Kroger Company (KR) — Q2 2016 Earnings Call Transcript

Thank you, Laura. 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 ir.kroger.com. After our prepared remarks, we look forward to taking your questions. Please save the date for our 2015 investor conference, which we will hold at the New York Stock Exchange on October 27. Details will be coming soon, and we hope you can join us.

Thank you, Cindy. Good morning, everyone, and thank you for joining us today. With me to review Kroger's second quarter 2015 results is Mike Schlotman, Executive Vice President and Chief Financial Officer. The next time you see Mike, please congratulate him on his well-deserved and well-earned promotion. We are pleased with our second quarter results. Our 5.3% identical supermarket sales growth, without fuel, allowed us to continue investing in our business and delivering on our aggressive growth plan. Strong fuel margins toward the end of the quarter allowed us to deliver results that exceeded our original expectations. During the second quarter, we achieved our 47th consecutive quarter of positive identical supermarket sales growth. We exceeded our goal to slightly expand FIFO operating margin, without fuel, on a rolling 4-quarter basis. We kept costs down, which, together with identical supermarket sales growth, allowed Kroger to leverage operating expenses at a rate of sales. And we continue to grow market share by improving our connection with customers, which fuels both our top and bottom lines and enables strategic Customer 1st investments. These consistently remarkable financial results are possible quarter after quarter because our business is built on the belief that serving customers is serving shareholders. Based on the strength of our second quarter results, we are raising our net earnings per diluted share and identical supermarket sales growth guidance for the year. While customers continue to feel optimistic about the economy throughout the second quarter, they also continue to tell us they want to spend less. More and more, they want retailers to help them save money with sales and coupons. We are well positioned with our everyday low prices and our weekly sales and digital offers to solve this for our customers. As you know, the food retail business is in a constant state of change. Part of what makes our Customer 1st Strategy so powerful is it provides Kroger a firm foundation from which to approach new opportunities in the right way to benefit our customers, associates and shareholders. While there are many examples where our business is rapidly evolving, I'd like to highlight 3 key areas of innovation and investment today: technology, food and people, and how the steps we are taking in each of these areas are broadening our competitive advantage for the future. We are actively expanding our use of technology in ways we believe will make a difference for customers and associates. This summer, we expanded our online ordering pilot in Cincinnati to 3 additional divisions. We are now offering our 'order online, pick up at the store' solution in select Kroger stores in Louisville and Indianapolis and Fred Meyer stores in the Portland area. This is, of course, in addition to the Harris Teeter's successful Express Lane service. When you think about digital opportunities, we do not limit our focus to e-commerce. Digital for Kroger includes a broad range of efforts to interact with customers in increasingly relevant and meaningful ways, whether online or through our mobile app. A key metric is our measure of digital and household engagement, and during the second quarter, we continued to gain household engagement at record numbers. Our Kroger technology team continues to earn recognition for leading-edge initiatives to establish the Internet of Things in our stores. Earlier this summer, Kroger's electronic temperature monitoring project was named a winner of the CIO 100 Award by CIO Magazine. And as we shared with you in June, the talented team at 84.51° is helping us grow and evolve even faster due to their closer daily involvement in our business. 84.51°'s specialty, helping us make data-driven decisions that truly put the customer first, is a significant competitive advantage for Kroger. Our multitiered Corporate Brands portfolio has always been a powerful differentiator for Kroger. Simple Truth continues to see explosive growth. Private Selection remains a vibrant, billion-dollar brand that is growing in the double digits and developing unique offerings in many categories. I'm pleased to share with you that later this month, we will launch an entirely new brand called HemisFares. HemisFares brings only the best food finds from around the globe to our food-curious customers for an amazing authentic eating experience. It's a guided tour of the best tastes on the earth. Imagine landing in a country known for its incredible food and experiencing the finest examples of its region's most famous and delectable eats. Every HemisFares product is curated from the source and imported directly to our stores. The most exciting part is that no one else has a brand like this. HemisFares is a great example of what makes our Corporate Brands unique, and we think it will appeal to millennials, foodies, and ultimately, all customers. And by the way, I've tried a lot of the products, and it's outstanding. It's not just great. And I think you're going to love it when you get a chance to try it. Our reputation for consistent execution rests squarely on the shoulders of our 400,000 associates who make it all happen in our stores, distribution centers, manufacturing facilities and offices. Our workforce is expanding rapidly to support our growth strategy. Last year, we created 25,000 new jobs, and right now, we are hiring to fill an estimated 20,000 new and permanent positions in our stores. We are looking for people who want to be part of a team, take pride in everything they do and want to grow with us. One important and untapped resource for new associates is our country's military veterans. Since 2009, more than 29,000 veterans have joined our ranks, and hundreds of current associates continue to actively serve in the military. Over the past several years, Kroger has formalized our military hiring initiatives. We joined the 100,000 Jobs Mission, a coalition of companies with the common goal of hiring transitioning service members and military veterans, and we have increased our presence at military recruiting events. Next week, we are hosting our first-ever Honoring Our Heroes hiring event, during which we will hold open interviews at every one of our supermarket locations on Tuesday, September 15, for all veterans and their family members. The fact that nearly 70% of our store managers started out as hourly associates or stocking shelves or bagging groceries speaks to Kroger's opportunity culture, which we believe is a differentiator for us today and will continue to be so in the future. Before I turn it over to Mike, I'd like to comment on our announcement yesterday of a new organizational structure for our senior leadership team. We take a team approach to leadership, and this new structure is designed to better align resources to our company's goals. It also streamlines decision-making and accelerates progress on our growth strategy. As I said in our announcement yesterday, Kroger is incredibly fortunate to have such an exceptionally strong group of leaders across our company, and our senior leadership team has unmatched depth and experience to continue delivering for our customers, associates and shareholders. Now Mike Schlotman will offer more detail on Kroger's second quarter results, provide you an update on labor relations and update our guidance for 2015.

