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Second Quarter 2009
Investor Conference Call Prepared Remarks
September 15, 2009
Carin Fike, Director of Investor Relations:
Good morning and thank you for joining us. Before we begin, I want to remind you
that today’s discussion will include forward-looking statements. We want to
caution you that such statements are predictions, and actual events or results
can differ materially. A detailed discussion of the many factors that we believe
may have a material effect on our business on an ongoing basis is contained in
our SEC filings, but Kroger assumes no obligation to update that information.
Both our second quarter press release and our prepared remarks from this
conference call will be available on our website at www.kroger.com.
After our prepared remarks, we look forward to taking your questions. In order
to cover a broad range of topics from as many of you as we can, we ask that you
please limit yourself to one topic with one question, and one follow-up
question, if necessary. Thank you. I will now turn the call over to David
Dillon, Chairman and Chief Executive Officer of Kroger.
Comments by: Dave Dillon
Thank you, Carin. Good morning everyone. Thank you for joining us today.
With me today to review Kroger’s second quarter 2009 financial results are
Rodney McMullen, Don McGeorge, and Mike Schlotman.
As many of you know, Don announced his decision to retire earlier this year and
will remain with us in an advisory capacity for the next few months. Rodney was
named President and Chief Operating Officer effective August 1st. In a few
minutes, Rodney will offer details on certain aspects of our performance during
the quarter and then Mike will provide details on the financial elements we
report. First, I’ll start with an overview of the current environment.
Second Quarter Overview
We are pleased with our performance this quarter as it aligns with our long-term
strategy of winning households for life, making Kroger a stronger retailer now
and in the future. Our customers are increasingly turning to Kroger’s family of
stores to meet even more of their everyday household needs. As a result, our
customer-focused strategy is generating and will continue to generate solid
long-term value for Kroger shareholders.
Identical supermarket sales increased 2.6% in the second quarter, without fuel.
This is a solid increase, particularly considering changes in customer behavior
and significant deflation in Produce and Dairy. In fact, our product cost
inflation estimate, excluding fuel, dropped to a negative <0.2%> from the
positive 3.6% we estimated in the first quarter. The increase in identical
supermarket sales also signals that more customers are turning to Kroger to
consolidate purchases, driving the exceptional unit growth we saw in the
quarter.
In fact, this is a quarter where we believe our identical sales results do not
fully reflect the strength of our business. Our comments today should give you
some additional perspective. Growth in the number of loyal households we serve
is just one example. Loyal households represent our very best customers. During
the second quarter, our data showed a strong increase in the number of loyal
households that shop our stores. Our data also indicates these customers are
making more trips to our stores and buying fewer items per trip. Yet, over the
course of a month, these households are buying more total items from Kroger than
they were a year ago, which indicates they are consolidating more of their total
spend with us.
In addition to deflation and changes in customer behavior, two other factors
influenced Kroger’s results this quarter: planned investments and competition.
As a result of all of these factors, gross margin declined more than expected.
Rodney will share details on each of these factors with you shortly. But first I
will update you on Kroger’s exceptional tonnage growth and discuss guidance for
the remainder of the year.
Tonnage Growth
Our overall tonnage growth in Grocery increased at almost double the rate we
experienced in the first quarter. Strong Corporate Brand sales drove overall
tonnage growth in Grocery, just as it has for the past two quarters. We also saw
tonnage growth in National Brand products. This is a trend change from the past
three quarters where we had seen declines in National Brand unit sales.
We experienced very strong tonnage growth – particularly in Dairy, Meat and
Produce – as customers responded positively to lower costs and better pricing.
I want to thank our associates in our plants, warehouses and stores who are
doing an outstanding job keeping up with the tremendous volume growth we are
generating. Keep up the great work!
2009 Outlook
Looking ahead to the rest of the year, we have confirmed our full-year identical
supermarket sales guidance of 3% to 4%, without fuel, for fiscal 2009. This
guidance assumes product costs for the remainder of fiscal 2009 are consistent
with or slightly lower than they were in the second half of fiscal 2008.
