Kroger Company (KR) — Q3 2015 Earnings Call Transcript

Thank you, Emily. Good morning, everyone, and thank you for joining us. Before we begin, I want to remind you that today's discussion will include forward-looking statements. We want to caution you that such statements are predictions, and actual events or results can differ materially. A detailed discussion of the many factors that we believe may have a material effect on our business on an ongoing basis is contained in our SEC filings, but Kroger assumes no obligation to update that information. Both our third quarter press release, which includes a reconciliation of certain non-GAAP measures discussed today, and our prepared remarks in this conference call will be available on our website at ir.kroger.com. After our prepared remarks, we look forward to taking your questions. Thanks, again, to those who participated in our October investor conference in person or via webcast. We appreciate that many of you made the trip to Cincinnati, and as always, we enjoyed the dialogue and the opportunity to show you our stores. I will now turn the call over to Rodney McMullen, Kroger's Chief Executive Officer.

Thank you, Cindy, and good morning, everyone, and thank you for joining us today. With me to review Kroger's third quarter 2014 results are Mike Ellis, Kroger's President and Chief Operating Officer, and Mike Schlotman, Senior Vice President and Chief Financial Officer. Kroger continues to deliver consistently remarkable results. We are well on our way to achieving our 10th consecutive year of lowering costs and reinvesting those savings in our people, products, pricing, and improved store experience, which together are driving our growth. Few can deliver this level of sustainable high performance. After a while, it can be easy to take this consistency and reliability for granted. So it's important to keep in mind that these results are possible only because 375,000 associates engage with our customers every single day. Our associates delivered yet another quality quarter of inspired Customer 1st performance. We continue to implement our growth strategy and consistently deliver on the key performance indicators we first outlined in October 2012. In the third quarter, we achieved our 44th consecutive quarter of positive identical supermarket sales growth, excluding fuel. We exceeded our goal to slightly expand FIFO operating margin without fuel on a rolling 4-quarter basis, and we continued to gain market share. Our third quarter financial results were driven by strong sales and core business performance, which was better than we expected. Higher fuel margins drove our results above our previous guidance range. Our guidance range for the full year assumes fuel margins will not be as strong in the fourth quarter as they were in the third quarter. Mike Schlotman will have more to say about our supermarket fuel operations in a few minutes. How our customers are doing today depends on the stability of their family finances. Overall, our customers continue to spend a little more as confidence in the economy improves over time. While inflation is apparent in certain commodities, fuel prices have been going down, which helps all customers, especially those on a budget. We try to help those customers stretch their food budget in a variety of ways. Our weekly promotions and fuel rewards help, along with price investments. We continue to make natural and organic foods affordable and accessible to all customers, especially with Simple Truth. Our expansive corporate brands offering is resonating with customers seeking high-quality food at very good prices. In fact, our Corporate Brands had their best performance in several years in the third quarter. Our ability to deliver this combination of value sets us apart. Now I will turn it over to Mike Ellis to discuss our operational performance in the third quarter. Mike?