Thanks, Rodney, and good morning, everyone. First, I'd like to spend a few minutes discussing our results for the quarter in each of the key performance target areas for our long-term growth plan. Our first metric is identical supermarket sales without fuel. Our identical supermarket sales growth of 5.3% in the second quarter demonstrates the strength of our core business. Our identical supermarket sales growth was driven by a combination of strong tonnage growth and an increase in the number of households shopping with us in the second quarter. We also met our goal to grow the number of loyal households at an even faster rate than total household growth during the quarter. All geographies and supermarket departments had positive identical supermarket sales, excluding fuel, during the quarter. We continue to see outstanding double-digit identical sales growth in our natural foods department. Our meat, deli and pharmacy departments also posted strong sales. Rolling 4 quarters FIFO operating margin, excluding fuel, the 2014 and 2013 adjustment items and the contributions to the pension and foundation in the third and fourth quarters of 2014, I hope you got all that, increased by 20 basis points. This exceeded our commitment to grow the rate slightly over time on a rolling 4 quarters basis. Return on invested capital on a rolling 4 quarters basis was 14.24%. We are not presenting a comparative number this quarter because last year's second quarter calculation does not include a full year of Harris Teeter assets and results. We continue to expect our return on invested capital for fiscal 2015 to increase slightly from fiscal 2014 results. This is an important metric as we continue to increase our capital investment to drive our future growth. Before I share our second quarter results in more detail, I'd like to discuss how we are successfully managing through the current operating environment, which has more volatility than normal, especially as it relates to fuel margins and inflation. We benefited from higher fuel margins late in the second quarter. As Rodney said, our nonfuel results were right in line with where we expected them to be. We expect fuel volatility to continue for the remainder of the year. Another factor that we are actively managing is product costs. While inflation continued at a lower rate during the second quarter, which we estimate was approximately 1.4% without fuel, some commodities had high inflation and others had deflation. Seafood and milk were deflationary, produce prices were less deflationary in the quarter, and we continue to see inflation in generic pharmaceuticals. It bears repeating that if you look back over the past several years, we have had periods of high and low inflation, and we've shown that regardless of the environment, we will deliver greater value and convenience for our customers. Now I'll share our second quarter 2015 results in more detail. As you know, we don't provide guidance for total sales because of the unpredictable impact that fuel has on our overall results. Total sales in the second quarter were impacted by the lower retail price of fuel, much like the first quarter. The average price of retail fuel during our second quarter was $2.67 compared to $3.54 last year. Total sales in the second quarter increased 0.9% to $25.5 billion compared to $25.3 billion in the same period last year. Excluding fuel, total sales increased 5.7% for the second quarter compared to the same period last year. In the second quarter, our net earnings totaled $433 million or $0.44 per diluted share. Net earnings in the same period last year were $347 million or $0.35 per diluted share. Kroger reported a $21 million LIFO charge during the quarter compared to a $26 million LIFO charge in the same quarter last year. FIFO gross margin, excluding retail fuel operations, decreased 7 basis points from the same period last year. Strong identical supermarket sales growth and cost controls allowed Kroger to leverage operating expenses as a rate of sales in the second quarter. Total operating expenses, excluding retail fuel operations, decreased 35 basis points as a percent of sales compared to last year. Second quarter FIFO operating profit, excluding