We have revised our 2009 earnings per share guidance to reflect continued
changes in customer behavior and an uncertain operating environment. We now
expect full-year fiscal 2009 earnings of $1.90 to $2.00 per diluted share. This
is a wider range than our previous guidance of $2.00 to $2.05 per diluted share
because of the uncertain economic environment and the subsequent caution on the
part of customers.
In the short-term, there are several factors influencing our business that
caused us to change our original projections. These factors may continue to
influence Kroger’s financial results for the remainder of the year and will help
determine where in the earnings guidance range we end the year. Scenarios that
would lead to earnings per share at the high end of the range include:
- Improvement in customer sentiment that leads to a sales mix change which
enhances Kroger’s gross margin;
- Moderating deflation in Produce and Dairy;
- A lessening of competitive or promotional activity in key markets; and
- Stronger margins in our retail fuel business than we currently anticipate.
The reverse of these scenarios could lead to a result at the lower end of the
guidance range.
Despite the challenging operating environment, we remain on our plan, and we are
confident our approach and the investments we are making will continue to make
Kroger a stronger retailer now and in the future.
Now I will turn to Rodney who will discuss other aspects of our performance
during the quarter. Rodney?
Comments by Rodney McMullen:
Thanks, Dave. Good morning everyone. The Kroger team produced solid results in
the second quarter. As Dave said, four primary factors influenced our results
this quarter: deflation, changes in customer behavior, planned investments that
were part of our original plan, and competition. I want to take a few moments to
discuss each of these factors with you, beginning with deflation.
Deflation
In general, we can grow our business in an inflationary or deflationary
environment. But sudden deflation in a highly competitive market can lead to
retail prices – and product costs – that drop quickly, creating lower margins.
This was the case in the second quarter. In categories like milk and produce,
where we experienced significant deflation, we certainly sold more units, but
lower retail prices and profit per unit pressured our second quarter results.
And, for the first time in several quarters, we began to see deflation in most
grocery categories.
Changes in Customer Behavior
We continued to experience changes in customer behavior during the quarter.
Consistent with the past two quarters, customers are buying more of what they
need and less of what they want. The most prevalent trend this quarter was the
willingness of customers to switch within a product category. For some
customers, it meant switching from one national brand to another lower priced
national brand. For other customers, it meant trying a Kroger brand or switching
to our Value brand. Our Corporate Brands continued to enjoy exceptionally strong
growth, in fact continued double digit growth in units, representing 26% of
grocery sales dollars and 35% of grocery units sold. This is almost 200 basis
points higher than their unit share in the same quarter last year.
Another trend we are seeing is in food stamps and other benefits. Government
data indicates an increase in these benefits due to the economy. At Kroger, we
are seeing an even sharper increase in our sales from customers using food
stamps.
While all of these changes in customer behavior can adversely affect Kroger’s
sales and profitability in the short-term, they do benefit us in the long-term
because it keeps customers in that category and in our stores.
Planned Investments
As part of our overall strategy, we plan our price investments strategically and
make decisions based on our deep insight into customer behavior through our
partnership with dunnhumby. This is a competitive advantage for Kroger. As a
result of our insight, we move some planned investments up and delay others
based on the competitive market and customer behavior, as we did during the
quarter.
Competition
The competitive landscape also changed during the quarter. While our industry
has always been competitive, we did see heightened activity in more markets than
we typically do. This is not surprising because customers are spending less and
retailers are aggressively competing for their dollars. We continue to enhance
Kroger’s strong competitive position in this environment. Our positive identical
supermarket sales results and strong tonnage growth demonstrate our ability to
continue to gain market share in all economic environments.
Delivering Value
As part of our customer-focused culture, we deliver value in a number of ways
through our people, products, prices and the overall shopping experience in our
family of stores.
Additionally, our Fuel Rewards program continues to reward our most loyal
shoppers through discounts on fuel earned through their purchases inside our
supermarkets. No other U.S. grocery retailer can currently replicate the value
proposition we offer. Customer response to our programs and initiatives
continues to be overwhelmingly positive. Through these types of investments, our
customers have saved $1.5 billion in the past year.
