克羅格 (KR) 2010 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the second quarter 2010 The Kroger Co.

earnings conference call.

My name is Carissa, and I'll be your coordinator for today.

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

We will be conducting a question and answer session towards the end of today's 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, but Kroger assumes no obligation to update that information.

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

After our prepared remarks, we look forward to taking your questions.

In order to cover a broad range of topics from as many of you as we can, we ask that you please limit yourself to one topic with one question, and one follow-up question if necessary.

Thank you.

On behalf of all of us at Kroger, we look forward to seeing many of you later this month here in Cincinnati for our 2010 investor conference on September 28 & 29.

It will be an engaging and informative session, and we appreciate you taking the time to join us to learn more about Kroger.

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

Thank you, Carin, and good morning, everyone.

Thank you for joining us today.

With me to review Kroger's second quarter 2010 results are Rodney McMullen, Kroger's President and Chief Operating Officer, and Mike Schlotman, Senior Vice President and Chief Financial Officer.

Kroger's Customer First strategy is on target, as our strong second quarter results show.

We continued to grow identical sales, even as we worked to better balance margin investments.

Identical supermarket sales increased 2.7%, without fuel, during the quarter.

This represented more than six years of positive identical sales growth for our Company, an impressive record by any measure, and even more so considering the uncertain economy, and the competitive environment.

The strength of Kroger's identical sales growth, excluding fuel, continues to be broad based across the store, and nearly all geographies.

17 of our 18 supermarket divisions produced positive identical sales growth, excluding fuel, during the quarter.

The other division was essentially flat.

Kroger's ability to sustain such longstanding identical sales growth is a direct result of the effort and committment of our talented associates.

Our associates strive daily to make each shopping trip the best experience possible for each customer.

This relentless focus on our customers day after day, year after year, builds long term credibility with our shoppers.

Our team understands the importance of finding ways to make each customer visit better than the last one.

I want to thank all of our associates for their outstanding work in producing the results Kroger reported today.

Our performance reflects the consistent, successful execution of all aspects of our strategy, not simply a single factor.

We are building momentum through our Customer First strategy, which serves Kroger customers, associates, shareholders, and our community as well.

Our Customer First strategy continues to deliver results through improvements in all four key areas that we target, our people, our products, the shopping experience in our stores, and the prices.

As a result, the total number of families we serve continues to grow, and our most loyal customers are buying more with us.

We are creating value for shareholders by reducing debt, and returning value to them through dividends and share repurchases.

Growth in loyal households, and strong sales of our own brands and national brands, continued through the second quarter, demonstrating the strength of Kroger's overall competitive position, and the value proposition we provide to customers.

The economy, food cost, and the competitive environment continued to influence Kroger's business.

Customers are uneasy in this economy, and the variability of their spending behavior continues to reflect their concerns about the job market, cost of living, and healthcare expenses.

Customers in all segments continue to adjust their lifestyle, even if their households aren't directly affected by the economy.

Many are making significant lifestyle changes, while others feel they should spend less as the economy continues on its uneven path to recovery.

This environment is consistent with our view at the beginning of the year.

Changing food costs are also affecting Kroger's financial results.

During the quarter, most of our perishable departments experienced higher product costs compared to the same period last year, but we continued to see product cost deflation in the center of the store.

Rodney will provide some additional color on this topic in a few minutes.

The competitive environment remains challenging.

During the quarter, we saw significant and aggressive promotional pricing at several competitors.

Our customers tell us that while price is important, it is not the only factor that influences their shopping decisions.

The customer experience matters, and that's why Kroger's strategy incorporates all elements that are important to our customers.

Our sales have remained solid in the face of competitive and economic challenges because of the strong credibility we have with our customers.

We continue to build momentum through our strategy, which serves all of our various customer segments well.

As our results show, we are committed to achieving solid financial results in the near term, while we invest in the future growth of Kroger's business.

We have confirmed our identical supermarket sales and earnings guidance for fiscal 2010.

Mike will share more details on guidance with you shortly, but first Rodney will offer more details of our performance during the quarter.

Rodney?

Thank you, Dave, and good morning, everyone.

First, I want to thank everyone on the Kroger team for their outstanding efforts during the quarter.

I am particularly pleased with our identical sales and operating cost results.

Excluding retail fuel operations, Kroger's OG&A rate increased seven basis points compared to the same period last year.

This year's second quarter OG&A expense included increases in reserves related to workers' compensation claims in prior years.

It also includes expenses associated with the transition to a new banking partner for Kroger Personal Finance.

Excluding these items, Kroger's non-fuel OG&A rate would have shown a three basis point of improvement compared to the second quarter last year, even with the rising credit card fees, healthcare costs, and pension expense that we continue to face.

There is incredible enthusiasm and excitement in our stores, and our customers are responding as growth in both total and loyal households continued.

I will also share updates on customer feedback, corporate brands, food costs, and food safety initiatives.

Let's begin with household counts.

The number of total households we serve continued to grow in the second quarter.

Customers in all income brackets are consolidating more of their household spend with Kroger.

While we believe this ongoing trend is an important indicator for our business, we focus more intently on growing our loyal household base.

Loyal households represent our very best customers.

We define them based on several factors, including total basket, and frequency of purchase.

Our loyal household growth grew at a faster rate than total household count.

During the course of the month, loyal households visited our stores more frequently, and purchased more items from us than they did this time last year.

This is a very important trend.

We believe this outcome is a reflection of our Customer First strategy, which is designed to reward our loyal customers, and not cherry pickers who simply shop various outlets based on the lowest available price.

