Kroger Company (KR) — Q2 2018 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 2017 Investor Conference, which we will hold in New York on October 11. Details will be coming soon, and we hope you can join us. 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 second quarter 2017 results is Executive Vice President and Chief Financial Officer, Mike Schlotman. As you know, Kroger has competed in an ever-changing retail landscape for 134 years. Our success over time boils down to one thing: our relentless focus on the customer. That focus allows us to deepen our connection with customers and create shareholder value. The customer remains the center of everything we do. The four core elements of our Customer 1st Strategy are as relevant today as they were when we first introduced them. How we invest each year to drive customer engagement changes regularly based on customers' changing needs and wants. This showed in our second quarter results as we returned to positive identical supermarket sales growth, and both loyal and total households increased. Traffic was up, unit movement was up and market share was up. Our customers' perception of our prices is excellent and they continue to get even better. Based on our second quarter results and expectations for the balance of the year, we have confirmed our annual net earnings guidance. The operating environment will continue to be incredibly dynamic, but more importantly, customer behavior is changing faster than ever before. For the last few quarters, we've talked with you about our expanded view of all the food our customers eat and how we've been working to redefine the market as share of stomach rather than share among traditional grocery stores. We know that the massive $1.5 trillion U.S. food market creates a unique and sustainable growth opportunity for Kroger. You'll see changes in the way we go to market as a leading indicator of the lens through which we view our market. We see anyone who sells food as competitors in the future. Kroger has a history of successfully evolving to meet our customers' changing needs because we put the customer at the center of everything we do. We are transforming today, too. We are reprioritizing and accelerating investments in our Customer 1st Strategy in order to anticipate and meet rapidly evolving consumer demands to shop with us for anything, anytime, anywhere. Our transformation is all about redefining the customer experience. As our business continues to improve, we remain committed to delivering on our guidance for 2017 and believe we have the ability to grow identical supermarket sales and market share in 2018 as well. In this dynamic operating environment, we will continue to provide annual guidance as we've done for many years, but we'll no longer provide longer-term guidance. This will provide needed flexibility in how we invest to position us for the future success. We look forward to getting into the details of our goals and priorities at our upcoming Investor Conference in October. But in the meantime, I'd like to begin to create a vision by sharing several ways we are redefining the customer experience to be America's inspiration and destination for everything food. We're doing this by combining our knowledge of food and our ability to personalize through the use of data analytics. We're doubling down on digital and we're leveraging new and ongoing partnerships to deepen our connection with customers and drive revenue. I'll take a few moments to share more about each of these areas where we have deep credibility from our past and are aggressively developing for our future. Food retailing is more exciting than ever before, especially as more of us become foodies. Customers have nearly an unlimited number of options when you combine tastes, flavors, and types of meals with the growing number of food outcomes that consumers are focused on. Those outcomes might include eating for health or for enjoyment, lifestyle or performance reasons. Kroger is uniquely positioned to be the partner our customers turn to for their meal needs because we know food and we know our customers better than anyone. Meals have always been our expertise. Kroger is often the one driving change and innovation behind the scenes. We are very proud of the role we played for over a decade in making natural and organic products more affordable and accessible to America, especially for shoppers on a budget. We've always believed that our customers shouldn't have to pay higher prices just because a product is natural or organic. We developed our Simple Truth brand to be honest, easy, and affordable because our data told us this was a great customer need in the marketplace. Today, Simple Truth is the biggest natural and organic brand in the country by volume. This market continues to provide a robust opportunity for Kroger. Similarly, our culinary innovation team is bringing truly affordable and an incredibly tasty meal kits to American households through our Prep+Pared offering. Just last week, we announced that we were expanding our offering of Prep+Pared to more than 50 stores in three of our divisions: Cincinnati, Louisville, and Ralphs. Across Kroger, we know our customers better than anyone. We have a 13-year advantage of using data insights to connect with customers. Data analytics are fully integrated in our business as 84.51° helps us make merchandising, operations, and marketing decisions. In the last year alone, Kroger has made more than 3 billion personalized recommendations to customers through product offerings, promotions, recipes, and more. Data analytics is helping us win with our brands by identifying the best products to bring to market based on customer behavior and taste trends. Research by an independent third party shows us that our customers prefer our brands over national brands and competitor offerings. The strength of our brands ensures that our customers perceive Kroger quality as superior and at a very affordable price. It truly is quality without compromise. Kroger's customers get the best and most innovative quality at the best prices. We will build this momentum to be the premier private label destination in America. Combining our love of food with our data expertise allows us to offer content that inspires. We recently launched a new My Recipes feature on Kroger.com that serves up a personalized selection of suggested recipes. The recipes offer greater diversity of meal ideas, all based on your individual purchase behavior. Our growing collection of recipes is also searchable by a variety of filters, including seasonality, world cuisine, meal or dish type, and cooking style. While online recipes are not new, serving them up as personalized recipes for your family is, and customers and their families will love the new offerings, which is distinctively Kroger. Personalized recipes are just one example of how we're bringing the combination of food and data together to create new and highly relevant customer experiences, especially through digital and e-commerce. Customers expect a great shopping experience and the ability to interact with us digitally or online in a seamless way. Our digital efforts are all about making things easier for our customers and providing personal, affordable, and exclusive options that fit their needs. This includes our mobile app, for example, in addition to Vitacost.com, ClickList, ExpressLane, and home delivery. Today, we have more than 25 million digital customer accounts. As we said in our press release, our total digital sales are up 126%, driven by ClickList. We operate more than 813 ClickList and ExpressLane locations, offering the convenience of online ordering and curbside pickup. By the end of the year, we will offer this service at more than 1,000 locations. Customers continue to respond exceptionally well to ClickList. We know that in the future, more customers will want the option of home delivery. So we are also testing various home delivery models with companies like Uber, Shyp, and on our own in more than 150 stores. We will keep making these strategic investments to serve customers anything, anytime, anywhere in the near future. With new entrants in a fragmented market, we are also transforming our business and building partnerships to deepen our relationships with and create value for our customers. We've been preparing for new market entrants for years, and the fact that Kroger is trusted by more than 60 million households annually is a great strength when customers have more food choices than ever before. We continue to gain share in key categories like natural foods, produce, and fresh prepared foods. We will continue to focus on growing our core business to generate free cash flow and deepen our personal connection with customers. These changes also create opportunities to work with our existing partners to deliver more value for customers and to identify new partnerships to create alternative revenue streams. Now, here is Mike to share more details on our second quarter results and to walk through changes to our capital allocation process and long-term guidance. Mike?

