克羅格 (KR) 2011 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the third quarter 2011 Kroger Company earnings conference call.

My name is Stacey and I will be your conference moderator for today.

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

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

(Operator Instructions) As a reminder, this conference call is being recorded for replay purposes.

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

Cindy Holmes, Director of Investor Relations.

Please proceed.

Thank you, Stacey.

Good morning and thank you for joining us.

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

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

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

But Kroger assumes no obligation to update that information.

Both our third--quarter press release and our prepared remarks from this conference call will be available on our website at www.thekrogerco.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 as necessary.

Thank you.

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

Thank you, Cindy, and good morning, everyone.

Thank you for joining us today.

With me to review Kroger's third-quarter 2011 results are Rodney McMullen, Kroger's President and Chief Operating Officer, and Mike Schlotman, Senior Vice President and Chief Financial Officer.

Kroger Associates delivered on our Customer First strategy in the third quarter.

We had strong sales and earnings per share growth.

This is exactly the positive momentum we strive for as we enter the holiday season, our most exciting time of the year.

And we are very pleased.

Keep in mind that a year ago third quarter earnings were helped by a $0.02 tax benefit and a $50 million lower LIFO charge.

In that context, this was an outstanding quarter.

Based on the consistency of our results over the course of this year, we have the confidence to raise our earnings and sales guidance for the year.

Identical supermarket sales increased 5% without fuel for the quarter.

This continues Kroger's industry-leading trend of positive identical sales growth for 32 consecutive quarters.

Consistent identical sales growth lets us know that our Customer First strategy is connecting with customers in a meaningful way.

Our focus on four keys -- our people, products, prices and shopping experience -- is how we grow customer loyalty each shopping trip.

Positive identical store sales also drive earnings growth as illustrated by our results so far this year.

Our third quarter performance was broad-based across the Company.

Each of our 18 retail divisions had positive identical sales, excluding fuel.

Every department achieved positive identical sales as well, led by growth in natural foods, deli and produce.

I would like to especially recognize our associates for their excellent work to control costs this quarter.

Kroger's financial results are solid, dependable and predictable, especially on a rolling four quarter basis.

They reflect the balance that we seek between cost savings and investments to consistently grow our business and deliver a value, both for our customers and our shareholders.

In a few minutes Rodney will share some additional customer insights with you, including loyal household and tonnage trends, along with the performance of Kroger's exclusive corporate brands.

But first, I'd like to touch on the two themes that we told you at the beginning of the year would influence Kroger's fiscal 2011 financial results.

First is our commitment to the Customer First strategy that we just discussed.

We want to reduce the overall cost of running our business in ways that do not negatively affect our customers.

And then reinvest those savings in our customers to drive higher sales.

Higher sales in turn produce higher earnings.

The second theme includes the external factors that are influencing Kroger's business this year -- the pace of the economic recovery, the impact of food and fuel prices on customer spending, the competitive environment, higher pension and healthcare costs, and retail fuel margins.

Inflation and the economy have had a more negative effect on the overall operating environment than we had originally expected.

We have successfully navigated these influences by following our business strategy and making tactical adjustments as needed over the course of the year.

Rodney will now offer some more insight into the business for the third quarter.

Rodney?

Thank you, Dave, and good morning, everyone.

We are very pleased with the results our Kroger team has achieved in the third quarter.

As Dave mentioned, our associates have done an incredible job serving our customers by controlling expenses and cutting costs.

We are investing those savings in ways that enhance the shopping experience and help our customers save, even as food inflation persists at high levels.

Executing our Customer First strategy enables us to deliver value today while continuing to invest for the future.

I would like to begin by discussing how our customers are navigating this challenging consumer environment and how that is impacting our business.

Despite the consumer caution and rising food prices, Kroger continued to add both loyal and total households and the third quarter, adding loyal households at a faster rate.

The combination of growing loyal households and an increase in shopping trips resulted in more units sold to those customers.

We are seeing increasing stress on certain customers, both in terms of what they tell us is happening to them and how they are behaving.

Smaller baskets are the norm across all customer segments, in line with trends we began detecting in June.

Customers are shifting what and how there are buying groceries and consumables.

For example, we saw significant growth in sales in our corporate brand items.

Some customers are buying smaller pack sizes for items in certain categories.

These changes are a result of customer reaction to the combination of food inflation and a poor economy.

When you consider that household income has remained stagnant for the past year, in fact for the last several number of years, some shifting in purchasing behavior is understandable.

This is one of the reasons we embarked upon the strategy we did several years ago.

Even though our estimated product cost inflation, excluding fuel, was approximately 6% for the quarter, we were able to increase our $0.01 profit per item in the grocery category.

Mike will say more about how food inflation impacted our gross margins for the quarter.

I do want to note that not every single retailer calculates product cost inflation in the same way.

Kroger's calculation is weighted to take product movement into account so we can get a better measure of what the true effect on the consumer is over time.

We believe 6% accurately reflects what the consumer is, in fact, experiencing.

Using a calculation that measures inflation at a particular point in time would result in an inflation estimate different than the one we actually calculate.

In looking at unit sales, we have seen a continued slowing of the rate of growth of unit movement throughout the year.

When considering different promotional activity and changes in pack sizes some customers are buying, we believe our tonnage is essentially flat.

We will continue to pass along product cost increases from suppliers.

At the same time, we will confidently invest for the future in pricing, people, products and the customer shopping experience.

We estimate that we have lowered our customer's shopping bill by $2.2 billion per year.

