Kroger Company (KR) — Q3 2018 Earnings Call Transcript

Thanks, everyone. 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 third quarter press release and our prepared remarks from this conference call will be available on our website. While there, we encourage you to visit the Events and Presentations page to find the full slide set outlining Restock Kroger as laid out at our Annual Investor Conference. Restock Kroger will be the framework we will be using over the next few years to clearly communicate how we plan to serve America through food inspiration and uplift and, as a result, create shareholder value. After our prepared remarks, we look forward to taking your questions. 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 third quarter results is Executive Vice President and Chief Financial Officer, Mike Schlotman. I'd like to thank you for joining us at our Investor Conference last month where we outlined Restock Kroger, our plan to create shareholder value by redefining how America eats. Food retailing is more exciting than ever. More Americans identify as foodies and customers have more food choices than ever before. In the past, we have defined our market as share among traditional grocery stores. Today, we've redefined our market as share of stomach. This sharpens our focus when we look at our industry and our customers. We see anyone who sells food as competitors, which doubles the size of our market to $1.5 trillion. If you're eating, we want to serve you that meal. The fact that Kroger is trusted by more than 60 million households is an incredible competitive advantage. Kroger has competed in an ever-changing retail landscape for 134 years because our touchstone has always been the customer. We place the customer at the center of everything we do. And because of our relentless focus on serving customers, Kroger is uniquely positioned to be the partner they turn to for meals. Restock Kroger has four main drivers: Redefine the grocery customer experience, expand partnerships to create customer value, develop talent and live our purpose. These pillars combined will create shareholder value. Going forward, I plan to highlight an item or two each quarter that we've made headway on. This quarter, I’d like to begin by talking about how we are creating a seamless environment where our customers can choose how they engage with us, in-store and online. Our efforts are all about making things easier for our customers and providing personalized, affordable, and exclusive options that fit their needs. Seamless will play a major role in redefining the grocery customer experience. Our hypothesis has always been that our customers will want to have options on how they engage with us. This hypothesis shaped our strategy and we've been executing that strategy by accelerating Kroger's digital and e-commerce efforts for the last several years. We know that our customers have already decided they love ClickList, which is why we continue to rapidly expand that offering. By year's end, we will be serving customers at more than 1,000 click-and-collect locations. Our third quarter digital revenue growth was 109% driven by ClickList. We also know that some customers desire home delivery. We've gone from 0 to more than 300 locations offering home delivery in a span of a little over a year by partnering with service providers, including SCRIP, Roadie, Uber, and others. We'll continue to build on our home delivery offering in 2018 with these partners as well as Instacart, who we are developing a unique relationship with. We have initially launched a partnership with them in Southern California. We'll continue to use our data and customer insights to make it really easy for our customers to navigate across the channels they choose when shopping with us and we'll continue leveraging our physical proximity to our customers as a competitive differentiator. To do all of this requires the investment we outlined in Restock Kroger. Everything that we're seeing in our data and in customer behavior tells us Kroger's transition to seamless is working. Today, households that engage in our seamless offerings, engaging digitally and with our physical stores, spend more per week than households that do not. The future looks even more promising. We'll continue to add even more services, expand our available product selection, and more effectively use our insights to create a personalized experience that every customer will love. Winning in a seamless world also means optimizing space and ensuring our brick-and-mortar experience is curated to deliver exactly what customers are looking for. We firmly believe that customers of the future will continue to frequent physical stores with compelling offers and experiences. A very recent example of this is Kroger had our best-ever Black Friday results for general merchandise led by record sales at our Fred Meyer division. Another focus area on redefining the grocery customer experience is winning with Our Brands. It's no surprise that America's most beloved grocery store has some of America's most beloved brands, which, as a portfolio, we will continue to champion for growth. In fact, Our Brands as a stand-alone company would be in the top one-third of the Fortune 500. In the third quarter, Our Brands continued to deliver strong performance, making up 28.2% of unit sales and 25.6% of sales dollars, excluding fuel and pharmacy. Simple Truth continues to resonate in a big way with our customers with sales growing 19% in the third quarter. Another important Restock Kroger area is focused on accelerating cost of goods savings and sales leverage. We will continue to work on controlling costs to invest in areas that matter most to customers. For example, we are leveraging our relationship with suppliers to drive costs and inefficiencies out of our various businesses. These processes have successfully driven significant savings in cost of goods, which allow us to invest in price for our customers. At the same time, this helps our suppliers generate volume growth. Our use of data and science creates opportunities and efficiencies that both parties benefit from. Across the board, customers are recognizing our efforts to redefine the customer experience and they are rewarding us with their loyalty. This, in turn, creates value for our shareholders. That's exactly what Restock Kroger is designed to do. We will create shareholder value by generating incremental margin dollars and free cash flow over the next three years. As our business continues to improve, we remain committed to delivering on our 2017 earnings guidance. We are also confident we have the ability to grow identical supermarket sales and market share in 2018.