The insights I have shared with you indicate that Kroger's best customers are the primary beneficiaries of the investments we are making in the four key areas of our Customer First strategy.

Our strong partnership with dunnhumby allows us to use shopping behavior data from our loyalty cards to create specific offers and savings for individual households.

This enables Kroger and our family of stores to reward our best customers for their increased loyalty.

Our Customer First strategy is based on listening to what our customers and associates tell us is important to them, and acting on their feedback.

Every quarter, we track what our customers are saying about us, across four key areas, our people, our prices, our products and services, and the overall shopping experience in our stores.

We measure progress in specific categories, such as the friendliness and attentiveness of our store associates.

These surveys, which track feedback for more than 50,000 customers each quarter, provide valuable insight we use to improve what we offer customers.

During the first half of 2010, our customers have told us we continue to make steady progress in each of the four key areas we target.

We continue to seek feedback from our customers, and incorporate what they tell us in our business plans.

By the way, one other thing you may find of interest.

We conduct similar surveys with our associates.

We listen to them, and use their feedback to make improvements because we want Kroger to be a great place to work.

Associate engagement, obviously, is a critical element of our Customer First strategy.

Our corporate brands are a key competitive advantage for Kroger.

Our exclusive preferred brands help strengthen customers' loyalty because of their quality, price advantage, and breadth of offerings, and they can only be found at Kroger.

Kroger's corporate brand team has created a best-in-class program that is difficult for competitors to emulate.

We continue to introduce new items based on what our customers tell us they want.

In the past year, we launched over 600 new corporate brand items, including several in the second quarter such as the enhanced Kroger Wholesome at Home line in the deli, and our new refrigerated salads and side dishes to complement our rotisserie and fried chicken.

Our deli chicken meets our customers' needs for a quick meal solution.

And now our new salads and sides, such as the BLT pasta, one of my favorites, round out our meal offerings.

We partnered with one of our large national brand vendors to develop the new salad recipes through a customer-driven process.

The process started with customers selecting their favorite salad ideas, providing input as prototypes were developed, and gaining their approval on the final product.

Customer acceptance of all three tiers of our corporate brands' portfolio continue to be strong.

In the grocery department, corporate brand units, excluding milk, were up slightly for the quarter compared to the prior year.

Recall that this is on top of double digit growth this time last year.

By the way, I am excluding milk because of overall customer demand diminishes as retail prices increase.

Our milk tonnage remains strong compared to overall milk consumption.

While we continue to be pleased with our progress in corporate brands, we do not have a target for share growth in this part of our business.

Our approach is to offer high quality, innovative, and fresh corporate brand products that provide good value to our customers, and then we let our customers decide whether to purchase our brand or the national brand.

That is why we are also pleased to see continued strong growth in the grocery department of national brand tonnage compared to the same period last year.

In fact, we saw tonnage growth across all of our store departments.

That includes produce, which enjoyed double digit tonnage growth in the same quarter last year.

As Dave mentioned, most of our perishable departments experienced higher product costs compared to the same quarter last year.

Across all of our supermarket departments, excluding fuel, we estimate that our second quarter product cost inflation was roughly 1%, yet product cost deflation persisted in the grocery department, which represents about 0.5 of a typical supermarket.

Excluding milk, we estimate that our grocery department experienced product cost deflation of approximately 1.6%.

This compares to the 1.8% deflation figure we experienced last quarter.

Earlier in the year, we did expect grocery deflation to moderate, but it hasn't, largely due to increased promotional spending from vendors.

Some investors view food inflation as a positive indicator for our business, and food deflation as a negative indicator.

The experience of our grocery department this quarter illustrates why this relationship is not that simple.

Gross profit dollars for our grocery department were higher this quarter compared to the same quarter last year, despite the deflationary trend I described for you.

Food safety is a priority in our business.

We partner with our customers to help them keep their families safe.

All of Kroger's manufacturing facilities have been certified using food safety audits, benchmarked by Global Food Safety Initiative, an international organization that promotes comprehensive food safety standards.

In fact, all of our manufacturing plants have passed certification on their first audit.

Great job to our plants.

We are also an industry leader in mandating that all of our private label manufacturing partners receive the same certification.

And we only thought it was appropriate that we should focus on our own plants, and get them certified before we asked our partners to do the same.

Also, our customers have praised our recall communication program, where customers can receive updates about the most serious recalls via our loyalty data through multiple channels.

Our website, messages on their receipts, phone calls to their home, and in-store signs.

We are also hopeful that Congress will do its part by sending a food safety reform bill to the President this year.

Kroger has endorsed comprehensive food safety reform legislation, and we believe our customers and our business will benefit from these reforms.

Turning now to labor relations.

Our objective with every contract is to reach an agreement that is good for our associates, good for our customers, and good for the Company.

Our goal is to continue to provide our associates good wages, high quality, affordable healthcare, and stable pension funds.

At the same time, we are very mindful that we must manage labor and all costs carefully, so that we can reinvest in lower prices, and the other important aspects of our strategy customers care about, to keep Kroger competitive and grow sales.

We are very candid with union leadership about our goals and challenges, especially in this economy, and competitive environment.

We have been able to achieve agreements that manage rising healthcare costs for both our associates and the Company, and pension funding remains a significant part of our labor discussions, too.

We have successfully negotiated agreements for Michigan, North Carolina and Richmond.

Negotiations continue with the UFCW Locals, including Houston, Little Rock, New Mexico, Portland, Seattle and Toledo, and with the teamsters in southern California.

