Kroger Company (KR) — Q1 2017 Earnings Call Transcript

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

Thank you, Kate. And good morning, everyone, and thank you for joining us today. With me to review Kroger's first quarter results is Executive Vice President and Chief Financial Officer, Mike Schlotman. Our associates delivered another solid quarter. We continue to execute our growth plan and to deliver on our financial performance commitments. Most importantly, we continue to strengthen our connection with our customers, growing loyalty and market share and achieving Kroger's 50th consecutive quarter of positive identical supermarket sales growth, excluding fuel. Most companies can only aspire to achieve these results. It says a lot about our consistently remarkable performance and our ability to grow in a balanced way with a long-term focus. We've managed through nearly every conceivable operating environment and demonstrated through different cycles that by providing value to our customers and partnering with our associates, we'll continue to make a difference for our customers, associates, and communities. And when we do that, we create value for shareholders as evidenced by our growing dividend and our consistent net earnings per diluted share growth above our long-term guidance of 8% to 11%. In fact, our net earnings per diluted share growth rate on a compounded annual basis was 14.1% for 3 years and 18.8% for 5 years. We demonstrate our long-term focus by continuing to invest for the future. We are making investments in our people, our digital and online capabilities and our strategic partnerships. Across the board, Kroger has an incredibly strong management team and a deep bench of leaders, who are making us better every day. We continue to make strategic investments in leadership development and training for all of our associates, including high-volume store managers and future senior leaders. Many people come here for a job, and Kroger creates opportunities for all associates to build a career. Despite record low unemployment figures, when we held a one-day hiring event in every supermarket location in May, we received more than 116,000 applications. From that pool, we hired more than 12,000 new associates. We see our opportunity culture as a competitive advantage. We are expanding our digital presence and marching steadily toward a time when we can provide our customers with anything, anytime, anywhere. As you know, we are taking a disciplined approach to digital growth, testing new offerings in local markets so we can make sure we get it right before we scale offerings more broadly. Our ClickList and ExpressLane offerings are now available in 25 markets with more to come. Our merger with Harris Teeter gave us a base of learnings that allowed us to ramp up quickly the development of ClickList. Customers have now downloaded nearly 3 billion digital coupons and offers from our mobile app and website, and we continue to experiment with Vitacost.com's ship-to-home technology and platform. Earlier this week, Kroger's technology business unit was named one of the Top 100 Places to Work by Computerworld Magazine. We are obviously very proud of this honor. We've launched a new website, kroger.com/liveKT, to connect with and recruit top talent from around the world to join the Kroger team. Similarly, we are finding out that ClickList also serves as a great tool to both hire and retain great people. Kroger is a fantastic place for tech talent to build careers because the technology they create can improve the lives of millions of customers each and every day. In April, we announced a strategic investment in Lucky's Market, a specialty grocery store chain focused on natural, organic and locally grown products currently operating in 22 locations. We invested in Lucky's because of their great people and unique go-to-market strategy, which includes smaller-format stores that resemble an indoor farmers market, plus the culinary department that showcases amazing restaurant-quality prepared foods. Lucky's approach is very much aligned with our efforts to provide affordable, fresh, organic, and natural foods as part of our Customer 1st strategy. We expect to learn a lot from each other. There are a lot of questions about the economy and the customer, inflation or lack thereof, consumer sentiment or competition. These are all issues that we've managed through, some several times over the last 50 quarters. Inflation, for example, I've often said that a 2% to 3% inflation would be a great environment to operate in. However, you rarely get the perfect operating environment. What we know is that by focusing on our associates and our customers, it will be a winning formula in the future as it has been in the past. At times like this, it's even more important to have 84.51° on the team so we can generate insights into what our customers want and figure out a way to give them that without having to guess at it. Kroger's core business is solid. We are providing exceptional customer service in the highest-quality, freshest products. Customers are giving us higher marks for better product selection and store layout as well as friendlier service. We remain focused on customer loyalty that grows tonnage in both our top and bottom lines, which then creates value for shareholders. Where we are right now, it looks like we will be at the low end to midpoint of our 2016 net earnings per diluted share range. Where we end up in that range will be driven primarily by fuel margins. I do want to stress that we are never satisfied and our to-do list remains longer than our done list. Now Mike will offer more details on Kroger's first quarter financial results and discuss our guidance for the remainder of the year.