fuel, increased approximately $93 million over the prior year. Now for retail fuel operations. In the second quarter, our cents-per-gallon fuel margin was approximately $0.19 compared to $0.183 in the same quarter last year. We expect fuel margins to continue to be volatile during the second half of the year. Corporate Brands performance during the second quarter was solid, representing approximately 26.4% of total units sold and 25.1% of sales dollars, excluding fuel and pharmacy. I will provide a brief update on labor relations. We recently agreed to new contracts in Columbus and Memphis and have ratified all the local agreements associated with a master agreement with the Teamsters covering several distribution and manufacturing facilities. We are currently negotiating contracts with the UFCW store associates in Denver and Portland and with the Teamsters covering our Southern California distribution centers. Our objective in every negotiation is to find a fair and reasonable balance between competitive cost and compensation packages that provide solid wages, good quality, affordable health care and a retirement benefit 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 and profitability, which helps us create more jobs and career opportunities and enhance job security for our associates. Our long-term financial strategy continues to be to repurchase shares, have an increasing dividend, fund increasing capital investments and to maintain our current investment-grade debt rating. Our strong financial position has allowed us to return $1 billion to shareholders through buybacks and dividends over the last 4 quarters. During the second quarter, Kroger repurchased 1.1 million common shares for a total investment of $43 million. Capital investments, excluding mergers and acquisitions and purchases of leased facilities, totaled $812 million for the second quarter compared to $672 million for the same period last year. We expect capital investments, excluding mergers, acquisitions and purchases of leased facilities, to be at the high end of the $3 billion to $3.3 billion range for the year. We are turning towards the high end because we see a strong pipeline of high-quality projects, and we continue to be encouraged by the results from our new stores. In order to have a steady flow of projects and increase the total number of store projects, we are spending on stores scheduled to open in 2016 to make sure they are ready to meet our target dates. Additionally, we continue to reduce the amount of time it takes to complete projects. The company's net total debt-to-adjusted EBITDA ratio decreased to 2.02 compared to 2.32 during the same period last year. Kroger's net total debt is $11.3 billion compared to $11.1 billion during the same period last year. Again this year, or again this quarter, we have essentially maintained our absolute debt level while returning $1 billion to shareholders through share buybacks and dividends over the last 4 quarters, investing $3.1 billion in capital on a rolling 4 quarters basis, plus an additional $426 million on mergers, acquisitions and purchases of leased facilities. In other words, we are keeping our commitments to our bondholders and shareholders while delivering value to our customers and increasing opportunities for our associates. Now I'd like to update our growth objectives for 2015. Based on our strong year-to-date performance, we raised our identical supermarket sales growth guidance, excluding fuel, to a range of 4% to 5% for 2015; the prior guidance was 3.5% to 4.5%. We also raised our net earnings per diluted share guidance to a range of $1.92 to $1.98 for fiscal 2015; the previous guidance was $1.90 to $1.95 per diluted share. This range exceeds the company's net earnings per diluted share growth rate guidance of 8% to 11%. Shareholder return will be further enhanced by a dividend expected to increase over time. We continue to expect the third quarter to be at the high end of our long-term growth range, and the fourth quarter to be below the range. Our second quarter results demonstrate that our base business is performing very well. The volatility of fuel in the back half of the year will determine where we end up within that range.