Thanks, Rodney, and good morning, everyone. We're pleased with our second quarter results, especially the return to positive identical supermarket sales. That, combined with strong market share, tonnage growth, and both loyal and total household growth, demonstrates our ability to evolve with the changing preferences of customers. Kroger has the team, the skills, the knowledge, the scale, and data analytics to be a winner in food retailing. Another positive sign is that we had overall product cost inflation for the first time since 2015. As you know, the change from inflation to deflation and back again is one of the toughest environments to operate in for our stores, and we're proud of our team's ability to manage through it. Our Customer 1st Strategy has always guided our strategic investments to be there for our customers today and, more importantly, to where they are going in the future. To undergo the transformation Rodney discussed, we recognize that we need to make these Customer 1st investments more aggressively and faster than ever before. Like Rodney said earlier, we are eager to share the specific elements of our plan with you at our Investor Conference in October, but today, I will highlight two examples. First, 84.51° has helped us redefine space optimization for the entire store. As this comes to life, it will drive sales and operating profit growth. In the short run, there is a cost to doing this, but we feel the return is significant. This is another example of using 84.51° in new and innovative ways. Second, we're making sure we have the right products at the right cost and at the right retail prices for our customers. We are approaching these efforts along with the areas Rodney outlined earlier with even more focus and urgency than we have in the past. For example, we've already re-prioritized the way we invest capital by both reducing the amount we spend and by turning our capital allocation process upside down. We now look first for sales-driving and cost-saving opportunities through both brick-and-mortar and digital platforms. Second, we will continue to make sure our logistics and technology platforms keep pace with and scale to these demands through continued investment. Then finally, we will allocate capital to storing activity. This process has allowed us to use less free cash flow for capital investments. One thing I want to be very clear on is that we are not talking about a new strategy to replace Customer 1st. We are talking about better executing the elements of our plan to deliver on all four keys for our customers. As Rodney said earlier, our customer remains our focus. We continue to see strong growth and amazing potential in our brands. During the second quarter, Our Brands sales grew more than national brands in our grocery, drug/GM, and meat departments. Identical sales for Our Brands also outpaced identical supermarket sales. The second quarter brought strong sales and unit growth with Our Brands representing 27.7% of total units sold and 25.4% of sales dollars, excluding fuel and pharmacy. All of this is consistent with the research we commissioned last year to give us an objective view on our brands. This included blind taste tests with national brands and other private label foods. The research showed that the most loved brand sold in our stores are our brands, above even national brands. And in the blind taste tests, our brands outperformed competitive national brand and other private label products. Now for an update on retail fuel. In the second quarter, our cents per gallon fuel margin was approximately $0.217 compared to $0.198 in the same quarter last year. The average retail price of fuel was $2.28 versus $2.20 in the same quarter last year. Our net total debt-to-adjusted EBITDA ratio increased to 2.37 compared to 2.11 during the same period last year. This result is due to the merger with ModernHEALTH and the incremental repurchase of shares. Over the last four quarters, Kroger has used free cash flow to repurchase $1.7 billion in common shares, paid $448 million in dividends, invested $3.1 billion in capital, and merged with ModernHEALTH for approximately $390 million. The flexibility to return value to shareholders is a key strength of our financial strategy. We are committed to balancing the use of cash to maintain our current investment-grade rating. We have reduced our 2017 and 2018 planned capital investments by a total of $600 million to maintain this balance and flexibility. Return on invested capital for the second quarter on a rolling four quarters basis was 12.37%. On the labor relations front, we recently ratified an agreement with UFCW for store associates in Atlanta and Dallas. We are currently negotiating an agreement with the UFCW for store associates in our Food 4 Less warehouse stores and with the Teamsters for the master agreement. This fall, we will begin negotiations with the UFCW for store associates in Charleston, West Virginia. Our objective in every negotiation is to find a fair and reasonable balance between competitive cost and compensation packages that provides solid wages, good quality affordable health care, and retirement benefits for our associates. Kroger's financial results continue to be pressured by inefficient health care and pension costs, which some of our competitors do not face. Kroger continues to communicate with our local unions and the international unions, which represent many of our associates, the importance of growing Kroger's business and profitability, which will help us create more jobs and create more career opportunities and enhance job security for our associates. Turning now to guidance for fiscal 2017. We had previously indicated that the environment during the first half of the year would be similar to the back half of 2016, and that is what we saw. Cost inflation trends for the second quarter were consistent by department with grocery, liquor, produce, and meat all positive for the quarter. Deli was deflationary and pharmacy continues to be inflationary. We are confirming our 2017 net earnings guidance for 53 weeks of $1.74 to $1.79 per diluted share. We are also confirming our adjusted net earnings guidance range of $2 to $2.05 per share. Our LIFO expectation remains unchanged at $80 million. We expect identical supermarket sales growth, excluding fuel, of 0.5% to 1% growth for the remainder of the fiscal year. Our guidance does not include any effect from Hurricanes Harvey or Irma. Our insurance provides coverage and caps losses at $26 million for each event. Until the claim is finalized, it is difficult to provide an exact amount. And we expect capital investments, excluding mergers, acquisitions, and purchases of leased facilities, to be in the $3 billion to $3.3 billion range for 2017.