Thanks, Rodney, and good morning, everyone. Our core business was strong in the third quarter. We are very pleased with our ID sales exceeding 1% in the third quarter. We're especially happy to see the very strong performance in our fresh departments. The results in produce and meat were terrific and we continue to see double-digit growth in natural foods. Our ID sales results were driven by both higher spend per unit and strong growth in the number of households. Total visits continue to grow throughout the quarter and our market share was up. Our business is gaining momentum and our customers are recognizing the investments we are making. We noted at our investor conference that over the next three years, Restock Kroger will be fueled by $9 billion in capital investments, cost savings, and free cash flow. We recognize that in order to be there for our customers today and, more importantly, to be where they are going in the future, we need to make investments more aggressively and faster than ever before. We've already prioritized the way we invest capital by both reducing the amount we spend and optimizing our capital allocation process. We now look first for sales-driving and cost savings 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 those demands created through these investments. Then finally, we will allocate capital to storing activity. This process has allowed us to use less free cash flow for capital investments. As Rodney said earlier, we are aggressively managing OG&A costs and implementing new programs to reduce our cost of goods sold. One example is our recent decision to require on-time and in-full delivery from suppliers. We're implementing penalties when scheduled deliveries are missed within a designated window. Over time, this will help keep costs down by ensuring more predictable operations, but more importantly, it will ensure that we have the products on our shelves that our customers want and when they want them. We expect Restock Kroger to generate $400 million in incremental operating profit margin over the three years from 2018 to 2020. We also expect to generate more than $4 billion of free cash flow after dividends over the next three years. Our goal is to continue generating shareholder value even as we make strategic investments to grow our business. Fuel performance was also outstanding in the quarter. Our cents per gallon fuel margin was approximately $0.249 compared to $0.179 in the same quarter last year. The average retail price of fuel was $2.46 versus $2.17 in the same quarter last year. This, along with our strong core business results, demonstrates the diversity of our earnings. The fuel performance in the quarter also created the opportunity for us to make an incremental $111 million contribution to our UFC Consolidated Pension Plan. As you know, we announced last month our intention to explore strategic alternatives for our Convenience Store business, including a potential sale. This was a result of a review of assets that are potentially of more value outside the company than as part of Kroger. This process is ongoing and there has been a high level of interest. We have said for some time that we expect our net total debt-to-adjusted EBITDA ratio to grow. This is because we are bringing an off-balance sheet item onto our balance sheet or funding an obligation already on our balance sheet. As a result, we are updating our target range for this ratio to 2.2x to 2.4x. These obligations, whether recorded on or off Kroger's balance sheet, have generally been considered when our credit profile has been reviewed. Our current result of 2.57x is above this range. We expect to use free cash flow and potential proceeds from the sale of assets to get us back in the range. Protecting associate and retiree pensions is one significant way that we take care of our associates. Another is hiring and job creation. Kroger is currently hiring to fill 14,000 part-time and seasonal jobs. This is in addition to the nearly 10,000 permanent jobs we've already created in 2017. Through Restock Kroger, we plan to invest an incremental $500 million in human capital in wages, training, and development over the next three years. Our financial results continue to be pressured by inefficient health care and pension costs, which some of our competitors do not face. We continue to communicate with our local unions and the international unions which represent many of our associates about the importance of growing our business profitably. We expect fourth quarter identical supermarket sales growth excluding fuel to exceed 1.1%. We confirmed our 2017 net earnings guidance for 53 weeks of $1.74 to $1.79 per diluted share and our adjusted net earnings guidance range of $2 to $2.05 a share. Our LIFO expectation has been lowered to $60 million from $80 million.

Thanks, Mike. We are pleased with the third quarter results and the fourth quarter is off to a solid start. Our associates are providing friendly and fresh service to our customers in a seamless way. In addition to Restock Kroger, we outlined our investment thesis last month at the Investor Day and I would like to share it with you again today because we feel like it really highlights our strengths. As America's grocer, we are growing in a fragmented market. Kroger has more data than any of our competitors, leading to deep customer knowledge and unparalleled personalization. We have incredibly convenient locations and platforms for pickup and delivery within 1 to 2 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, Kroger has been named America's most loved grocery store several times. We connect personally with our associates, customers, and communities to uplift and improve lives. We have a proven track record of consistently returning capital to shareholders through an increasing dividend and share buyback program. And with Restock Kroger in place, we are confident in our ability to continue winning with customers, growing our business, and creating shareholder value.