Thanks, Mike. Kroger's business is strong. Our team of associates continues to drive our Customer 1st strategy by taking care of our customers in big and small ways, offering fresh foods and keeping costs down so that we can reinvest those savings in our associates, store experience, products and prices. As a result, we continue to earn customer loyalty and gain market share. We are investing to grow our business for the future while delivering on our promises today. Our stores are hiring to fill 20,000 new permanent jobs. We are expanding our digital and e-commerce offerings. Our confidence in Kroger has never been stronger. Now we look forward to your questions.

I don't want to sound negative, but I'm curious about your guidance for the year. It seems to indicate a slowdown in the two-year comparisons for the third and fourth quarters, even though inflation appears to be improving slightly. Could you provide any insights on this? Are you being conservative with your projections? Any information you can share would be appreciated.

Well, the guidance is always one of the hardest things to estimate. As you know, we've always expected inflation to continue to slow down during the year, and we expect that trend to persist. We're working hard, as always, to ensure that we're on the right track. So far this quarter, we continue to perform within the guidance, similar to our performance in the second quarter. We feel positive about our current position and see exciting opportunities. Mike, did you want to...

Yes, Karen, another thing to keep in mind is if you look at real growth, if you look at our current ID sales trend, and even what we would be projecting, and take away the relatively benign inflationary environment today, it's actually as strong of a real growth as we've had in quite some time, really, going all the way back to 3 or 4 years, actually 4 or 5 years. You really don't see a trend as strong as we have today when you look at it on an inflation-adjusted basis. Our tonnage growth is quite strong. And from our standpoint, as long as we continue to have the tonnage growth in many of the departments that we have, we'll be just fine, because that's the ultimate demonstration of the strength of your business is how many items are the customers buying on a weekly and monthly basis.

Okay, that's helpful. I was also wondering about your updated pension guidance. There seem to be changes in both the company and the multiemployer aspects. It's not clear to me if your previous guidance on the multiemployer included the $60 million that was previously accrued, but it's evident that you've increased the company-sponsored amount. So, you're raising your guidance despite those two headwinds, right?

Yes, the $60 million would have been recorded as an expense when it was accrued. It's important to note that with multiemployer plans, when there's a contractual obligation or actual funds deposited, it is treated as an expense, while in a company plan, contributions might not immediately count as an expense. Therefore, the accounting for the two types is quite different. This doesn’t significantly alter our expectations between the two plans, although there are some differences.

More of a headwind? Okay, I'll get back in the queue.

So I wanted to touch on your pharmacy business. We've seen some of your competitors call out some headwinds within their pharmacy business on the margin line. I just want to get a sense of whether you guys are also seeing some headwinds within your pharmacy business as well on the margin line.

As you know, our total portfolio of businesses is very important to us. Each year, we have some areas that perform well and others that may not. In the pharmacy business, our experience aligns with what some competitors mention. We continue to see strong growth in the number of prescriptions filled, which has been consistent over time, and our pharmacy teams excel at serving our customers. Financially, our situation is quite similar to what others have described. The advantage of having a diverse portfolio is that some segments are clearly growing significantly beyond the overall average.

Okay, great. And then, switching topics to maybe expenses. So the leverage this quarter is much better than what we saw last quarter. Besides sales leverage, was there anything else that may have contributed to the better leverage this period?

I think we have implemented really effective cost controls across various areas of the business. As we often mention at Kroger, strong sales are key. When we achieve over 5% identical store sales growth, the impact on expenses can be significant. However, when our sales surpass our expectations, it can be challenging to increase staffing quickly enough to match the sales growth, and there may be a delay in catching up. That might have played a role, but I wouldn't pinpoint any specific area as particularly problematic. Overall, we've maintained strong cost controls across many locations.

One of the other things that we mentioned on the first quarter, we were pretty aggressive on incrementally investing hours in some places. Some of that, you begin to get the flow of it and you understand, where does it make sense and where doesn't it make sense as well.

So, I have two questions. When you consider the business momentum and your investment needs, do you believe we've reached a point where it's challenging to maintain a slight increase in EBIT margin excluding fuel without making investments that you think won't yield a return? Or do you think we're simply in a phase where the timing of investments has been slower, which is partly why you're seeing the 20 basis points?

When you consider the overall business, I still believe that a slight improvement is the right long-term approach for the business and what generates the most sustainable long-term value. This ultimately benefits our shareholders. It's not always easy to precisely determine every quarter how to invest and how the margins will be impacted. I feel positive about our current position, but I don't anticipate needing to make any adjustments to the guidance we've provided. Mike, do you have any additional insights?

Yes, one important aspect to consider, John, is that we have a portfolio of investments we aim to pursue over time. These are not promotional activities. We aren't planning to engage in unsustainable promotional efforts that do not contribute to long-term growth. We have a range of areas where we intend to continue investing. In fact, some of the strength we are experiencing today can be attributed to investments made in the third and fourth quarters of last year. You make an investment, and after a few months, the benefits start to materialize. This is a key factor behind the strong performance indicators we've seen in the first half. We are working towards a system where we are more thoughtful about when and how we invest, ensuring it aligns with consistent results. I believe we are performing as well as we ever have, and we still have a portfolio of areas where we want to invest.

Rodney, you mentioned the organizational structure, which is quite different from what has been in place for quite some time. You indicated that it's appropriate for this moment. Can you elaborate on the advantages this new structure provides? It seems that many individuals will have more direct reports than they did previously. What adjustments, if any, do you need to make in your tactical management of the business to accommodate this increase in oversight?