Thanks, Mike. I'm often reminded of the saying, may you live in interesting times. These are interesting times in our industry. And I know some of you wonder how Kroger can continue to thrive in such a dynamic operating environment. We have a history of evolving to meet our customers' ever-changing needs. The key is to proactively see where the customer is going and to proactively address the changes. That is what we are doing today. Through innovation, Kroger is redefining the food and grocery customer experience based on our core strengths. Kroger has more data than any of our competitors, which leads to deep customer knowledge and unparalleled personalization. We have incredibly convenient locations and platforms for pickup and delivery within one to two miles of our customers. We have a leadership team that combines deep experience with creative new talent. We have the scale to win with more than 60 million households shopping with us annually. In fact, we've been named America's most beloved grocery store several times. We have a proven track record of consistently returning capital to shareholders through an increasing dividend and share buyback program. And we have a track record of connecting with our associates, customers, and communities to uplift and improve lives as evidenced by our team's response to Hurricane Harvey. Now, we look forward to your questions.

Starting, I guess, with your guidance. I guess, what I'm trying to understand is, obviously, you maintained your earnings guidance, but you now have operating margins down 30 to 40 basis points versus the prior 20 to 30. So by my math, that's about $0.09 to earnings. And so, I guess, I'm wondering, just to clarify, the offset has to be below the line, unless I'm missing something? And I just had a follow-up on the operating margin guidance change.

The benefit comes from multiple places throughout the income statement, Karen. There are efforts underway that will make the operating margin decline that you saw in the second quarter not as much in the third quarter. We feel very good about the health of the business today, the trend of ID sales, our efforts on cost of goods reductions and our efforts on productivity and operating cost reductions. And when we combine all of those, we feel comfortable with the $2 to $2.05.

The operating margin rate has decreased by 30 to 40 basis points compared to the previous range of 20 to 30. Can you elaborate on whether this decline was primarily limited to the first half, or if we should expect further changes in gross margin or operating expenses in the second half that we had not previously considered?

Yes. I'm not going to go into every specific line of the income statement, but we are seeing good flow of cost of goods coming in and good cost savings opportunities in the back half of the year.

Okay. And then, just one quick question. I guess, on Bloomberg, you indicated sales in the third quarter to-date were off to a nice start. I think that's what you said. Maybe can you get a little more granular, meaning are they at the high end of your second half guidance or a little more color there?

