克羅格 (KR) 2018 Q3 法說會逐字稿

Good morning, and welcome to The Kroger Co.

third quarter earnings conference call.

(Operator Instructions) Please note this event is being recorded.

I would now like to turn the conference over to Rebekah Manis, Director of Investor Relations.

Please go ahead.

Thank you, Laura.

Good morning, and thank you for joining us.

Before we begin, I want to remind you that today's discussions 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 ir.kroger.com.

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

(Operator Instructions)

I will now turn the call over to Kroger's Chairman and Chief Executive Officer, Rodney McMullen.

Thank you, Rebekah.

Good morning, everyone, and thank you for joining us.

With me to review Kroger's third quarter 2018 results is Executive Vice President and Chief Financial Officer, Mike Schlotman.

At our Investor Conference at the end of October, we shared several big ideas.

The defining idea is that we are transforming our business model through Restock Kroger and then beyond.

We will grow market share by both redefining Kroger customer experience and alternative profit streams through complementary businesses and partnerships.

Redefining the customer experience means offering customers incredible physical and digital experiences, a fantastic offering and friendly and caring associates.

Delivering an exceptional customer experience through the Kroger ecosystem creates incremental new profit streams, which in turn drives the economic model that makes the seamless experience possible.

In this way, our new growth model will be a virtuous cycle.

This all means that Kroger is also reinventing our financial model.

We're moving from a traditional grocer to a growth company with both a strong customer ecosystem that offers Anything, Anytime, Anywhere and asset-light, high-margin alternative partnerships and services.

I will break it down a bit in more detail.

Successful long-term businesses constantly explore new directions and adjacencies to grow their top-line.

At our Investor Conference, we highlighted one of the most successful to date, Kroger Personal Finance as well as several businesses under our 84.51° portfolio, including our Kroger Precision Marketing media offering.

Kroger Personal Finance delivered record year-to-date profit and is on track for their most profitable year ever.

Our high-margin media business is strong and growing.

Revenue for Kroger Precision Marketing, Powered by 84.51°, is up more than 150% year-to-date.

One service line, our boosted products and search business, where advertisers can influence how their products show up on our sites, benefited advertisers with more than 700 million product impressions in the third quarter alone, personalized to Kroger shoppers, with click to conversion rates that are 2 to 3x the industry standard.

We see tremendous potential in these asset-light, margin-rich businesses build off of a robust grocery supermarket experience, which is being redefined every day at Kroger.

Nowhere is this more obvious than digital.

Our digital sales grew by over 60% in the third quarter.

Our seamless coverage area now reaches more than 90% of Kroger households.

This includes Kroger Pickup and Delivery.

Kroger Ship is now available in all supermarket divisions.

Ship customers can shop from a curated selection informed by 84.51° data and insights of more than 50,000 grocery and household essentials that matter the most to our customers, plus there are 4,500 Our Brand products available only from Kroger.

We are aggressively investing to build digital platforms because they give our customers the ability to have Anything, Anytime, Anywhere from Kroger and because they're our catalysts to grow our business and improve margins in the future.

As we stated at our Investor Day, we expect to be able to cover not only 100% of our customers but also the entire U.S. population.

Our Brands continue to perform exceptionally well with customers and is one of the most profitable parts of our supermarket business.

Our Brands made up 28.7% of unit sales and 26.6% of sales dollars, both of which are record third quarter results.

Our Private Selection and Simple Truth brands saw strong sales, units and gross margin gains in the third quarter.

Simple Truth and Simple Truth Organic is our fastest growing brand, with sales up double digits, again, in this third quarter.

As we've shared previously, Our Brands account for 4 of the top 5 items sold through Kroger Pickup, and 41 of the top 50 items sold on Kroger Ship.

We have now been executing for 3 quarters our Restock Kroger Plan to create shareholder value by redefining the grocery customer experience, partnering for customer value, developing talent and living our purpose.

We feel good about the progress and how everything is coming together.

We are proactively investing for the future in stores and online and in our customers and associates.

We are using our assets, especially our love of people and our love of food, to transform our business in ways that drive sustainable competitive advantage.

Now here is Mike to share more details on our third quarter results and to update you on our guidance for the fourth quarter of 2018.

Mike?

Thanks, Rodney, and good morning, everyone.

We are pleased with our net adjusted operating earnings per diluted share result of $0.48 for the third quarter.

Strong fuel margins and continued execution of Restock Kroger contributed to this result.

We continue to make several Restock Kroger investments in the third quarter.

These included investments in price, especially in support of Our Brands and in space optimization, store remodels and technology enhancements.

Part of these investments will allow customers to buy Anything, Anytime, Anywhere from Kroger.

As we discussed at our Investor Conference, space optimization is a massive undertaking, and we continue to expect to end the year with 600 stores completed.

Our ID sales for the third quarter were in line with our expectation.

ID sales were led by natural foods, pharmacy, seafood, produce and deli departments.

Looking at gross margin.