Labor
Let’s turn now to labor relations. Last month, our associates in Dayton, Ohio
ratified a new agreement. Negotiations continue in Atlanta, Arizona and Portland
and we have contract extensions in all three markets. In Colorado, our efforts
at the bargaining table have not produced an agreement. We have made a balanced,
strong offer for a new contract there and we expect it will be in the hands of
our associates for a vote soon. We are hopeful that our associates will approve
the offer without a work stoppage. In Dallas, the contract for our store
associates expires later this year. In addition to the normal pressures on our
business, rising health care costs and underfunded pension plans will have to
play out at the bargaining table. Still, we continue to be a destination
employer that is hiring and promoting associates in this tough economic climate
and offering high-quality, affordable health care for associates and their
families.
Now Mike will offer additional color on the quarter. Mike?
Comments by Mike Schlotman:
Thanks, Rodney. Good morning everyone. I will review several aspects of Kroger’s
second quarter performance beginning with net earnings.
Net Earnings
Kroger’s second quarter net earnings were $254.4 million, or $0.39 per diluted
share. This compares with net earnings of $276.5 million, or $0.42 per diluted
share, in the same period last year. We estimate that our retail fuel operations
added a penny less to second quarter earnings per share this year compared to
the prior year. I’ll cover retail fuel operations in a few minutes, but first
let’s review key financial metrics of our core supermarket business.
FIFO Gross Margin
Let’s start with gross margin. As many of you know, we use a term internally to
measure the difference between the retail price that a customer pays for a
product in one of our stores and the cost we pay to procure that product from a
supplier. This term is “supermarket selling gross margin” and it declined 88
basis points during the second quarter, excluding our retail fuel operations.
This decline is significantly larger than our average investment over the past
several quarters. It reflects the planned investments that Rodney described for
you. It also reflects the unplanned factors he described – including the impact
of sales mix changes, some heightened competitive activity, plus produce and
dairy deflation that has been deeper and more sustained than we anticipated.
These are temporary factors. As they normalize, we would expect Kroger’s selling
gross margin investment to normalize as well.
Kroger’s FIFO gross margin, excluding our retail fuel operations, decreased 60
basis points on a year-over-year basis. The difference between Kroger’s FIFO
gross margin and supermarket selling gross margin is primarily the operating
costs that are embedded in our FIFO gross margin. These operating costs include
shrink, warehousing, transportation, and advertising expenses. During the
quarter, we achieved meaningful improvement as a rate of sales in all of these
areas. In addition to lower diesel fuel costs, we were particularly gratified to
see improvement in logistics and non-fuel-related transportation expense
leverage, given the significant tonnage increase handled by associates in our
distribution system to service the additional customer demand in our stores.
LIFO
Turning now to LIFO, we recorded a $14.7 million LIFO charge during the quarter,
a decrease of $31.5 million from the prior year. We now anticipate a full-year
LIFO charge of approximately $70 million for fiscal 2009. This estimate is based
on our forecast of 1% to 2% inflation for the year. This particular inflation
forecast is based on cost changes for products in our inventory and is used for
our LIFO calculation. The LIFO calculation does not consider the velocity at
which a product moves, only how many units of an item are in inventory and the
year-over-year change in the item’s cost. When Dave referenced 20 basis points
of product cost deflation relative to sales, that calculation did consider the
velocity of product movement.
OG&A
Turning now to Operating, General and Administrative expenses, Kroger’s OG&A
rate, excluding retail fuel operations, decreased 7 basis points compared with
the same period last year. This decline reflects strong cost controls, lower
incentive compensation expense, and our ongoing efforts to control utility costs
through several of our efficiency initiatives. We also enjoyed some relief in
expenses tied to petroleum costs – for example, the plastic shopping bags
provided in our stores.
We are very pleased by this OG&A performance. Achieving OG&A leverage is
particularly challenging in an environment of declining retail prices and higher
unit sales, and we appreciate the progress our team made in this important area.