A significant part of that is the growth that the team has experienced. I am confident that the growth they've achieved as leaders will enable them to manage a broader scope than they previously did. We are fortunate to have such a talented group of people who have been with Kroger for a long time. They have a deep understanding of our business and our objectives. For me, this change streamlines decision-making by eliminating one layer, which enhances our operational efficiency. The team is collaborating exceptionally well, and I am really excited about how this will lead to smoother day-to-day operations moving forward.

It's Ed Kelly here asking a question for Stephanie. So I guess, my first question for you is...

Your one question. Very good.

I have a follow-up. But so just related to IDs. I mean, your IDs are clearly exceeding expectations. You're raising the full-year guidance for the ID again this quarter. I would guess that the level of inflation is less than what you probably thought coming into the year. And Mike, you talked about it with tonnage, right, being the strongest that it's kind of been in some time. Could you just maybe help us understand how you're driving such strong growth in the business? And maybe even what's surprising you as you look at the top line performance today.

That's a great question. The key point about what Kroger has been doing for an extended period, not just this quarter, is our commitment to connecting with our customers and associates on multiple levels. We are continually improving our products and our merchandisers are discovering new ideas. Our operators are enhancing execution and finding ways to reduce costs, which we reinvest based on customer feedback about what matters most to them. It’s all these efforts working in unison. However, one unpredictable factor is how competitors will respond to our actions and how customer preferences continually evolve, which requires us to anticipate these changes. This year, we are very pleased with how we've adapted to the changes in customer behavior and are establishing deeper connections with them. Customers are expressing satisfaction with the way our associates serve them, our product offerings, and our pricing, indicating that we have successfully improved in these areas through a blend of all our initiatives.

Maybe just a quick follow-up here on inflation. I think I heard you guys say that you continue to expect inflation to slow throughout the rest of the year. We have, I think, heard from one of your smaller competitors yesterday about particularly produce and maybe produce bottoming and getting better. So could you just maybe provide a little color on some of the categories and how you see that progressing throughout the rest of the year?

Yes, Ed, as I mentioned in my prepared comments, the situation regarding produce has shown that deflation has slowed. If you look at the very end of the quarter, there was a slight bit of inflation in the final weeks. While it wasn't significant, it indicates that deflation was present for the quarter but decreased and turned slightly towards the end. Other categories continue to present a mixed picture. Grocery remains slightly above flat with a bit of inflation, which is a major contributing factor. Another important aspect to consider regarding inflation is the pharmacy sector, which remains a significant area of inflation. The costs of generics are still rising. This is related to the challenges we face with gross margin in pharmacy; we are unable to pass on costs as quickly as the price of the underlying medications increases. Overall, it's still a mixed scenario. Some meat categories are experiencing less inflation and even deflation in certain areas, while slight inflation persists in others. Seafood is currently a little deflationary, but the situation remains varied across the board.

Wanted to ask on the digital initiatives. You guys had said that a few more divisions now have the pick-up-at-store capabilities. Can you give us a little bit more color as to what you're seeing in terms of traction, usage there? What may be in the basket, and then maybe kind of some thoughts going forward for further rollout?

We want to share some insights regarding customer shopping behavior. Some customers enjoy shopping online while also buying items in-store. We believe that digital engagement is complementary, not an alternative. Our goal is to provide more options for customers to interact with us in their preferred way. Feedback from customers has been positive, although it varies among different customers. Our collaboration with Harris Teeter has accelerated our learning and helped our store associates execute well. As for future initiatives, we will continue to test and adjust our approach based on how quickly customers engage with us. At this time, I can't provide specific details as we are still evaluating the situation.

Okay. That is helpful. As a follow-up, I want to focus on the digital initiatives. I understand you have mentioned ongoing strong growth in loyal households. Have there been any changes on your end since the exclusivity with dunnhumby has shifted over the past couple of quarters? Have you altered your approach to understanding those loyal customers or identified new partners going forward?

I wouldn't say there's been a change. The biggest difference is that the leadership team at 84.51° is now involved in every meeting. When making decisions, having the right people at the table provides valuable insights that contribute to the discussions early on, rather than getting feedback later in the process. The primary improvement is the quality of our discussions. While I wouldn't say we're gaining additional insights right now, we are working on many new projects that I believe will benefit us in the future. I feel confident that this will make it easier to accomplish these initiatives without needing to negotiate with a third party.