We were pleased to see that our shrink rate continued to improve during the third quarter compared to the previous year.

The gross margin rate reflects the timing and size of company's price investments compared to a year ago, rising transportation costs and growth of the specialty pharmacy business, which is a high-sales, low-margin rate business that generates strong gross profit dollars.

Keep in mind that last year in the third quarter, our gross margin rate was higher than our typical run rate.

For the third quarter in 2018, gross margin, excluding fuel, was actually higher than the second quarter of 2018.

These fluctuations illustrate how results in a given quarter can vary based on the cadence of the investments we make in the business.

Part of our investments this year support the Our Brand strategy where we continue to offer high-quality products at a great value.

The improvement in unit movement in the quarter demonstrates these investments are resonating with customers.

We intended to continue investing in price to drive unit growth while also delivering on the bottom-line for our shareholders.

We are pleased that OG&A costs decreased by 20- basis points as a rate of sales.

The significant improvements we are seeing from our focus on reducing store associate turnover is contributing to this positive movement.

We continue to focus on productivity and waste and improvements in our cost to fill prescriptions and increased adoption of self-scan contributed to this improvement.

Our investments in Restock Kroger in redefining the customer experience, partnering for customer value and developing talent will be paid for by cost of goods savings, strong ID sales and productivity gains.

This will contribute to generating $400 million in incremental FIFO operating profit through 2020.

Now for an update on our fuel -- retail fuel performance during the third quarter.

Our cents per gallon fuel margin was approximately $0.261 compared to $0.249 in last year's third quarter.

The average retail price of fuel was $2.81 compared to $2.46 in the same quarter last year.

We expect our tax rate for 2018 to be approximately 23%.

Excluding the 2018 adjustment items, Kroger expects its tax rate to be approximately 21%.

These rates reflect the third quarter adjustment related to a regular IRS audit.

The IRS audit resulted in a reduction in prior year tax deductions at pretax reform rates and future tax deductions at post-tax reform rates.

Our financial strategy is to use free cash flow to drive growth while also maintaining our current investment grade debt rating and returning capital to shareholders.

We continually balance the use of cash flow to achieve these goals.

Over the last 4 quarters, we used cash to invest the combined $589 million in Ocado securities and Home Chef; contribute an incremental $185 million pretax through a company-sponsored pension plan; $467 million to satisfy withdrawal obligations to the Central States Pension Fund; repurchase 91 million common shares for $2.3 billion, which includes $1.2 billion repurchased with after-tax proceeds from the sale of Kroger's convenience store business under an accelerated stock repurchase plan.

We paid $435 million in dividends and we invested $3 billion in capital, excluding mergers, acquisitions and purchases of leased facilities.

At the end of the third quarter, we had approximately $546 million remaining under the current share repurchase authorization.

We remain committed to generating the $6.5 billion of Restock free cash flow by 2020 as part of our Restock Kroger Plan.

We have working capital improvements built into this guidance and off to a great start with $100 million improvement in net operating capital -- net operating working capital, so far, this year.

Kroger's net total debt to adjusted EBITDA ratio on a 52-week basis is 2.72.

Our net total debt to adjusted EBITDA ratio target is 2.3 to 2.5x, and we remain committed to bringing the leverage ratio back into the target range.

We are investing an incremental $500 million in our associates in wages, training and development over the next 3 years through Restock Kroger.

This will be in addition to our continued efforts to rebalance pay and benefits while also focusing on certifications and performance incentives, career opportunities and training.

In March, we also announced investing a portion of our tax savings in our educational assistance program, Feed Your Future, and an increased 401(k) match for nonunion associates.

The average hourly rate for our store associates is more than $18 per hour when you factor in our comprehensive benefits that many of our competitors don't offer.

We recently ratified a new labor agreement with the UFCW covering more than 13,000 Kroger associates in Columbus, Ohio.

The agreement raises starting wages and accelerates wage progressions after 1 year of service.

We are currently negotiating with UFCW for contracts covering store associates at Smith's in Albuquerque and Fred Meyer in Portland.

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

We continue to strive to make our overall benefits package relevant to today's associates.

Our financial results continue to be pressured by inefficient health care and pension costs, which some of our competitors do not face.

We continue to communicate with our local unions and the international unions, which represent many of our associates on the importance of growing our business in a profitable way, which will help us create more jobs and career opportunities and enhance job security for our associates.

Turning now to guidance for the remainder of 2018.

We continue to expect identical sales growth, excluding fuel, in the second half to be similar to the first half results.

We updated our GAAP net earning guidance to $3.80 to $3.95 per diluted share for 2013 (sic) [2018] from the previous range of $3.88 to $4.03.

The change in GAAP guidance is due to the third quarter market value adjustment of $0.09 per diluted share for Kroger's investment in Ocado shares and does not reflect any future changes in the market value of those shares because those cannot be predicted.

On an adjusted basis, we maintained our net operating earnings guidance range of $2.00 to $2.15 per diluted share for 2018, and keep in mind that fiscal 2017 included an extra week.