Yes. So far this quarter, excluding the effects of the hurricanes, we are performing better than we did in the second quarter and are trending towards the higher end of our guidance range. We are excluding the hurricane impact because it creates volatility; some days our business can be up significantly, while other days it could drop to nearly zero. Once we fully assess the impact of the two hurricanes and release our results for the third quarter, we will provide more detailed insights. For now, we are ahead of our second quarter performance and leaning towards the upper limit of our expectations.

And Houston is doing just fine. They have all but two stores back in operational and our warehouse is fully operational.

I want to follow up on the ID sales. You mentioned the recent traction, but your second half guidance would imply that you actually narrowed the annual range by 30 to 40 basis points. So could you just talk about parts here, estimates, traffic trends and maybe walk through the decision to narrow that range rather than just holding it steady or taking up the low end?

Yes. Frankly, we talked about it a lot, and what our intention to do is really to take flat for the year off the table because we don't see that in the cards. We still clearly see 1% for the year in the cards and our intent was really to get the notion of flat off of the table. It may be confusing to people so far today, but that's what our intention was. We may not have done it as perfectly as we could have, but we still think the high end of the original annual guidance range is in the cards. But we don't believe flat is in the cards, which is why we wanted to take that off the table.

Regarding the range adjustment, as Mike mentioned, if we had maintained the previous range, it might have indicated that we would experience negative identicals for the second half of the year. We clearly wanted to convey that we do anticipate positive identicals. The trends we are observing so far show that identicals are continuing to improve.

Okay. That's helpful. Appreciate that. And Mike, I also wanted to follow up on the quarterly EPS cadence that you provided last quarter. Should we still anticipate EPS up slightly in Q3 and then flat in Q4, excluding the extra week?

Yes. We actually purposefully pulled the quarterly guidance cadence out of the earnings release in light of focusing more on an annual earnings per share target. I don't see any big alterations to that guidance that we had last quarter. Halfway through the year, you kind of have to wind up with those kinds of numbers to be in the $2 to $2.05 range anyway.

Rodney, I have two strategic questions. First, regarding the space optimization project you mentioned, is it focused on reducing center store space while increasing fresh offerings? Are you shifting from more brands to a greater emphasis on private label? What actions are you taking in this area? Additionally, are the costs related solely to labor for rearranging shelving and similar tasks?

In terms of scope, it includes everything you mentioned and more. As Mike pointed out regarding space optimization, 84.51° is assisting us in analyzing the entire store layout and our space usage. In some instances, this will involve continuing to add more fresh space. Additionally, every product needs to justify its place on the shelf, and categories must prove they deserve a certain allocation. Therefore, it encompasses all these factors. The expenses will primarily stem from two areas. First, making changes may require writing off some equipment. Along with the costs associated with implementing these changes, some equipment can be written off almost immediately. So, both of these aspects relate to what Mike was discussing.

And if you move things around too much inside of a store, there's obviously disruption for a short period of time to the customers being able to easily navigate as we move a lot of shelving and things around.

When it comes to capital allocation, it appears that there is a preference for investing in existing stores rather than new ones at this time. How does this influence your approach to mergers and acquisitions? Does this indicate a reduced interest in traditional M&A, and does it suggest a greater inclination towards digital acquisitions instead of physical ones?

From an M&A perspective, we are just as enthusiastic about potential partnerships today as we were two years ago when we find the right match. We seek partners who bring as much to the table as we do. We will continue to actively explore digital opportunities that enhance our capabilities. Over the past year and a half, we successfully merged with Market6 and YOU Tech, leveraging 84.51° in both cases to enhance their work and ours while bringing valuable talent into our organization. We will increasingly assess what unique capabilities potential partners could offer and how we can collaborate effectively. For the right merger opportunity, whether digital or physical, our excitement remains as high as it was two years ago, but it is essential that the partner aligns well with our operations and has a robust business.

I agree.

Have you seen any of your competitors lower prices yet as a direct result of changes at Whole Foods? Can you also share how your stores have been performing over the last couple of weeks? It's not necessarily that Whole Foods has reduced prices significantly, but there's been a lot of media coverage related to it. I'm trying to understand what you are observing in the marketplace so far.

Well, as you mentioned, Ken, it's only been one and a half weeks. So it's very early in the process. And as I mentioned in our prepared remarks, we're really proud of the work that we started over a decade ago on making sure natural and organic products are affordable to all customers. And we've never felt like just because something is natural and organic, you should charge a premium for it. In terms of the impact, obviously, it's way early, but there isn't anything that would cause you to develop any point of view at all in terms of changing trends. But it's only been one and a half weeks, so I would caveat it a million different ways.