We will begin negotiations soon in Cincinnati.

All of these negotiations are challenging for the reasons I mentioned.

Now, Mike will offer more detail on the quarter, and Kroger's financial strategy.

Mike?

Thanks, Rodney, and good morning, everyone.

Earlier today, Kroger reported strong second quarter financial results.

We believe these results demonstrate that we're managing our business well in a challenging operating environment.

Kroger's second quarter net earnings were $261.6 million or $0.41 per diluted share, compared to $254 million or $0.39 per diluted share in the same period last year.

We are pleased with these results.

Our lower effective tax rate, which I'll discuss in a minute, was offset by the transition expenses associated with Kroger Personal Finance, and the increase in prior year's worker compensation reserves that Rodney mentioned earlier.

As a result, these three items had essentially no net effect on Kroger's reported earnings per share.

These results are consistent with the fiscal 2010 forecast we shared with investors in March.

We forecasted first quarter earnings below the results we reported for the first quarter of 2009, second quarter results more comparable to the prior year, and solid growth in the third and fourth quarters compared to the corresponding periods in 2009.

Our outlook for the balance of the year has not changed.

Turning now to some of the details behind our second quarter earnings.

FIFO gross margin, excluding our retail fuel operations, decreased 16 basis points.

Supermarket selling gross margin, excluding fuel, declined 12 basis points as we began to lap many of the significant pricing investments we made last year.

While it remains our objective to deliver additional value to our customers through permanent price investments, we are committed to striking a better balance between investments in all four keys of our Customer First strategy, and near term financial results.

Rodney already covered OG&A, so I'll move on to Kroger's second quarter operating margin, which declined 20 basis points as a rate of sales excluding our retail fuel operations.

This is a sequential improvement from the first quarter of this year, when Kroger's non-fuel operating margin declined 85 basis points.

Combining the first two quarters of fiscal 2010, Kroger's non-fuel operating margin rate declined 57 basis points compared to the same period of the prior year.

For the full year, we now expect a slight decline in this measure.

In order to achieve this result, we are still predicting an increase in Kroger's non-fuel operating margin rate for the second half of the year compared to the same period last year.

We have not altered our long term business model of slight expansion in Kroger's non-fuel operating margin on an annual basis.

Kroger's second quarter tax rate was 31.7% this year, compared to 34.8% for the same period last year.

During the quarter, the IRS concluded an examination that resulted in an adjustment to our tax contingency reserves.

This adjustment of $14 million benefited Kroger's second quarter earnings by approximately $0.02 per share.

Including this adjustment, we now anticipate a full year effective tax rate of approximately 35.5%.

Strong margins at Kroger's retail fuel operations added approximately $0.01 per share to second quarter earnings on a year-over-year basis.

The cents per gallon fuel margin was $0.143 compared with $0.136 for the same period last year.

On a rolling four quarters basis, the cents per gallon fuel margin was $0.119 compared to $0.133 in the same period last year.

Our guidance for fiscal 2010 assumes a normalized margin for this business of approximately $0.11 per gallon.

Because fuel prices can be volatile, we manage this business by focusing on gallons sold.

We're very pleased that our convenience stores, and supermarket fuel centers, delivered another quarter of strong identical gallon growth.

As Dave mentioned, today we confirmed Kroger's full year 2010 earnings guidance of $1.60 to $1.80 per diluted share.

We are striving to achieve results in the top half of this range.

Several factors are affecting Kroger's business this year, including an inflation and deflation in product and operating costs, the competitive environment, fluctuating fuel margins, and the uneven pace of the economic recovery, and the influence on our customers' purchasing behaviors.

Uncertainty remains in all of these areas, but we believe we can continue to manage Kroger's business appropriately to generate solid return for shareholders.

This is the key part of Kroger's value proposition for investors, the ability to create and deliver shareholder value in a variety of operating environments.

We are creating value for shareholders by reducing debt, and maintaining our capital spending, and returning value to them through dividends and share repurchases.

The strong cash flow of Kroger's business allows us to maintain our current debt rating.

We reduced Kroger's net total debt by nearly $400 million compared to one year ago.

We still expect to invest approximately $1.9 billion to $2.1 billion in capital projects this year, with a strong bias towards remodels and infrastructure projects.

This is exciting because these investments allow us to maintain and improve the quality of our asset base by keeping our stores fresh, inviting and innovative, which enhances our customer shopping experience.

We also remain committed to deliver value to our shareholders through a solid quarterly dividend and share repurchases.

We view these as important components of overall shareholder return.

Now Dave would like to make a few remarks before we take your questions.

Dave?

Mike, thank you.

Based on the results we reported today, it is clear that the Kroger experience is the right answer for today's shoppers.

Even as the economy continues to languish, we remain focused on delivering results for our customers and shareholders through our Customer First strategy.

We understand the importance of building credibility over the long term, while taking the right steps in a challenging economy to invest in our people, our stores, and innovation to refine our customers' overall shopping experience.

Our customers reward us with their loyalty.

We believe our strategy will continue to differentiate Kroger today, and will position us well for profitable growth for years to come.

As we head into our prime selling season, Halloween through New Year's, our associates are energized and focused on delivering a great experience in our stores for all of our shoppers.

Insuring success in the second half of the year will take discipline.

Our team is committed to executing our strategy well to benefit our customers and shareholders.

As Carin mentioned earlier, we look forward to seeing you and talking with many of you here in Cincinnati later this month at our investor conference.

