克羅格 (KR) 2013 Q2 法說會逐字稿

Good day, ladies and gentlemen.

Welcome to the Kroger Company second-quarter 2013 earnings conference call.

My name is Derek, and I will be your operator for today.

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

We shall facilitate a question-and-answer session at the end of the conference.

(Operator Instructions)

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

I would now like to turn the conference over to Ms. Cindy Holmes, Director of Investor Relations.

Please proceed.

Thank you, Derek.

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 call will be available on our Website at IR.

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 question and one follow-up question if necessary.

We are hopeful that you can join us for our 2013 investor conference in New York on October 30.

We look forward to seeing many of you then.

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

Thank you, Cindy.

Good morning, everyone.

Thank you for joining us today.

With me to review Kroger's second-quarter 2013 results are Rodney McMullen, Kroger's President and Chief Operating Officer, and Mike Schlotman, Senior Vice President and Chief Financial Officer.

I'm very pleased with our strong second-quarter results, which puts us on target to deliver the identical supermarket sales and earnings per share growth we promised for the year.

Kroger's second-quarter operating performance and financial results show that the common thread in our story is consistency.

We achieved our 39th consecutive quarter of positive identical supermarket sales, maintained return on invested capital, and expanded FIFO operating margin without fuel on a rolling four-quarter basis.

Every supermarket division and every department had positive ID sales.

We controlled costs throughout the business.

As you know, we announced a merger agreement with Harris Teeter, a Company we have admired for a long time, which will expand Kroger's footprint into new, exciting growth markets.

Customers continue to tell us our associates are improving their shopping experience.

As we've shown quarter after quarter, our consistent execution of the Customer First strategy deepens customer loyalty, increases sales, and creates sustainable shareholder value.

As you know, the list that I've just covered was prepared in advance so that we could formally review the quarter that we just finished.

I'm not sure it does the quarter justice.

So, let me depart from our normal script and describe our results this way.

We've just completed what is nearly 10 years of positive identical sales growth.

We have invested in price for each of those 10 years when compared to the year before.

At the same time, we've focused on lowering our costs.

We've actually lowered our costs now for over eight consecutive years.

Last year, in our investor meeting, we raised the guidance for our long-term earnings performance expectations.

In fact, for the past two years, and our guidance suggests that this, 2013, would be the third year, we have been performing within this new higher earnings per share growth range already.

Plus, don't forget the dividend.

Also last October, we offered a number of other keys to our successful growth plans for future years.

Everything you're hearing today in our quarter suggests we are on the path to successfully achieve all of those goals that we set out for you last year in October.

Maybe even more important, the progress we've achieved these past 10 years sets a wonderful foundation in which to build for an even brighter future.

And, the most important part of all is that the team at Kroger is large, broad-based, with dedicated associates.

Team Kroger, who have collectively come together to achieve these results.

And, it is that combination that I think is unmatched in the industry today.

The results achieved by our team, Team Kroger, make me most proud.

I don't use the words lightly this quarter especially, when I say we are very proud of the quarter we have just delivered.

Now, I would like Rodney to cover some more details about the second quarter.

Rodney?

Thank you, Dave.

Good morning, everyone.

As you know, we regularly seek customer feedback on how well we are executing in each of the four key areas of our customer first strategy.

We continue to improve our performance in each area, and our efforts are being noticed.

Customers are telling us that our associates continue to connect with them by showing them that our people are great, our product selection and quality is improving, we are making the shopping experience faster and easier, and we continue to give our customers better value for their money.

Doing the four keys together is what separates us from our competitors.

Competitors of both the past and the future because the hard part is doing all four and doing them reliably.

We are also more agile in balancing our investments in the four keys with the savings we realized.

And, we are consistently improving the efficiency of those investments on a rolling four-quarter basis.

Our lower gross profit rate today means customers are saving nearly $3 billion a year compared to when we started this journey.

I want to echo Dave's appreciation and also thank our associates for keeping their focus on our customers and delivering shareholder value.

We are very proud of reaching a merger agreement with Harris Teeter, and we are especially pleased it has not diverted our associates' efforts to achieve a good quarter and continue to driving the business.

One of the most important measures of our business is loyal household growth.

It lets us know how well we are connecting with our best customers.

And, our loyal customers on average spend about 50% of every dollar with Kroger, which means we have tremendous opportunity to increase their spending across our family of stores.

During the second quarter, we grew the number of loyal households.

Our loyal household count grew at a much faster rate than total household growth, which was also up for the quarter.

Overall, customers continue to visit our stores more frequently, purchase fewer items per trip, and buy more on a monthly basis.

Total units sold were up compared to last year.

We estimate the rate of product cost inflation at 1.6%, excluding fuel and pharmacy.

As we have discussed throughout the year, and in fact for the last several years, consumer confidence continues to improve, but at a slow and steady pace.

Factors that affect consumer confidence at any given time include fluctuating gas prices, payroll taxes, and government policy uncertainty, along with the overall state of the economy.

We continue to monitor these factors closely.

Overall, we would characterize the economy as continued to improve but fragile.

Kroger leveraged operating expenses in the second quarter as associates did a good job controlling costs and driving positive identical sales.

Our OG&A costs plus rent and depreciation, without fuel, were down 17 basis points as a percent of sales.

On this basis, and excluding one-time items, as Dave mentioned before, we have improved this metric for eight consecutive years, and our year-to-date results have set us up to achieve our ninth consecutive year.

Now, I would like to update you on our corporate brands offering, which is one of our key differentiators for Kroger versus our competition.