We continue to expect capital investments, excluding mergers, acquisitions and purchases of leased facilities, to be approximately $3 billion for 2018.

And now I'll turn it back to Rodney.

Thanks, Mike.

We're not quite through our first year of executing Restock Kroger, and we feel great about where we are.

We are laser-focused on our customers and fulfilling their needs.

We are clear on our vision to serve America through food inspiration and uplift.

Our 2018 accomplishments and investments set us up well for 2019, and we are committed to delivering on our Restock Kroger financial targets by the end of 2020.

We have a clear path through both redefining the customer experience and growing alternative profit streams.

Now we look forward to your questions.

(Operator Instructions) And our first question today comes from Vincent Sinisi of Morgan Stanley.

I just wanted to ask a bit further on the alternative revenue streams.

Since your guy's Investor Day, we, on the phone, of course, have been getting a lot of questions from investors as well around that.

You called out today kind of the Kroger Personal Finance seeing nice results there, but can you just kind of give us a little bit more color on that specifically?

And just kind of as a category alternative revenue streams, kind of what are some of the puts and takes?

We know it's one of the more important components of your EBIT guide.

If you look at the October meeting, we went through several different ones.

Obviously, today, if you look at -- we highlighted Kroger Personal Finance in October because we wanted everybody to see that we actually have a great track record of delivering against identifying new business opportunities and having it grow in a meaningful way that's actually substantial to us.

One of the announcements that we made last year was the Kroger Precision Marketing where we're using the insights from 84.51°.

All of those things are really based on the traffic from our stores and our digital properties in creating a seamless experience for customers.

And all of those things that we're doing will help our customers shop one of our stores easier.

And, like in the media experience, it will allow our CPG partners and other people to target specific customers through our pipeline.

If you look at over the last 4 years, the compounded annual growth from a profitability standpoint has been 16%.

If you look at our expectations as you look at '18 through '20, we would expect that to accelerate to 28% growth per year.

And certainly, the progress that we're having in '18 would support the 16% that we projected based on the historical 4 years.

Mike, anything you want to add?

No.

I think we also -- Rodney gave some color on the Kroger Precision Marketing.

The fact that it's up 150% year-to-date and I think it's pretty impressive that the boosted search of relatively new product with 700 million product impressions just this third quarter.

And when you get click-to-conversion ratios 2 to 3x industry standard, that's the kind of thing that keeps that momentum going and keeps third parties interested in continuing to have that boosted search.

Okay.

All right.

That's helpful color.

And then maybe just as a -- maybe a SaaS follow-up, just in the press release this morning, just with some of that price investment commentary, is that -- would you say kind of normal cadence, nothing out of kind of the ordinary?

Or did you see any particular changes on the competitive front or by category this quarter?

Yes.

I would say it was just -- if you look at the overall strategy, it's executing the overall strategy that we started -- what we talked about at the beginning of the year but we've been embarking upon for several years.

So I wouldn't say anything out of the ordinary.

As Mike mentioned in his prepared comments, last year's third quarter was higher than trend-line.

The other thing, I think, that's important just to note is that we did have a couple new warehouses starting up and a warehouse conversion that also negatively affected the margins in the quarter.

And those are one-time -- well, it will take a couple of quarters for those to get started up in the transition, but that also negatively affected the quarter.

The next question will come from Karen Short of Barclays.

So I just wanted to ask a question about full year guidance and the implied fourth quarter.

So the range is pretty wide for 4Q getting kind of like $0.38 to $0.53.

So I'm wondering if you could just give a little color on that and the puts-and-takes to operating margin.

And then, I guess, maybe comment on the guidance in light of the fact that gas margins seemed pretty strong in the quarter-to-date.

And I know in the past when that has been the case, you've pulled forward expenses into the fourth quarter or into the quarter -- whatever the quarter was where there were strong gas margins, so a little color there would be helpful.

Sure, Karen.

And the wide range, I -- we all agree here at Kroger that the range for the fourth quarter is quite wide, keeping it at $0.15.

And it's purely driven by what you zeroed in on, and that's gasoline margins and where they wind up because they've been very volatile over the last several weeks, while a very strong year, they can turn pretty quickly both positively and negatively.

And if you think about what one margin in gallon means to earnings per share or $0.01 margin per gallon means to earnings per share, it can equate to almost $0.01 a share.

That volatility is what caused us to decide to keep the range fairly wide.

It has nothing to do with our view of how the business is going to operate in the fourth quarter.

It's purely, will margins continue to be strong?

Will they get weak the next -- will they get weaker the next 5 or 6 weeks or where exactly will they go.

And it's really, you're unable to predict where those margins go on a weekly basis so we just decided to keep it a little wider purely based on where gas margins may wind up in the fourth quarter.

Okay.

So is it fair to think though if they remain strong, you'll pull expenses into the fourth quarter?

Or it's just impossible to predict?

Yes.