It is always a pleasure to have you with us.

Creating sustainable long term value for you is our objective, and we will discuss that more in depth during the conference.

Now we would be happy to take your questions.

(Operator Instructions).

Your first question comes from the line of Scott Mushkin of Jefferies.

Please proceed.

Thanks, hi guys.

Just wanted to, Mike, I think you said something in your rundown that I wanted to make sure I got.

You said operating margins now are expected to slightly decline.

Did I get that right and what were you thinking before?

I didn't remember what you had guided to before on that measure.

We now expect them to be down slightly.

Our original guidance for the year was slightly down to slightly up but where we see the world at this point we expect them to be slightly down.

Some of that is a result of things like the tax rate and the offset of the workers comp reserve and the Kroger Personal Finance transition expenses.

Those two expenses affect the operating margin, obviously the tax rate doesn't, so while they had no effect on earnings per share they do affect the operating margin rate.

Thanks for that clarification.

If we were going to look at the outlook, and I'm dying to hear what you went through Labor Day, where you think we are as far as the outlook goes for the industry.

Are you seeing any differences in behaviors or things improving?

Are they kind the same?

I just want to get an idea of what you think the outlook is right now.

Let me just comment really on how bullish we are about the sales trends.

You saw in the first quarter strong sales, identical sales.

You saw in the second quarter the same thing.

Remember, we had a Memorial Day shift from the first quarter in 2009 to the second quarter in 2010 and that shift meant that you have to adjust down a little bit the sales we've just added in the second quarter and you have to adjust up a little bit in the first quarter.

So the way I look at it, I look at the two quarter sales as simply squarely right in the middle of the sales guidance that we've given for the year.

And to give you a sense of our trend, after four weeks in the third quarter, we're seeing same thing, that it's much down the center of the guidance we've given for the full year.

So we see that as positive.

And let me add a little bit more color on the sales to give you a sense of how we're feeling.

Our sales improvements really were broad based, and I want to use that term in all senses, from every possible direction.

So we already commented that essentially all our divisions were positive IDs.

We had one that was flat.

All of our departments, the way we look at them, the larger departments we had some variations within them but the larger departments were all positive on sales.

All of our departments had improvements in scanned units.

That's how we measure tonnage is the units that are sold out through the front end.

Another point of view is look from the customer angle.

All of our customer segments, as we think about them from a dunnhumby point of view, all of those segments had improvements in sales.

Further, Rodney pointed out we had growth in our loyal households, the number of loyal households served, and we had a growth in total households.

Both are important.

Our growth in loyal households was greater than the growth in total households and that's a positive sign because that indicates that these are the people shopping with us most regularly and that that area is growing.

So when we use the term broad based in this quarter, and really for the year so far, we're seeing from almost every vantage point I can think about really positive trends.

So I'm very optimistic about the future.

But you can see with the economy as it has been and the competitive environment we've had some variability during the year and during each quarter.

Thanks, Dave.

And one final one is you didn't take up the low end of your guidance, maybe some people would be surprised given the strength of the quarter.

Any thoughts on why you didn't nudge it up a little bit?

Yes, if you look at the strength of the quarter, Scott, you have to look at that relative to the Wall Street expectations.

You can't look at it relative to our internal expectations.

While we did outperform Wall Street expectations, if you step back and look at where we are first half to date, we're squarely on top of our internal expectations for where we expected to be for the year.

We've told the world we are striving to achieve results in the upper half of our guidance range and given the uncertainty that's out there with the economy, the pace of the recovery, consumer confidence and the other factors influencing consumers today, we just felt it was prudent to keep the range at $1.60 to $1.80 because we are right on top of what we expected to deliver in the first half.

Thanks, guys.

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

Please proceed.

Hi, good morning and congratulations on a nice quarter.

David, if I look at your IDs versus the industry, it's pretty clear you're taking share in accelerated rate.

A few years ago your comps would outperform what I would call an industry average by 200 or 300 basis points and today it's closer to 500 basis points.

Can you talk about what you think has happened here from a competitive standpoint?

Are your competitors starting to get tired?

Are you seeing smaller regional independent players drop at an accelerated rate?

Is it just your internal initiatives?

Your thoughts here would be helpful.

Let me answer it this way.

First, we're not going to comment on specific market share changes.

We try to take a look at that once a year and the reason we do is market share trends you really have to look at over a longer period of time.

You can't really look quarter to quarter and make much sense of it so we try not to make that the focus point.

But more importantly, frankly, we look at our ID sales as not so much taking market share from others as growing the market share we have with our customers, our very best customers.

That's why the loyal households that we look at is for me one of the most important indicators, is to see what's happening with them.

And some of the improvements that we've seen I think have to be at the expense of things like restaurants or other places that they could buy food products, and so it's not just at the expense of other competitors.

Now, you'd be right to say if you look at our other traditional competitors and their ID sales versus our ID sales there's a difference.

The difference could be simply that we're connecting better with what customers wanted today and as a result are growing our business and that they haven't connected quite as well.

That may be the difference and it may not be so much a shift to market share or play out of competitive strength just in the industry but maybe instead looking at a play out with all of the customers with where they buy food wherever they buy it.

Rodney, do you want to add anything to that?

I would just add a couple of things.

I think our associates are getting increasingly good about executing our plan and putting excitement into that plan and I think our customers are rewarding us for that because our associates are making the shopping experience more fun.

The other thing, and you've heard us talk about it over several years, there's still about 45% of market held by people without our economies of scale, and those people continue to lose share as they have over the last five or six years.