Our focus is on new products, which we are continually evolving as customer tastes change.

We have modeled our team to facilitate a culture of innovation.

This year alone, we will have introduced more than 650 new items by the end of the year.

In the second quarter, corporate brands represented approximately 24.5% of total units sold, and sales dollars were 23.8%, excluding fuel and pharmacy.

Finally, an update on labor relations.

Our store associates ratified new labor agreements covering stores in Indianapolis, Roanoke, and Little Rock.

We have several contracts that have expired or will expire soon, including contracts in Seattle, Cincinnati, and Dallas.

Our objective in every negotiation is to find a fair and reasonable balance between competitive costs and compensation packages that provide solid wages, good quality affordable health care, and retirement benefits for our associates.

Kroger's financial results continue to be pressured by rising health care and pension costs, which some of our competitors do not face.

Kroger and the local unions, which represent many of our associates, have a shared objective, growing Kroger's business and profitability, which will in turn help us create more jobs and career opportunities and enhance job security for our associates.

In fact, over the last five years, we have added 33,000 jobs.

Now, Mike will offer more detail on Kroger's second-quarter financial results and our guidance for the year.

Mike?

Thanks, Rodney.

Good morning, everyone.

Total sales increased 4.6% to $22.7 billion in the second quarter compared with $21.7 billion for the same period last year.

Total sales, excluding fuel, increased 3.9% in the second quarter over the same period last year.

Net earnings for the second quarter totaled $317 million, or $0.60 per diluted share.

Net earnings for the second quarter of last year were $279 million, or $0.51 per diluted share.

FIFO gross margin, including fuel, was 20.6 -- 20.46% of sales for the second quarter.

Excluding retail fuel operations, FIFO gross margin decreased 11 basis points from the same period last year.

The Company recorded a $13 million LIFO charge during the quarter compared to a $35 million LIFO charge in the same quarter last year.

This is consistent with our original expectations.

FIFO operating margin, excluding fuel and the extra week in fiscal 2012, on a rolling four-quarters basis increased 9 basis points.

Turning now to retail fuel operations, we disclosed many items with and without fuel due to its effect on operating costs and gross profit rates, but we view fuel as a core department that over time is expected to contribute to earnings per share growth.

About 50% of our supermarkets have fuel centers today.

In the second quarter, our supermarket centers -- our supermarket fuel centers' rolling four-quarter margin per gallon was approximately $0.14 compared to $0.136 a year ago, excluding the 53rd week.

Total gallons sold showed solid growth.

On a rolling 52-week basis, return on invested capital grew slightly to 13.49% compared to 13.44% during the same period last year.

As we increase capital, it will be more difficult to grow ROIC in the near term.

However, as these investments mature, we expect them to be accretive to return on invested capital.

Our planned uses of cash remain unchanged.

Maintain our current investment grade debt rating.

Repurchase shares.

Pay dividends to shareholders.

And, fund capital investments.

You will see on our balance sheet that our current portion of long-term debt has decreased because of our recent financings, and our net total debt-to-adjusted-EBITDA ratio has declined to 1.77.

We have not been repurchasing as many shares as we originally expected at the beginning of the year.

This is purely because of our work to prepare for the Harris Teeter merger.

This lower ratio gives us the flexibility to finance the Harris Teeter transaction, and we are now well positioned to re-establish and maintain our targeted 2 to 2.2 times net total debt-to-EBITDA ratio in line with our long-term financial strategy within 18 months after the Harris Teeter transaction closes.

In fact, this puts us in a better position than we originally expected from a debt standpoint.

We are committed to executing our financial strategy, including maintaining our current investment grade rating and repurchasing shares.

During the quarter, Kroger repurchased 2.4 million common shares, for a total investment of $90 million.

Kroger's strong financial position has allowed the Company to return more than $920 million to shareholders through share buybacks and dividends over the last four quarters.

Capital investment, excluding acquisitions, and purchases of leased property, totaled $507 million for the quarter, compared to $444 million for the same period last year.

Year to date, we have spent $1.1 billion.

We continue to expect full-year capital investments to be in the $2.1 billion to $2.4 billion range.

Now, I will update our growth objectives for fiscal 2013.

We are maintaining our net earnings guidance to a range of $2.73 to $2.80 per diluted share for the year.

This is consistent with our long-term growth rate guidance of 8% to 11%, based on fiscal 2012 adjusted earnings per share of $2.52.

Shareholder return will be further enhanced by a dividend that we expect to grow over time.

Keep in mind, our long-term growth rate assumes no effect from year-over-year LIFO swings.

A higher LIFO charge in any given quarter a year will lower the growth, and a lower LIFO charge will increase the growth.

As you look at our guidance for the year, please note that we expect an EPS growth rate in the third quarter similar to what we reported today for the second quarter.

We still expect this year's fourth quarter to be behind the fourth quarter of last year on a 12-week basis.

This is because we currently assume a $13 million LIFO charge in the fourth quarter, compared to a $41 million credit in the fourth quarter of last year.

The bottom line of this is we think current estimates for the third quarter are a little low, and for the fourth quarter, they are a little high, but by offsetting amounts.

This is why we continue to be comfortable at the $2.73 to $2.80 per share level for the year.

We are increasing our identical supermarket sales growth expectations, excluding fuel, to approximately 3% to 3.5% for fiscal 2013.

The original guidance was 2.5% to 3.5%.

And now, I will turn it back to Dave.

Thanks, Mike.