Thanks, Rodney, and good morning, everyone. IDs came in at 2.4%. As Rodney said, we've been in environments like this before, and we will continue to focus on growing households, growing units and making sure we are delivering the right value proposition for our customers. Inflation was nonexistent in the first quarter. Lower inflation has persisted and, in fact, was slightly deflationary without pharmacy. When you add pharmacy back in, we had approximately 30 basis points of inflation. This is the lowest we have seen in the last 6 years. During the quarter, trips per household were up and units per basket declined. This, combined with more households, led to positive tonnage growth. Operating costs, excluding fuel and Roundy's, were 4 basis points better in the first quarter. Operating, general, and administrative expenses were 11 basis points better and grew by approximately 2.9%. Rent and depreciation were a combined 7 basis points worse. We continue to work diligently to keep operating costs in check. As you know, this is the fuel we use to run our Customer 1st strategy, and as Rodney just said, this is an area where our to-do list is longer than our done list. Now for an update on retail fuel. In the first quarter, the average retail price of a gallon of gas declined by $0.45 compared to last year. Our cents per gallon fuel margin was approximately $0.143 compared to $0.116 in the same quarter last year. On a rolling 4 quarters basis, we were at $0.182 this year compared to $0.184 last year. We expect this downward trend to accelerate as we cycle some very strong margin quarters for the rest of the year. Our first quarter net earnings per diluted share increased 12.9% to $0.70 compared to $0.62 during the same period last year. This result was helped primarily by our operating results and higher fuel margins during the first quarter. A lower LIFO expense and share buybacks also contributed to the EPS growth. Our integration with Roundy's is well underway. Synergies are coming together nicely. We are beginning to focus on the physical assets in Wisconsin while continuing to open new Mariano stores in Chicago. Roundy's associates share our deep commitment to putting our customer first, which makes it easy for us to work together as one team. For our corporate brands portfolio, we are off to an exciting start on the new innovation in 2016. Last quarter, we told you that we had just introduced Simple Truth household and personal care products, expanding our popular natural and organics line into a true lifestyle brand. Customers have responded enthusiastically as both sales and unit volume have exceeded our expectations in all categories. We continue to launch new Simple Truth offerings in laundry, household, baby, and health and beauty care. We also continue to push the boundaries of culinary trends with new Private Selection spices, marinades, condiments, and cooking sauces. Customers are savoring global flavors in our delicious Private Selection products, such as Korean black garlic kalbi marinade and Peruvian Aji Amarillo hot sauce. During the first quarter, corporate brands represented approximately 27.9% of total units sold and 25.9% of sales dollars, excluding fuel and pharmacy. The company's net total debt to adjusted EBITDA ratio increased to 2.12x compared to 2.09x during the same period last year. This result illustrates our commitment to use free cash flow to both grow our business and return cash to shareholders while maintaining an appropriate level of leverage for our credit rating. Over the last year, Kroger used free cash flow to repurchase $1.1 billion in common shares, paid $397 million in dividends, invested $3.6 billion in capital, and merged with Roundy's for $866 million. Kroger's strong EBITDA performance resulted in a return on invested capital for the first quarter of 14.08%, excluding Roundy's, compared to 14.03% for the first quarter of 2015. Our balance sheet is as strong as ever. I will now provide a brief update on labor relations. We recently agreed to new contracts covering store associates in Houston, Indianapolis, Portland, and Roanoke. We are currently negotiating contracts with UFCW for store associates in Little Rock, Nashville, and Southern California. 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 healthcare, and retirement benefits for our associates. Kroger's financial results continue to be pressured by rising healthcare and pension costs, which some of our competitors do not face. Kroger and the local unions, which represent many of our associates, have a shared objective: growing Kroger's business profitably, which will help us create more jobs and career opportunities and enhance job security for our associates. Turning now to our 2016 guidance. We continue to expect identical supermarket sales growth, excluding fuel, of approximately 2.5% to 3.5% for 2016. This reflects lower inflation as well as Roundy's results, which are an approximate 30 basis point headwind to identical supermarket sales growth. For full-year net earnings, we expect a 2016 range of $2.19 to $2.28 per diluted share. As Rodney said earlier, based on current fuel margin trends, we expect to be at the low end to midpoint of our guidance range. We expect fuel margins will be at or slightly below the 5-year average. Shareholder return will be further enhanced by a dividend that is expected to increase over time. Thinking about the cadence of our quarterly results compared to our long-term 8% to 11% guidance, we believe the second quarter will be the toughest quarter with slight growth over 2015. Keep in mind the second quarter last year grew by 26%. Both the third and fourth quarters will be at the low end to midpoint of the range. We continue to expect capital investments, excluding mergers, acquisitions, and purchases of leased facilities, to be in the $4.1 billion to $4.4 billion range for 2016. Finally, we continue to expect Kroger's full-year FIFO operating margin in 2016, excluding fuel, to slightly expand compared to 2015 results. Now I will turn it back to Rodney.