It feels like it's been longer in my world. Can I just follow up on one thing? In terms of your guidance for the comps in the back half of the year, I just wanted to dig in a little bit more on that because the business is doing, clearly, in some ways better, right? You're talking about comps being positive. You have positive tonnage, but the guidance does imply a fairly meaningful step down in the 2-year stack in comp in the back half. And I know there's many ways of looking at that, but that's one of the questions I've gotten from investors this morning. I just wanted to see if you had a comment on that, if you could sort of help us out understand why you're sort of thinking that comps will be a little bit maybe weaker on a 2-year level and maybe that means fundamentally weaker? Or is that not how you look at it?

I don't focus much on 2-year comparisons because I sold what I sold last year and I'm selling even more this year. We're confident about the health of our business. As mentioned in the prepared remarks and in response to questions, ID sales this quarter are at the higher end of our guidance. We have increased loyal households, total households, and achieved significant market share and tonnage growth. It's important to note that as our brands continue to strengthen and capture more units and sales, it does lead to a lower retail price, which slightly impacts reported ID sales. We have been very proactive in how we present those products in our stores.

On the digital revenue growth, pretty significant and obviously making progress there on the ClickList side. I'm curious, did that have any meaningful contribution to the comp that you reported in the quarter?

It's a great question and difficult to answer because we're focused on providing a seamless experience for our customers as they shop in-store. This approach allows us to capture a larger share of their total purchases, benefiting our comparable sales by increasing their overall spending with us. While it does assist with comparable store sales, it's challenging to quantify ClickList's specific impact in percentage terms.

No. It's clear that the customers love the service and it gives them an incremental connection with Kroger. And as Rodney said, it gives us a bigger share of their wallet the longer they're engaged in ClickList.

Understood. And then, second question on the private label business. That's been a big success factor for you. Rodney, you've highlighted in some of your initial comments the customer perception of the brands that you offer under your corporate brand. I'm curious, as you think about the future opportunity, a, what is the magnitude of that opportunity as a percentage of sales? And then, b, how much capacity do you have for self-manufacturing to deliver on that higher penetration opportunity?

Yes, I want to provide a broader response beyond just your question. First, let’s discuss our brands in comparison to private label. It took us longer than it should have, but our brands are truly our own, and customers have expressed their love for them. We should have pursued this earlier, but we recently became more proactive in hiring a third-party company to conduct a comprehensive study on taste and quality preferences for our brands compared to various national and other private label brands. We always believed we had a good offering, but the results exceeded our expectations significantly. So it really highlighted the progress that our team has been making on improving the innovation in our brands, the variety of offerings. If you look at Simple Truth, obviously, five years ago, it didn't exist. Today, it continues to grow double digits. So when you look at overall, our customers tell us they love our brands and we continue to even get more aggressive in terms of creating additional innovation brands, offerings within it, new flavors. In terms of the potential, at this point, the only thing that I would say is it would be massive. And one of the things that we did several years ago, we went to the outside and hired a new leader for that team and about half of our team is from the outside. And when you go and look at Europe, obviously, on our brand products in Europe, the market shares are significantly higher than the U.S. And we would be much more focused on how do we make sure the innovation, the quality, and the offerings that we have, we earn the right for the customers to take it to that kind of level. In terms of our plant capacity, our manufacturing team would likely say they are nearly at full capacity. However, we have consistently found ways to produce additional products efficiently. Understanding how to operate plants allows us to consider expanding capacity easily, whether through process changes or adding new plants, depending on what is necessary.

Rodney, Walmart, you highlighted your impressive digital sales growth. Could you share what percentage digital sales make up of your overall sales?

Not at this point. I don't know, Mike, if you have that information. As you know, we're continuing to provide a bit more insight than before, but...

I will continue to pursue that topic, but perhaps at a later time. I wanted to ask about Walmart, as they are aggressively rolling out their version of ClickList. Can you discuss where you see overlap with them and what the competitive dynamic looks like, considering both companies are leading the charge in this new grocery shopping approach? Additionally, regarding competition, Lidl has been operating longer than Amazon's Whole Foods. Could you provide an update on what you are observing in that area?

Yes. On the crossover with Walmart on digital, I actually don't know the answer to that. Mike, do you?

I don't know how many we overlap with. I do know that the thing that customers really appreciate about our offering is the fact that most of our customers live within a mile or two of the store. They shop and they can go pick the ClickList up offering in. So it's extremely convenient for them to engage in that kind of an activity, and often use the click-and-collect service, and not all of our competitors have that advantage.