We are really proud of what we are accomplishing.

We are growing in such a consistent way that it may seem deceptively simple.

But, the truth is that our hard work over the past 10 years, since we began our Customer First journey, has created a platform for sustainable growth.

We are improving our connection with customers and associates, creating new jobs and strengthening job security, and rewarding shareholders with consistent earnings per share and dividend growth.

Now, we are happy to take your questions.

(Operator Instructions)

Our first question is from the line of John Heinbockel, Guggenheim Securities.

So, two things.

One, when you look at that 50% share of loyal households, when you talk to those customers and get a sense why they're not spending the other -- a larger piece with you, what do you typically hear from them?

And then, secondly, I know you don't want to give too much detail here, but where do you think there are particular opportunities where are you way under-indexing with those loyal customers in certain product categories?

Thanks, John.

If you look at why they're not shopping with us, it is kind of interesting when we talk to them, they will tell us they're actually giving us more business than they give us.

And, it is really a mixture of two things.

One, things that they don't put on their Kroger list, and then they've just for the last several years have put it on another retailer list.

And, the other part would be when they're out taking their kids to soccer practice, or some other type of event, they're just stopping by and pick up a few items somewhere else, and most of the times, people will pick up a few extra things.

The big opportunities, the easiest way to answer it, there are certain categories where we've significantly improved what we offer from a variety and a price standpoint that those customers don't realize that we've changed.

And, it really is trying to make sure the customers realize the improvements that we've made, would be the biggest opportunity that I could answer your question, without giving a tremendous amount of detail.

Obviously, there is a lot of detail behind that statement.

But, it is safe to say that the things that they might think of first at another retailer, whether it be paper, cleaning, HBA -- I would think those are all areas where you probably under-index, as opposed to food, correct?

That would be correct.

Anything that is not food-related, we would probably under-index on.

Okay.

And then secondly, because I know you like to try to peer around the corner a little bit, what is the current take -- because I know have you been a little bit skeptical about the whole food e-commerce channel.

Do you think that will ultimately be, maybe not two years from now, but 5 or 10 years, something people will -- it will be more mainstream?

And, something you want to start noodling around with?

And if so, do you still think it would be more store level pickup, the better option for the consumer ultimately than home delivery, as you think about it?

Well, we continue to experiment with it, as you know, in Denver, Colorado, and we have for the last several years.

We have a few customers that are very loyal to it.

But, it is modestly growing.

And, it has modestly grown for a long period of time.

We think over time, it will just be one part of the way a customer shops, along with physical assets, too.

So, we don't think it is in place of.

We think it is part of.

And, we're really focused on trying to deliver something along those lines.

One of the things we're looking forward to merging with Harris Teeter, Harris Teeter has a pickup model in a lot of their stores.

We don't have too much -- we have a little bit of insight, but it is very little at this point until we merge.

Because obviously, in some markets, we're in the same markets together, so you don't have the complete understanding of how successful it is.

But, we want to make sure we understand that, and what pieces of that make sense to use in other places.

And, John, I would add that we're thrilled in the meantime at the development of the whole digital world and how our customers are engaging with us.

Everything from the Kroger app, to the online work we do, to the downloading of digital coupons -- has all been very successful for us.

And, it is kind of exciting, but if you look at our digital app now it is one of the top 2% -- it is in the top 2% of downloads off of -- from Apple.

Okay.

Thank you.

Thanks, John.

Your next question is from the line of Scott Mushkin, Wolfe Research.

Hi.

Thanks for taking my questions.

I had kind of a housekeeping one to start off with.

I know you gave us the four-quarter rolling on fuel.

Did you have it for just this quarter, on fuel [penny] profit?

It was higher than the rolling four quarters.

Go ahead and ask your second question, and I will get -- I don't have that exact number in front of me, but we will get it.

Thanks.

And kind of along what John was asking but maybe asking a little bit different way, it is more a strategic question.

Kroger has probably been the biggest share gainer in the industry for a long time.

I think partly because you have just driven the price gaps down with Walmart, and then also widened them with some of your conventional guys.

But, you also did a huge amount on service and perishables and merchandising.

But, I guess the question is going forward, how do you envision share gains?

Do you think you can keep up the same pace?

And, what is going to be the biggest mechanism to drive it?

As I mentioned in my own comments, we see this as a sustainable model that continues to build on itself.

And, I think the most important fact that demonstrates that we believe this can continue for a very long time is the fact that roughly 50% of the business our best customers can give us, they are giving some place else.

And, Rodney addressed that in his comments earlier.

I think that is the best evidence.

Now, there's plenty of other evidence, too.

Just the fact that we have 39 quarters in a row of positive identical sales illustrates that there continues to be room to grow.

And so, we think that the future is still bright and that we see very good opportunity to grow our market share ahead.

Thanks.

Thanks, Dave.

Appreciate it.

Scott, the quarter was $0.17 versus $0.164 last year.

So, while higher, the spread was about the same.

So, the profit margin per gallon in the quarter was 0.6 higher and the rolling four-quarter was 0.4 higher so the rolling incremental was not that significantly different even though the absolute number was higher.

Okay, perfect.

I appreciate that.

And then, my last question goes to the current environment.

Are you seeing anything different out there as far as your current trends go?

But, I also wanted to talk about, there has been a lot of talk of some changes to the food stamp program, and some of those are just going to happen.

And then, maybe there is going to be some further adjustments as we go forward into the fall.

So, both current environment, and then how you're thinking about the current environment vis-a-vis some of these changes that may roll through the food stamp program?