Thanks, Mike. We are proud of our team's performance during the quarter, especially in light of the challenging operating environment. We've been through business cycles like this before. The best thing we can do is to deliver on our promise while investing for the future. We will continue to execute our Customer 1st strategy, and by doing so, we'll create long-term value for our shareholders. Now we look forward to your questions.

Can we maybe start off with just color on the cadence of the IDs through Q1, what you're seeing so far in Q2? And then, Rodney or Mike, could you maybe dissect sort of like tonnage trends versus inflation trends and then lastly, as part of all this, the impact that Roundy's had on the Q1 comp?

Okay. Ed, I'll start out and let Mike fill in. But if you look across the quarter, I would say it bounced around a bit. Part of that was driven by weather. Earlier in the quarter, we had basically no weather benefits this year versus a lot in the prior year. As you get toward the end of the quarter, Memorial Day moved from the first quarter to the second quarter, and early in the quarter, you had the Super Bowl. So there's a lot of things going on. The other thing on inflation, inflation, we had expected that it would start picking up some, and when we look going forward, we just don't see that picking up. If you look at so far this quarter, we're inside the range, just slightly below the midpoint of the range of the 2.5% to 3.5%, but as you know, it's still very early in the quarter. Overall, the core continues to be strong, and we're cycling incredibly strong numbers from last year, and tonnage continues to be solid. I don't know, Mike, anything else you'd want to add or thoughts?

No. One of the things we have done is if you look at our real growth, that's IDs minus the inflation number that we give. If you look at the 2-year stack of that, it’s amazingly consistent quarter-to-quarter, with less than a 50 basis point swing over the last 5 or 6 quarters. So when you examine things over a longer time frame and adjust for the effects of inflation on the reported numbers, our results have been remarkably consistent.

And, Mike, just the impact of Roundy's on that 2.4% you report this quarter?

It's about 30 basis points.

I know it's still early with ClickList in some markets, but what have you seen thus far in terms of how that's changing consumer behavior? And is it yet a new customer acquisition vehicle?

It's still early in our experience with ClickList, and as I mentioned in my earlier comments, we're currently operating in 25 markets. What we've observed is that various aspects of our service are meeting customer needs in different ways. We've gained some new customers, and in certain cases, customers are spending more with us. Our focus remains on understanding what our customers want and need, and we've received positive feedback from some who find our service incredibly helpful. This is why we are committed to continuing its rollout. We believe that ClickList enhances the shopping experience, and customers still visit our stores, finding this service adds convenience to their lives.

Okay. As a follow-up, do you anticipate any differences in how you will operate ClickList or in customer behavior within a marketplace compared to a traditional food retail store, considering the variations in size and other factors?

We have it in both types of stores, and we find the behavior is quite similar. However, we do not have the Marketplace product on the website. So if someone wants to purchase something from the Marketplace, they need to mention it in the comment section and we will accommodate that request. We don’t see differences in behavior between the two store types. One of the considerations is whether we have the space to implement it in a store, which influences the size of the store. There are some Marketplace locations where we would like to offer it, but we simply do not have the space available.

How would you describe the macro environment in the quarter? Do you have any insights on the consumer side overall? I noticed that units per transaction were down slightly. Does that suggest the consumer might be a bit softer? Any information you could provide would be appreciated.

Yes. While we saw a slight decrease in units per basket, this was offset by an increase in the number of trips made, resulting in more total units during the quarter. These two factors led to a modest increase in tonnage, and the addition of new households positively impacted it as well. Rodney mentioned the complexity of the current macro environment, including inflation, deflation, and rising gas prices during the quarter. It was a unique period with various unusual elements affecting us, such as the Super Bowl, weather conditions, and Memorial Day changes. As Rodney noted, the cadence of ID sales varied quite a bit week by week. However, our primary focus remains on the customer, ensuring we fulfill the value propositions they're seeking. Based on their shopping behavior with us, it certainly looks like we're meeting those expectations.