Thanks, Rodney. Good morning, everyone. During the third quarter, we continued to grow the number of loyal households, and our loyal household count grew at a much faster rate than total household growth, which, incidentally, was also up for the quarter. Loyal household growth is an important measure of our business because it lets us know how well we are connecting with our best customers. Inflation increased in the third quarter, as Rodney mentioned, among commodities such as meat and pharmacy, and increased to a lesser extent in all other supermarket departments. As Mike Schlotman will discuss shortly, we raised our LIFO charge estimate for the year again this quarter due to the higher-than-expected inflation. We estimate inflation was 3.5%, excluding fuel, for the third quarter. Even so, we saw strong tonnage growth in the third quarter compared to last year. And in fact, it was slightly ahead of the second quarter's unit growth. Corporate Brands had an outstanding third quarter, representing 27.3% of total units sold and 25.8% of sales dollars, excluding fuel and pharmacy. Corporate Brands experienced its highest sales growth and total retail dollar share of any quarter in the last 3 years. Our rebranding efforts, including the rebranded opening price point in Kroger banner brands, are resonating well with our customers. Simple Truth and Simple Truth Organics continued to achieve double-digit unit and sales growth. A key driver of Kroger's sustainable growth is Customer 1st innovation. For the past few quarters, we have been highlighting innovations that are improving our connection with customers. This quarter, I will highlight some of the new and exciting work of our manufacturing team in the dairy department. We recently opened a state-of-the-art dairy processing plant in Denver. We built and engineered the plant to deliver exceptional quality and freshness for our customers and to provide an avenue for innovation in the dairy category. We incorporated new technologies for our customers that ensure our milk will stay fresher longer than ever before. We are the first dairy in the U.S. to deploy robotic technology that enables us to pack cases and pick and palletize orders entirely by automation. Another innovation that this dairy will bring is the ability for us to produce long shelf life products to meet growing demand for aseptic products and packaging. The dairy, our first ground-up manufacturing plant of any kind in 20 years, opened in May and began full production of fresh milk in August. We have been producing fresh milk, organic milk, juices and drinks, and customer response has been very, very positive. Now I'd like to give a brief update on labor relations. We recently completed several successful contract negotiations covering Smith's associates in New Mexico, Fry's and Smith's associates in Arizona, Food 4 Less associates in Southern California, and Kroger associates in Toledo, West Virginia, and the Ohio Valley. We are currently negotiating with the Teamsters covering several distribution and manufacturing facilities. 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, should have a shared objective: growing Kroger's business profitably, which will help us create more jobs and career opportunities and enhance job security for all of our associates. Before I turn it over to Mike Schlotman, I'd like to thank our associates for the impressive quarter. Once again, you showed our customers how much we care about them, and each and every day, you continue to deliver. Because of your efforts, we are able to continue investing in our products, lowering prices, and improving the shopping experience in ways that generate customer loyalty.