I'm not sure I followed the first part of your question about current trends.

Are you just talking about generally in the economy?

Yes, generally in the economy, and I guess your trends.

Have you seen anything different out of the consumer that lifts your comps that you produced this quarter?

And then, as we to forward, how are you thinking of your business particularly on the sales line with impending cuts?

First, as you saw, we moved the lower end of our sales guidance up, which should tell you that we are reasonably confident in what the second half of this year looks like.

Sales so far, we have 3.5 weeks in this quarter, and while that is hard to predict the whole quarter from that.

But, they are slightly ahead of where we were for the second quarter, so we're good -- we're comfortable with that picture.

Rodney described the economy the way we're thinking about it, is it is still quite fragile, but continues to improve.

And, those signs of improvement are many.

So, there's lots of categories and items and areas that you would say are more kind of discretionary items that people are buying more of today than they were before, and the growth in areas like apparel and cosmetics and toys and greeting cards, Starbucks, sushi -- all of those areas -- natural food, Boar's Head, cheese, prepared meals all of those are doing very well and growing at good pace.

Food stamps are still at a reasonably high level.

They did kind of plateau for a while, and you could argue right now in the last few weeks anyway, that there has been a slight softening, but it is still at a very high level.

And so, I wouldn't read too much into that.

Your question about food stamps is what happens if those get cut substantially?

And, I know there is lots of conversations in the Congress on that topic.

We, of course, don't know how Congress comes out on that.

We don't know how the states will come out on that.

We do know that there is a reasonably high demand for food stamps.

But, remember that the food stamp customers also spend some of their own cash on food.

That is not their only source to pay for food with us.

And, while we is have a lot of households that use food stamps, just the fact that we've seen some little softening in these last few weeks, and yet the sales through the 3.5 weeks I've just mentioned is a little stronger than last quarter.

That is a good sign, too, that even in a case where food stamps might get a little softer, we still think we can do quite well in sales.

Rodney, do you want to anything add to that?

No, it is something that we certainly look at, and we work every day trying to make sure that we give all customers a better value for their money.

And, if you look at our digital app and everything that we're doing, we're trying to make sure that we continue to take costs out of the business so we can give the customers a better value for their money.

So hopefully, a customer that is on food stamps would be able to take advantage of many of those opportunities as well.

All right, thanks so much for taking the time to answer my questions.

Thanks, Scott.

Thanks, Scott.

Your next question is from the line of Deborah Weinswig, Citigroup.

Thanks so much for taking the question.

So, if you look back to the beginning of the year when you had the 2.5% to 3.5% projection, and now raising the bottom end of that to 3% to 3.5%, what have been the biggest differences in terms of -- whether it be consumer behavior?

But, just in terms of increasing confidence, et cetera?

Actually, I think the answer is a silly answer, but it is the six months' passage of time.

That before, we were looking at a whole four quarters trying to predict where it was going to be, and now we've seen two of the quarters.

And, we just have six months left in front of us to try to predict, and I think we feel more confident of that.

But, the factors are the same as I listed with Scott that help get us to a confident level.

And then, in terms of, if you look at the general merchandise sales that you have seen so far, can you maybe give us some color in terms of what you have seen in the quarter?

And, will you also see pockets of opportunity as well?

Well, we certainly see pockets of opportunity, but in the GM -- I listed several GM categories that I noted have improved, and GM on the whole has improved.

One of the points I made earlier was that all of our departments had positive identical sales, and GM did have reasonably good improvement.

But, it had been for a long time, it had been more of a laggard.

So, we're glad to see some improvements there.

You want to add anything, Rodney?

I was going to say, it is a little embarrassing, but in terms of the opportunity, I think we're really -- the Fred Meyer team is really having a tremendous amount of success working deeper with all their divisions across the Company in picking up some good new items across the Company.

We're having very good success on identifying the right items to add in our stores.

We're starting to re-do some of our marketplace stores with categories different than what we initially did and very pleased with the success there.

If you looked at it half empty, you would have said well, why didn't that happen 10 years ago?

The half full is, at least it is happening now.

Great.

And then, last question.

Obviously, with all the work that you have done with dunnhumby, et cetera, and with the relationship that you have with the customer, can you talk about how aggressive you are in terms of pushing mobile coupons?

What you have seen in terms of customer response, and just what the opportunity lies ahead?

You said coupons, but I couldn't quite, Deborah, hear what you said right before coupons?

Did you say mobile coupons?

Where are you right now in terms of pushing mobile coupons, with your relationship that you've had with dunnhumby?

And, where are you in terms of working with the consumer, and what has been the customer response?

If you look at the usage of digital coupons, it is significantly higher than the percentage improvement in the download of our apps.

We're working with dunnhumby in terms of making sure those coupons are targeted for each customer, and some are at the segment level, some are at the individual customer level.

Those would be some of the things that we continually work with in trying to improve.

Dunnhumby is putting a lot of resources on R&D today to get better and better at that, in terms of targeting overall.

And, obviously, we're partnering with them to make sure that we continue to improve that.

The percentage increases are so big that it really doesn't mean much because it is triple digits, but it is huge triple digit increases.

And Deborah, just to illustrate the point, one of my favorite things on our Kroger app, when I go to my own list, and I'm starting to make my shopping list and I want to download some coupons.

It used to be I would get a long laundry list of coupons that were available to download, and now they're in the order of priority based on my actual shopping.