Yes. It's very simple to create a shopping list with us thanks to the efforts of our teams collaborating with 84.51°. We invest significantly in forecasting what items will be on your shopping list to streamline the process. One insight I can share is that our ClickList success is remarkably consistent nationwide. You won't find a scenario where one area sees only 1% success while another experiences 100%. The level of success tends to be quite uniform. On Lidl, obviously, they continue to open stores. So far, what they've done has been pretty consistent with what we expected. And obviously, you've heard us talk about, from a pricing standpoint, we won't lose on price. We're not trying to lead the market down on price, but we're not going to lose on price. The success so far in terms of being able to maintain our business and grow our business, we feel very good about our ability to compete against ALDI, Lidl, and anybody else. So I wouldn't say there's been any surprises so far. Obviously, they're a great competitor, but there's a lot of great competitors out there.

Is the move away from providing long-term guidance related to the ramp-up of ClickList? Does this mean it puts short-term pressure on store profitability? Should we view ClickList as beneficial, but a strain on margins in the short term?

We base our investment decisions on what we believe is best for our business in the next three to five years, which directly aligns with what's best for our shareholders in that same timeframe. Currently, ClickList presents a challenge to our earnings. We have been increasing the pace at which we roll out ClickList, making it an additional challenge. However, looking ahead over the next three to five years, we are confident that our customers will appreciate the ClickList service, our associates will be pleased to provide it, and our shareholders will see the benefits. We can see a future where it doesn't matter whether customers shop in the store or use ClickList. There may be initial difficulties, which could impact our long-term guidance perspective.

This is Mark Carden on for Michael Lasser today. So you commented earlier that periods transitioning from deflation to inflation can lead to a challenging operating environment. And so given we saw food at home CPI turn inflationary again this quarter, can you comment on how the competitive environment has held up relative to your expectations? And by that, has it been different from past cycles or pretty much in line with what you've seen recently?

Yes. I would say it's fairly common or a fairly traditional kind of a transition. It's just that anytime you go from higher prices to lower prices, the thing that gets disrupted is how quickly will people lower prices. And then, the flip is the case as inflation creeps back in, how quickly will people adjust their prices the other direction to continue to protect their gross margin dollars that they would have in those products. And that's what causes the disruption in the short run as you're cycling through the two of those. I would say broad-based there isn't anything that's really out of the realm of what you normally see. The one exception to that would be what we talked about earlier in the year relative to some low milk prices earlier in the year and eggs continue to be pretty inexpensive as well, but those would probably be the only two categories that I would hold out as maybe exceptions to the norm right now.

Okay. Great. And then, I guess, a little bit more near-term, you mentioned that, with hurricanes, there's obviously some variability. One day you could see a benefit from stock-up trips while the next day you see a decline from closed stores. I guess, historically, have you seen this trend towards either a net benefit or a net loss? Or is it really just varied based on the storm?

It really varies based on the storm. At the end of the day, it depends on how the insurance claim is reconciled. From your business perspective inside the store, there is usually a slight benefit. We have always done a great job of being one of the first to fully resume operations, allowing us to service both our customers and the communities where our stores are located. It is crucial for those who have been evacuated to have us back in business once local authorities lift the evacuation order. If we are not operational, these individuals face significant challenges as they return to their homes. Many have lost products and need to restock as soon as they can return. There are numerous factors to consider, but we prioritize supporting our associates, customers, and communities, as they rely on us for food. We’ve always been there to provide that support.

We have excellent relationships with local agencies, and we are often seen as part of the first responder group because people recognize the importance of keeping grocery stores stocked. Therefore, our associates are typically granted clearance as first responders.

Clearance to access the store is often one of the initial priorities once power is restored. There are many essential services that must be established before returning from an evacuation, including the availability of food. We consistently ensure that we are prepared to provide assistance during these times.

So I also just wanted to touch on maybe some of the larger CPG players out there. We continue to see weakening trends from a number of the larger players. And I was just curious, as you look at your partnerships with them, are you at all starting to see more efforts by them in terms of maybe supporting their products in store or even maybe improving competitiveness?

We consistently collaborate with CPG partners to explore ways to grow our businesses together. Both parties are committed to expanding our operations. CPGs are increasingly eager to collaborate with us to enhance their growth. Our strong insights from 84.51° enable us to engage with most CPGs in a deeper and more innovative way. There is significant change occurring, and CPGs are aware of this transformation. We are dedicated to assisting each other in business growth while also concentrating on our own expansion initiatives.

Okay. Great. And going back to maybe a question that was asked earlier on the promotional environment. Because it sounds like some of the items that were more promotional, eggs and milk, you continue to see pockets of increased promotions out there. But outside of that, how would you characterize the promotional environment versus what you were seeing earlier this year?