I wouldn't necessarily predict pulling expenses into the fourth quarter.

If you look at where we're sitting here in early December, our promotional activity and our ads are pretty well set, how we plan to go to market over the holidays coming up and New Year's and even as we get into later January getting ready for the college football playoffs and the Super Bowl, all those big events.

Those kinds of plans are pretty well locked and loaded and the supply chain is ready for those kinds of activities to come through.

So to do a lot of other unusual things in the next, call it, 8 weeks, 8.5 weeks would be -- I think we're pretty comfortable with the plans we have in place.

Okay.

And then just a general question on the alternative revenue streams.

I mean, presumably, those are high-gross margin and this quarter isn't really the quarter to see the flow-through, obviously, given the comparisons from last year, but gross margins were still a little lower than we were modeling.

But any color on how to think about how alternative revenue streams will impact reported gross margin ex fuel going forward?

The -- I wouldn't -- longer term, I wouldn't say that we're really to a position to start giving some of the detailed insights.

Your hypothesis is absolutely correct in terms of the margins in our alternative profit streams are significantly higher than the core business, which is one of the reasons why we want to make sure that we call it out and point it out.

The other thing, as you know, that's incredibly important is in those -- in that space, it's typically very asset light.

So if you look at Kroger Personal Finance, we have an incredibly strong partnership with the bank.

The assets that's used to grow that business is reasonably modest.

If you look at Kroger Precision Marketing, it's using insights and data to create that revenue stream so it's easily scalable as long as you're producing the results for your customers.

So it's a piece that's incredibly exciting.

In terms of giving some specifics, I just think it's still a little too early for that.

The next question will come from Edward Kelly of Wells Fargo.

Can we start with just IDs?

Could you maybe talk about the cadence of the IDs throughout the quarter?

What you're seeing so far in the current quarter?

And any update on the optimization drag?

I think, obviously, your guidance implies Q4 will be better.

I'm just curious as to whether you're seeing some of that yet.

Well, if you look at the cadence throughout the quarter, it was fairly consistent throughout the quarter.

As you look at so far this quarter, we would be in the same range as where we ended the third quarter, so we've started off at about the same spot.

When you look at space optimization and the fact that we're in the holiday season, we've been disciplined to not have stores disrupted during the holiday season, so we would expect to have those stores start to perform better like we talked about at the Investor Conference.

We will start up next year -- space ops.

We will start some stores in January after the holiday season.

When you think about the slide I showed at the Investor Conference on space op, what we're seeing in ID sales for those stores is not materially different than what I showed back in October.

All right.

And then I wanted to ask you about SG&A.

It was a positive surprise this quarter, for sure.

Can you talk about your ability to drive 20- basis points of OpEx leverage this quarter?

And you've been talking about cost discipline, right?

Is this now starting to inflect into the P&L?

And I'm just kind of curious as we think about things going forward, how we should be thinking about this line item?

How important is it to your $400 million over time?

Just any color there would be good in terms of like what this quarter means as to how we think about modeling going forward.

Yes.

I think what it means is a lot of what you said, and when you look at the areas that I called out in the prepared comments, when you think about retention, and our retention getting significantly better than it has, it does multiple things.

One, you don't spend the dollars you have to spend to hire somebody, just the actual hard cost of getting somebody into the system whether you do a background check or any kinds of other screenings on the individual, getting them through a training program and then getting them on to the sales floor, at a productivity level lower than someone who has 6 or 9 months experience.

So when you have more and more people who have that 6 to 9 months experience and start to get to the 12 months experience, that helps the productivity inside the store.

More people then wind up staying, particularly the part-time workforce, as they start to understand and appreciate, when they're here 6 months, they start to get the benefit of Feed Your Future where they can get $3,500 a year towards furthering their education.

That cost, while it sounds expensive, actually will be offset by that person staying for another 12 or 18 months versus having that person turn a couple of times and having lower productivity and training.

So you kind of create a virtuous cycle and better opening wage rates, more contemporary benefits, helping them with their college education or GED or English as a second language.

We have a lot of folks here work for Kroger in management positions that have decided to go back and get their MBA and other advanced degree certification.

So all of those together help with that.

We continue to see improvements in our cost to filling our pharmacies.

Our pharmacy business continues to be a very strong piece.

Our script count on a 30-day adjusted basis continues to grow nicely.

And as we leverage that and are able to leverage down our cost to fill prescriptions, that certainly helps.

And then the efforts we've had both on our front-end transformation that we tried to work in with space op, when possible, of reconfiguring the self-checkout units so that it's an easier, a more friendly experience for our customers.

And then the added benefit of the Scan, Bag and Go, all of those help create productivity, which is a positive to it.

A lot of things I said there.

I don't know that I would promise 20- basis points going forward, but certainly cost reduction as we've been talking since we announced Restock Kroger on October '17 is a very important part of getting the $400 million of operating profit.

I agree totally with everything that Mike said.

And I think the last part that Mike said is the important part.