And, that would be true for any of our loyal customers that would have enough of a pattern to give us that, and that way I don't have to go through 100 coupons to find the 4 or 5 or 6 that I want.

It is a terrific feature, as an example.

So, we keep making improvements about every six weeks or so, we make improvements in the app which often is focused on the digital coupons and improving that experience.

And overall, we communicate with about 9 million households on a regular basis, and all 9 million have unique offers based on their behavior.

Great.

Well, thanks so much.

And, congratulations again on a great quarter.

Thanks, Deborah.

Your next question is from the line of Priya Ohri-Gupta, Barclays.

Good morning.

Thank you for taking the question.

Mike, I was hoping you could just provide a little bit of an update on your thoughts around sort of the timing of issuance related to Harris Teeter, and whether that has changed at all given the current market trends?

And then, as we think about what you could potentially issue across the curve, you previously talked about wanting varied exposure.

And given that you just came with 10s and 30s, should we expect more front end issuance around that?

Thank you.

Thanks.

Relative to the timing, obviously there are shareholder meetings October 3, and then we will still be waiting on final FTC approval after that.

So, we will gauge where we are in the FTC process post the shareholder meeting and try to time it relatively close to when the transaction would close so we don't have a lot of negative carry.

As we said, back when we did the 10s and 30s a couple months ago, we had several calls during that time, and we were very open about the fact that if you wanted 10s and 30s from Kroger, you needed to be in this deal because the next issuance was going to be at the front end of the yield curve.

It does two things.

One, it does what you said, it gives us exposure across the yield curve.

But, it also gives us the better maturity smoothing so that we have some debt coming due every year.

So, as we have the opportunity to pay off some debt to get our ratios at that 2 to 2.2 times, we can do that by actually having some debt maturing.

Great.

And, just around your desire to maintain some floating rate exposure, how should we think about that?

Do you have a targeted percentage or amount that you look at?

Don't necessarily have a set amount.

We currently today are extremely fixed.

We were floating for a lot of this year, until we did the bond issuance.

In fact, post that bond issuance, you can see in our balance sheet, we have cash invested, which is -- some of that will go towards financing the Harris Teeter transaction.

But, I would expect our exposure of floating rates would be either -- it will probably be some combination of commercial paper issuances plus potentially a floating rate note issuance as part of the financing for the Harris Teeter transaction.

Okay.

Thank you very much.

Your next question is from the line of Karen Short, Deutsche Bank.

Hi, thanks for taking my question.

I just wanted to focus a little bit on inflation and deflation.

Looking back the last time when you saw deflation, it also happened to coincide with a pretty challenging economic and competitive environment, and if I remember, you were investing pretty heavily in price so [spelling] gross margin was down pretty materially, in that particular time frame.

I guess looking to 2014, commodity costs appear to be coming down quite a bit, and it looks like there is a potential for deflation.

So, I guess my first question is, what is your outlook for inflation into next year?

And then, the second question would be, how do you think about pushing the vendors, kind of in face of the potential for deflation and input costs?

Because I'm assuming you really don't want to be in a deflationary environment in the center store?

I guess your question on don't want to be in an inflationary environment, I can't do anything to change that so our job is to make sure we can operate in whatever the environment gives us.

At this point, I think there will be still some slight inflation next year from everything we can see.

Don't forget while there are certainly some commodities that are down, things like meat and some of the other categories continue to have some pressures out there relative to herd size and things like that.

Now, the chicken complex may come in as the corn crop gets harvested, and if it is as strong as it sounds like, that could help.

But, when you look at the grocery category, which is in my mind the one that is most important, we've actually had more inflation in the first half of this year than we had in the back half of last year.

In the back half of last year, grocery inflation was under 1%.

It was still inflationary but slightly, and so far this year, it is north of 1%, in the grocery category, both the first and second quarter.

So, I don't think -- I'm not really overly concerned about actual deflation.

There could be less inflation, but that is still prices going up.

Okay.

That's really helpful.

Thanks.

And then, I guess the second question I had was just ROIC.

Obviously, now that your compensation is tied to ROIC, you commented that ROIC might take a hit near-term?

And, I guess the first question is why -- because Harris Teeter's ROIC was fairly respectable.

But, maybe just a little color there, just on that comment?

I don't know that the comment said that it was going to take a hit.

I said what we're trying to describe is the fact that of the metrics we gave last October, it is going to be the one that takes the longest to have upward momentum on because we are increasing CapEx as we do it.

And, keep in mind, all of the numbers we gave today on our expectations and our predictions and thoughts about the rest of the year are exclusive of Harris Teeter.

Once that transaction closes, we will obviously update our expectations as a combined Company, but today we just can't do that.

Okay.

Great.

That's really helpful.

Thank you.

Thanks, Karen.

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

Good morning, everyone.

Hi, Chuck.

Taking a look at your increased comps guidance, which is great to see, and a generally tamer inflation outlook for the second half of the year then maybe we were talking about on the last call, are you suggesting better volume growth?

Certainly, Chuck, this is Rodney -- certainly based on what we see today, and Dave mentioned earlier what we're seeing the last three weeks or so and a little bit of the last part of the second quarter, we would feel a little bit better volume growth in terms of what our expectations are.

What implications does that have for mix?

Well, as Dave mentioned, we're having extremely good growth in the perishable departments and those areas of the store.

And, grocery is improving a little bit.

So, when you look at mix, we would expect it to probably be more driven by the center of the store than the perishables just because of where we're starting out.

So, that would suggest customers doing more of their shopping at your stores?