And our weekly promotions and personalized rewards to loyal households continue to grow customer loyalty in a difficult economic environment.

In the third quarter, more customers chose our exclusive items, which grew Kroger's corporate brand share and sales more than national brands.

Corporate brands represented approximately 27% of grocery department sales dollars and 35% of the grocery department units sold.

These figures compare with 26% and 34%, respectively, for the third quarter of last year.

Considering the consistent share growth of Kroger's corporate brand products for several years, it is obvious that once -- after customers try them for the first time they continue to choose them for their great value, both in terms of quality and low price points.

Our corporate brand team continues to develop innovative product lines to address unmet customer needs.

During the quarter we launched some great new products for customers looking to change their eating habits, including a new 99% natural zero-calorie baking sweetener that measures cup for cup like sugar.

In our bakery department, Kroger's new no-sugar-added pies, available in apple, cherry, pumpkin and other delicious flavors, are a great option for those on low or no sugar diets.

We also have good progress to report in labor relations.

Several previously unsettled labor negotiations have resulted in contracts that have been ratified, including those in Southern California, Southeastern Ohio and Charleston, West Virginia, along with the Teamsters at one of our distribution centers in Washington state.

I'd like to thank our associates and division leadership for their work to reach mutually acceptable agreements.

We are in discussions with the UFCW from Memphis area stores and with the Teamsters for some distribution centers and dairies in the Midwest.

These contracts are on extension while negotiations continue.

As you know, our objective in every negotiation is to find a fair and reasonable balance between competitive costs and competition packages that provide good wages, high quality affordable healthcare, and retirement benefits for our associates.

Now Mike will discuss our third quarter results and Kroger's financial strategy in detail.

Mike?

Thanks, Rodney, and good morning, everyone.

As we reported earlier today, net earnings for the third quarter totaled $195.9 million or $0.33 per diluted share.

Net earnings in the same period last year were $202 million or $0.32 per diluted share.

FIFO gross margin, excluding retail fuel operations, decreased 34 basis points.

Food inflation accounted for most of this decrease.

The FIFO gross margin declined was more than offset by a 29 basis point improvement in our OG&A rate excluding fuel, and improvements in rent and depreciation of 19 basis points, also excluding fuel.

We look at operating margin on a rolling four quarters basis because tactical adjustments to the strategy can have a positive or negative impact from one quarter to the next.

On this basis, excluding fuel, operating margin expanded by 5 basis points.

This is the third consecutive rolling four-quarter period with an expanded operating margin.

This calculation of operating profit is on a LIFO basis, meaning that the calculation includes the LIFO charge.

During the quarter, our estimate of this year's LIFO charge increased $35 million from $150 million to $185 million.

To get LIFO caught up year-to-date, we had an incremental $27 million charge over what we had budgeted in the third quarter.

Excluding the LIFO charge from the calculation, our rolling four quarters operating profit increased 21 basis points.

Due to due to the increase in our LIFO estimate, we expect operating profit margin on a LIFO basis to show a slight decline for the year, but on a FIFO basis it will show a slight increase.

The reduction of 29 basis points in OG&A without fuel demonstrates the leverage of our strong identical food store sales and cost control efforts in the face of rising debit and credit card fees, pension and healthcare expenses.

Also, as a result of current expected operating performance for the year, our incentive plans are estimated to pay off at a higher rate than last year.

Collectively, debit and credit card fees, pension, healthcare and incentive plans have increased 45 basis points with incentive plans being the largest of these.

Kroger's retail fuel operations in the third quarter earned approximately $0.137 per gallon compared to $0.127 per gallon in the same quarter last year.

For the last quarter of the year we expect margins of approximately $0.115 per gallon.

Given the trend in higher credit and debit card fees, earnings from fuel were essentially flat compared to last year.

And the cents per gallon margin after debit and credit card fees was also essentially flat.

I will now update you on our long-term financial strategy.

We are very focused on allocating the substantial cash flow of Kroger's business to reward our shareholders, both today and in the future.

Over the last four quarters Kroger has returned over $1.8 billion to shareholders through share buybacks and dividends.

During 2011, Kroger is using cash flow from operations and cash on hand to repurchase shares, pay dividends to shareholders, fund capital expenditures and maintain our current debt rating.

During the quarter we leveraged Kroger's strong cash flow to invest $471.2 million to repurchase 21 million shares of stock at an average price of $22.39.

At the end of the third quarter, approximately $721.6 million remained under the $1 billion stock repurchase program announced in September of 2011.

Capital investment excluding acquisitions and purchases of leased facilities totaled $497 million for the third quarter compared with $484 million in the same period last year.

We expect capital investment for the year to be slightly above $1.9 billion excluding acquisitions and purchases of leased facilities.

We also saw a strong improvement in the EBITDA return on net operating assets, or ERONOA, of 19.68%, an increase of 108 basis points from a year ago.

Net total debt was $7.7 billion, an increase of $476.6 million from a year ago.

On a rolling four quarters basis, Kroger's net total debt to EBITDA ratio, adjusted for the impairment charges in 2010, was 1.89 compared with 1.93 during the same period last year.

As we reported earlier this morning, Kroger has increased its fiscal 2011 guidance.

We now expect identical supermarket sales growth, excluding fuel, of 4.5% to 5% for the year.

Previously identical supermarkets sales were expected to range from 4% to 5%.

We are also increasing the range of our net earnings guidance to $1.95 to $2 per diluted share for the year.

Previously we expected net earnings in the $1.85 to $1.95 range.