Thanks, Mike, and good morning, everyone. As you know, when we outlined our growth strategy in 2012, we identified the key performance targets for our shareholders to measure our progress. I'd like to spend a few minutes discussing the results in each metric. Our first metric is identical supermarket sales without fuel. Identical sales performance is the best measure of our growing connection with customers over time. We're very pleased with our third quarter ID sales growth of 5.6% without fuel. This strong performance was supported by ID sales growth in every supermarket department and division, and our natural foods department continues to lead with double-digit growth. Rolling 4 quarters FIFO operating margin, excluding fuel and adjustment items, expanded by 9 basis points. This exceeded our goal of slightly expanding FIFO operating margin without fuel on a rolling 4 quarters basis. We are not reporting our third metric, return on invested capital, this quarter because the calculation would actually overstate our result. We expect our year-end return on invested capital, which will fully reflect Harris Teeter in our calculation, to be similar to our return on invested capital at the end of fiscal 2013. Now I'll share the rest of our third quarter 2014 results in more detail. Please note that this quarter includes Harris Teeter in Kroger's consolidated results of operations. Year-over-year percentage comparisons are affected as a result. In the third quarter, our net earnings totaled $362 million or $0.73 per diluted share. This includes a $0.04 benefit in the third quarter due to certain tax items. Excluding these items, Kroger's adjusted net earnings were $345 million or $0.69 per diluted share for the third quarter. We view these tax benefits as nonrecurring. So as you begin to think about 2015, please note that we will not be growing off of that next year. Net earnings in the same period last year were $299 million or $0.57 per diluted share. Last year's third quarter net earnings per diluted share benefited from certain adjustments totaling $0.04 per diluted share. Excluding these adjustments, last year's third quarter net earnings were $0.53 per diluted share. We recorded an $85 million LIFO charge during the quarter compared to a $13 million LIFO charge in the same quarter last year, resulting in an incremental $0.09 per diluted share charge to net earnings in the third quarter compared to the same quarter of last year. We began fiscal 2014 estimating a LIFO charge for the year at $55 million. At the end of the first quarter, we increased our LIFO guidance to a charge of $90 million, and at the end of the second quarter, we increased our LIFO charge estimate for the year to $100 million. As reported this morning, we have again increased our LIFO charge estimate for the year to $180 million. FIFO gross margin decreased 2 basis points from the same period last year, excluding retail fuel operations. Operating, general and administrative costs plus rent depreciation, excluding retail fuel operations and adjustment items, decreased 21 basis points as a percent of sales compared with the prior year as a result of good expense control and strong sales leverage. Now for retail fuel operations. In the third quarter, our cents-per-gallon fuel margin was approximately $0.232 compared to $0.171 in the same quarter last year. This does not include debit and credit card fees. Last year's third quarter margin was well above historical averages, which means this quarter's margin performance was remarkable. Our long-term financial strategy continues to be to maintain our current investment grade debt rating, repurchase shares, have an increasing dividend, and fund increasing capital expenditures. Achieving a 2 to 2.2 net total debt to adjusted EBITDA ratio by mid to late 2015 remains a key objective. Kroger took on debt to finance the Harris Teeter merger and has yet not realized the full year Harris Teeter EBITDA. As a result, the company's net total debt to adjusted EBITDA ratio increased to 2.29 as of the close of the third quarter compared to 1.86 during the same period last year. This is an improvement from the 2.33 reported last quarter. Kroger's net total debt is $11.5 billion, an increase of $3.4 billion from a year ago, including the debt related to the Harris Teeter transaction and Kroger's share repurchase program. Kroger's strong financial position allowed the company to return more than $1.8 billion to shareholders through share buybacks and dividends over the last 4 quarters. During the third quarter, Kroger repurchased 600,000 common shares for a total investment of $29 million. All $500 million of the buyback authorization granted in June remains available. Capital investments, excluding mergers, acquisitions, and purchases of leased facilities, totaled $681 million for the third quarter compared to $641 million for the same period last year. We expect capital investments to be at the low end of the $2.8 billion to $3 billion range, including Harris Teeter, for fiscal 2014. Now I'd like to review our updated growth objectives for fiscal 2014. Based on our strong third quarter results, we raised and narrowed our adjusted net earnings per diluted share guidance to a range of $3.32 to $3.36 for fiscal 2014. The previous guidance was $3.22 to $3.28 per diluted share. For the fourth quarter of fiscal 2014, Kroger expects identical supermarket sales growth, excluding fuel, of approximately 4% to 5%. We acknowledge this is a wide range for one quarter, and we are seeing great strength and momentum at the start of the fourth quarter, but this year's fourth quarter is difficult to project narrowly because of the uncertainties relative to a year ago, including the positive effect that weather had on our identical supermarket sales during last year's fourth quarter. As you start to think about fiscal 2015 estimates, we encourage you to build your models based on fiscal 2014 adjusted results, which exclude certain tax benefits and charges related to the restructuring of certain pension plan agreements. If fuel margins return to historical levels, we expect 2015 results to be closer to the low end of our long-term net earnings per diluted share growth rate guidance of 8% to 11%, and shareholder return will be further enhanced by a dividend expected to increase over time.

Thanks, Mike. Our third quarter performance is further evidence that Kroger is improving our connection with customers and delivering growth for our shareholders. We continue to increase capital investments, which creates exciting opportunities for our business and for our associates. We enjoyed discussing several of those opportunities with you during our investor conference in October. Our positive momentum is expected to carry through to the fourth quarter and sets us up well as we look to 2015. More importantly, Kroger's to-do list remains longer than our done list. There is a lot more to come.

I have a couple of questions about your guidance and this quarter. Gas margins have significantly outweighed the higher LIFO charge this quarter, and this year has been exceptional in terms of earnings growth. Looking ahead to next year, Mike, you mentioned the lower end of the earnings growth range. I realize you're following a very strong year. My question is whether this year's strength was primarily due to exceeding expectations with the Harris Teeter accretion or if it was widespread across both the core business and Harris Teeter. If it was mainly due to Harris Teeter, that might explain why you're projecting at the lower end of the 8% to 11% range for next year. However, if the growth was broad-based across both areas, are you simply being conservative for next year, despite this year's impressive performance?

This year has been very strong for us with impressive ID sales across all departments and divisions. Our core business is doing exceptionally well, and it's not just incremental gains from Harris Teeter, but strong performance from all our core operations. The reason we're projected to be at the lower end of 8% to 11% for next year is primarily due to fuel prices being at $0.23 for this quarter. The last two quarters have significantly exceeded historical averages in the amount of fuel gallons we sell, as well as our fuel margins.