I'm just trying to understand gross margins a little bit better. So Mike, you just said in the prepared remarks that you expect margins to moderate in the fourth quarter. And obviously, everyone was very surprised by the 30 basis point increase in gross margins this quarter. So, I guess, I'm wondering if you could just shed a little more light on what might have been transitory this quarter?

What I mentioned regarding the moderation of margins in the fourth quarter is that we anticipate our fuel margins to ease, and we have already observed this trend. The gross margins this quarter showed a 30 basis points increase excluding fuel, ModernHEALTH, and the LIFO charge discussed in the earnings release. We have been much more focused on reducing our cost of goods and improving our negotiations with vendors. Our sales mix was notably strong this quarter, with an emphasis on more natural foods and Our Brands, which has contributed to an increase in our margin rate, offsetting ongoing price investments. While our cost inflation remains higher than retail inflation—reflected in the chart I shared during the investor conference—they are beginning to align, and both are now in positive territory.

So is it fair to say then this dynamic in terms of being better at lowering cost of goods is something we should expect at least for the next three quarters? And then, in any way, you could just give what cost inflation was versus retail inflation?

Yes. I won't get into the habit of predicting where gross margins may go on a quarter-to-quarter basis because you never know exactly what negotiations or what benefits may fall in a particular quarter, but we do feel good about the results we posted.

Okay. Just one follow on. On the expenses because you did talk about multiemployer quite a bit, can you give any color on how to think about multiemployer expenses next year versus this year just directionally?

As I sit here today, there are two components of multiemployer expenses. One is based on a cents per hour basis as part of our contracts to third-party plans that we don’t manage. I anticipate a slight increase in that number. Regarding contributions to the UFCW plan we established five years ago, I expect them to be slightly less next year than this year due to the contribution we just made and the strong return on assets they are experiencing.

So if the rate of gross margin that you saw in this quarter continues, would you use that as an opportunity to accelerate and deepen your price investments? And what are you seeing on the competitive environment as far as pricing at this point?

Well, one of the things that you've heard us say for a long time is we will not lose on price and we'll continue to use our data and insights to understand where we should be priced on a basket of goods and individual items. So we will continue using that data to influence and cause us to invest in pricing going forward. As you know, at our Investor Day, Mike outlined that, looking over the next three years, we would view over the next three years we will aggressively continue to invest in price and we'll use the savings from all the things that Mike outlined to pay for those continued investments for our customers.

And my follow-up question is if we did get tax reform and your tax rate goes down significantly, how would you look to deploy that benefit to your P&L? Would you just let it flow to shareholders or would you look to subsidize investments you might make with that savings?

We are very excited about the direction of tax reform, particularly the House version, which begins to take effect almost immediately while the Senate's plan is delayed by a year. We believe this will enable us to keep investing in our business, which will lead to job growth. Ultimately, we anticipate a mix of benefits: some for our shareholders, some for our associates, and some for our customers. We see all of these elements as essential to building a sustainable business that consistently improves over time. This has been our strategy for a long time, and we view this as an opportunity to further grow our business, create jobs, and share the benefits with our associates and customers.

So let me start, Rodney, Mike. I know it's harder to manage this balance than we think, right, between comps and margin improvement. How would you characterize the balance right now? Are you happy with the balance between the two? And then, I know you said you won't lose on price. Do certain competitors out there, has that message gotten through such that some selective irrationality has dissipated? Or is that still going on?

For us, I felt really good about the balance for the quarter, but I would broaden it a little broader than your example because I would also include cost controls. We're making some improvement on shrink and some other elements as well. So when I look at the overall balance, I felt good about what we were able to accomplish. At the same time, focusing on investing in some entry-level rates for our associates in several markets as well. The other thing that I liked about the balance for the quarter is it sets us up well going into the fourth quarter as well. On pricing, I remember years ago Joe Pichler told me that, on economists, all short statements are wrong. If you tell me what you want me to find, I think I can probably find it on pricing across the market. So we would not view that the market is any different today than it was two months ago, five months ago, or whatever. It's really more store-specific.

And then, I was going to say, secondly, on ClickList, right, you haven't said how many you're going to open next year. What's your thinking in terms of how fast you want to go? Does that incline you to go faster if the organization can handle it?