And I don't see that changing at all so I think it's really those two factors in addition to what Dave said.

My second question is maybe a little bit of a mild criticism but you're clearly outperforming your peers.

In my opinion anyway you're probably not getting fully paid for it in your stock, but you haven't been that aggressive with your share repurchase, and I know this quarter you were a bit more.

But you still ended the quarter with north of $1 billion of cash sitting on the balance sheet so why not be more aggressive while your stock is at this level?

We try to buy our stock back at a ratable pace throughout the year rather than surging at any point in time.

As you noted, we did buy a few more shares this quarter as there was weakness in the stock.

That's been our practice.

If you look since January of 2000 we have bought back over 30% of the shares of the Company, quite a dramatic amount of share repurchase since then.

When you look at the balance sheet cash, keep in mind that we issued debt, $300 million 30 year bond at a 5.4% yield, and that really was done to pre-fund a maturity that's going to happen next year so subtract $300 million from that.

Some of that cash in the balance sheet is also cash to operate our stores.

So I would look at our excess cash in the balance sheet, if you want to look at it that way, as being $500 million.

We also continue to have a strong capital spending program to keep to invest in our infrastructure and keep our stores fresh.

So we try to balance our spend and not surge it at any point in time and I think what we spend in a quarter does demonstrate our view that the stock has been a good buy.

All right, and then just last question for you.

Can you talk maybe a little bit about the cadence of your selling gross margin?

Sequentially things are clearly looking better.

It looks like you're delivering on your promise to be a bit more rational.

There's some concern out there about rising cost in areas like meat and produce and the ability to pass them through, but it seems to me like if we continue down this trend that there is a good possibility you'll see positive gross margins in the back half on the selling side.

Can you talk to that a little bit?

If you look at selling gross margin, something that we've really been focused on trying to make sure we balance with the other parts of taking costs out of the business, so far, when you look at things overall on rising costs, I would say in total, they've been passed through as you would expect them to be.

And I think our competitors are doing that and we're doing that.

Now, you can find specific categories where that wouldn't be true but when you look at it overall, I would certainly think that.

In terms of the balance of the year or the second half of the year, really don't want to go into predicting what our selling gross will look like in the second half of the year because that really will be driven by the competitive environment, what's going on, the inflation we have, and our ability to take costs out of the business too.

So there's a lot of factors that will influence where we end up in the second half of the year.

But as Mike mentioned, from an operating margin standpoint, we would expect the second half of the year to have increases in operating margin when you look at it overall.

Great.

Thank you.

Your next question comes from the line of Karen Short of BMO Capital.

Please proceed.

Hi there.

Congratulations.

So, definitely not to diminish your accomplishments this quarter in general just because you are so clearly ahead of your competitors but I just wanted to go back to the guidance question a little bit.

Maybe the way I see it is the environment doesn't really seem to have gotten better and you could argue maybe its gotten worse.

You have a few costs you hadn't really expected, you're now saying slightly down operating margins and we're not really going to see inflation.

So, just to follow-up on Scott's question, it sounds to me like it might be fair to say it will be tougher to reach the high end of your guidance than you previously thought.

Is that fair?

I'll start and Dave and Rodney can certainly jump in.

In response to Scott's question, I did try to explain why we expect the operating margin to be down slightly and that is some of the expenses we didn't expect and it just happens to be the line they're on.

We look at it from the standpoint we are a big company.

There are a lot of gives and takes on the individual lines.

We think we have a solid plan in place to deliver the results in that upper half.

That's what we're striving for.

Everybody knows that's what we are incentivized to deliver, as well.

I don't think collectively we look at it as any tougher a challenge to get there today than we did at the end of the first quarter when we first made that adjustment to our guidance.

Is it a slam dunk?

No.

That's why we didn't change the earnings guidance range but we're squarely focused on trying to deliver results in that area.

Karen, I think at the beginning of the year, we certainly saw that the year was going to be uncertain and had we not thought that we probably would have given a narrower range for our guidance for the year.

And you could have hoped perhaps that by halfway through the year that the uncertainty would be a lot clearer but I think the same uncertainty we saw at the beginning of the year is what we see still today, and as a result, we're leaving the guidance where it is.

But we are clearly focused on achieving in the higher end in the top half of that guidance range that we've given.

So I agree with what Mike said.

That's very helpful, thanks.

And just looking at the competitive environment, it sounds like maybe it took another step down?

Did I read that correctly?

And then maybe if you could elaborate, is it challenging across every division or are there pockets in the country?

You want to talk about competitive environment, Rodney?

It's puts and takes so it's really hard to say because I can give you examples where it's not as competitive.

I can give you other examples where it's more competitive.

I guess the biggest comment I would make is when you look at competition overall, it's pretty consistent with what we thought it would be and where we thought it would be as the year started.

There were certainly bursts of things going on with some competitors that would have been more aggressive than what we expected but there's other cases where I can show you people aren't being as aggressive as we would have thought.

But when you look at everything in total, it's pretty consistent with what we thought and there's going both directions and I can show you on both sides of it.

Okay, and then just last question.

In terms of vendor support, obviously your sales trends and volume trends are much stronger than most of your competitors.

Can you talk a little bit about what you're seeing on the vendor side in terms of promotional?

I'll give you the answer and Carin will cringe over here because when you look at the CPG world, I always think it's a three phase process, and everybody on the phone has probably heard me explain this about a hundred times.

If you look, usually in Phase II, they're making good margins but they are having very little tonnage or negative tonnage growth.