Yes. And the economy yet to me, and Mike and I have talked about this, it's really hard to describe, and it's very mixed. How much of that is driven because of the election and everything else, I'll let somebody that has better insights into that than us to speculate on that. The strength certainly doesn't feel as strong as the numbers suggest. But with that said, if you look at the things that would be discretionary items or more upscale items if you look at wine, Boar's Head, Murray's, Starbucks, all of those continue to grow very nicely from an identical standpoint and well outperform the total. So it's really pretty hard to describe from what we can see.

Yes, appreciate the color. And just a quick follow-up. So it sounds like you guys are driving additional trips. Is that a function of consumers utilizing your fuel rewards? Is it more of a shift towards fresh and produce, more produce, more fresh?

You do see those types of items in a lot of the baskets of the incremental trip. As people strive to eat healthier and eat more fresh products rather than buying it and putting it in the refrigerator or freezer, it does appear as though they're making their trips to the grocery store a little more regularly and buying for a few days rather than for a week-long stock-up. That's certainly what it seems to be.

First, I had a quick clarification to your answer to Ed on the quarter-to-date trends. I think you said you're slightly below the midpoint of the range. Is that correct?

Correct.

And then does that include or exclude the Memorial Day shift?

That would include the shift, the Memorial Day.

Okay. That's perfect. So you're slightly below the midpoint with the shift included. That's great. Now, my main question is about a significant competitor that has been making a lot of noise regarding pricing. Have you noticed any increased competitiveness in the market from them? Have they achieved what they committed to in terms of cleanliness and stock availability? How seriously do you take their claims about investing several billion dollars in pricing and their willingness to accept deflation in their own comparisons to make that happen? What is Kroger's strategy to address this if it occurs?

We take all competitors seriously and don't focus on just one. It's vital for us to understand our customers' needs. Annually, we've invested $3.6 billion in maintaining our pricing since we began this journey and plan to keep our price position strong. However, the overall customer perspective on value encompasses more than just price. We prioritize the total customer experience, including the freshness of products, shopping experience, wait times, and treatment from our associates. We are committed to enhancing all these aspects and have made significant improvements. Customers don't decide where to shop based solely on one factor, and we believe these additional elements give us a substantial competitive advantage.

Okay. Great. And then I had one question. Obviously, the 10-year bond has been falling quite steadily here over the last 3 or 4 months, and that, obviously, has impacts on pensions. Want to get your guys' thoughts on this. We've seen the drop, what, like 50, 60, 70 basis points or something like that. How should we think about pensions next year? Any framework there, Mike, on that? Do you think about this or no?

I do think about the impact of interest rates. It's interesting how many pensions calculate their liabilities based on interest rates, specifically the present value of those liabilities. State, local, federal, and multiemployer pensions determine their liabilities using the expected rate of return as the discount rate. For the UFCW plans, their unfunded status is not really impacted by interest rate changes unless there's a shift in their expected rate of return. This is similar to how state plans operate. It may have a slight effect on the company plan, but keep in mind that our company plan is frozen. Benefits continue for current workers, but no new participants can join. We aim to maintain a funded status that avoids reporting issues for participants. I prefer not to have the fund overfunded since, once the last person receives their check, retrieving any excess funds is difficult. Therefore, we intentionally manage it to be slightly underfunded. We anticipate that interest rates will rise in the future, so I don't want to invest too much now only to find the fund overfunded in five years when I can't utilize that surplus.

And any idea kind of a rule of thumb what the expected rate of returns on these UFCW plans are? And then I'll yield.

They're somewhat varied, but I would say the most common range is in the 7s, which is similar to how all the state pension plans operate.

Just on the topic of food inflation, deflation. This morning, the government data again showed the decline in food prices. So just want to get a sense of what your latest full-year outlook is and how you're thinking about the cadence going forward.

Well, as I said in prepared remarks, we would have expected to start seeing a little bit more inflation right now than when we were sitting here 3 or 4 months ago thinking about it, and it just hasn't happened. As I sit here today, it certainly doesn't feel like we're going to have the pickup in overall food inflation. Milk would have been projected to start having some cost increases, but the federal market order on milk isn't showing any upward trend or any significant upward trend. So I think we're going to wind up most of the year in a fairly low inflationary environment.

But as Mike mentioned before, tonnage continues to improve. We continue to improve market share. If you look at year-on-year, we continue to improve the connection with the customer, and our gross profit dollars and departments remain strong as well. So I think it's important to look at all those things together.