Outside of that, I wouldn't say there's been a significant change in trend. There’s an old saying in economics that all short statements are misleading. Present me with a scenario and I can find a different angle. The most notable change would continue to be milk and eggs across the country. Everything else would have its ups and downs.

I just want to go back a little bit more to the overall pricing strategy, right? Obviously, kind of since last quarter, it's been a big topic for you guys. What is the 84.51° data telling you? Like, when you're making decisions in different geographies to either be a leader or a match or a close follower on pricing on some of these high-velocity items, is it kind of always the case that you kind of have to match it to keep that loyal customer? Or if they go somewhere else, how long does it take to get them back? And maybe just a little bit around the consumer behavior that the data is telling you.

The key takeaway from the 84.51° insights is that customers choose where to shop based on their overall experience. This experience includes the shopping environment, the treatment from associates, available rewards, and personalized offers, which are often only noticeable to individual customers. Additionally, the freshness of products like produce, meat, and deli items plays a significant role. It's crucial to recognize that all these factors combined influence customer decisions. Pricing varies as different customers prioritize different products. Ultimately, the insights emphasize that customers value the overall experience rather than just one aspect of it.

Okay. And then, maybe just a quick follow-up. Just going back to the maintained EPS guidance for the year. It would seem that, at least with 10 basis points lower margin, at least one of the larger offsetting factors would be from fuel. So maybe just any thoughts on the profitability on the fuel side for the back half of the year. And also, just I don't know, I might have missed it, but can you give us an inflation number as well for this quarter?

What was the last part? You kind of tailed off.

Yes, the inflation for the quarter.

Fuel remains strong this year. While I don't want to focus too much on the impact of hurricanes, it's important to note that some refineries have been shut down and the Colonial Pipeline experienced disruptions, leading to tight supply in certain areas. As a result, we may see some disruptions in the third quarter. We transport fuel from various distant locations to ensure our stores remain supplied. Overall, I believe the second half of the year will still see relatively good performance in fuel. Regarding inflation, I noted the categories that experienced both inflation and deflation. For the first time, we saw inflation in the grocery category, registering around 48 or 49 basis points, which significantly influences the overall business direction. This is the first instance of inflation in grocery since the fourth quarter of 2014 on a quarterly basis.

Just to better understand the reduction in the nonfuel operating margin guidance, is that more about gross margin or operating expenses versus sort of the initial thought process?

Yes. What was your comment on the guidance of reducing the nonfuel operating margin?

Yes. Is the reduction more about gross margin being a little worse than initially thought or operating expenses being a bit higher?

I am not aware of us providing guidance on operating margin for the second half of the year.

It's in the 8-K.

It's in the 8-K? Okay. I understand. I was going to mention that we didn't cover it during the call. It continues along the lines of what we've observed. We believe that in terms of dollars, we will start to see some improvement in gross profit dollars and operating profit margin dollars as the year progresses. As ID sales keep increasing, that will contribute to the growth in dollars, which is essentially the key factor in enhancing earnings per share. Ultimately, our focus is on the dollars rather than the rate.

Okay. Fair enough. And just to follow-up on the milk and eggs comment, I think you might have mentioned just now sort of across the country, and I don't know that, that was consistent with sort of the last time I heard about that. Has it broadened out? Did I catch that right? And pursuant to that, were the price investments that you guys announced last quarter, do you feel like still they're already sufficient?

Yes. My comment about milk and eggs was not meant to suggest any changes from the first quarter regarding their distribution. What was the second part of your question?

Second part is just around the price investments in those categories. Do you still feel pretty good about that? Or what you've done already, is that sufficient at this stage based on the geographies where you're seeing that pressure?

Well, I would just, I guess, I would broaden it we feel good about the pricing investments that we make. And based on what the customer's telling us, it continues to connect as we expected and we feel good about it when you look at everything in total.

Got it. And this is the last one, just on the inflation comment. Was that specific to groceries or to center store? Or was that kind of all-in applicable to IDs? And if not, could you give us sort of an all-in number?

Well, the all-in number was ID sales, without inflation, without the pharmacy business, was about 60 basis points of inflation, so not a whole lot different than the grocery category.

So nonfuel FIFO gross margins, excluding ModernHEALTH, were down about 30 basis points. That was a pretty good improvement versus the first quarter. Could you guys just walk us through some of the puts and takes of that decline? And is that more reflective of some moderation in the price investments? Is it private label mix? Just any color there would be great.

I would say there would be two things that helped that. And one is the continued strength and growth of our brands, which, while it dampens the top line a little bit, comes at a better gross margin rate. And the second is we continue to do a great job on cost of goods and the input cost of that. And one of the things the CPGs partners like about the cost of goods investments is we do pass those on to the customers, but it does help strengthen the gross profit rate in dollars over time when you have the better cost of goods that are out there.