Well, as I mentioned in the prepared comments, we're seeing good growth in loyal households, and that growth is -- and we have total growth as well.

We would believe we're continuing to pick up meaningful market share, and it's both in terms of new customers and loyal shoppers spending more with us.

We have seen some of the marketplace stores in our travels including some with the apparel in them.

Can you comment on that group of stores?

Marketplace is one of our many formats in terms of driving our growth.

What we're finding is the Fred Meyer folks are helping us identify the right apparel items to have in, and customers are -- it is one more reason to come to one of our stores.

Obviously, it is not typically on your Kroger list, but once you're in the store, you can get a great value for some reasonably trendy apparel at a reasonable price.

So, so far we're pleased, and we continue to add it in our new marketplace stores and as we remodel our marketplace stores.

Will the one in -- maybe it is even open -- will the new marketplace in Hilton Head have apparel?

That one, I don't know.

Mike actually probably knows that one better than me.

Everybody gives me grief that I'm the construction manager for that project.

It is actually not a marketplace store.

It is about a 90,000 square foot supermarket.

So, it will be a big supermarket, kind of like when you think -- if you have been to our Anderson store here in Cincinnati, or the Fort Mitchell store, it will be more along those lines than a marketplace store.

The site just wouldn't accommodate 123,000 square foot footprint.

Got you.

Thank you.

Great quarter.

Thanks, John.

Your next question is from the line of Todd Duvick, Wells Fargo Securities.

Good morning.

Hey, just filling in for Todd here.

Most of our questions were answered.

But, just kind of want to circle back on financial policy and just more of a confirming question, I just want to make sure I heard you correctly.

So ultimately, I guess, as everything kind of flushes through over the next couple of years, you would like to be at 2 to 2.2 times on a net debt-to-EBITDA basis, is that correct?

That has always been our long-term target.

Typically, over the past several quarters, we have been right around 2. We were just under 2 at the second quarter.

And, just in anticipation of the Harris Teeter transaction, we were a little conservative from July 8 when we announced that until now on the use of cash to try to pre-lower that ratio a bit, if you will.

We're actually a little bit ahead of where we are, and we feel comfortable we are going to be able to execute on all prongs of our financial strategy going forward, including the 2 to 2.2 times.

We think that is a good proxy for what it takes to maintain a BBB [flat] credit rating.

Got you.

Markets are hard to gauge a couple of months out, and I know you have a meeting coming up, but can you talk to where that ratio would be maybe in '14 in terms of kind of a max?

Or, any type of range?

I wouldn't -- I am not going to speculate on where it will be immediately post the transaction.

But, if you assume a $2.4 billion, $2.5 billion acquisition price, and all that debt goes on day one, it is going to take a full year to add in any Harris Teeter EBITDA.

So, the ratio is going to look pretty high on day one, but by the end of year one, and you have all of that EBITDA.

If you just assume the EBITDA they have been generating, you would probably get pretty close to a range of what we would expect by the end of the first full year post the transaction.

Great.

Thank you very much.

Appreciate it.

Your next question is from the line of Stephen Grambling, Goldman Sachs.

Good morning, and thanks for taking my question.

I know you don't like to give the quarter-by-quarter guidance, but since you did make some references there, is there anything in the fourth quarter that we should be thinking about?

It looks like even as you strip out some of the timing shifts, it looks like it embeds a little bit of a change in trend.

I'm not sure what you mean by change in trend.

If you look at purely the swing in LIFO, it is a $0.09 or $0.10 per share effect, just the swing of what last year's LIFO credit was and what this year's was -- or what this year's is projected to be.

So, it is a pretty dramatic shift between just on that line between the two years.

If you were to neutralize that, I don't think you would -- I think you would find a quarter that is within our guidance range for the year.

The first couple of quarters have benefited from the opposite of that in that we had a higher LIFO charge last year and a higher LIFO charge -- and a lower LIFO charge this year.

If you were to neutralize the first and second quarter LIFO charges, our results actually were nicely at the high end of the range, not a 17% quarter, like the headline reads, it is probably an 11% or 12% quarter growth with LIFO neutralized.

And, that's why for the year, if you want to say it's a change in trend for the fourth quarter, mathematically, that's how it would work.

But, that is just because of the LIFO shift.

One of the quarters has to be low, when we're at 17%, the first two quarters and our guidance is 8% to 11%, and it is purely that LIFO in the fourth quarter.

It is not a change in the base business.

Obviously, with raising the low end of our ID sales expectations, it is not any expectation that the business won't be strong in the fourth quarter.

Okay.

That's helpful.

And then, one quick follow-up on I believe it was Chuck's question.

Just fresh produce has been highlighted as -- you highlighted it last year, it is a big opportunity at the conference, and we have also heard some re-emphasis from Walmart, the high gross specialty players.

Can you just highlight some of the things that you're doing that have been driving the growth there?

And then also, more long-term, as you think about the category, how it might be changing either in terms of pricing, the relevance, et cetera.

Thank you.

Well, if you look, as you know, we continue to add organic produce.

We continue to work on shortening our supply chain.

Our produce team has done a great job on connecting with local suppliers.

We have significantly increased the amount of local produce that we have.

And, we're doing a better job telling the customers about it.

So, it is really all of those things together.

From a trend, we would expect that to continue into the future.

In produce, we think we are going to be very strong and successful in produce.

But, we think it is probably some of the other companies you talked about, I think there is enough growth that all of us will be successful.

Great.

Thanks.

Good luck.

Thank you.

Your next question is from the line of Jason DeRise, UBS.