And is it fair to say that Harris Teeter has come in slightly better than expected for the year so far?

Yes, I would characterize Harris Teeter as performing how we expected them to perform. We've, as has been widely publicized, they've not been shy about advertising it. We've made the price investments in their business that we expected to make during the year. The customers are responding to those price investments, and I would characterize Harris Teeter as right on track with what our expectations would be relative to our overall guidance for the year.

The Harris Teeter team has done a nice job of running their own business, but the other thing is they've been incredibly helpful helping teach all of Kroger some ideas as well. So it's been great so far, and the synergy's moving along as we expected as well.

Okay. And then, just last question. On next year's earnings growth, what's embedded in terms of share buybacks?

We'll give full guidance in March. We just know that at this time of the year, with 3 quarters behind us, clearer fourth quarter guidance, since we only have one quarter left, people start to refine their 2015 estimates. And we just wanted to give some insight of our view of a percentage growth rate and where we would expect to fall in that range as you all start to prepare your estimates for 2015 or refine those estimates. But we'll wait until we give full guidance in March. We feel we've gone far enough with the EPS because our board has its annual business plan review meeting in January, and it's probably better served to let them approve our business plan for next year before I give you too many lines.

It's actually Steve Forbes filling in for John today. In terms of gas prices, we've historically struggled to find a genuine link between gas prices and comparable performance. What trends have you noticed recently with these declines? I know you've mentioned it previously, but are there any specific regions worth noting? You referenced the lower-income consumer; is there any demographic you can elaborate on?

If you examine our own numbers, we struggle to identify some of the same correlations. When gas prices rise, our fuel reward program tends to gain traction. Conversely, as gas prices decrease, consumers have more disposable income. As you know, we view fuel as another service we provide to our customers, offering them an additional incentive to shop at Kroger. Regarding the comments that Mike and I made, we are still observing improvement in the economy. Although it's gradual, it's progressing in a positive direction across all customer segments. However, if you focus on the mainstream demographic and above, those customers have fully bounced back. Customers who are more budget-conscious are seeing improvements, but this is occurring at a much slower and more limited pace.

Okay. Regarding the deployment of these windfalls, what are your thoughts on how to invest these benefits? Do they happen too quickly to allow for proper planning for deployment, or is it better to let them contribute directly to the bottom line? How do you view these one-time or short-term benefits?

If you look at the tax settlements and stuff, we just let those, for the most part, be when they are. And we just disclose it to let you know what it is. And it flows to the bottom line, but it's one-time. If it's things that we think are things that are sustainable, those are the things that we would look at in terms of continuing to invest in the business from a service standpoint and a price standpoint. But it's, as you mentioned, it's always a balance between those 2 pieces, and we are always focused on what's going on in the marketplace and what do we think is the best use of that opportunity when it happens. So it doesn't answer your question directly because the answer's actually different depending on what we see the opportunities to be.

Judah on for Ed. You mentioned in the release and also on the call the kind of rolling 4-quarter x fuel operating margin being a little bit stronger than you expected it to be. I mean, is that a way of saying you would have liked to maybe invest more in price? Or how should we kind of translate that?

I believe this is not about wanting to invest more in price. It's primarily due to having Harris Teeter included for only part of the year, unlike last year when it was not part of the numbers at all. The slight decline in the gross margin I mentioned is similar. If we exclude Harris Teeter from the previous year, we would have seen a significantly larger investment in price aimed at providing value to our customers. The historical performance of Harris Teeter has been better than ours, and it is the comparison of these two factors that is causing some unusual differences in our results.

Okay. And if I could just sneak one more in there, maybe shifting gears. On natural organic, it sounds like it's still comping really well. You've mentioned, in the past, maybe eventually seeing some margin compression in the category. And now that you have one of the bigger players in this space with a national ad campaign out there highlighting value, have you seen anything in kind of the near term on margins there?

I haven't really seen margin pressure overall. We continue to invest in price where we feel appropriate, and the customer really drives our pricing strategy for the most part. But again, we had strong sales growth and double-digit growth in national organics. And to go back to our Simple Truth brand, which will hit $1 billion this year, we're really proud of where that's going and what it's contributing.