We are in the middle of our business planning process.

Based on what we are seeing today, we expect to reach 8% to 10% annual earnings per share growth in 2012 plus a dividend of 1.5% to 2%.

This does not factor in the 53rd week in fiscal 2012.

As you know, our long-term growth model is to generate 6% to 8% annual earnings per share growth over a rolling three to five year time horizon.

We will provide full guidance in March, but thought it would be helpful for you to know how we currently see 2012 shaping up.

Now I will turn it back to Dave.

Thanks, Mike.

I'd like to conclude by reflecting that when we began our Customer First strategy we had to make investments in price and other areas of the shopping experience.

Those choices were an imperative.

And while we still see opportunity to continue these investments, today we have the flexibility to pick and choose how and when to do so.

I mentioned at the start of the call that our financial results are solid, dependable and predictable, especially on a rolling four quarter basis.

Looking at Kroger's operating margin on that longer time horizon demonstrates this powerful positioning.

A rolling four-quarter view is important because we are constantly making tactical decisions about these investments.

Our margin in any one quarter may fluctuate depending on our decision to accelerate or decelerate investments.

But if you look under the hood at our operating margin over the course of a year, you'll see that the results reflect the strategic balance we seek between cost savings and investments that we believe are necessary to consistently deliver value to our customers and our shareholders.

I'm very proud of this year.

I'm personally proud of what our associates have achieved.

Kroger is winning in the marketplace and delivering value for our customers, associates and shareholders.

We have a great strategy.

It has worked well in a variety of economic environments.

That gives us the confidence to be bullish on the rest of this year and 2012.

Now we look forward to your questions.

(Operator instructions).

Deborah Weinswig with Kroger.

Actually with Citigroup.

Thanks so much, and we appreciate all the transparency on the quarter.

So, David, you talked about the inflation and the economy has had a more negative impact than expected, and that you've made tactical adjustments.

I don't know if you could maybe enlighten us and expand on those?

Well, the point really is to look at what's happening with our customers.

We knew all along in the year that the real issue would be -- how does the world, the operating world that our customers find themselves in, the macro environment that affects everyone, how will that affect us?

And what has happened is the intersection of inflation, which means higher prices for the customer, and a poor economy, which means the customer doesn't have as much money in their pocket, those two factors together have caused, at Kroger and, I think, elsewhere and many of the CPG companies, as retail prices have gone up, tonnage, the growth in tonnage has declined a bit, to where, as we've said now, as our tonnage last quarter was essentially flat.

We think that's essentially a sign of our times.

And it is because when customers have to spend more money to get the groceries they need, they don't have money to buy more groceries than they were buying before.

So, it is hard to keep the business growing in tonnage in that kind of environment.

So, if I looked at any issue in the quarter, to me that's the macro issue that all of us are trying to deal with.

The really good news, and the thing I'm most pleased about, is that even in the face of that, we ended up growing households, we ended up growing our business, we ended up growing our earnings per share.

And so we are thrilled by that outcome.

And we are thrilled in that environment that our strategy has produced such solid results.

As we look out down the road, what are you hearing from suppliers in terms of cost inflation?

How do you think about 2012?

I'm going to let Mike comment a little bit on that.

But we've seen, as you know, there's a lag between what we see in the commodity markets and what we see in the actual pricing that we receive, and then what gets passed on at retail.

Because for several quarters we predicted higher inflation, but it didn't happen.

And then when it did happen, of course, it's been pretty strong inflation for the last several quarters.

Looking forward -- Mike, do you have some comments?

I think in the first half, we would expect inflation to continue close to where it is today.

Keep in mind that we didn't really start to see a huge uptick in inflation until late in the second quarter.

And it has obviously continued in the third quarter.

It grew throughout the first half of the year.

So, we will be lapping that when we get into 2012.

If you look at basic commodities, corn and wheat are down a little bit, but still well above the five-year moving average.

And I don't think there's been enough movement in those to actually think about having price declines.

But I think there could be price stabilization when we get to the back half of 2012.

And then last question, just in terms of tonnage growth.

Obviously, you guys have done an incredible job.

When do you think we'll start to see that pick up, if you can take out your crystal ball out of your pocket?

I don't think I have a crystal ball on that.

We do expect, given how our performance has been earlier this year, that even in this environment we expect to do well.

But the concern I have, of course, is customers are pressed, and we talk about inflation.

But the other factor that I think is maybe the most important factor is what's the economic environment going to look like to our customers.

That can put a dampening or an accelerating effect on how customers view their future and their own behavior.

So, we try to measure the behavior, we try to react to that.

You asked earlier about what kind of adjustments do we make?

We look at what consumer behavior looks like, and we try to focus on what can we do on behalf of the consumers at this point in time, given what they are trying to live with.

I think that's the biggest unknown, is what that economy is going to look like.

And so far, it looks like it is going to stay soft for quite a while.

Well, great, thanks so much, and best of luck over the holidays.

John Heinbockel with Guggenheim Securities.

David, if you could talk a little bit about, maybe expand as you look out to 2012, how you see the economic environment.

Particularly since there may be a possibility here that unemployment benefits and the payroll tax cut does not get extended come January 1.

Is it possibly a tougher macro in 2012, or about maybe the same?

And then, what goes along with that, when you think about the 8% to 10% earnings growth, would the comp be lower next year than this year, or do you think that would be close to the same?

I will answer the last question first.

I don't think we're going to try to give full guidance today, so we are not going to answer that question.

But I will talk a little bit about how we see the environment going forward.