As you look at now through 2020, you should expect to see us reducing cost of -- how much cost it takes us to operate our business.

And Mike gave a bunch -- several great examples, but we're really -- our operations team is doing a great job working with our stores and our technology team on some innovation ideas to improve processes and take cost out.

So it's really all of those pieces working together.

But absolutely, as you look out through 2020, you should expect us to improve cost and how much it costs us to operate our business.

And the next question comes from Michael Lasser of UBS.

In light of the fact that space optimization disruption should be a little less in the fourth quarter plus given the re-acceleration of your price investments, should we expect that IDs are going to meaningfully accelerate in the subsequent months over your fourth quarter?

Yes.

I think that the only place that would go on -- ID sales is our guidance as we expect the second half to be comparable to the first half.

Our third quarter was close to the second quarter and our first quarter was a little better than the second quarter.

So we do have a little bit of ground to make up on that guidance, but we didn't -- we said similar, we didn't say exactly equal to.

But we are expecting a little bit better fourth quarter.

We're working hard to do that.

I think we have great plans in place.

And Mike, what would be the offset to some of those benefits?

Are there industry factors, consumer pressures?

What are your thoughts there?

I don't know what you mean by offset.

Because you're going to see less disruption from space optimization and you should get a sales lift from the price investments that you've been making, so I'm just wondering if there's offsetting drags to those factors.

Yes.

I wouldn't point to any particular offsetting drag as it relates to the top-line.

Keep in mind, our fuel rewards program continues to be incredibly important to our customers and our associates when they think about the total value that we give them on a day in, day out basis.

And that $0.10 a gallon they get off, keep in mind, we reduce reported IDs for that because you have to buy groceries to get the lower fuel discount.

Not all of our competitors account for it that way.

So as that continues to be popular and more and more people engage in that, we're selling more in the stores, but it actually slows how quickly ID sales grow just because of the way we do our accounting.

So there are always puts-and-takes on that top line.

That's helpful.

And my follow-up question is on Kroger Personal Finance.

It's been seeing very healthy growth.

What's been driving that?

And how much of that is the private label credit card?

It's really all of the portfolio of products they offer.

So in the last 2 or 3 years, we've done a couple of mergers with Roundy's and Harris Teeter so there's good growth there.

There's good growth in the existing business.

And then the credit card business continues to be an incredible tie-in for -- loyalty for Kroger customers, so it's really all pieces of that business continues to grow.

Obviously, credit write-offs are low as well, but that' a pretty small part of the overall impact on the profitability of that business.

The next question comes from Ken Goldman of JPMorgan.

In the past, around this time of year, you've provided some initial thoughts about the upcoming fiscal year, at least, on some occasions.

Mike, at the Investor Day, you did say, I think, 2019 has to have some, I think, the word you used was decent operating profit margin dollars.

I just wanted to see if you could elaborate a little bit on that in terms of what you're expecting next year?

Or in general for next year, are there any unique tailwinds, headwinds we should be thinking about?

Just opening up that topic if we can.

Yes.

I won't go too far on 2019, but it's -- if you go all the way back to 2017 and then the first quarter of this year, when we talked about pulling forward some investments from '19 into '18, clearly, operating profit margin has to grow in 2019 over 2018 and start that march to the $400 million that we're going to generate over the 3 years of the Restock Kroger Plan.

I will say, and I knew at some point we would get this question because we were a little -- we were pretty more prescriptive this time last year on the call about what we expected for 2018, and a lot of that had to do with the fact that we had a range of estimates out there at that point in time that were as low as in the $1.40s and $1.50s and up to above $2.20 kind of range.

It was a massive range.

And what we were trying to do was rein in that range as we got into the end of the year.

And knowing that we were going to give guidance in March, we didn't want that wide of a range out there.

I think, today, people are understanding that this is a 3-year program we're undertaking.

And as we make -- as we pull those investments from '19 into '18, they should start generating a little bit more in '19, then even more in '20.

So it is a 3-year growth of algorithm to get to the $400 million where we continue to see a clear path to the $400 million.

The other point that I would add, and we talked about it in October, is if you look at digital, our overall digital business continues to be a significant investment for the future of the business.

And we would expect for '19, that to become a less of a headwind that it was in '18.

And that is also an important part to remember as well.

And then a follow-up.

If I look at your SG&A dollars and -- they were down year-on-year if I exclude the one-time pension contribution last year, some extra weeks, it actually was down for the first time in at least 22 years according to my model.

So I realize you're gaining efficiencies in store associates, I get that Personal Finance is a contrast SG&A item, but I'm still not 100% sure why that decline was so sudden.

I mean, your SG&A came in $200 million below where The Street was.

So can you help us understand a little bit of what the big dramatic change was in the quarter or maybe I'm just -- we're all just modeling it wrong and didn't see something.

Yes.

From a dollar standpoint, Ken, don't forget that last year would have had the C-stores in our OG&A rate and they're disposed of now in our dollars.

Yes.