We continue to see opportunities for additional operating cost savings, which
will be important as we face ongoing cost pressures in pension, health care
expenses, and credit card fees.
Operating Margin
Kroger’s long-term objective is to balance cost savings with investments. While
we did not meet that objective this quarter, we believe the period was a
short-term anomaly. Total operating costs did decline and we are pleased with
the direction, especially considering the effect of deflation on the top line
and strong unit growth. Through the first two quarters of fiscal 2009, Kroger’s
operating margin, excluding our retail fuel operations and the benefit of a
lower LIFO charge, decreased 17 basis points. On this basis, we now expect a
slight decline in Kroger’s operating margin for the year.
Retail Fuel Operations
Let’s turn now to Kroger’s retail fuel operations. Kroger now operates more than
800 supermarket fuel centers and about 700 of our convenience stores sell fuel.
Gasoline is an important part of Kroger’s “one-stop” shopping strategy, allowing
us to offer a convenient service at a great value to our loyal customers.
Customers continue to respond well to our fuel offering. During the quarter, we
sold more fuel gallons – both on an absolute and identical basis.
In the second quarter, the cents per gallon fuel margin for our convenience
stores and supermarket fuel centers was 13.6¢ compared to 17.9¢ for the same
period last year. Because of the margin volatility inherent in selling large
volumes of fuel, we always encourage investors to take a longer view of this
part of our business. On a rolling four-quarters basis, the cents per gallon
fuel margin was 13.3¢ this year compared to 12.0¢ for the same period a year
ago. Please keep in mind that the fuel margins we realized in fiscal 2008,
particularly in the second and third quarters, were exceptionally strong. Our
expectations for the current fiscal year are based on a more normalized fuel
margin of 11¢ per gallon.
Financial Strategy
Now I’d like to update you on Kroger’s financial strategy, beginning with
capital investment.
Capital Investment
We continue to view the current environment as an opportunity to improve
Kroger’s store base and overall operations. We believe capital investment is
important for the continued growth of our business as it positions Kroger as an
even stronger retailer in the future and we continue to see returns above our
hurdle rate. For the second quarter, capital investment, excluding acquisitions
and purchases of leased facilities, totaled $518.0 million, compared to $461.1
million in the prior year. On this basis, through the first two quarters of
fiscal 2009, we have invested $1.1 billion. We continue to project fiscal 2009
capital spending of $1.9 to $2.1 billion, excluding acquisitions and purchases
of leased facilities.
During the first two quarters of the year, we spent $115.3 million to purchase
some of our leased properties at very attractive rates, including several retail
stores and one distribution center. We expect additional real estate
opportunities to come our way, and we have the financial strength to be able to
take advantage of them.
Debt Reduction and Leverage Ratio
Net total debt was $7.3 billion, a decrease of $198.5 million from a year ago.
On a rolling four-quarters basis, Kroger's net total debt to EBITDA ratio was
1.78 compared with 1.90 during the same period last year. We expect to continue
to improve Kroger’s debt coverages on a year-over-year basis.
Share Repurchase
While Kroger’s bias toward debt reduction remains in the current environment, we
have continued to make some share repurchases. During the quarter, Kroger
repurchased 2.8 million shares of stock at an average price of $21.58 per share
for a total investment of $60.1 million. At the end of the quarter, $425 million
remained under our current stock repurchase authorization.
Dividend
Also during the quarter, Kroger returned $59 million to shareholders in the form
of cash dividend payments. We believe Kroger’s quarterly cash dividend, which
currently yields over 1%, is one way that our Customer 1st strategy rewards
shareholders.
Now I will turn it back to Dave for some closing remarks.
Comments by Dave Dillon
Thanks, Mike. As you can hear from our comments today, we remain on our plan.
Our approach and the investments we are making continue to strengthen Kroger
today and position us well for future growth.
It may seem counterintuitive to hear me so optimistic in such an uncertain
environment, but based on what I am seeing firsthand in our stores, I am
enthusiastic about the “Can Do!” selling passion our associates have embraced.