The bottom line in my mind is that we expect next year, at least the foreseeable part of next year, to be much like what we've seen this year from an economic point of view.

There are two big factors that I think about in my own thinking on this question.

First, what do the facts mean?

And factually, how does the economy behave?

And I think everything I've seen suggests that that's going to be slow.

I don't see it as crashing and burning, but on the other hand, I also don't see it as robust and climbing.

So, we see that as relatively flat.

But the other factor that we don't talk a lot about usually gets played out as consumer confidence.

And I think it really is more specifically looked at -- what are the events that occur during the year that cause people to feel either good or bad about the world that they operate in, which affect their behavior.

Consumer behavior and confidence can have a lot to do with whether or not an economy can pick up or not.

And it has a lot to do with how our business does.

So, we are very interested in how our consumers are feeling.

They get affected by lots of things.

We talked last quarter about how they had been affected by the debt crisis discussion in Congress, and how that got played out in such a wild way in the media.

We are expecting a replay of something like that soon.

And that could have a similar kind of effect.

On the other hand, there's lots of positive, optimistic things out there today.

And if those get played up in a way that the customers see them, and feel good about the world, then that part of the economic action actually is an improvement.

Having said all of that, that's how I think about it.

I think ultimately we think it is going to be about the same as this year, with high variability just like we experienced this year.

As a follow-up to that, we've had -- I think you'd agree, this year's been remarkably stable in terms of competitive rationality.

People have done the right things, not made many stupid mistakes.

In your forecast, do you see that continuing?

Or is there a risk that, as the macro stays soft, that we see some reversion back to more intense promotions and dumb decisions?

I can't speak, obviously, for competitors, and wouldn't pretend to.

But my answer, from our point of view is, yes, I think it's been a more rational marketplace.

I think it's gradually been a more rational marketplace over the last 10 or 15 years, based on what the economic forces are rather than based on emotion.

And I think that everyone seems to be taking steps that make more economic sense.

And certainly we strive to do that at Kroger.

Our whole point of view is to make rational choices that make sense for the long-term success of our business.

And that's why I think you've seen our rational behavior, and I think that's probably why you've seen it elsewhere, too.

So, yes, I expect that to continue.

Then just one final thing.

If you think about the ongoing need to make price investments, where do you see the best opportunities to take cost out, going forward?

And I assume it is in the store.

You may not be specific, but as you look at processes, is that the biggest opportunity, to take stuff out of receiving, front end, those kind of areas?

Or is it something else?

I will let Rodney specifically comment.

But let me generally comment by saying that we're interested in taking cost out of places that either don't matter to the customer or perhaps actually improve things for the customer.

And we are also interested in things that can be high dollars.

So, those are often things that are in the stores because you multiply that times 2,500.

Or it can be in our distribution processes because you multiply that times all the items that go through the system.

Having said that, Rodney, you might want to add a little more specificity.

Obviously, we won't be able to give specifics, but one of the things that we work awfully hard is to try to get ideas across from the whole organization because we have an awful lot of fabulous associates across the whole Company.

And then making sure that we facilitate a process where we execute against those across the Company.

What we've found over time is, when you think you've got all the savings you can, you know about, smart people come up with other ideas on how to make processes improve, as you mentioned.

So, we feel very confident that we've got a whole litany of lists of ideas to continue to improve the customers' experience and take costs out of our business.

Okay, thanks, guys.

Ed Kelly with Credit Suisse.

Nice quarter.

I want to get back to this issue on tonnage.

Your tonnage is relatively flat, but it is down almost everywhere else out there.

And I guess that's because of elasticity.

A lot of your competition is showing fairly sizeable declines.

Are they okay in this situation where they are seeing negative tonnage?

Do they just look at the top line and say -- okay, my top line is getting a little bit better, so I won't be more promotional?

What's the mindset as tonnage goes negative at your competition?

I don't know about their mindset.

My mindset is that I see the economy has changed.

Customers only have so much money.

And when you take 6% more of their money from higher prices, they have 6% less to spend on other things.

And that's not to mention that fuel is a little bit higher this year, too, which, if you haven't filled up a car lately, you haven't experienced it, but you'll find that it takes more money out of your available spending.

When that happens, there's only so much to give.

And when that happens, you shouldn't chase.

We can't, we don't try to chase the customer in that environment.

You can't get them to spend money they don't have.

So I think we are rational about that, and I think that the market is rational about that, too.

It does help that the sales are positive for nearly every retailer.

And even those that aren't, they're close to positive.

And that helps because that helps make ends meet; that helps you pay the bills.

As long as you can pay the bills, then you can continue to work down the path of some rational operating behavior, which is what I think we have.

As we think about next year, as inflation, let's say, begins to ease in the back half of the year, tonnage at some point probably starts to come back, but my guess is there is some delay in that.

One, do you agree with that?

And, two, that would mean that IDs just mathematically probably have to at least slow a little bit.

Does that make sense?

I'm not going to speculate on how that will end up playing out.

I think that actually will be played out -- in fact, we'll know the answer to that when we see the facts.

And partially because if I were to answer that, it is starting to try to lock in on guidance for sales for next year, which I don't plan to do today.

I actually don't mean to ask it like that.

My real question is -- if we're in a situation where back half of next year, let's say your IDs are up, I don't know, 3.5%, because you've got less inflation rolling through, but maybe modestly better tonnage, as an organization do you manage your business differently at all based on that decelerating ID?

We probably would manage the business a little bit differently.