But last quarter, in 2Q, it was still -- you still were up year-on-year with SG&A, so it was a little bit more of a dramatic change.

I could follow it up off-line if it's -- I don't want to hold everyone up on the call.

Hold on one second.

Ken, they're pulling up stuff to talk.

I'm sorry, I didn't mean to do this.

Yes.

We were up a little bit in the second quarter.

I would say the second quarter is probably more a function of, in the prior year, we would have had some bonus accrual reductions because of the year it was at -- where the year was heading that we didn't enjoy this year.

The next question will come from Chris Mandeville of Jefferies.

So as it was noted, you guys are doing quite well in OG&A but gross margins were a bit lower than what we were all expecting.

Mike, can you just maybe help ballpark the impact on gross margins based on the noted items that you called out?

And I know you don't necessarily like to guide to any one line item, but just given the particular strength in fuel margins that we're seeing quarter-to-date and how that plays into overall earnings, can you give us a sense of just how to think about gross margins ex fuel in Q4?

Yes.

If you think about that margin rate in Q4, I'm more comfortable doing that than listing out the effects in any one quarter of some of those things because 1 quarter is not an indication of where they go long term.

The one I did call out is Kroger Specialty Pharmacy.

It's a very profitable business.

It has a very low margin rate.

But because of the individual cost of those prescriptions for the patients, it generates very strong gross margin dollars which is why we're in that business.

And as that business continues to grow, it will be a headwind.

That one alone was a double-digit basis point headwind, but I won't give the exact amount.

When you think about the fourth quarter, you should probably think about the fourth quarter change in gross margin rate the way we talk about that basis point change being more similar to the second quarter than the third quarter.

Okay.

That's helpful.

And then just my follow-up.

Over the last couple of weeks now, we've seen several sizable product recalls.

And I think some of it was even specific to the Kroger brand in both meats and pet food.

So I'm just curious on what Kroger has been doing of late or what it plans to do when it comes to supply chain and improving sourcing helping mitigate recall costs.

Well, if you look, food safety has been something that Kroger has been incredibly proud of for many, many years.

And we have a team of folks here that, that is their only responsibility is to make sure that products are safe throughout the food channel.

We will do routine audits of our suppliers as part of that process.

One of the things that we are incredibly proud of is, in the unfortunate situation where there is a recall, we reach out to our customers and let them know that there's a recall on products they bought so that we try to get that customer to get the product back to us as quick as possible to make it easy on them and to let them know.

It's something that we also review with our board on a regular basis.

If you look at severity of incidents, we've actually, over the last 5 or 6 years, there's been a decline on severe incidents.

Now if you look at overall recalls, it continues to increase just because I think the overall food safety chain in the U.S. continues to improve.

Okay.

And maybe just 2 quick housekeeping questions.

What was inflation, deflation in the quarter?

And was there any notable call-out from hurricane impacts on the comp or expenses in the...

Yes.

If you look at the hurricane impacts, it would have been a little bit of a headwind to ID sales.

We didn't necessarily call it out primarily because it wasn't that dramatic, but it was several basis points of a headwind.

More than a couple, but it's not like it was 20- or 30- basis points.

So -- but it was meaningful, but not directionally going to change the answer.

If you look at your question on inflation, deflation, I'm looking at my chart here.

I have 30-year-olds that make a chart for their eyes, not my eyes.

So if you look at inflation, deflation without fuel and pharmacy, on a cost basis, we had about 11- basis points of inflation.

If you put pharmacy back into the mix, we had about 22- basis points of inflation.

So a very benign environment.

It ranges around the categories of who had some inflation and deflation, and there were some categories that had a little bit of inflation and others that had a fair amount of deflation.

And our next question comes from Rupesh Parikh of Oppenheimer.

So on capital allocation, I was curious how quickly you anticipate being back to that 2.3 to 2.5x leverage ratio.

And then as we look out to next year, I know you have $1 billion term loan coming due.

So just curious if you have any initial thoughts in terms of whether you would pay that down or refinance that debt.

So we actually have about $1.1 billion of long-term debt that is now classified as current coming due in, call it, the next 90 days -- or next 60 days.

Some this month, some next month that we would anticipate refinancing that in the market.

We do have forward -- we have forward starting swaps against both of the types of debt we would wind up expecting to issue at very favorable rates.

The 30-years hedge is almost 100- basis points below where the 30-year is today, and the 10-years hedge is not quite that strongly but almost as strongly.

We haven't decided exactly what we'll do with the term loan.

It is -- some of our banks like the business, some don't like the business, but we certainly would have enough capacity with commercial paper to be able to use commercial paper to pay off the term loan if we chose to.

So we'll have -- we always have a financial policy committee meeting with our board in January and we'll discuss our plans of how much flexibility do we want.

If we rolled over the term loan, it keeps more revolver capacity so you can handle fluctuations day-to-day.

Relative to the net total debt-to-EBITDA range, we are always in contact with the rating agencies.