And our customers tell us they see it too. That is why they are choosing to
spend more time and more money in Kroger’s family of stores. If you haven’t
visited one of our stores in a while, I encourage you to do so. There is an
excitement and energy among our associates that is inviting and is really fun to
see. They are doing an outstanding job and that is why Kroger’s future is so
promising.
With that, we would like to take your questions.
Closing Comments for Associates:
Before we sign off, I would like to share some additional thoughts with our
associates.
First, thank you for your hard work during the quarter. We are making a
difference in the lives of our customers by offering them more and more ways to
save money and take care of their families. You are a direct link to our
customers and we appreciate all you do every day.
I want to say a special thanks to the 55 associates who will be featured on
products for sale in our stores next month as part of our Giving Hope A Hand
breast cancer awareness campaign. These terrific ladies are encouraging others
to take charge of their own health by sharing their personal journeys as breast
cancer survivors with their fellow associates and our customers. They are an
inspiration to each of us and we are fortunate to have them on our team.
On a final note, I want to thank Don McGeorge and congratulate Rodney McMullen.
Don has devoted his 32-year career to The Kroger Co. He has influenced every
aspect of our business over the years. He is a true champion of associates and
customers and we are all indebted to Don for his exceptional leadership –
balanced with just the right amount of humor. Rodney has stepped into the job as
President and Chief Operating Officer. Many of you already know Rodney but for
those who haven’t met him yet, you will find him to be a passionate retailer,
who, like Don and I, started in our stores. We look forward to his insightful
leadership in his new role.
That completes our call today. Thank you for joining us.
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The remarks contain certain forward-looking statements about the future performance of the Company. These statements are based on management’s assumptions and beliefs in light of the information currently available to it. Such statements are indicated by words or phrases such as “confirmed,” “guidance,” “expect,” “anticipate,” and “project.” These forward-looking statements are subject to uncertainties and other factors that could cause actual results to differ materially. Our ability to achieve identical supermarket sales and earnings growth and earnings per share goals may be affected by: labor disputes, particularly as the Company seeks to manage health care and pension costs; industry consolidation; pricing and promotional activities of existing and new competitors, including non-traditional competitors; our response to these actions; unexpected changes in product costs; the state of the economy, including interest rates and the inflationary and deflationary trends in certain commodities; weather conditions; number of shares outstanding; the success of our future growth plans; goodwill impairment; and our ability to generate sales at desirable margins, as well as the success of our programs designed to increase our identical sales without fuel. In addition, any delays in opening new stores, or changes in the economic climate could cause us to fall short of our sales and earnings targets. Our ability to increase identical supermarket sales also could be adversely affected by increased competition and sales shifts to other stores that we operate, as well as increases in sales of our corporate brand products. Our estimate of product cost changes could be affected by general economic conditions, weather, availability of raw materials and ingredients in the products that we sell and their packaging, and other factors beyond our control. Our LIFO charge will be affected primarily by product cost changes during the year. Our fuel margins could fail to normalize at $0.11 per gallon if the pattern of rapid changes in fuel costs continues. Our capital expenditures could vary from our expectations if we are unsuccessful in acquiring suitable sites for new stores; development costs vary from those budgeted; or our logistics and technology or store projects are not completed on budget or within the time frame projected. Our operating margins could fail to meet our expectations if we are unable to pass on any cost increases, if our strategies fail to deliver the cost savings contemplated, or if changes in the cost of our inventory or the timing of those changes differ from our expectations. If our estimates of product cost changes prove incorrect, it could affect our ability to achieve our identical supermarket sales growth and earnings per share growth projections. Our selling gross margin could fail to normalize if our customers purchase a mix of products that generate lower margins; heightened competitive activity continues; and if the deflation in certain categories, including produce and dairy, continue to be deeper and more sustained than we anticipated. Our ability to continue to improve our debt coverage could be affected by unanticipated increases in net total debt, our inability to generate free cash flow at the levels anticipated, and our failure to generate expected earnings. We assume no obligation to update the information contained herein. Please refer to Kroger’s reports and filings with the Securities and Exchange Commission for a further discussion of these risks and uncertainties. ###
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