So as you go into Phase III what happens is they get tired of negative tonnage growth and they get more aggressive on trying to make sure they get some tonnage growth.

And I think a lot of what we're seeing is promotional allowances related for them driving their tonnage growth.

Now, I think when you look at the CPGs overall they've done a nice job of taking costs out of their business so they can be more aggressive on pricing and still maintain their earnings and everything else where they need to be.

But when you look at it, it really is consistent with what we would have guessed.

Probably this cycle it took a little longer to get to Phase 3 than what it would have the last couple of times but it certainly is consistent with what we would have guessed going in.

I would add to that, Rodney.

I agree completely.

In fact a year ago or so, that's what we were even saying we thought would happen, but I would think about it this way too.

I don't think we're getting anything that the whole industry isn't seeing for promotional money.

But what maybe is different at Kroger is with the combination of dunnhumby and the way we're thinking about partnering with vendors we may be getting more effective use of the money.

So by targeting it better with dunnhumby and by partnering with vendors for better results, you can see that we've had solid tonnage growth with these national vendors, and our gross margin has been solid in the national brand vendors in grocery as well.

So on the whole I think we're pleased with what we see there.

Any sense of what the benefit was year-over-year in the gross margin?

I don't think we would go there, Karen but I do want to remind you that the effect of those promotional dollars that both Dave and Rodney talked about, because you had touched on inflation and deflation as well in your question, that increased promotional activity by the CPGs can create deflation in our grocery category the way we calculate it because it's based on the volume of items as they're sold and the cost of them.

So the cost would be down but it doesn't affect the profitability of the category because those pricing reductions are supported by the vendors.

Right.

Thanks very much.

Very helpful.

Your next question comes from the line of Meredith Adler of Barclays Capital.

Please proceed.

Good quarter.

A couple of questions for you.

Mike, just focus on expenses.

You did do a good job of managing OG&A broadly.

I was also hoping within that Mike would give us an update on pension expense, where he thinks that's going to be given everything that's been going on.

And then a question also about workers comp.

If you look at the pension expense, I don't think we see pension expense this year being any different than what we had talked about at the beginning of the year.

In the 8-K we filed today, we did give some color on that.

On our 401k plan, which is our Company plan for a lot of folks, we would expect a slight increase in the expense.

We expect the Company sponsored plan to be about $64 million of expense and the Taft Hartley plans are right on track for what we had originally guided to for the year.

And that's about $250 million, to refresh your memory.

So we really don't see any significant changes in pension expense this year compared to what we had thought them to be.

It's still an increase over prior year.

Yes, you're right.

It's consistent with what we thought.

I know you had a question on workers comp?

Actually before that, just other expenses.

I know you have a number of long term projects to manage expenses, maybe just an update on where you are along that.

It's one of those where it's half full and half empty.

I will always tell you that we want to keep getting better and keep doing more.

But with that said, when you look at it overall, we're very pleased with the expense management we had, the execution against the projects that are out there, and we have a nice pipeline of projects coming on stream.

So when you look at it overall, very pleased with where we are, very pleased with the projects going forward, but with that said, we always have the opportunity to get better.

And then my question about workers comp is it sounded like you had to do some kind of a true-up on the reserves which impacted this quarter, but I was wondering whether this reflects something longer term.

Are you seeing an issue with workers comp?

Yes, I wouldn't go to the level of saying it rises to an issue.

I think it's mid year every year we take a look at our prior year workers comp reserves and where it looks like those are trending.

There's a lot of calculations that go into that, the discount rate, your reserves as a percent of the claims that have been paid, what your history is from an ultimate standpoint of what percent of paid claims typically are to the ultimate amount of those expected claims.

And we had to take an increase in the prior year claims to get the reserves where we thought they needed to be overall.

It's an ongoing process.

We have those kinds of pluses and minuses a little bit every year.

We called it out this particular quarter because it was a little bigger than it has been and that plus the Kroger Personal Finance expenses did essentially offset the benefit of the lower tax rate.

Okay, thanks very much.

Your next question comes from the line of Chuck Cerankosky of Northcoast Research.

Please proceed.

Good morning, everyone.

Nice quarter.

One thing I want to talk about is gasoline.

You guys have been putting a lot of pumps in place pretty consistently.

Can you talk about customer receptivity to the rewards program?

And just looking at your merchant gas business what kind of comps gallons you've been doing and how you put the gasoline business within the overall customer service strategy.

I think we've said, Chuck, to you and everybody really before is we're bullish on gas because our customers really like the convenience of having it there.

We also do some tie-in with merchandising and marketing in ways that help strengthen that connection a bit.

But we think gasoline is a really big plus primarily because it's something that all of our customers, almost all of our customers, desire and value, so it's just worked really well for us.

That's why we're growing it.

Can you talk about gas comp gallons?

They were up.

How about a number?

I was trying to be gentle there.

It's mid single digits positive.

Obviously significantly better than where the industry is overall.

And our C-stores and supermarkets were both up so it's important to note.

Both up a comparable amount.

Great.

Looking at other cash uses besides share buyback, what are you thinking about the dividend these days in terms of both the yield out there and payout ratio?

That's a dicey question to talk about.

We pretty much talk about our dividend yield and payout with our Board on a regular basis, and we have established a track record of continuing to increase the dividend.

And we said back when we instituted the dividend, we didn't want to institute one if we didn't have the ability to maintain and grow it over time and I think that would continue to be our long term strategy.

We do focus more on the payout ratio than the yield.