In the second quarter, we saw improvements in some operating cost categories compared to the first quarter.

And should we expect that to continue into the third quarter, that trend?

I would think so.

Okay. Great. I have a larger question regarding the retail environment, which has been quite tough in the last year or two. Do you anticipate an increase in store closures from weaker competitors over the next couple of years? I'm not sure how much insight you have into this, but if that happens, would you consider acquiring any of these assets or locations, similar to your approach with Marsh? Additionally, how does your decision to reduce capital expenditures fit into this situation, if at all?

We strongly believe that we can expect more consolidation moving forward. This will occur as you mentioned, along with other methods such as mergers and various initiatives. There's no doubt that we will continue to see significant consolidation. As we've always stated, you can assume that we've evaluated anything that takes place. Our acquisition of Marsh is a prime example of this strategy yielding positive results, allowing us to enter specific trade areas where we previously had no presence. By purchasing stores in such scenarios, we can penetrate new markets and utilize our existing infrastructure. While we are keen on these opportunities, they tend to come in clusters; you might not see any for a couple of years, but then a surge will occur. We remain interested in such opportunities and consistently evaluate potential mergers or acquisitions.

Great. Just curious about your natural and organic portfolio, the growth rate you're seeing there, what portion of your business it now represents. And related to that, what is your private label penetration in natural and organic?

If you look at natural and organics overall, it's over a $16 billion business for us on an annual basis. So obviously it's an important part of our business. It continues to grow strongly and we would continue to see a great opportunity in that space. We find more and more customers, for some items, they will purchase a natural or organic item. In other places, they will buy traditional items. And for us, what we try to do is we don't judge a customer on how they eat and we try to make sure we have what the customer wants at a great value. In terms of market share, it depends on how you define it. Last year, Simple Truth represented a $1.7 billion category for us. Looking at the total of $16 billion would include some non-branded and other items, which provides some insight into market share. Overall, grocery typically accounts for about 30% in units, indicating there is still substantial room for growth.

Great. And my follow-up is just on click-and-collect. Just curious what kind of penetration you've seen in stores that have had it longer? Where do you think that can go? And also how do the visits and basket compare to an in-store customer?

Yes. When you look at the total, we are capturing more of our customers' business, which is why we remain supportive and committed to this initiative. Regarding the share of business, we are not ready to disclose specific details about stores or the percentage of their business represented by ClickList. The figures vary widely and are influenced more by specific stores than general trends. For example, there is one store with a relatively high percentage because it is conveniently located off the interstate, attracting many new customers. Its ClickList trade area is quite different from that of the store itself. We have designed a business model that incorporates a certain percentage of in-store operations, which allows for greater efficiency without requiring additional asset investments. As the business grows, it can easily transition to dark stores or standalone warehouse facilities that utilize more automation. Our goal has been to create a model that supports partnerships and generates profits while adapting to whatever percentage of our business our customers choose to engage with. We have focused on developing a model that is easily scalable based on varying levels of market penetration. Thanks to everyone on the call. Obviously, hopefully, you hear some of the comments that Mike and I are making. Kroger is playing to win. And the things that we do are what we believe will be best when you look out three to five years for our customers and associates. And what we've always found when we do both of those, that our shareholders are well-rewarded as well. And the business continues to generate great free cash flow and we have great opportunities in front of us. And then, one other comment. As you know, I always like to share some additional thoughts with our associates that are listening in. First of all, I'd like to send our well wishes to the people of Houston and especially members of our Kroger family whose lives have been turned upside down by the recent hurricane and its aftermath. Our thoughts and prayers are with those who are now bracing for Hurricane Irma as well. Since the rains stopped in Houston, you have shown nothing can stop the strength, resilience, and power of our amazing associates. Many of you stayed in or couldn't easily leave stores, distribution centers, plants, and offices and stayed overnight and worked tirelessly to not only serve our customers but to provide food and supplies to first responders and local shelters. As a company, we've sent nearly 2,800 semis packed with food, water, and other critical supplies to the region. More than 350 individual associates from all corners of the country traveled to Houston to lend their hands to help uplift the community. Having a physical presence and truly being part of a community is always important. This is perhaps never more apparent than when you have natural disasters strike. You and our stores are a vital part of the communities we serve. What I'm most proud of is how you've taken care of each other, whether that's giving a hug to someone who needs it or traveling across the country to work side by side in reopening our stores and warehouses. We take care of each other. It's who we are. Each day, we open our doors and welcome our neighbors with true hospitality and generosity. And together, we make the world a better place. Thank you for all you do, in big ways and small ways, to feed the human spirit. We are truly Kroger strong. That completes our call today. Thanks for joining.