Okay. Great. And then just going back to your commentary on traffic. If you look at traffic this past quarter versus recent quarters, has it improved? And if so, what's been some of the drivers do you believe behind the improvement?

We have seen strong growth among all households, both loyal and non-loyal. I want to emphasize our continuous focus on understanding the customer, determining their needs, and finding ways to meet those needs while ensuring we offer the right value for both them and our shareholders.

On the food retail turning slightly deflationary, just to echo Scott's question, is that being driven at all by competitors taking pricing down either more so than the deflation or just taking it down to try to get business going? Or is that all, as far as you can tell or mainly as far as you can tell, from the lower product costs?

If you take a look, most of it is in the fresh department, specifically in meat, seafood, and deli, which are primarily influenced by commodities. In the grocery section, milk is experiencing significant deflation, driven largely by the federal market. Overall, it appears to be more influenced by commodities than by competition. Mike, do you have anything to add?

No, I absolutely agree.

Okay. Regarding the guidance, maintaining the ID sales at the same level while facing lower inflation indicates that you anticipate an improvement in volume. It seems like volumes have increased slightly, but what is the reasoning behind that outlook?

It's our expectation for the year. If you look at the first quarter, we delivered the 2.4% in exactly that kind of an environment, and that was without the weather from the prior year and Memorial Day moving. So we continue to focus on driving units, driving tonnage and making sure that the customer is getting the well-rounded shopping experience that Rodney just spoke of.

Can you provide an update on ClickList regarding its profitability? Specifically, if a store generates a decent volume through ClickList, will that be as profitable as having a customer shop in-store for their groceries? Or does the model need to evolve towards a larger, more dedicated picking facility?

During the start-up phase, it can be challenging as expenses are higher. However, our model is designed to scale effectively, allowing for profitability regardless of whether customer engagement is at 5% or 20%. Our team has put in significant effort to create a ClickList model that can adapt to any volume level. We are confident that we can manage profitability at different percentages, and ultimately, it will depend on customer preferences regarding the volume they wish to engage with.

Is there any way that you can roughly quantify the benefit of the Memorial Day shift on 2Q today? Because you haven't really talked about that since 2004, and it's a long time ago. But from that, we estimate maybe a shift like that can help roughly about 100 basis points on a quarter-to-date number. So I'm just curious, is that roughly in the right range, meaning on a like-for-like basis, you're doing maybe a bit below 2% so far in the quarter, excluding the benefit from Memorial Day?

I don't know that we'll give you the exact number, but the 100 basis points isn't remotely correct. And don't forget you have the week after as well, and you really have to look at the 2 weeks together.

Not remotely correct, meaning it's lower than 100 or higher? I'm hoping lower.

It's not even close to 100.

Yes, you're not even in the right ballpark.

Never been so happy to be wrong, but I appreciate it.

I am as well. And if that's the impression that is out there, I've never been so happy to help you be wrong.

I want to follow up on EPS and apologize if this was already discussed, as I didn't hear it. It seems we're coming in closer to the bottom or midpoint of the range, with fuel being cited as the reason. However, you didn't change your guidance for fuel margins, which are expected to be at or slightly below the 5-year average, and that was the same wording you used last quarter. I'm unclear on what has changed that led to the reduction in the outlook.

Fuel prices remain highly unpredictable. As we sit here in June, it's challenging to forecast the remainder of the year, but indicators suggest that fuel prices will trend at or below current levels. In the first quarter, we sold a couple of billion gallons of fuel, and even a small fluctuation in retail prices can significantly impact our finances. It doesn't take a large change, such as $0.04, for it to have a major effect. The trend appears to be leaning toward being below the 5-year average rather than at that average. However, predicting the exact outcome remains difficult. In the past few days, oil prices have dropped. We will find out soon if this will result in lower wholesale prices for unleaded fuel.

Plus, the first quarter was slightly better than where we expected it to be.

Right.

But when we only look at the year, we really don't see the change.

Can we walk through some of the moving parts to the gross margin line in the quarter? With gross margin, ex fuel down slightly, can you talk about how things like deflation, price investments and the impact of Roundy's come into play here?