But I'd be pleased with a picture that was growing tonnage like that because it would spell a healthier picture.

But even in this environment where tonnage is flat, we feel we're growing our market share a little.

Not as fast as maybe we were before, but that's the environment we're in.

So, you can grow.

What we're mostly interested in is winning with households.

And whether that is winning with households at flat tonnage or winning with households at positive tonnage, I probably would prefer positive tonnage.

But on the whole, it's still winning.

And we end up having a really bright future if we win in market share.

As you know, that's more our formula.

Not everybody requires market share to be successful, but our market share really is helpful to us.

Just last question for you.

There's been a lot of talk about Wal-Mart recently because they've quantified what they're going to do from a pricing standpoint at their analyst meeting.

Are you seeing anything different there at all?

I don't think I will comment specifically on what we are seeing at Wal-Mart, or really any other competitor.

We watch them all very closely, as they watch us very closely.

I will leave that up to you.

Okay, thank you.

Meredith Adler with Barclays Capital.

I have a couple questions.

You mentioned that penny profit was up in the dry grocery category, which is really good to hear.

I was wondering if you could talk about whether you see differences in the nature of the categories where you see the penny profit up.

Is it that there are some categories that customers will accept a price increase and others they won't?

Or is it more across the board?

That's a great question, Meredith.

As you know, if you look at the perishable departments, or the fresh departments, that is as much driven by what's going on in the competitive environment and how long do you think the inflation is there.

So, that, you will see a lot more increase or decline in pennies profit per item that may or may not align with the inflation.

In grocery, we see much more predictability, and we are seeing predictability so far this year in drug/GM also.

So, I would really separate the two.

And we actually -- you see a little bit different behavior in both areas.

But one is really affected as much by the competition.

And then I think there was a little bit of a question about CPG, but just maybe if you could elaborate a little bit.

You have said all along that you would pass along the increases, and they would have to make a decision how they felt about their volume being down, or managing their gross margin.

Are you seeing any change at this point?

Are they increasing their promotional funding?

Are they holding back, do you think, on any of the increases they are passing through to you?

The thing that we don't really know about with the CPGs is how they've hedged their raw materials.

As a general rule, we would see them holding back in terms of what the costs come through versus the inflation of the raw materials.

But in a lot of cases, we would assume that they've hedged that, so they probably haven't had the cost increase the same as what you would read in the marketplace.

So, as a general rule, we would see it lagging there.

Not necessarily a lot on promotion, no different than a year ago.

You'll constantly see somebody feel like they're losing share a little bit, and they will come and be more aggressive with promotion dollars.

They like a specific promotion, those kind of things.

But nothing really huge changed there.

And then I'd just like to ask you about your labor negotiations.

I just wondered if there are any themes you can draw from all the negotiations you've done, say, in the last 12 months.

Healthcare clearly is an issue; pension is an issue.

But how is it working out?

And are there concessions being made on the wages to keep healthcare and pension benefits?

In terms of, if you look broadly, the two that you raised, obviously every negotiation, healthcare and pension is a very critical part of that negotiation.

If you look at -- on wages, wage increases are not as much as what -- a lot of the increase ends up going in pension and healthcare where our associates receive versus the cash wage.

But as a general rule, our cash wage increase also goes up when you look at -- in a basket.

Our associates our working together with us on changes in work rules as we've talked about before, constantly changing processes, everything else, so that you try to balance all those things out.

So far we feel pretty good that we've been able to have negotiations where we have competitive costs, but at the same time we have an excellent benefit package and solid wages versus the market.

So far, we feel good about where we've ended up.

Now, that road of getting there isn't always so smooth as what I just outlined.

Yes, I follow southern California.

Thank you very much.

Alton Stump with Longbow Research.

If you could just touch on the inflation topic in a bit more detail.

I think we all know that dry foods prices are probably going up next year.

But on the perishable side of things, is there any cost relief coming there, in your view, over the next three- to six-month period?

If you look at the perishables, if you look at produce, it's really hard to predict because it really depends on what kind of growing season you have, both in Mexico and California and Florida.

So, today we don't see anything unusual.

But you can have a freeze tomorrow that changes that comment.

So, it is really hard to say there.

On meat, we would expect to continue to see inflation because of the things that Mike talked about.

If you look at corn especially, it is lower than what it was, but still, when you look at year on year, it is a tremendous increase.

So, we would expect in meat to continue to see some of those cost pressures there.

Dairy probably not quite as inflationary as it was, but that's also highly volatile based on how the weather is, and how much the supply of milk is.

Okay, that's all I had, thank you.

Scott Mushkin with Jefferies & Company.

Good morning, everyone, this is actually Mike Otway in for Scott.

Thank you for taking the questions.

Stepping back a little bit, last quarter -- and I know you've touched upon this probably a little bit, but last quarter you seemed a bit more cautious, pulling forward some of the price investment.

And now with the raised guidance, it appears there's some more optimism.

And just wanted to get a sense for what may have changed between the third quarter and the second quarter, and what may be causing that optimism?

I think if anything changed -- I don't really think a lot changed, but if anything changed, in my mind, it's that we've seen more of the environment.

What we saw looking down the road last quarter was an environment that was increasingly looking difficult for the consumer.

And the question was -- how well would we be able to get through that with higher prices, and would the customers stay with us?

And the fact that we've grown households in that environment, loyal households have grown at a good clip compared to total, but total is up as well, but loyals are the ones we're most interested in.

The fact that we've been able to do that, and to make ends meet really well suggests to us that in this environment we can be successful.