There's been so much change in Southern California amongst some of your larger peers. And I realize it's not easy, maybe it's impossible to quantify, but can you give us a sense for how much those changes have either benefited you or created a more challenging competitive environment? Just thinking about some of the issues that Haggen has had, some of the changes that Albertsons put into place. If you can address that at all, I'd be appreciative.

Yes, it's a good question but difficult to answer. Overall, we are pleased with our performance in Southern California. We believe that our associates and leadership team are effectively enhancing our customer service. However, it’s unclear whether changes made by competitors or customer preferences are the reasons for our success. It's essential to note that Costco is a significant competitor in Southern California, along with Whole Foods and many high-quality independent stores. The competitive landscape is quite varied, extending beyond just Safeway, Albertsons, and their merger, as well as Haggen. Therefore, it's challenging to attribute our results to specific actions taken by others. Our primary focus remains on understanding customer feedback regarding our service. Mike, do you have anything to add?

I agree. When there’s any disruption in the market, we view it as a positive opportunity rather than a source of concern. Changes in branding or marketing can lead customers to seek new shopping options, and we want to ensure that our team continues to engage and excite our customers and associates in Southern California.

And then, my follow-up, I just wanted to confirm that I heard correctly. You did say, I think, 3Q QTD ID sales, ex fuel, similar to what we saw in 2Q, right?

What I said is quarter-to-date, it's pretty similar to where we are in quarter 2.

So I had a question on Simple Truth. I think it's in some of your convenience stores now. I was just wondering how the brand's performing in that channel and how many C-stores it is in, I guess.

I've had C-stores for 2 days, and I already got it in there. Honestly, I don't know the answer to that question. How many it's in or how broad the...

Yes, on a few selected items, it's quite prevalent in many of our convenience stores, but it's somewhat restricted. It's still early in the process, and we are really trying to understand how far the brand can expand and who connects with it. Historically, convenience stores have not been known as places for healthy offerings. We are aiming to ensure that customers who seek these options can find what they want. So, while it's still early in the process, we are working to determine how far the Simple Truth brand can reach.

Okay. Regarding the M&A opportunities, we observed a decrease in repurchases during the quarter, and leverage has returned to the levels seen before the Harris Teeter acquisition. What are your thoughts on the current M&A environment and opportunities available?

Our appetite for mergers and acquisitions remains unchanged. If the right opportunity presents itself with the right stores, assets, and management team, we will consider it. We are aware of most activities in this space. The reduction in share buybacks this quarter should not be interpreted as an indication of any M&A plans. We mentioned earlier that we intended to front-load our share repurchase program. What you are seeing in the second quarter is primarily related to the use of stock option proceeds and the tax benefits from this to repurchase shares and counterbalance dilution. We are content with our current leverage, which provides us with considerable flexibility. Additionally, we are increasing our capital, which also requires some cash.

I was wondering if you could provide more details about the HemisFares rollout. It appears to be aimed at a premium quality and price point. Specifically, in which categories will you be launching this, and in how many stores? Additionally, what is the overall strategy for introducing this to Kroger? Was it developed from an 84.51° data science initiative, or can you share any insights on how it will reach the market?

The Corporate Brands team utilizes insights from 84.51° along with additional research. We observe that customers are increasingly identifying as food enthusiasts, and our goal is to discover outstanding products that cater to their culinary desires at an affordable price. The quality of this product rivals that of what one would expect in a restaurant, costing four to five times more than what we offer. Customers enjoy a unique experience with exceptional quality. Our team is continuously exploring the globe to source unique, region-specific items. As for the initial products, I don’t have details on the full range, but what I’ve sampled includes pasta, sauces, olive oil, and balsamic vinaigrette, primarily inspired by Italian cuisine, though I know there are others.

Yes, the whole idea of HemisFares is to allow our customers to take a journey of food experience around the globe without having to leave home. And it'll be very specific on the packaging where the product's from. The folks at our Corporate Brands who've procured this actually have met with and visited with and helped with the folks who manufacture this product or produce the product on-site in their home country. And some of this product, it's the first time that anybody's gone through the trouble of importing the product with some of the items into the U.S. that we have. So they've done a phenomenal job with this, and we're really excited about yet another great offering for our customers in the stores.

We would expect it to be in almost all of our stores. We think most customers will want to engage with it. On some of the items, there is a limited amount of production, so it's not something that you can just go out and produce 2x as much if it sells 2x as much.

That's very helpful. And then, just wanted to ask another question on deflation in some of the categories. I think you mentioned that all departments still comped positive, even though you had some deflation in dairy and produce and maybe seafood for the quarter. So just curious how you manage that. Do you do some incremental promotions in those categories in order to drive volume and increase the comps there when you experience deflation? Or how do you manage that so stably?