We feel as though we have a little more control over exactly where our earnings can wind up coming out and what the payout of that can be versus short-term changes in the stock price and trying to chase a yield when the stock goes up or down because of factors sometimes out of our control.

Thank you very much.

Your next question comes from the line of Charles Grom of JPMorgan.

Please proceed.

Thanks, good morning.

Just wanted to ask Karen's question earlier on guidance from a little bit of a different angle.

If I look at the lower tax rate for the full year going down 150 bps, which I think helps your earnings for the year by about $0.05, and the nice buybacks you did in the second quarter, which if I flow that through into the back half of the year helps by, say, $0.04 to $0.05.

It looks like the floor to your guidance shouldn't be $1.60.

It should be in that, say, $1.75 range.

Just wondering if you can help me connect the dots as to what's going to be offsetting those two factors.

Yes, there's just a lot of uncertainty out there.

I haven't calculated the tax benefit exactly the way you did.

I don't think our expectation would be that it's going to be a $0.05 benefit.

It's around $14 million or $15 million was the benefit.

Perhaps our original guidance of 37%, which is closer to the statutory rate, was a little high.

Certainly if you look at our effective tax rate for the year compared to the effective tax rate for last year, you wouldn't get $0.05.

It was about 3% better, for instance, in this quarter which would get you in that $0.02 range of quarter-over-quarter improvement.

Relative to the share buyback, we did have share buybacks built into our original expectations for the year when we gave the $1.60 to $1.80 guidance.

Okay, great.

And then in addition just on the guidance with regards to the ID outlook, you're running 2.5% year-to-date, your comparisons ease nicely in the back half.

Do you think there's an opportunity, Dave, for you guys to exceed that 2% to 3% outlook in the back half?

I think we're just going to stay with the guidance that we've given you for the year and that you've seen clearly through two quarters plus the four weeks in the third quarter that we're solidly in the middle of that sales guidance.

Okay, great.

And then the last question would just be on the competitive environment, specifically Wal-Mart, if you could just comment on what you've seen from them.

They've been stating that they've been backing away from win-play-show strategy, backing away from some of the heavy price investments that they made, adding back SKUs into their store.

Just wondering what you think they're doing and the opportunity for you to capitalize.

They're a very good competitor.

We admire them as retailers and learn a lot from them.

But I don't think it would be a good idea for me to try to offer suggestions on what I think they're doing or how they are doing it.

Actually you'll have to ask them that.

Great.

Thanks.

Your next question comes from the line of Deborah Weinswig of Citigroup.

Please proceed.

Good morning and congratulations on a great quarter.

Can you talk a little bit about how you're planning the general merchandise category year-over-year on the back half of the year?

You had talked a little bit about the variability that you're experiencing at the customer and just that environment, I would think it is difficult to plan those categories.

If you look, our planning really is that things will get a little bit better.

Now, if you look at things within categories, there will be a lot of changes within categories.

And if you look at what we've accomplished so far this year, we've had very solid progress across really the whole department.

The only areas that wouldn't be true are things where digital is affecting.

So if you think about music, as an example, or DVDs, CDs, things like that, obviously a lot of that business is going to digital.

But if you look at the regular parts of the business, the apparel, that part continues to move along.

But we're planning for it to get a little bit better but not meaningfully better, but it really is area specific.

The other thing we're really focused on is trying to identify items that you can sell across all stores.

And the Fred Meyer folks working with the folks here in Cincinnati and Portland have done a nice job of identifying some items that we believe we can sell across all stores and we'll have that available for our customers to buy.

Okay.

And then are you surprised about what you're seeing in deflation and why do you think we're experiencing that so late in the cycle, if you will?

I think one of the primary reasons is some of the deflation that we talk about, and keep in mind when we talk about it, it's our product cost deflation and it's simply what we paid for the products this year versus last year, adjusted for volume, adjusted for how the items scan out the front of the store, and as CPG companies increase their promotional allowances, that does create product cost deflation.

That's not a negative compared to our overall expectation of inflation because the profitability in the gross margin dollars, as Rodney talked about in the category's biggest grocery, continued to increase, because those dollars are getting funded by the vendors.

Right, but are you surprised that we're seeing it, if you will, so late in the cycle?

I don't know if I would categorize it as surprise.

Is it slightly slower than we expected to see inflation?

Yes.

I would probably say that we're probably seeing slightly more promotions than we expected which is part of what's fueling the current trend.

Rodney?

I'm going to answer the same question but a little bit differently.

If you look at the inflation number overall, it's pretty consistent with where we thought it would be.

If you look at the way we're getting to that inflation number, it's different than how we expected it to be.

The perishable side is more inflationary than what we thought.

The grocery side, the deflation hasn't moderated quite as much as what we thought.

We still believe the trends are the same as what we expected before.

It's just that we think it will take a little longer to play out than where we thought before.

I really think it's consistent with what Mike said.

It's just that I look at it a little bit differently.

That makes sense.

And last question.

If we look at what's happening in terms of the acquisition of more loyal households, are you getting there in terms of more traffic or ticket?

When you look at it from a loyal household, it's really both.

If you look at it on a monthly basis, it's the number of items loyal households are buying from us and loyal households.

If you look at it from a traditional way that we used to measure before we did loyal households, it's about 90% number of people, 10% ticket.

But if you look at it the way we measure loyal households it's about 50/50 between the two so it's really both pieces which is one of the things obviously we're excited about.

That's great.

Congratulations again on a great quarter.

Your next question comes from the line of Mark Wiltamuth of Morgan Stanley.