I also wanted to ask a bit more on the natural organic. Obviously, Simple Truth continues to perform very well. But can you also give us a little color on how some of the other categories and products within natural organic are doing? And maybe touch upon, also, some of the Vitacost products?

Well, in natural foods, the expansion of item selection is continuing to grow. And you're finding more and more products in the dairy category. We just introduced a new line, the Simple Truth lunch meats. So there's a lot of activity. And we're still finding so many of our customers that didn't shop natural foods are beginning to migrate over to that business, which has been really, really good for us. On the Vitacost piece, we're still in a honeymoon. It's only been a couple of months since we merged with Vitacost, and there's a lot of work going on, but we have big plans for Vitacost, and we're excited about the merger. I've been to the facilities, down to their offices, to their warehouses, and it's a great business that we have. And we're excited about where we're going to go into next year.

Okay. Great. And just a follow-up, if I may. Regarding your relationship with dunnhumby, as you continue to see growth in your loyal households and customers, I understand you're not only focused on encouraging your current loyal customers to spend more but also on converting others into loyal customers. Can you discuss any new strategies or insights you’ve gained as you've been working through this?

If you look at all of our data insights, and dunnhumby that you referenced is obviously one piece of that, but there's a lot of other insights, you're continually getting insights and testing things. And the things that work, you do more of, and the ones that don't work, you stop doing. And that never stops. So it's an ongoing basis in terms of trying to understand customer needs. So if you think about your earlier question on natural and organics, well, that's some insights from our customers. But one of the things our customers are very clear is they don't want to have to pay a premium for natural and organics, and we're trying to make sure that we have where they can get a good-quality product at a price that's comparable to the nonorganic brands and, in some cases, actually the same price.

So I just wanted to just touch on inflation. Clearly, you had a nice benefit in inflation this quarter. I just want to see if you guys can share, maybe, your early thoughts for inflation for the upcoming year.

As we discuss our current situation, we expect that inflation next year will likely be somewhat more moderate than this year. However, I'm cautious about making predictions, especially given the volatility in our LIFO charge related to inflation. In the protein categories, inflation doesn’t seem to be easing. Chicken prices could stabilize if corn prices remain low, but we anticipate that beef and pork will likely face close to double-digit inflation again next year. Regarding milk, current federal market order trends suggest that prices may decrease somewhat, which would benefit several categories next year. Overall, considering the trends in key input categories, we foresee inflation being a bit lower than the 3.5% currently projected.

We believe it’s important to note that over the past decade, Kroger has effectively navigated various inflationary conditions, whether facing deflation or inflation. While there is often a challenge when circumstances shift dramatically, our associates have consistently demonstrated their ability to adapt to all market environments.

That's helpful. Now, shifting to your ID sales, do you think that you are gaining new customers at a faster rate compared to earlier this year?

The exciting aspect, as Mike noted in his prepared comments, is the strong growth we're experiencing with our current customers, alongside the addition of new loyal shoppers. This growth is well-balanced on both ends, which is particularly thrilling. It has actually increased a bit compared to earlier in the year, although we did see strong performance then as well. Mike, would you like to add anything?

No, I think you covered it. It's been solid, yes. Thank you, Rodney.

I have a strategic, long-term question regarding the company's growth trajectory. You kindly took us to a Marketplace store recently converted from a regular grocery store, and it appears that the conversion has been successful. I'm trying to understand how Kroger is positioned, as it seems you have a superior model at this point, with the Marketplace store being a significant element. Historically, in the late '60s and early '70s, Kroger underwent a substantial store upgrade cycle that transformed it into a strong performer, as noted in Jim Collins' work. How close are we to entering a major upgrade cycle for your store fleet where you deploy the Marketplace concept more aggressively? That's my first question about your long-term growth.

We are very enthusiastic about the Marketplace stores and how we are utilizing all our formats together. This is one of the reasons we committed a couple of years ago to increasing our capital investment by $200 million each year, and we are still on track with that. We believe this amount is appropriate to enhance our capital capacity in order to operate the store at the level you observed, while also maintaining a balance with our cash flow. As long as we continue to achieve the expected performance from those stores, we will keep increasing that capital investment. This was the motivation behind our decision in October 2012 to raise our capital allocation by $200 million annually. Mike, do you want to add anything?