They understand what our program is and we are executing against the program we've described to them relative to them keeping our ratings where they are.

And it's important for us to get back into the range.

Absolutely.

Okay.

Great.

And then switching topics on price investments, so they clearly accelerated, I think, the past quarter or 2. So just curious in terms of whether the volume uptick so far -- thus far -- is meeting your expectations.

Yes.

I wouldn't -- I don't know if I would be as strong in the comment that they clearly accelerated.

If you go back to each of the quarters so far this year, we talked at the end of the first quarter that we started making the pull forward investments in the fourth quarter.

So from that standpoint, what we were pulling forward from '19 into '18, it's a fair assessment that beginning then, we did make those pull forward investments.

I wouldn't characterize the third quarter as a big uptick in what our price investments plans were for the year.

It's just that we continue to make the price investments throughout the year and it's more a function of how we made price investments last year a little bit choppier than we did this year.

And are they meeting your volume expectations as far as the volume uptick...

So we continue to be happy with what we're seeing from the results of the plan.

It's not a single plan.

It's not a single investment.

So as with anything, when you make price investments in a wide range of things, there are those out there that you probably are getting more volume than you expected and some, not quite as much.

Not everyone is perfect, but we're constantly stepping back and assessing all the results.

Overall, I would say we're very happy with what our investments are giving us.

I don't want to give the appearance that each and every one of them is perfect because that probably wouldn't be believable, but we are very happy with the collection of them.

And the ones that are doing well, we do more of.

And the ones that aren't quite so well, we try to tweak and -- or see what else might work.

The next question will come from Judah Frommer of Credit Suisse.

Just to follow up on the price investment first.

Can you give us some insight to how internally the decisions are made around seeing better fuel profitability and kind of how quickly you can turn that in to pulled forward price investment.

And then how should we think about that pull forward?

Does it actually offset investments that you may have made next year?

Or since the environment is so competitive, is there just this race to the bottom with everybody?

I wouldn't -- it's obvious from some of the questions out there that there is this notion that when fuel profitability is very strong, we invest more in price and that's driving our gross margin down.

I actually don't think that's true for this particular calendar year.

We had a price program in place as part of Restock Kroger.

We knew what we wanted to invest this year.

Washington gave us a Tax Reform Act that lowered our cash taxes.

We elected to pull some of our investments from '19 into '18 to get that expense behind us in the first year.

The lower taxes start to drive better growth in those categories as we get into '19.

I don't -- I wouldn't say that we've made any big moves on pricing as a result of strong fuel margins, it's just where everything shakes out.

Yes.

The other thing, I think it's always important to remember when we go to market, our fabulous associates in terms of the great experience they deliver in fresh product is also important.

So for us, it's the overall shopping experience that we're trying to create for the customer.

And we're aggressively investing in the Anything, Anytime, Anywhere so they can do it anyway they want to, whether that's digital, delivery, pickup or physically in a store and have the same great experience and great fresh product in all those together.

Okay.

And then just a quick follow-up on the OG&A line.

I would say, historically, your unionization was thought of as kind of a knock on the business.

And today, I would say that the expansion into online and digital is seen as needing incremental investment in OG&A.

But would you say we're at a point where the unionization may be helping you in some ways, given the tightness of the labor environment?

And is there anything you can do to dispel online grocery necessarily adding meaningfully to SG&A or bringing down the margin there?

I think when you look at our workforce overall, whether you're unionized or nonunionized, when I look at -- because not 100% of Kroger is unionized.

And when I look at overall results in a unionized market versus a non-unionized market, whether it's -- at the end of the day, the OG&A rate and what you pay associates to perform their jobs, when you look at your employee relations, employee satisfaction, there's really not a tremendous difference between those, particularly in the wages.

But we offer all of our associates a great health care option and if they're in a union, they're in a more defined benefit plan.

If they're not in the union, they would be -- some of them will be in a defined benefit plan, but some are in a defined contribution plan.

So it's really a mix of benefits inside those.

When I look at some of the home delivery and the online stuff that you refer to, there's a lot of cost in that system that everybody can point to and say how you're going to do it.

It's one of the reasons we joined up with Ocado to build the fulfillment centers that we're going to start building, and we announced the first one here in Cincinnati.

While there are certain costs that will add as a part of the total supply chain for the customer, there are other parts of that cost that will come out of the supply chain -- more efficient picking because it's done robotically, it's done significantly faster on a 50-item order compared to how long it takes a 50-item order inside the store.

I don't take product from the manufacturer to the warehouse to the store.

I take it from the manufacturer to the Ocado warehouse, and then it goes right from there to a customer.

So there's different efficiencies which is, overall, why we think that's going to help offset some of the costs people are worried about.

And the next question comes from Paul Trussell of Deutsche Bank.

Could you speak to any additional color around your digital business?

I know you mentioned up 60%.

Just kind of what you're seeing out of Kroger Ship versus pickup and Home Chef.

In addition, if you can maybe just speak to the new pilot with Walgreens.