Please proceed.

Hi, good morning.

Certainly a positive on the selling gross margin here, showing some good discipline there.

Now, that is normally an element of strategic price investment and also reaction to the promotions of others.

Could you just give us a little color on how the selling gross margin improved?

Was it really just the reaction to promotions of others or did you really moderate your strategic price investments?

I would think about it just slightly different than that, but maybe it comes out the same place.

What happens with selling gross is an investment in what we specifically decide to do on our everyday selling price.

It's also on what we decide to do on some of our promotions based on how we read the market at the time.

And then third is there is also included in there some reaction to what's happening in a competitive market.

And I do think if you were to compare to last year this time versus now, I would say that there's been a little less emphasis on the promoting side of things and a little more focus on what we're doing overall in our strategy, and as a result I think it has tended to moderate.

Now, we've been intentional about balancing as well, as we've said now in several conference calls.

Rodney?

Yes, I would just highlight Dave's last point.

We are cycling some of the things we did a year ago and now we're able to put new things in place a little bit more along the way rather than doing it all at once, which we did in 2009.

The other thing I would add that's helping selling gross some is mix.

If you look at it, we have very strong sales when you look at our Boar's Head products, Starbucks, service cheese, some of the, I call it about the food, but there's probably a better term for it, but natural foods.

We've got very strong growth in those areas which also helps selling gross which obviously is driven from the mix change too.

So I wouldn't underestimate the benefit of that either.

How about if you look at the third item, reaction to the competitive markets of others, what's it look like as we roll forward?

It seems like the promotions were very heavy in the third and fourth quarter of last year.

Was a lot of that reacting to others or was it really your programs that were dragging the selling gross margin down a year ago?

Probably it depends on who you talk to.

I think it's probably a little of both because I think probably some people reacted to things we did and obviously we reacted to some of the things our competition did.

I don't think it's ever quite as easy to say.

Your question is a very good question.

It's not just quite as easy to answer as what you think it would be or should be.

What I'm trying to get at is can we see the selling gross margin up in the second half?

And I'll answer the same comment I made before.

Mike's comment about look at the operating margins and we do expect operating margins to be higher in the second half.

I'm not going to get into the details on the mix between selling gross and OG&A and other things on how we get there because the market will change every day and we just need to make sure we have the flexibility to deal with what the market is.

Okay.

And did you mention what your overall volume tonnage number is and how you like that balance right now versus where you were a couple quarters ago?

If you look, we continue to have nice tonnage growth.

It would be mid single digit type range and overall.

And overall we felt very good about how we achieved that.

And as Dave mentioned in his comments, every department had tonnage growth.

Okay, thank you very much.

Thank you, Mark, and we have time for one more question.

Your final question will come from the line of Andrew Wolf of BB&T Capital Markets.

Please proceed.

Thanks and good morning.

A couple follow-ups to some of the questions that were already asked.

First on the competitive environment, Dave, if I construed what you were saying right, I think you're saying it's balanced in that, or Rodney might have said this, that more or less for every operator getting more intense, maybe someone is backing off.

First I want to make sure I got that sense of it correctly.

And secondly I want to ask, so if things haven't changed necessarily on average, how about just the degree of either rationality or intensity?

Six months ago folks were selling milk at cost or as close as they could get to and things like that.

My sense is that you did correctly interpret what we said, and what Rodney had said, that the competitive environment, while still very aggressive out there, just changes.

Some markets are less competitive and others are more competitive.

So I think that's the change we're seeing.

And I suspect a little of what we're seeing is some more rationality in the market.

As you remember last year, one of the comments I made was that in times when just about everybody's running negative IDs, in part maybe mostly driven by the economy, it's real easy to conclude that there's business out there that I need to go get and that causes some competitors to be more promotional, and to go through that cycle.

And you spend money and promotion, and you find it doesn't produce the sales you thought it would and then you tend to say, well I better be a little more rational.

So I actually think that's more of what's going on in the minds of the whole industry, including us for that matter.

And so I do think it's a little more rational.

But the competitive environment has not gotten worse.

I don't see it getting materially better other than maybe a little more rational.

Rodney do you want to add anything to that?

And the other follow-up is just on the gross profit dollar discussion you introduced on grocery being up, talking about the granularity there.

What about on the perishable side where there is the inflation?

Are those categories also showing up profits and can we infer that the market, or at least Kroger, is passing through most of that inflation or a lot of that inflation?

If you look overall, we believe when you look at it in total we are passing through the inflation.

There are specific items where we wouldn't be quite as comfortable but when you look at it overall, we would be.

And if you look at the perishable departments, we would also have increased gross profit dollars there, too.

Thank you, and congratulations on the quarter's results, as well.

Andy, thank you.

And before all of you hang up, I just wanted to take a minute to thank our associates for a terrific quarter.

Because of your individual efforts our results are a little bit better than this time last year, a remarkable outcome considering the operating environment of the past year and the challenges it continues to present.

The real test now comes as we enter the second half of the year and it will take our collective efforts of each of us to make our entire year successful.

There are many variables at play.

This environment requires continued discipline in order to keep Kroger the right solution for today's shoppers.

Just as we listen to our customers, we also listen to you.

And the associate survey, which is now underway, provides valuable insight that we use to make positive changes that matter to you.

We look forward to hearing from you.

On behalf of your leadership team we look forward to seeing your enthusiasm and creativity at work for our customers as we head into the holiday season.

Thank you for making each shopping visit a special one for our customers.

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.