So, we are very pleased and proud with what we accomplished.

And it helps to be able to look back now and say -- we made it through that pretty well, we can work in an environment like this and make it successful.

So, I think if there's anything about attitude, that's how my attitude shifted.

We went from the unknown to the known.

I will just add a couple of comments to Dave's comments.

Part of the optimism, I would say, is driven by some of the things we did in the second quarter, and how the customers reacted to that.

The other thing is our strong free cash flow.

We've been able to buy back more shares than what we had originally planned to do.

That obviously helps earnings going forward, too.

So, it is really both of those things together.

And then just a small housekeeping item on the tax rate.

It was a little lower than the 36.5% guidance in the back half.

And I know there's always moving parts, but any color there?

I would say there is no one big item that would cause it to be slightly different.

We gave the guidance for what we expect for the year in the 8-K, as well.

Great, thank you for taking the questions.

Todd Duvick with Bank of America Merrill Lynch.

I want to ask about your financial policy and balance sheet, if I may.

You may have heard that one of your competitors started down the path of a mini-leveraged recap yesterday.

And as a result, its credit rating was downgraded.

That company's leverage is going up on a net debt to EBITDA basis, while yours is flat to down.

And, Mike, I think early on the call you mentioned an objective of maintaining your debt rating.

With that backdrop, I wanted to know, can you provide updated thoughts on how you plan to allocate capital in the near term?

And really what governs your share buyback appetite?

Good question, Todd.

As I said in the prepared remarks, we do expect to continue to use our free cash flow, and balance the use of that between buying in shares, paying a dividend, a strong capital expenditure program, and maintaining our current BBB-flat credit rating.

We like to have the access to the A2/P2 commercial paper market.

It is very deep and very liquid, and very attractive rates to allow us to finance our needs on an overnight basis when we have those needs.

And we would continue to expect to manage our net total debt to EBITDA ratio to stay under 2 times, which we think is a good proxy for the way the rating agencies calculate our leverage.

We think if we use that target, it transfers into the leverage ratio that the rating agencies would be comfortable keeping us at BBB-flat.

Okay, that's helpful.

And also, you have an $850 million in debt maturing in the first half of 2012.

Can we expect you to refinance most or all of that closer to the time of maturity?

Yes, about half of that comes due in April, and the other half in June.

And we would expect at this point to refinance that some time early next year.

We've already, as you may have seen in our second quarter 10-Q, entered into a series of interest rate forward-starting swaps to lock in some of the interest rates, as some of the 10- and 30-year Treasury, those days where they've taken a dip, we've been active on locking in some of those on a forward-starting swap basis to take some of our exposure to rates between now and then off the table.

Okay, that's great, thank you.

Ken Goldman with JPMorgan.

You talked a little bit about customers buying smaller pack sizes, seeing that across categories.

But Heinz talked a couple of weeks ago, they wanted to introduce a greater number of these packages, but they were a little bit late versus their own expectations in doing so.

Is this something you are experiencing, that you want to fill your shelves with more of these reduced-size items, maybe can't get them yet from manufacturers?

Or are you happy with what you are receiving?

And along this line, can you help us understand a bit better in which categories consumers are looking for these smaller sizes?

Where they're not?

Where the strategy is effective, where it's less so?

Just hoping to get some color because it is a little bit of a sea change in how consumers are shopping.

Actually what we are seeing is people shifting pack sizes not just to smaller but also to larger, depending on the item and the situation.

It is really customer specific and customer need specific.

Rodney, you may have some comments on the rest of the question though.

In terms of specifics, every category is different.

So, literally, you'd have to go through 100 different categories for the answer.

Whether we pick up an item or not, as you know, is really based on our belief in what customers tell us is important to them.

So, if they come up with something that we think the customer will want, we'll add it.

If they don't, we won't.

If you look in our own corporate brand categories, you will find some items we've moved to smaller packs, other items we've actually moved to bigger packs.

And it really is category specific.

And then you've had the lead in consumer insights for years in grocery.

And obviously you do a great job with that.

Some of your competitors, though, have spoken lately about getting better at this.

So, I'm just curious if you are seeing anything interesting in the marketplace in terms of other supermarkets benefiting more from loyalty cards or personal e-mails than they previously did.

Anything like that?

I know you don't have specific insights, but maybe how it is affecting you, if at all.

Or maybe nothing's changed as far as you can tell.

Everybody wants to get better than they are at this, as we do.

And we expect to improve, just as they are expecting to approve.

I don't think I'll speculate on what their success has been.

The only other thing, Dave, I would add is that we're working really hard to make sure that we have that next generation of what's being done.

We started doing some personalized offers and pricing four or five years ago.

There's all kinds of things we're doing that's really the next version of that, and in making it even better for our customers.

So, we are not standing still either.

And we've always assumed our competitors will keep getting better.

Great, thanks.

Chuck Cerankosky with Northcoast Research.

Nice quarter.

I'd like to ask a little bit about your pharmacy operations, and how that's been tracking.

Are you happy with it?

And are you doing anything there to tie it into the customer loyalty strategies?

If you look at pharmacy, we are just delighted with our trend and where we are.

Obviously, there's a lot of things going on in the marketplace at the moment.

In terms of using loyalty, that's something that, yes, we are working hard on improving how to use loyalty data for the benefit of our customers.

They are just like we are in every department.

One other thing that I'm sure you know, as you look out to 2012, there's a lot of major drugs that will be moving to generics that will affect sales in that department.

But gross profit rate will be helpful.