There's a whole host of questions there, and I'll just...

That was a good one question.

I'll try to organize it in a way that makes sense.

As you mentioned, our digital business overall grew over 60%.

All pieces of the digital business continues to grow.

The -- if you look at what was the biggest drivers of the growth, it would certainly be continuing to add locations where customers can pick up and get delivery.

From an online standpoint and the stores that were -- already had it a year ago, their continued growth, and then Home Chef as well.

Home Chef would be pretty much exactly where we thought it would be from a growth standpoint or where Pat and his team thought they would be and then we were part of it.

If you look at Ship and some of the other pieces, it's still pretty early in the process.

We would have had a lot more expenses in terms of setting up where all the systems worked versus so much of a sales driver.

But obviously, over time, you would expect that to become more of a sales driver, but that is very early in the ramp.

The relationship with Walgreens, it's -- both of us are very excited about what it can be, but it's one of the things where you really have to start small and learn from it.

And that's really the prioritization is let's take baby steps and see if we can identify something that works for a Walgreens customer and a Kroger customer in some way that both of us can grow our business and make money.

So excited -- that thing, I guess, I'm most excited about is when I spend time with our combined teams and their openness and aggressiveness on trying to identify something that's great for our customers, for both of our customers, is the thing that's so exciting.

But it's pretty early to be able to start giving some more specifics than that.

I appreciate the color.

And then just to quickly circle back on inflation or lack thereof.

It's clearly a benign environment in terms of the impact to your third quarter results.

I just wanted to just circle back on your outlook as you think about what's to come over the next few months.

Any change in your outlook on inflation, deflation impact to your results?

Yes.

I would say no.

I don't really see a lot out there.

I know there's a lot of noise in the marketplace about CPG companies pushing price increases through and the like.

Over time, that -- we'll see where that goes and how everybody winds up reacting to it.

Keep in mind, when we talk about inflation, deflation, it's relative to Kroger and not marketplace forces necessarily.

So it's our cost of goods this year versus our cost of goods last year.

And as everybody knows, a key component of driving the $400 million of operating profit over the next 3 years is continued improvement in cost of goods.

So some of that deflation is actually doing things to get better pricing inside Kroger and that may not be something that's replicated at other places.

The other thing, I think, it's always important to remember is I always think it's a dangerous thing for CPGs to raise their cost more than what the economic cost of something increasing.

And what we find, over time, when somebody does that, our own brands will pick up a disproportionate amount of share whenever somebody does that.

So to me, it's a fine balance that we're all doing to try to find what's that optimal price point.

And that final question will come from Robbie Ohmes of Bank of America Merrill Lynch.

Just a couple of quick ones.

Sorry if I missed this.

Mike, can you give us traffic versus ticket in the quarter?

And maybe Rodney chime in, I'm just curious the tone of the customer through the quarter, were there any variances there?

Are you seeing trade-up when you look at what they're doing?

And then also, again, sorry if I missed this, but loyal households, is that -- was that still growing in 3Q similar to previous quarters?

When you look at, overall, the basket value grew a little bit in the quarter, and that's primarily a result of mix of what's going inside the basket.

When you look at transactions in the quarter, when you add in all of the entities, it was up a little bit in the quarter as well.

The tone of the customer, they continue to -- the economy still feels very good.

People continue to buy wine, anything that makes their life easier, they will aggressively buy.

So it wouldn't be anything -- and then from a household standpoint, we did continue to have a slight growth in households as well.

We are incredibly confident about the future of Kroger, especially with Restock Kroger.

One of the exciting things about our earnings call is that many of our associates listen in to better understand and gain insights into our business.

And of course, many of our associates are shareholders as well.

So as always, before we end today's call, I'd like to share a few final comments directed toward them.

Last week, we celebrated Giving Tuesday.

In conjunction with our partner, Feeding America, we set a goal to raise enough money to provide 4 million meals to those in need during this holiday season.

Together with our customers, we raised enough to serve almost 6 million meals, helping us move closer to our Zero Hunger | Zero Waste goal of eliminating hunger in our communities.

Last Friday, a major earthquake rattled Alaska.

We operate 7 Fred Meyer Stores that were affected.

And thankfully, all of our associates and customers inside our stores were safe.

I'm so proud of the awesome job that Fred Meyer and Kroger team did.

Under the leadership of Joe Grieshaber and our teams, everybody worked together to get all our stores opened within 1 day.

Each holiday season, I'm reminded of our privilege to serve more than 9 million customers who shop with us every day.

Every celebration or tradition is as unique as the customer who walks through our door.

Among the hustle and bustle of the season, you welcome our customers and help to make their celebrations brighter.

We lift our customers' spirits and they uplift our spirits as well.

These are just a few examples of what it means to live our purpose to Feed the Human Spirit.

It's an amazing thing of what we can do together.

Thank you for all you do for our customers, communities and each other.

Merry Christmas, Happy Holidays and Happy New Year to you and your family and all those listening in.

That completes our call today.

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