Yes, I don't think I'll go down to that level of detail and walk through all the individual numbers. We continue to make the investments we plan to make in price throughout the first quarter. Certainly, the dynamics of deflation when you look at the whole gross profit margin for the entire company makes it kind of interesting because as you have deflation, if you pass on exactly the lower cost to the customer, it drives your gross profit rate up. It's just simple math. Pharmacy continues to be a bit of a headwind to the gross profit numbers as well with some of the inflation in there and where the reimbursement rates are. So it's just a really big mixed bag. I would need several hours probably to explain it to you.

Okay. We'll take that one off-line then.

Sorry to interrupt, but when you look at it overall, it was pretty close to where we expected it to be.

Yes. I mean...

Okay. Great. And just secondly, there's been a lot of talk about the online meal prep companies like Blue Apron. Have you considered expanding into this business? And if so, how are you thinking about it in terms of build versus buy?

I want to answer, but I don't want it to sound flip. The short answer is absolutely. And as you can imagine, we would look at any and all approaches. The thing that's important is if we find somebody to make an investment in that they would value the leverage that we bring to the party as well and assign some value to that. So it's not just something that has pure option value in the way they're getting valued. So the short answer is yes, we would be very open to doing it on our own or doing it with somebody. I think if you look at our track record, we've had both approaches.

Wanted to dig in a little more on the Walmart question. We did a May price survey that was showing Walmart actually cutting in produce in 2 markets, cutting about 9% and 5% to 6% cutting in another market. Are you seeing that in your view of the marketplace? And do you think it really matters relative to your offering in produce since you have a broader offering and a little more robust?

I prefer not to go into specifics, as you will observe significant variations among retailers when examining individual markets over the past two years. It really depends on which market you are assessing. I would be cautious about asserting that something fundamental is shifting, as these behaviors are common in specific markets. We have devoted considerable resources and effort to enhancing the freshness of our products, particularly in the produce department. Our customers have informed us that they are noticing meaningful improvements in freshness, especially in produce. We are seeing similar feedback in other departments, but produce stands out. It is crucial for us to continue making progress in this area. Additionally, we have an exceptional variety of organic produce, and customers are increasingly engaging with that selection.

Yes, and inflation in produce in the first quarter was almost 400 basis points lower than the fourth quarter. Still inflationary, but from fourth quarter to first quarter, it declined almost 400 basis points less inflation.

Okay. And, Mike, while we got you on, wanted to ask about the buyback. You did like $1 billion of buyback here in the quarter. Do you anticipate more throughout the rest of the year? Do you have any remaining in your buyback plan? Just give us an update on where you are there.

I currently have exhausted the authority the board's given me. And if you look at our history, we don't like to be without authority for any particular point in time, and we have gotten the cadence over the last couple of years of front-end loading our buyback for the year. But we always want to have dry powder if the stock reacts in a way that we don't think is prudent based on our view of the underlying value of the company.

I wanted to ask two questions. First, could you provide more insight into your outlook on inflation versus deflation? Mike or Rodney, you've mentioned the concept of good deflation versus demand-driven deflation. Are you starting to see any signs of demand-driven deflation in your outlook that may be a concern? Additionally, could you comment on the outlook for milk and perishables? How has the center-of-store inflation outlook changed since your last update to us last quarter?

I would say it hasn't really changed much except that it seems to be progressing more slowly, which could result in lower inflation for the entire year by the end of it. As Rodney mentioned earlier, what we're observing is mainly price-led deflation rather than driven by demand. I'm trying to grasp the concept of demand-driven deflation on the go here, since what we're discussing is the price we pay for a product compared to last year’s price. It seems that demand would need to shift quite significantly in the market for it to impact our grocery category. Overall, we are just experiencing slightly less inflation than we anticipated at this point, and it appears that this trend will continue.

Can you provide an estimate of the impact on the FIFO operating margin from Roundy's for this fiscal year? Additionally, is the investment in Roundy's, including Mariano's, tracking as planned, or do you expect it to exceed your initial projections? Any additional information on this would be appreciated.

If you look overall, it's on track. I would say the thing that has taken a bit longer than we expected is getting everything underway. In Wisconsin, I mentioned it in the prepared remarks, but remodeling stores and making those changes took longer to begin than we anticipated. I’m not sure why we thought we could start so quickly, but we’ll learn for the next time we undertake something like this since we're still moving faster than we could in one of our historical Kroger divisions. I am extremely pleased with our associates at Roundy's and their welcoming attitude and excitement to be part of Kroger, ensuring that we take advantage of Kroger's size. The synergies have turned out to be better than we expected, and we will continue to invest those synergies to drive our business. I don’t know, Mike, you work on it more closely than I do.