There's a lot of change going on right now in pharmacy, as you know.

We are very pleased with the quarter that we had, and the trend that we are on.

Do you do any gas rewards tied to the pharmacy?

I don't recall, but I think you do.

That would be correct.

Get your prescription refilled at Kroger, and you can see how it works.

Open some stories here, Dave.

(laughter).

How about gasoline profitability, just looking at that compared to a year ago and the most recent quarter?

If you look at gasoline profitability, the dollars were essentially exactly flat.

So, it didn't help and it didn't hurt the quarter on a year-on-year basis.

The reported cents per gallon margin we talked about was up.

But when you reduce that margin for the debit and credit card fees, because they go up as the retails go up, that margin was essentially flat.

And finally, what did Thanksgiving business tell you about the customer?

Let me give you an update just through the quarter, the fourth quarter.

We have 3.5 weeks, I think, in this quarter behind us.

And our identical sales have been consistent with where they were in the third quarter.

And we would say Thanksgiving was at least that good.

We were very pleased at the Thanksgiving holiday, because Thanksgiving is embedded in those numbers.

We were pleased.

I don't think we can give much more details than that, but that will give you a sense that the quarter's starting out certainly in the right direction.

Thank you very much.

Karen Short with BMO Capital Markets.

The first thing, just on your next year's guidance, the 8% to 10%, excluding the extra week, I'm just curious what's driving the higher rate because you've obviously been fairly committed to the 6% to 8% rate for a while.

And then the second part of that is -- can you maybe just remind us what the EPS impact was from the extra week last time you had a 53-week year?

Part of the reason that we think next year will be a little bit higher, we think the base operations will perform in a similar fashion to this year.

But it is really the benefit of the higher share buyback this year, and the carryover effect of that next year.

You don't only get the benefit the year you buy the shares, you get some next year.

And it's recognition of that.

Relative to the extra week, we will give you guidance on what we think the extra week is worth in March because I don't want to go back to what it was last time because every year is different.

You have to look at which week the Super Bowl falls in and things like that before you really do it.

And I, frankly, am not that far into the 53rd week yet.

Okay, that's fair.

And then, I know you're trying to veer us away from this, but can you give us the selling gross margin trends in the quarter?

We're not going to give the specific number, but it was gently improved from where we were last quarter is about all we'd say at this point.

And then looking at your sales trends throughout the quarter, and then now into the first few weeks of this quarter, you said you were running in line with your second-quarter results for the first few weeks of the third quarter.

So that was a 5.3 type of number.

Can you talk about this trend throughout the quarter?

And then, it would seem that, at least when you look at the two-year trend for the first 3.5 weeks of the fourth quarter, your ID has reaccelerated.

So maybe just a little color there?

First, let me go back to the selling gross just for a second to make sure I said that in a way that is understood.

When I said it's slightly improved from last quarter, what I meant was, as you would look at it, the amount of the investment we made last quarter in selling gross in the second quarter, it was a little less investment in the third quarter.

Right, that's what I figured.

I just wanted to make sure I explained it right.

As for sales trends for the quarter, the quarter itself was basically consistent.

Of course, we had several ups and downs, but I can't see a pattern that I think would be useful to describe here.

And in what I said about Thanksgiving, Thanksgiving was at least as good as where the trends were, which meant it would've been a good week, a good solid week.

But I wouldn't characterize it as noticeably higher than, say, the trend in the third quarter.

So, I'd say the fourth quarter started out pretty much like the third quarter's average was, is what I meant to say.

I hope that's what I said.

That makes sense.

And then on the operating expenses this quarter, they seem fairly encouraging.

Anything to point to there on what was driving that?

Yes, they were encouraging.

And even more encouraging, when you realize the 45 basis points that we had to overcome on the incentive plan, the healthcare, the pension, and credit and debit card fees, that made it even a stronger result.

Nothing like strong sales to help; that's real important.

But perhaps the most important is the attitude of the whole organization.

Our associates are really focused on how they can reduce costs because they recognize -- and that's why we repeat so often what our business strategy is -- they recognize that the objective of lower costs is to fund investments in things that matter to the customer, which goes to produce more jobs for our employees, increased hours.

We are running, on average in our stores, more hours per week used in labor this year than we used last year for the same time period.

And that's a really positive trend.

And that's because we're finding places to save in order to invest.

So, I think that attitude, the empowerment of our associates, has probably driven that more than almost anything else.

Rodney, anything to add to that?

Okay.

Great, thanks very much.

Jonathan Feeney with Janney Capital Markets.

I wanted to follow-up on an earlier question.

I'm not asking here about Wal-Mart or any other competitors' pricing or execution in the marketplace.

I'm asking specifically here about expansion plans and total square footage dedicated to food retailing coming into your territories.

It seems like several alternate retailers, hard discounters, you name it, are expanding.

It seems like a consumer that's a little bit more constrained is getting more creative about the places where they will shop, particularly at the low end.

And others are expanding assortments.

I was wondering if you did any thinking about that, and if you could put a number on, over the past year or the past couple years, how much more capacity, if you will, has come into your markets, and whether that's accelerating or decelerating right now?

Thanks.

We won't be putting a number on it, but I would just tell you these two background points that may be helpful for you thinking about this.

First, one of the trends we saw 10 years ago, and it's certainly clear today, is the fragmenting of where people buy food.

It is no longer, and it hasn't been for many years now, no longer just in supermarkets.

And if you look at where food is purchased, you can see that is obvious.

So that trend continues, and that plays into a little of what you are describing.