Hi, it is Jason DeRise.

A couple of questions.

I wanted to potentially get a little bit more color on the FIFO gross margin ex-fuel down 11 basis points, if you can share a bit of the drivers within that?

And, if that is indicative of the range that you think can be maintained as part of the 8% to 11% growth model long term, as opposed to what has been happening in the past?

Now that we've got a couple of quarters in there.

And, I just wanted to follow-up on the guidance change for sales without EPS.

Is it just that the share count and interest view for the year has changed since the beginning of the year when -- or since last quarter, when that guidance was updated?

On the gross margin, as Rodney alluded to in his prepared comments, one of the things we've been focusing on, on a rolling four quarters basis, is the balance between the leverage of our ID sales, actual cost savings that we achieve, and when and how we invest those savings, that typically results in lower gross profit.

Some of those investments actually wind up increasing OG&A as people get training or something like that, so not everything affects the gross profit.

So, that gross margin is really dictated on our opportunity to save dollars elsewhere in the organization.

The other thing that has helped that, and until we cycle some of the bigger ones, clearly pharmacy gross profit rates are up because generic gross profit rates are higher than non-generic gross profit rates, and that's one of the tail winds that's in that number which ultimately will dissipate.

I don't know if that gets to your FIFO gross margin question?

That helps.

By any chance, would you want to quantify this quarter, what the pharmacy benefit was?

No.

I didn't think so.

I figured I would ask.

It was a good try.

What was your second question?

Just about reconciling that the sales guidance has come up, and EPS is still the same?

We raised our EPS guidance in the first quarter to reflect the results we had in the first quarter, and we continue to post sales essentially just above the midpoint of our current estimate.

And, any time you give a range, a Company is continually striving to at no worse be in the middle of the range and hopefully towards the high end of the range.

So, it is probably safe to assume that we weren't expecting -- we really didn't want 2.5% sales for the rest of the year to drive the EPS we were giving and really needed sales closer to where we are.

And, as Dave said with seven periods now in the books at 3.3%, for the year to have wound up at 2.5% IDs, that would have inferred a 1.6% ID number in the back half of the year.

We just don't see that in the books.

We see a number much closer to where we -- we don't see that in the future.

Rodney is touching wood by the way.

That is our expectation.

And, I would say it is in the -- both of those are within the range of what we expected when we began the year.

Okay.

And, I guess the part of the question that maybe you didn't hear on the first part, is that the share count and the interest outlook is different than when that guidance was issued at the end of Q1?

And, I guess, the Harris Teeter deal -- is that sort of the reconciliation there?

The share count and the interest have -- share count, a little bit of effect but not a dramatic amount of effect on the full year.

Interest, really not, because for the period of time we were drawing on commercial paper until we termed that out a couple of months ago, we actually were lower on interest during that period of time than we expected.

So, for the year, we will probably be a little better on interest than the original expectation.

And, that will actually help offset some of the lower share repurchases that we're expecting for the year.

I will reiterate one more time, none of our guidance has any assumptions relative to the effect of Harris Teeter.

When that transaction happens, we will have to reset the bar on what our expectations are.

So, there is nothing in there relatively to Harris Teeter, and one other thing I will remind you about on those is our guidance for the year would also exclude any transition or transaction expenses related to that, so we will call those out separately as they occur.

We had a little bit in the third -- in the second quarter, but nothing that changed the ultimate answer.

And again, we still have the expectation that Harris Teeter will be accretive in the first full year.

If I can squeeze one more in, with the new stores that you're opening up, and I guess some of the remodels that you're doing, how is that progressing at the early stage?

Are the stores generating the revenues that you'd expect?

We are very happy with the early results in the stores we're opening.

It is one of the reasons we're keeping our CapEx expectations and spend where we plan to be, and as we said last October, we expect to increase that $200 million a year, and I would expect at this point in time that 2014 would be $200 million higher than what we have out there as expectations for this year.

Again, excluding anything relative to Harris Teeter.

All right.

Thank you.

Your next question will be from the line of Andrew Wolf, BB&T Capital Markets.

Thank you.

Good morning.

Good morning.

I also want to follow up on the gross margin.

This year's rate has improved sequentially quite a lot.

You signaled at your last investor conference that I think the rate of price investment Kroger needed was going to abate -- or you would need less going forward.

So, I just want to ask you straightforwardly, is that the major driver of the improvement in the gross margin rate?

Or, less contraction to be precise, this year so far?

I know you called out other things like generic drugs, but is that one factor, if not the major one, one of the major ones?

And, what does that imply about the price environment in general?

Well, if you look, we obviously have an overall price strategy in terms of our relative price value versus our competition.

And, we've had that for several years, we can -- and we continue to be very aggressively promotionally in terms of giving customers a good value on promotion.

I wouldn't over-read what this year's number is versus the long-term trend.

We're really focused on making sure that we maintain our relative price position.

We continue to improve our reputation with our customers.

And, we balance that with, as we take costs out of the business, that we have a slightly improving operating margin.

So, it is really all three of those together.

One of the things that has been helpful this year is pharmacy that Mike mentioned.

We're also having good success on reducing some cost of goods on some things that we're doing as well.

So that is helping it.

The other thing we probably are investing a little bit more in service this year than a normal, typical year.

And, that is something that each year you would balance based on what we see the opportunities in the marketplace.

And, I just want to switch gears to labor negotiations.

There's been some press reports, and I think some Kroger officials have commented as well, that with the coming changes in health care in the system under the Affordable Health Care Act, there have been some changes to the contract terms.

