or even frankly next quarter.

We hope you'll see some changes next year.

We're pushing ourselves hard to make that true because that is an important part of our strategy.

Great.

Thank you much.

You have a question from the line of Chuck Cerankosky of Northcoast Research.

Please proceed.

Good morning everyone.

First sort of a macro question.

When you're talking about deflation, is it tied up with trading down?

How easy is it to tease those things apart because it seems to me the consumer is buying very often at the lower end of a category's price point range and so you're buying in lower price point merchandise.

If you look at the way we're estimating our deflation, it would not be as much because it's more looking at the price of what we're paying and selling product for.

If you look at individual cost per item, the deflation number would be significantly more than the 0.8%.

So if you look at what's within each basket that customers are buying, that average price per item is significantly more deflationary than the 0.8% is.

And that we're not reflecting in the 0.8%.

Got you.

So a mix adjusted rate of deflation would be significantly greater than the 0.8% to paraphrase what you just mentioned, Rodney?

Right, yes, that would be our estimate.

Obviously you can get a PhD before you know for sure but that would be our estimate or expectation.

Okay.

Thank you.

Mike, when you look at the CapEx budget contraction over the next three years, how fast does that drop?

You divide $1 billion by three, you get $333 million a year but is it more back end loaded or can you cut projects faster?

How should we look at that?

We're certainly looking at 2010, as we speak, but we are not in the mode of wanting to spend a dime to save a quarter by paying something to delay a project or incurring a penalty to delay a project.

We just don't think that would be prudent at this point.

So we are looking at 2010 and trying to make sure projects that we legally are committed to we don't do anything to incur a big penalty or a big charge as a result of it.

But we are trying to moderate the program in not just '11 and '12 but 2010, as well.

It will be more back end loaded, though.

We would certainly expect '11 reduction to be more than '10 and '12 to be more than '11 but '10 will still be meaningful.

All right.

When you look at what you describe as loyal households, what percent of Kroger sales do they generate?

It's a good question, I'm not sure that we would want to answer that one because that's one that's pretty proprietary.

It's a meaningful number is about all I can say, Chuck.

Okay.

And did you give us an actual number for your ticket and traffic in the quarter?

If you did, I missed it.

We did not.

If you look at it the way we historically measure it, traffic would have been more than 100% of our sales growth, average basket would have actually been a decline.

And if you remember, in the prepared comments, we talked about it relative to households versus the transactions themselves.

All right.

And again, back to this whole pricing and deflation question, is a reduction in deflation, some movement towards flat pricing or even inflation, how much does that help you if the consumer is buying carefully and buying at the lower price points within a category?

It obviously depends on what items change and that's the whole ballgame anyway.

That's true even on deflation.

Some items that change are harder to move in a market and others are not.

So the proof's ultimately in what the customer does.

I don't know if there's any better answer.

The only other thing I would add is if you look at the second quarter, we start cycling some of the significant deflation from the current year.

So you don't have that headwind that we're going against.

Now, the mix change can go either way because if the economy improves a little bit, customers could also start trading up a little bit too.

Yes, that's what it sounds like.

The economy is your biggest challenge right now and it's almost a waiting game for the stronger players.

Yes.

All right.

Gentlemen, thank you very much.

You have a question from the line of Scott Muschkin of Jefferies.

Please proceed.

Thanks, guys.

Want to hit on some points people asked before.

Rodney, I think you said that the supermarkets trail the economy by about six to 12 months.

I actually concur with that.

So as we look at next year, clearly this quarter was really tough, but if we look at next year it looks like we have employment inflecting, it looks like food and home sales actually already inflected real, and it looks like inflation is inflecting probably by the second quarter.

So if I listen to you, what you guys are saying, how you're really focusing on the expenses, it looks like we could enter a period with Kroger growing EBITDA dollars faster than sales sometime next year.

I wondered if you had any comments on that.

I know that's been something that's been hard for you guys but if we enter that period do you think it could last for a while?

To me it's one of those where we gave the guidance that Dave talked about, what we're assuming is the world stays kind of where what we see today.

To the extent that it gets better, that would be obviously the upside.

To the extent that it would be worse, would be the other side.

To commit today on your number, I wouldn't necessarily commit to it today.

It will be something when we normally give more description on the 2010 guidance in March, we will do that.

But I wouldn't want to commit to that at this point because I still think, one of the reasons why the range is so wide that we gave for the fourth quarter is there's still an awful lot of uncertainty and an awful lot of moving parts out there and I think it's too early to say those moving parts have stopped.