I agree with that. As you know, Scott, we continue to expect an increase in capital over the next several years by incremental amounts. If there's one disappointment I have so far this year, it’s that we are at the low end of our CapEx guidance. Some people believe we spend too much on CapEx, but that just means some stores aren't being developed as quickly as we had hoped. It doesn't indicate a lack of confidence in the new stores we're opening; it’s simply a matter of timing for these projects, and they will be completed. We remain very optimistic about our ability to continue opening new stores and having them perform well.

We now have Marketplace stores in nearly every division of our company across the country, and we are very pleased with the success of the Marketplace store. Regarding remerchandising, you've likely noticed apparel in some of our stores. We are experiencing success with some of the new brands and products we're introducing. We are continually refining our model to ensure it remains relevant to the customer, and we are very satisfied with our current offerings.

As a follow-up, what are your thoughts on how many stores in the fleet could eventually become Marketplace?

We probably do, but probably not for public consumption at this point, Scott. The other thing to keep in mind is, as we go down this path, and you'll probably see it a little clearer as we get into next year, we continue to invest in our business. And a fundamental piece of being able to invest in our business is continuing to generate a really good return on our new investments. And some of those dollars, we make conscious decisions of how many fall to the bottom line and how many we invest back into the business and the people, product, shopping experience and price. And while I know a lot of you would think that we should be at the end of investing in price, we still see plenty of categories and particular sections of the store where we have an opportunity to be more price competitive than we are today. So we're, in some respects, counting on that continued good results from that deployment of capital to both increase to have the 8% to 11% earnings per share growth and have the dollars generated to invest back in our business.

I have one more question before I yield. This relates to long-term growth and M&A, which we discussed at the Analyst Day. It appears that with Kroger, the fuel program, dunnhumby, and customer insights, you have developed a better approach. From my perspective, as you assess potential M&A activities, it seems like you have a checklist of criteria for what to look for in a target company. However, given your current business success, it feels like the situation might be different now. Do you have any additional thoughts on this? I know I brought this up at the Analyst Day, but I wanted to revisit the topic.

Yes, I wouldn't say there's anything significantly different from what we've previously answered. One of the key factors in any merger is how the people who manage the business align with our culture and values. This is one of the reasons we refer to mergers rather than acquisitions. While this standard limits the number of opportunities, we find that when people share that standard, they appreciate it in the reverse as well. It's worth noting that two of our last three CEOs came from one of our merged companies, along with several of our senior officers.

And our current President came out of one of the merged companies. So I think you're right when you say it's almost a checklist because it is, but it's something that's really worked well for us.

And just to follow up, considering it was a lengthy question, is there an increase in new users who are trying our service for the first time?

Yes, there are new customers constantly entering the natural, organic, and healthy foods category. This shift is largely due to improved selection and competitive pricing on our end. Interestingly, many customers switch to these products because they believe some items taste better. Taste is a significant factor, and in some cases, it’s the product innovation that attracts them. So, it’s not solely about a desire to live healthily or consume organic products; the appeal is much more diverse.

Thank you. Before we end today's call, I would like to say a few words about Dave Dillon, who is listening in this morning. All of you know Dave well, and this is his last official meeting as Kroger's Chairman. Dave has been a friend and a leader to all of us and a mentor to many of us. Thousands of associates can relate to that comment. For me, personally, Dave has been a partner like no other. On behalf of the entire Kroger family, we wish Dave and his family all the best as they begin the next chapter together. Dave, thank you from all of us. Finally, I'd like to share some thoughts about our associates listening in. During the next few weeks, there will be a lot of activity in our stores as we help customers prepare for their holiday celebrations. Thank you for helping make the holidays brighter for our customers and the communities we serve and live in. During Kroger's season of giving, with your help and the help from our customers, we will donate 30 million meals to local food banks. Customers will have the opportunity to add their support by dropping change into coin boxes at check stands and donating nonperishable food in collection barrels in stores. Thank you for all that you do for our customers and each other. Merry Christmas. Happy holidays to you and your family. That completes our call today. Thanks for joining.