Does Kroger view that -- these changes to the Affordable Health Care -- coming from the Affordable Health Care Act, is that something that Kroger can use either to -- well, to reach its goal?

Which you've stated to have the competitive cost structures?

Particularly, when you think about the industry having one of the most generous health care benefits in corporate America?

Thanks, Andy, for the question.

The law really isn't driving -- the changes that you would have read about, the law is not what is causing those changes.

As you know, you've known Kroger for a long time.

We want to make sure our associates and our family have access to affordable health care coverage, and we still are spending about $1.5 billion a year on health care.

We would expect that cost to continue to increase, even with the changes that you heard us talk about.

Every contract is separate.

Every situation is separate.

What we find in some cases, our health care plan is so much better.

A lot of spouses will be working, our health care plan is so much better than a lot of the spouses would have.

Spouses are coming to our plan on an increasing rate.

And, what we're trying to do is to set up where spouses that have coverage, they go to where they have coverage to in some cases to take it for that coverage.

So overall, we're looking at each contract individually, and it is the solution that works best for that market, for that situation.

To follow up, I think in Dave's preamble, you talked about how growth has -- it sounded like made a more amicable relationship with the unions.

So, am I understanding that correctly, that maybe the unions are more willing -- and I know each one is a separate entity.

But, in general, more willing to make certain helpful changes because they know Kroger is expanding and adding opportunity for more membership, for example?

I guess I would never say that the union is being more helpful.

I certainly believe the unions, we continue to have a partnership to try to work together to figure out what is best for our associates.

So, I wouldn't say that -- they're not becoming suddenly easy to negotiate with.

They're still looking out for their members.

But, when you look at it overall, one of the things that we're able to bring to the table is a growing Company that improves job security.

We're creating jobs that have -- obviously, when you're a department head, you get paid more money than when you're not a department head, and it is those type of opportunities that we're able to provide for our associates.

So, it is really all those things together that will create a growing Company.

Improve job security and improves what somebody makes on an individual basis because their getting promoted.

Thank you.

Congratulations on the quarter.

Andy, thanks.

We will have time for one more question.

The final question will be from the line of Edward Kelly, Credit Suisse.

Good morning.

Nice quarter.

Thanks, Ed.

I have a couple of follow-ups.

Mike, a question on generics?

The pharmacy margin in general and the contribution from generics, I know you don't want to give the amount, but sequentially versus last quarter, how did the contribution compare?

Was it similar or less?

A little less.

A little less?

Okay.

Could you also give us an update on shrink?

I know shrink was something last year that was a little bit of a head wind.

I know you have been making some progress.

Where do you stand on shrink today in terms of your progress, and how you feel about that?

Rodney, do you want to comment on that?

Shrink is one of those where I don't know that I would ever say I'm ever pleased.

We're certainly not satisfied.

But, we always work -- we're very careful when we are trying to improve our shrink results because it is one of the easiest ways to affect the customer's experience.

We don't want to have low shrink just for the sake of low shrink.

We're not as far along as we would like to be.

We're making some progress in some of the areas of the business.

But, it is one of those things where it is a constant balancing between the pieces.

So overall, the answer to your question is, we're making progress in some areas.

We're still not where we want to be, but we're making sure we do it on a balanced basis.

Okay.

And then, just final question for you, and I know you recently announced the Harris Teeter deal, but what does the M&A environment generally look like today?

Are you seeing more opportunity, less opportunity?

Just curious as to your general view on what is available.

Ed, I will give you a general comment, and Mike may want to add more specifics if he wants.

But, I think we see the environment pretty much like we've been seeing it.

That there is lots of things that we look at regularly, but very few of them actually fit things that we think are worth doing and worth spending the money on, and investing our time.

And, obviously, we have described Harris Teeter as one of those companies to merge with them.

We've admired them for a long time, and it's kind of an asset that really helps us grow into a new market.

Do you want to add anything else to the environment?

No.

Thank you.

Okay, so we're going to wrap up.

And, I had just a couple of comments.

I just wanted to -- Paul Heldman was nice enough to point out to me -- in my prepared remarks, I said corporate brand units were up.

Market share was 24.5%.

It is actually 25.4%.

I transposed those.

I just wanted to correct that before we got off the call.

Sorry, Dave.

That's good for the record to get that in there.

Thank you.

So, before we end the call though, as we often do, I would like to share some additional thoughts with our associates, who we encourage to listen in on this call.

October is Breast Cancer Awareness Month across our Company, associates, and the offices and the supermarkets and convenience stores, and our plants, distribution centers participate in many activities to honor and pay tribute to those who are fighting this disease including many local Susan G. Komen Race for the Cure and making strides against breast cancer events.

I'm always moved by the outpouring of support and generosity that I see from our associates at events like these.

In the next few weeks, we will also begin our annual Giving Hope a Hand campaign to support the fight against breast cancer in our stores.

This year, we will be featuring associates like Lori, an apparel manager at one of our Fred Meyer stores in Oregon, who says losing this battle is never an option.

Lori and 20 other courageous women will share their stories of hope and courage on specially marked packages of our corporate brands and national brand products.

These items will be sold exclusively in our stores from September 22 to October 5, and I encourage you to read our co-workers inspiring stories at www.sharingcourage.com.

That completes our call today.

We want to thank everyone for joining us.

Thank you.

Ladies and gentlemen, that concludes today's conference.

We thank you for your participation.

You may now disconnect.

Have a great day.