It often depends on the factors contributing to deflation. In certain categories, deflation can occur when a product is at its best, like in produce. Typically, if there's deflation, it indicates a surplus of high-quality products, leading to increased sales. In other instances, when deflation happens, it allows us to provide exceptional value for customers, which encourages more promotions and boosts volume. We tailor our promotions based on customer preferences and timing rather than solely aiming for positive performance across all departments. Fortunately, every department did see positive identicals. I know, Mike, you were checking some specific figures.

No, I was just looking to point out that when you examine the departments, the strength of both the IDs and the inflation-adjusted ID sales is quite remarkable in terms of its broad-based momentum. We even had some departments that maintained double-digit ID sales on an inflation-adjusted basis, excluding fuel and pharmacy. Ultimately, it's essential to recognize why we are so mindful of the volume we generate from a unit perspective, as that is fundamentally what drives your business.

Just actually 2 kind of quick ones. Mike, I think you were alluding somewhat to the wage pressures. Can you kind of walk us through, is the wage pressures a lot more than normal for Kroger right now? And is that sort of a broader economic thing? And then, maybe tie into that some maybe more commentary on any changes you're seeing in your overall customer. HemisFares sounds like a more upscale, private-label launch. Are you seeing any change in the amount of trade-up going on? Or any changes in the different levels of your customers' behavior would be helpful.

Yes, the comments I made earlier were not specifically about wage pressures. It was actually our own decision, which Rodney also mentioned, to invest additional hours in certain departments to enhance the customer experience. These departments are also experiencing strong performance. Those hours would have been used in the stores eventually, but we made the investments earlier. The wage pressures remain consistent with what we discussed in the first quarter. There are still some pressures, but we are focused on providing a comprehensive package for our associates, which includes competitive wages, a strong healthcare package, and a retirement plan. Our approach differs from many competitors, as we strive to balance these three elements for all associates. Regarding HemisFares, I would categorize it alongside our Private Selection and Simple Truth lines, as it represents a more upscale and high-quality product that appeals to a wide range of customers. Many customers shop on a budget for some items while choosing to splurge on others. HemisFares can be seen as a premium choice for those looking to indulge, while they may opt for more affordable options in other categories. As HemisFares evolves alongside Private Selection and Simple Truth, the shift in our product mix is contributing to a somewhat different customer experience than we've had historically.

It's clear that customers want high-quality food more than anything else. If you look at categories like natural and organic products, Boar's Head, Starbucks, and sushi, all of them are experiencing strong growth. It really seems that the situation is more about customer preferences than economic factors. While customers are definitely interested in saving money, their choices indicate a desire for premium options.

I'll keep this to one question. Just wondering if you could talk about changes in the competitive promotional environment for both the overall business and the natural and organic part of the portfolio. Are you seeing anything different as the second quarter progressed and even third quarter-to-date?

Yes, when we consider competition, we always expect it to become more aggressive in the future than it has been in the past. We find that if it doesn't, it makes things easier for us. This has been the approach we've adopted for our business planning over the years. We do not anticipate any major changes. There will always be some promotions or actions from competitors that we will notice, which can change even within weeks. However, I wouldn't describe any significant differences between the second quarter and the first quarter.

Certainly had a nice bounce to the fuel margins here in recent months. If some of this persists, would you anticipate reinvesting that back into the business? Or do you think that you would let that flow through to the bottom line?

That's a good question, but I can't provide a clear answer at this moment because it really depends on the market conditions and what we believe is the best way to utilize that. Therefore, I don't think it would be appropriate for me to address it right now.

Okay. And then, just curious on your click-and-collect experience in those newer markets. Are the customers signing up for some of those longer-term fees like the monthly or annual fees? Or are they gravitating more to the pay-per-visit approach?

You actually have customers doing all 3. I would say, the most customers are on the 2 extremes. They do the yearly approach or the per-order approach. But it's not one of those things where you see 80% of the customers going one way or the other.

And can you tell if it's incremental in those new markets?

Some of the basket may be incremental, but it's still early to draw conclusions. The information I provided reflects our current observations, but I wouldn't rely heavily on it since the sample size is still too small.

Yes, it's a data point, not a trend.

I want to follow up on the volatility you mentioned regarding your product cost. Specifically, in terms of pharmacy inflation with generics, can you quantify how much that impacted the gross margin?

Yes, I wouldn't talk about a direct effect on gross margin, but I will tell you that pharmacy inflation in the quarter continued to be above 9%.