Rodney, if I could maybe jump in and do a follow-up there.

We've talked about in the past EBITDA dollar growth not really keeping up with sales growth.

As you guys look at the customer first strategy and look past this economic kind of abyss that we entered about a year ago, is it the idea that you really want to get those EBITDA dollars growing faster than revenues?

If you look, our long-term strategy is to have slightly improving operating margins, and in order to have slightly improving operating margins would take EBITDA dollar growth slightly in excess of our sales growth.

And then I just had one other question.

And it goes to, if I look at your best customers, that have the Kroger credit card, receive your mailers, buy all their gas with you guys, it's unclear to me that you're actually even priced above Wal-Mart when you put all those factors in.

And I guess my thought is do you think that's right, number one?

And if yes, do you think you're able to communicate this well enough with your customers because your tonnage growth is great but if it's that much of a value maybe you could argue it should be even more.

I would answer yes and yes.

I really believe that that's a correct statement is that our customers, our very best customers, see the combination of what we offer and they like it, even from just the price point of view, they like it better than what others offer.

But I also would add that they like our stores better too, in addition to the pricing position.

When we do research, clearly customers rate us very highly on our people shopping experience and products.

And our best customers, our advocates, would understand the price value they're getting and that's the reason why they love us so much and it is our responsibility to make sure that every time a new customer comes in that they can see that total value because that's what's in it for all of us for the long term, and that's what we're really focused on doing.

So do you think the message is good enough for new customers, though?

It seems to me people would be coming to you in droves if it's yes to the answer that you are just as good a value, maybe even a little better than Wal-Mart, it seems like that would create a huge amount of growth in market share if communicated optimally.

Therein lies our opportunity.

And when you ask me on anything, I'm never going to say that it's good enough.

So that's just I think all of us are that way.

That's all I have for you guys.

Thanks for taking my questions.

You have a question from the line of Kim Gally of [Finer Investments].

Please proceed.

Please unmute your line.

Hello, it's Kim Gally, thanks for taking my question.

Couple questions.

A technical question on the impairment.

My understanding was that impairments are typically taken for a permanent loss of value and you talked about the cycle and things being somewhat temporarily depressed.

I was wondering if you could amplify a bit on that.

Secondly, and perhaps more core to the strategy, I'm wondering if you could just talk a little bit about what you're seeing in terms of elasticity of demand.

Clearly people want to save money and price is very important but I'm wondering if you're seeing the kind of results from price investment now that are the kind of results if you could compare them to what you're seeing now to versus what you might have seen a couple years ago.

Mike, you want to comment?

On the impairment, the literature doesn't allow you a lot of flexibility on looking at an aberration in the market today.

There's a little bit of flexibility of looking at market valuations today compared to the historic valuations but you certainly aren't going to sit here today and assume you're going to get back to the historic highs of market valuations, as well.

And just with where the economy is in Southern California, the unemployment in Southern California, and the effect that's having on the consumers in Southern California, adjusted for maybe not current market valuations but not over-robust market valuations either, it just wound up being a trigger event in the quarter that caused us to have the need to write the goodwill off.

Let me answer the last half of your question about elasticity of demand.

I think we're seeing more reaction to our pricing programs, both regular price, that is everyday shelf price, and also promotional prices, and I think that's a result of the customer becoming more sensitized to pricing in this environment and in this situation.

So the customer wants it, is reacting more.

That's one of the reasons we pointed out that the pricing program we put in place earlier in the year or the pricing programs, pleural, that we put in place earlier in the year, that we felt we got a stronger reaction than we had actually expected based on the past.

It's clearly a tough quarter and the deflation throws a monkey wrench into all of this but just looking at the gross profit per foot, this is the first down quarter I've seen in a very long time, 52 versus 53 week years excepted.

And you clearly talked a little bit about not wanting to react in the short term versus your long-term thinking but I guess I can read into your answer there then that you certainly think there's still more to be gained from price investment and that that should, while depressing margins, result in higher gross profit per foot over time?

We definitely think there's more room for us from a pricing perspective but we also are moderating that view and balancing that view with our ability to pay for it.

We think that's important.

As for shrinking gross profit per square foot or other ways you might want to measure it, we hope that this quarter and the quarter we're in now and perhaps another quarter or two are aberrations in that regard.

We do not expect that to be a permanent part of our strategy.

Okay.