No, I agree, and I see the value in Rodney's comment. I'm not entirely sure why we were so optimistic about starting the remodels, considering the quick turnaround from the announcement to the closing due to the early termination of the HSR filing, especially with the holidays since we closed on December 18. It takes time to draw up plans and get approvals for remodeling the stores. However, you can be assured that if we find the right partner in Wisconsin, there will be significant activity happening in and around many of the stores today.

And for Mariano's, are changes that you plan there either to assortment or anything else, is that maybe running a little bit slower than initially hoped for?

At Mariano's, there is not a significant emphasis on assortment. There might be some specific products requested by the team in Chicago, and we will provide them access and start carrying those items. However, the main focus for Mariano's is on expanding the number of stores. This year, we anticipate opening 4 or 5 new locations in Chicago, building upon a base of around 30 stores. This reflects a very ambitious capital plan in that area.

I'd like to take another crack at that question about the economy but not so much about how the U.S. economy is growing or slowing or whatever the case may be, but really looking at customer behavior as they look at some of these fresh departments and experience lower prices. What are you seeing between, say, types of protein? Are we seeing trading between those categories simply because people are more impressed with a lower price than they were last year?

There's no doubt that people are buying more beef and similar items. Those prices are among the best customers have seen in nearly three years. It's uncertain how much of this is due to the economy versus the appeal of good value with the recent price changes. Mike, you were looking at the details.

I completely agree with what Rodney mentioned. Specifically regarding the meat category, until late 2015, the early part of 2014 saw mid- to high single-digit inflation, which ended with double-digit inflation by the end of that year. Last year began with high prices, but by the third and fourth quarters, prices began to decrease significantly. This trend is likely being driven by increased consumer purchases and a return of shoppers to the category.

I'm wondering if you could give us a sense of just the overall competitive promotional environment in both conventional as well as natural and organic, how is it today versus what you saw in the quarter versus the prior quarter. And more specifically, have you seen any impact from all this in California?

We won't go into specifics about competitors or regions, but we always expect the competitive landscape to intensify when we develop our business plans. If there happens to be a year where this is not the case, it simply enhances that year's performance. The industry has consistently been very competitive, and we see no signs indicating it will become less so. Each year, we operate under this assumption and create a business plan that focuses on how we can invest our available resources for the benefit of our customers, aiming to drive increased sales volume, more store visits, and enhanced customer loyalty. As we pursue these goals, we see results in the growth of loyal customers, who visit stores more frequently and buy more over time. This remains our primary focus. As Rodney mentioned earlier regarding competition and pricing, we are aware of what others are doing, but we consistently return to our customers' needs and how we can meet them.

Got it. And just as my follow-up, wondering how we should think about the puts and takes to margins over the next few quarters. I know fuel margins are a big impact, but how much of an impact do you expect from things like the overtime legislation? And are you fully EMV compliant at this point?

We are EMV compliant, which is necessary. The convenience stores and fuel pumps have a different deadline for compliance. Some of our merged companies are not fully compliant yet since they started later than we did, and we are working to bring them up to speed. However, Roundy's has a minor amount of work left on EMV compliance, which is a relatively small part of our overall operations. Therefore, these issues will not significantly impact us. What was the first part of your question?

Yes, regarding the labor changes, we don't expect many management staff to be below the new minimum wage. We are assessing the impact, but our preliminary estimate for the annual cost would likely be between $15 million and $20 million for the entire year. Overall, it's not a significant amount, but we are still determining the best approach for all our associates, and there aren't many individuals earning less than that.

I wanted to revisit Roundy's performance, which seems to have exceeded your expectations. I'm curious about what factors contributed to that. Was it due to the Wisconsin markets or Chicago? Additionally, regarding the 30 basis points, do you anticipate that drag will continue for the next few quarters, or do you think there is potential for improvement? Any insights on this would be appreciated.

Yes, I believe the 30 basis points will be the impact for the full year. They are experiencing a headwind, leading to sales trends that are below the company average. It's not a simple switch where implementing a program will immediately resolve the issue. We're taking a careful approach to ensure that the stores are organized, reset, and remodeled where necessary. Some locations may even be shifted. Then we will reassess how to provide the best value to customers, similar to what we achieved pre-merger with Roundy's. The positive aspect is that we have successfully executed this plan before, transforming a business with slow sales at Kroger into one with strong sales. We expect to apply this strategy in Wisconsin as the year progresses, but it won't be an instant turnaround.