Okay, and again, that wasn't passed through due to the contracts and so forth?

Well, you have contracts in place that require you to wait before you can make adjustments. Also, keep in mind that as general inflation occurs, we have maintained the $4 30-day supply and $10 90-day supply price points.

Okay, that's helpful. When you mentioned managing inflation and deflation, you provided a good follow-up regarding pricing versus market share. So, regarding inventory, does Kroger aim to invest heavily in commodities that are inflating or keep a shorter position on those that are deflating? Or when you refer to management, is it more about being precise on pricing and balancing it to leverage either market share or profitability?

Yes, we do manage some aspects for our own manufacturing needs when considering product supply and the overall supply chain. We don't overly rely on hedges; instead, we prefer cash purchase contracts to secure prices for a set period. Typically, we only engage in these contracts if current and projected prices are falling below a 5-year rolling average. In conversations with industry professionals, particularly in oil, there is a consensus that prices are expected to decline. Conversely, when oil prices rise, there's a prevailing belief that they will continue to increase indefinitely. Most people working with commodities seem to share this perspective. Therefore, we are cautious in our approach. Our consumption volume is significant, so I often say it is better to be approximately correct than to be precisely wrong. Making an overly ambitious bet in either direction could lead to significant miscalculations.

Just a final question, is what you just described applicable only to the vertically integrated part of the business, such as manufacturing, or does it also extend to retail?

Yes, for example, I wouldn't go out and try to hedge the apple crop this fall if I see something happening in produce. It’s probably not something I can effectively do anyway. However, we work with growers to secure fields and similar efforts, which are primarily to ensure we have the exact product we need. We do this irrespective of the inflationary environment.

This is Brian Cullinane speaking on behalf of Scott. I wanted to discuss your business model, which is clearly unique and has advantages due to your data technology. I would like to hear your thoughts on expansion, whether that involves increasing square footage, making acquisitions, or opening more stores to reach consumers in areas where you currently do not have a presence.

Well, if you look in terms of going to territories that we are not in at all, as you know, historically, we've done that through mergers. And we're always, as Mike mentioned earlier, looking out for the right one to do something with. We're finding incredible opportunity on fill-ins, and most of the incremental capital that Mike talked about is, what we're finding, is incremental project opportunities for great projects in existing markets. And right now, that's the highest focus. Now, that doesn't mean that we wouldn't go into a new territory de novo at some point.

Great. Do you have any thoughts on increasing your capital spending to take advantage of the success you’re experiencing with some of the new stores and projects?

Well, we feel like we already are, if you look at the incremental capital that we're spending, and we continue to push that. So you're always looking for opportunities to grow, but grow and make sure you execute, and we feel like we have started picking up that pace.

Yes. I prefer a situation where I have several division presidents expressing dissatisfaction because they have excellent projects that we haven't been able to finance due to our capital constraints. Spending $3.3 billion this year doesn't seem very constrained to me. If they weren't asking for more funds, I would be concerned about our prospects. However, as long as they continue to ask for more, I feel confident about our position.

Before we end today's call, I want to take a moment to acknowledge that this morning marks the 14th anniversary of the September 11 attacks. I know many participants on the call were personally impacted by those events. We continue to mourn those we lost on that tragic day and honor their memory through our support for police, firefighters, and other first responders, as well as the military and their families. I recently visited the 9/11 memorial and museum, and it is incredibly moving. I’m sure many people on the call have experienced it, but if you haven’t, it is definitely worth seeing. It truly helps you appreciate the incredible work that police, firefighters, and first responders did on that day. Lastly, I want to share some additional thoughts directed at our associates who are listening today. One of the most exciting aspects of being part of a growing company is the new opportunities it creates for our associates. Many of you would agree that Kroger is a place where you can start with a job and build a career. When I ask associates and managers why they stay, most say they love working with people—our customers and fellow associates—or they have developed a deep passion for food. Often, it’s a combination of both. As I mentioned earlier, nearly 70% of our store managers began as hourly associates. I believe many young people working with us today will become our future leaders, taking on roles like Mike’s and other senior positions. Our associates are individuals who genuinely care, want to connect with something larger, and strive to make a difference in our communities every day. We encourage candidates to envision themselves at Kroger because whether you're seeking a flexible part-time role or a long-lasting fulfilling career, you can find it here. We are looking for friendly, bright individuals who are eager to learn and grow. This is an exciting time to be at Kroger. Together, we can make a difference. That concludes our call for today. Thank you for joining.