Then maybe just amplifying a little bit on Chuck's questions, could you go through a little bit of the methodology you use to calculate your deflation number?

I don't know if it's sales weighted or it's an even weighting of items or exactly how you do that but that might be helpful.

It's in the categories.

It's the cost of what we're buying the item for this year, compared to the cost of what we're buying the item for in the two-year period compared, combined, and then it's weighted by the velocity of those going out the door.

So it's based on your cost, then, so it doesn't take into account your actual selling price?

No, it's cost and the velocity going out of the tonnage going out the front door.

It does not take into account the price.

So to the extent that you're sharper on price this year versus last year, your deflation could well be quite a bit worse than that number.

Sales deflation would be but not product cost deflation.

Right.

But I'm thinking sales just from a top line perspective.

Sales could be deflated by more than our product cost deflation as a result of that, yes.

Okay.

Great, thank you very much.

I think we have time for a couple more questions.

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

Please proceed.

Yeah, hi, good morning.

I just want to ask you, have your comps, at least in your mind, stabilized here?

And I ask that question because you talk about Q4 IDs being the same as Q3, yet Q3 decelerated for most of the quarter which would imply that maybe the first four weeks were better than call it the last four weeks of Q3.

Your basket's flat.

Deflation at least looks like it's maybe peaked so I was wondering if you could comment on that.

I think you've sized it up pretty correctly.

About the only exception in the four weeks we've had so far would be Thanksgiving was softer than what we would have liked.

Because when I made the comment about our identical sales now are about similar to or par with where we were in the third quarter, that's where we were for the whole third quarter which would be a little higher number than where we were in some of those later weeks.

So I think that's accurate.

I don't know that I can predict, though, whether this is really the bottom or not.

And I'd have to say that it does play a little bit on our heads because we're not used to seeing, particularly in the last three, four years, we're not used to seeing numbers that are quite this small on our identical growth.

So we've tried to look a lot more at our household growth and our tonnage growth to really see what's the health of our business, and because we think it's strongly healthy, I'm willing to get past some of these low ID numbers.

So I'm hopeful that it's at the bottom but I don't know that I can judge that for sure.

But your fourth quarter of last year I believe decelerated through a lot of the quarter, because holiday was fairly difficult last year.

Is that right?

I think that's right.

I believe that's accurate.

Our IDs that quarter were 3.8 for the quarter.

I don't remember exactly how it fell through the quarter but I believe that's accurate.

And then there's been a lot of talk on the call about tonnage growth, and tonnage growth is great but the gross margin is down over 100 basis points and I don't think investors are going to give you credit for that unless you prove that you can keep it.

So what's your confidence that of the volumes that you're driving today as it relates to investment in price you're going to be able to keep once we come out of this?

It's a hard question to answer but we believe that because we're connecting with the customer and not just buying them through hot promotions and having them come in and cherry pick us, that we believe that that connection over time will produce somewhat consistency in our tonnage and our business with them.

Now, obviously, as inflation comes into play, some tonnage will dissipate.

One question often you all have asked is on Kroger brands, when all this changes, the economy's better, what do we expect Kroger brands to be.

I don't really expect it to be 35% of the units sold in grocery but I also don't expect it to fall back to our old levels.

And if you go back just a year or so ago, that old level was down around 32%.

And so I think some of this gain is permanent but not all of it.

And I think some of the tonnage gain is permanent but not all of it.

And the biggest issue for us is market share and the connection with the customer as we measure our loyal households.

I expect that to be solid going forward and our strategy is intended to try to keep it that way.

I would only add one thing to Dave's point.

The other thing, as you know, every quarter we measure how we perform with several thousand customers on how we're doing on delivering our basic services.

And customers continue to tell us that we're improving on the way our associates are treating our customers, that shopping experience and speed of checkout and some of those attributes we continue to get better on those, both on an absolute basis, compared to us, but also a relative comparison versus our competitors.

And to me, that's the other reason why I would add on top of what Dave said that gives us confidence that it's something that we can keep and maintain and grow from when the economy improves.

Good point.

I would agree with that.

Could you help us understand where the competition's coming from, Dave?

Is it regional guys?

Is it national guys?

Wal-Mart's clearly made a lot of noise about getting more aggressive on price.

I'm not sure if you're seeing that on the ground or not but does that play a role?

We generally don't talk about specific competitors, but let me just give you a "for examples." It would include, of course, Wal-Mart because you described that and that's certainly accurate and that's widespread.

It would include Safeway who's announced what they're doing.