If you look at our overall Roundy's strategy when we announced the merger, we really look at it as a 3-year approach, and obviously, some of the things that we've talked about as part of it. But as Mike just mentioned, real estate would be part of that remodeling stores, expanding stores. All of those things would be part of the total package. One of the reasons why we get excited about Roundy's was obviously Mariano's, but in addition to that, in Wisconsin, the quality of the real estate, most of the real estate they have there is very good locations and for the most part, good store sizes as well.

Okay. That's helpful. Then just wanted to ask, when you look at your households, you're increasing penetration with new households in particular. Wondering if you have any color on what kind of customer that you're getting there, that new customer. Is that a higher-income customer? A lower-income customer? Is it a diverse group? Any analysis that you've done around that would be helpful.

It's very diverse. If you look, it would certainly be heavily weighted to the mainstream and then scale from that. So it's diverse from ethnic diversity. It's diverse from income diversity. It's diverse from age, which, for us, we obviously get excited by it being all of those groups.

Great. And then one last question on the fuel margins for Mike. Is it fair to say a $0.01 change in the gas margin could impact the EPS by around $0.05? Is that a rough estimate to consider?

I actually don't have that calculation handy.

For the year, that would be fairly close.

Yes. For a quarter it wouldn't, as Rodney said, for the year it would be fairly close.

Mike, just a quick question on your view of the refinancing market right now. Looks like you had about $1.2 billion in CP, and you have $800 million maturing later this year. So just wanted to get your view on sort of continuing to use the CP market to roll some of your maturities versus terming them out in terms of the long-term market given where rates are.

Yes, we have $800 million maturing later this year and just over $500 million due in January. As our debt matures, we will be terming it out as it comes due. We have been implementing interest rate hedges on that debt over time to mitigate some of the interest rate risk in case rates fluctuate significantly. Regarding commercial paper, we will likely maintain our position in that area as it's the simplest way for us to access floating rates, especially with current commercial paper rates. If we need to adjust our floating rate exposure quickly, commercial paper allows us to do that easily, provided the markets are available. In contrast, adjusting swaps or hedges or dealing with a 3- or 5-year floating rate note isn't as quick or straightforward, so commercial paper will remain a key part of our strategy.

Actually, most of my questions have been asked already. My question's on Roundy's. Obviously, it's early in your experience there, but since last year's fourth quarter was a step period and now you've got 1 full quarter under your belt, I'm just wondering if you've seen any change sequentially in Roundy's operating performance. So sequentially, are you seeing any change there that's meaningful?

We are generally aligned with our expectations. As Rodney mentioned, if there's anything noteworthy about our internal view on Roundy's, it's that we had slightly higher hopes for the pace at which we could achieve certain initiatives, which have taken a bit longer than anticipated. However, we are starting to gain some momentum now.

Okay. And I think you mentioned and Rodney mentioned things took a little longer to get started in Milwaukee. But can you also maybe comment on how you view the challenges for Roundy's in Chicago compared to Milwaukee? Obviously, they're very different formats and different customer demographics. But to the extent that there's any real variability in terms of how those markets are performing, can you speak to that at all?

In Chicago, the situation is quite different. The condition of the store base is very good. Most of the stores, with the first one opening in 2010, were acquired from Dominick's when they exited the market. Those stores are currently undergoing remodeling, while the remaining stores are in excellent shape. The main focus in Chicago is dealing with the impact of many sister store openings following the Dominick's acquisition. The goal is to continue executing the plan, deepen connections with customers, and increase our market share. We really like the Chicago market; it's fantastic. Before we end today's call, I want to share some additional thoughts with our associates listening today. I always like to acknowledge our associates because so many tune in. First, I want to extend our deepest sympathies to the family and friends of those who lost their lives in the recent tragic attack in Orlando. This is a heartbreaking situation. I also want to thank the first responders who risk their lives every day to protect us. Our associates, especially those at Axiom Health Care outside of Orlando, throughout Florida, and across the country, are deeply saddened by these events. We stand in support of the LGBT community. An incident like this impacts us all, reminding us of the importance of caring for one another. I appreciate our associates everywhere who embody our values of diversity, inclusion, and respect, treating everyone with dignity, recognizing and embracing our differences, and uplifting one another. That concludes our call today. Thank you for joining us, and have a good summer.