And second is, that we see in every market, and have seen this in every year, changes that are always happening.

It is a dynamic kind of business.

And we look at it on a local market basis, and what's happening in each market, and we try to react in those markets.

So, certainly, you can describe markets where what you are saying is happening.

But you can also describe markets where that's not happening.

So, I would have to say that every year is different, and every market is different.

Rodney, do you want to add to that?

Yes, the only thing I would add is -- we're finding in some situations the competitors, when they open up, our estimates would show they take a lot more volume from their own stores than what we would have necessarily seen in the past.

There is a point where there's a certain amount of customers that like to shop a certain store or format, but it is not 100% of customers want to shop a certain type of store.

So, we are seeing that.

The other thing we are also seeing is competitors continue to fall out, too.

It's just the profile of those isn't as high as the ones that people open up.

Just as a follow-up, what do you think needs to happen for that to slow down or stop?

It seems like everybody in the industry, I don't think anyone in the industry is saying it's great out there, even some of the faster growing, smaller, limited assortment players.

So, what do you think needs to happen to convince people or make them unable or unwilling to grow their commitment to compete with established players like yourselves?

I think we've said before, it is a rational marketplace.

And if you were to look just at Kroger, for instance, what drives our thinking is what happens with the actual results.

So, the question you're asking is, if the results of the return on capital and assets doesn't end up paying the bill, in your experience, then you change your course.

So, I think what you see, if you go over a 10- or 20-year period of time, most retailers, behavior changes based on what their actual experiences have been.

Now, they sometimes have to go learn that lesson the hard way by getting in a market and discovering that -- this didn't work, or that didn't work.

But they eventually, all of us, learn those lessons, and change our behavior when that happens.

Great, thank you very much.

Andrew Wolf with BB&T Capital Markets.

Given that tonnage is up a little in Q2 and flat this quarter, and the gross margin got better, is it fair to take away from that that the penny profit per item not only was positive but the rate was better this quarter than last quarter?

And if so, what's driving that?

Is that pricing being passed through into the market?

Is rationality and retail pricing market-wide catching up to the inflation in product costs?

Or is it just something Kroger rationing back in Q3 from Q2?

A penny profit per item would be slightly higher in the third quarter than in the second quarter.

As Dave mentioned before, we certainly see the market being very rational out there.

Now, tomorrow that could change, but so far what we're seeing is very rational.

I wouldn't say it's so much of a Kroger change, as it's the whole market needing to continue to make sure that the costs we get, we go ahead and pass those through.

So then, when I look at the guidance for the year, you bumped up the high end of earnings per share to $2, by $0.05.

But you didn't take up the high end of same-store sales.

So, staying on the same theme, unless there's something going on in your cost structure or what have you, it would seem to me it is more about the marketplace rationality, and given the consumer is not in great shape, nevertheless is still accepting some further price increases.

Is it fair to say retail pricing market-wide is, to some extent, doing a better job of catching up to the inflation in product pricing?

I think it is.

I think that's true really across the market, that we see, generally speaking, prices are following the cost increases.

And am I right that -- and this is the last follow-up -- that that's essentially mainly what's embedded in the way the guidance increase shaped up?

I think, Andy, it's just a matter of we now know what the third quarter was.

Our guidance for the third quarter was, we expected it to be one of our softer quarters of the year because of the tax benefit last year.

We actually were able to post a very strong third quarter.

And when you look at where we are year-to-date of $1.50, and what we think we can generate in the fourth quarter given how we've performed so far this year, that's just where the world shakes out.

But you're right, we didn't raise the high end of our ID sales guidance, but starting out at 5%, that's a pretty strong trend.

And it's delivered the $1.50 so far this year, and we expect it to be able to continue to deliver for the balance of the year.

Great, thanks.

Thank you.

Before we end the call today, I'd like to share some additional thoughts with our associates who are listening in today.

We encourage them to listen.

You may recall that in November, Kroger was named the most generous company in America by Forbes magazine.

This was a great honor for our Company.

And each of you is responsible for having made it happen.

Thank you for caring so much about the communities in which we live and work.

Wherever we operate, our associates seek out ways to support the local charities and organizations that matter most to them and to our customers.

Looking at cash alone, for example, in 2010, Kroger donated $64 million to charitable initiatives through a combination of corporate and retail division contributions, our community rewards program, and funds from vendors in our Bringing Hope to the Table and Giving Hope a Hand campaigns.

That figure is much higher when you add in the food and product we donate to local communities.

It is closer to $200 million for 2010.

On the whole, Kroger donates the equivalent of 125 million meals a year to local food banks.

Even more impressive is your personal commitment and donation of your time as volunteers to support our neighbors in need, whether you organize a local fundraising event, volunteer at a food bank, or help deliver holiday meals to families.

You make a difference.

So, special thanks to all of you.

In today's environment, the role we are playing in our communities is more important than perhaps ever before.

We just talked about the stress that so many Americans are under, and that includes many of our associates.

Now is the time of the year they need our help most.

Finally, we thank our associates who work so hard throughout the holidays to keep our stores open and stocked for our customers.

I hope each of you also celebrate the season with your family and friends.

As one of our associates added to the blog this week -- as retailers, especially at the holiday time, many of us have made Kroger a part of our family.

It is true for many of you, as it is for me.

So it is personal for me to say to each of you individually, Merry Christmas, happy holidays.

That completes the call today.

Thank you all for joining us.

We thank you for your participation in today's conference.

This does conclude your presentation.

You may now disconnect, and have a great day.