It would include Albertsons, both sets of Albertsons.

It would include local and regional operators like Giant Eagle and HEB, and Meyer.

All of those are illustrations that it's been more competitors and it's more geography.

And there are others too but those would be good examples, good illustrations.

All right.

And then one last question for you here on share repurchase.

I'm looking at the cash flow statement and you bought back about $130 million in stock year-to-date.

Last year it's over $600 million.

I know you want to keep the rating and you've had concerns about the credit markets and the revolver.

But your stock's also $20.

You're talking about the fact that you do think earnings will improve next year.

It would seem like now is the time to buy.

So I was just wondering what your thoughts are on that.

As we said earlier, we're going to continue to balance the use of our cash flow to maintain our credit rating and give value back to the shareholders and that would be one opportunity to do it but we're not going to commit to exactly in what form that will take.

Okay.

Thank you.

We would agree with you that based on all those circumstances, it looks like a good time to buy.

So all those of you listening ought to pay attention to that.

Thank you, next question.

Your next question comes from the line of John Heinbockel of Goldman Sachs.

Please proceed.

A couple things.

John, you're going to be the last question, I think.

Okay.

It looks like vendor allowances had stepped up over the last six months both food and nonfood.

Have you guys seen that as well and does that go higher from here?

Vendors are responding in lots of different ways.

They're lowering some list costs and they're doing more promotional money and all of that to try to keep things moving.

That's pretty consistent with what we saw last quarter, too.

I think that's one of the reasons you're seeing deflation in grocery, is that you're seeing overall the costs of the products coming down and so yes, I think that's true.

Should that be helpful to gross margin or no, as you supplement your investments with vendor spending?

It depends completely on the items.

Some items are so competitive that it almost doesn't matter too much what the cost is, because we've got to have the right retail.

Other items that are not as sensitive, if we see a decline there, that actually should help gross margin a little.

And so we think in a deflationary environment, some items actually do help us but they didn't help us enough to offset the ones that didn't help us this last time.

All right.

And where are we now on SKU rationalization and how do you attack that in 2010?

You would think that would be a priority way to maybe get costs down and get sharper on items that matter most.

Is that going to accelerate in 2010?

I wouldn't necessarily say that it would accelerate.

Assortment has been something that we worked with dunnhumby on over the last couple of years and through that whole period of time we've had pretty meaningful change in the SKU rationalization and making sure that it's store specific.

That's something that I think we'll constantly have a debate in terms of how improve and how to make sure we have what the customer wants.

All right.

And then you look at the pressure you're under.

Obviously a lot of companies out there without your scale, without your comp momentum.

Do you guys have a sense, it's hard to tell but you wouldn't think that there would be a lot of dry powder for folks going into 2010, that there might be some moderation in the competitive environment.

What's your sense of that?

I don't think I can comment on that very well, but I think you've assessed it pretty well.

Okay.

And then as you guys look at 2010, what's your best guess, do you have a sense when we go from deflation to inflation?

Mid-year?

I would expect probably mid-year.

I would expect in the second quarter for some categories we'll begin to see it as we move through that quarter.

But I think in terms of looking at us overall I think mid-year is a good point to use.

All right.

And your 2010, the comments you made about 2010, so we're clear, you expect a comp better than 2% to 2.5% and you expect some level of earnings growth.

Correct.

If you look at the old model of EBIT, slight improvement in EBIT margin, and I think we always worked off of maybe a 3.4 EBIT margin for that number, have we reset the bar to something lower than that, so we're working off of that new number or we don't know yet?

I don't think at this point we would be ready to give that kind of detail.

We'll give further guidance in March.

Okay.

All right.

Thanks.

John, thank you.

We know it's been a long call.

We hope it's helpful.

But before we sign off I would like to share just a few additional thoughts for our associates who are listening in.

As you heard, our third quarter performance was not as robust as we had hoped it would be.

It is clear the operating environment continues to present challenges.

Some new and some we've already faced.

The economy will continue to put pressure on our customers and our organization.

We know the challenges ahead and we recognize the opportunities as well.

Your individual, your personal individual connections with our customers during this important holiday season will help strengthen our position into 2010.

We appreciate your dedication and hard work as we focus on delivering the best experience for our customers.

We wish you and each of you a wonderful holiday season with your family and friends.

Merry Christmas, happy holidays.

That completes our call today.

Thank you all for joining us.

Thank you for your participation in today's conference.

This concludes the presentation.

You may now disconnect.

Good day.