For 2018, we haven't specified a number yet. Internally, we are still working on it, especially as we approach the second half of the year. We plan to implement ClickList in every store where it makes sense. We use our insights to determine where it would be beneficial; in some locations, it isn't feasible due to space constraints. One of our goals is to find the necessary physical space. Currently, we continue to see improvements in our operational metrics as they develop, and we are leveraging technology to streamline processes for our store teams. At the current volume, I don't see significant changes in our approach, but we feel confident about our position, and we believe that as volume fluctuates, we can adjust our model accordingly.

Yes. I just wanted to follow-up a little bit on the ClickList. I mean, you guys had over 500 stores, I believe, this time last year. Any color you can give us just in terms of how those stores have kind of ramped and performed over the last few quarters and just in terms of any contribution to the comp and how that's impacted margins?

Yes. It helps comps. From an expense standpoint, it's continuing to invest in the future. Everything that we have learned and seen on ClickList, it takes three to five years before we're really indifferent on a financial perspective of whether somebody comes into the store and shops or somebody shops ClickList. And obviously that's the labor that the customer provides on picking their groceries versus us picking it for them, but over time, we continue to grow the business and we get better operationally from an expense standpoint. So if you look at the quarter and if you look at year-on-year, it continues to be incrementally more investment from a P&L standpoint. It helps identicals.

Are you seeing a similar progression to what you've observed at the Harris Teeter stores, where this service has been offered for several years, even before your acquisition of the company?

That's very much so. When we merged with Harris Teeter, their insights prompted us to actively pursue ClickList. The only modifications we made were based on the Harris Teeter team's advice on what they would have done differently if given the chance. We've implemented those suggestions, and the patterns we are observing now are quite similar to what Harris Teeter experienced before the merger and continues to see.

Great. I just have a question about cost inflation. Mike, did you provide a number for the cost inflation during the third quarter?

About 50 basis points.

Rodney, could you walk us through the cadence of the IDs throughout the quarter and what you're seeing so far in Q4? Your commentary suggested a number better than the 1.1%, indicating you might be higher than that now, so I'd like to hear your thoughts on that.

Yes. During the quarter, it was very balanced across the quarter, nothing that would jump out one way or the other. We had traffic growth throughout the quarter. If you look at household growth and things like that, it was pretty consistent. And we continue to see that so far in the fourth quarter. It's a nice steady balance moving in the right direction.

Mike, you said you were significantly more diligent, if I'm quoting you right, in lowering cost of vendors. Can you provide some color on what this means in practical purposes? What have you done in terms of your negotiations with vendors that's working for you? And I'm talking prices, not just really fill rates. And then, second, the food at home industry, the manufacturers have much higher margins than the grocers. And usually in any supply chain, those higher-margin players have the leverage. But you and some of your competitors, you're doing things lately, you're pressing on prices. You're asking for better delivery times. You're demanding it, right? That kind of suggests your leverage is a little bit stronger than what I might have thought. Otherwise, I guess, your vendors would just say no.

We've never really tried to look at it as a power struggle and we really appreciate the partnerships we have with our CPG suppliers. Relative to the fine to the late trucks, it doesn't do us any good to have folks around our warehouse expecting trucks to show up and the truck doesn't show up. It's really just trying to strengthen that relationship. If it's supposed to get here today and it's supposed to be a full truckload, you know, get it to us today and make it a full truckload. Our category managers are the ones with all the data and information, and we make decisions based on that. It's not just about getting the best price; it’s about a collaborative relationship.

We really do try to work with our partners on taking costs out of both of our systems and then giving that to the customer. We're very transparent in terms of the way we're negotiating and why we negotiate what we do.

I just wanted to talk about the fourth quarter and general merchandise. But just wondering if I was going to buy a TV or something from Fred Meyer up in Seattle, can I get that delivered? In other words, can I buy it online and have it shipped to my home?

Our ship to home is an evolving process. Not every customer wants things delivered to their house. There's still a joy and excitement of going out and shopping for things and we'll continue to offer and, over time, offer more opportunities and options for our customers on how they want products delivered.

The other thing, as we mentioned last month at the investor meeting, you have a certain amount of resources, and we're doubling down on food and making sure that we're doing everything we can on food. We will start addressing things beyond just food. But first of all, we just wanted to make sure that we got food positioned appropriately. For us, one of the things that we've seen is that our big stores continue to perform very well. If you look at how we use the inside of the space, we significantly allocate additional space for fresh departments today versus what we would have two or three or four years ago.

Can you provide any more details as to how space optimization at the initial stores is progressing? Does that factor into your space optimization efforts and how you think about utilizing vendor allowances and price investments by category going forward?

The space optimization so far continues to make good progress. Our teams are very surprised and pleased with the changes we've made. Pricing elasticity really depends. Every store would actually have different pricing elasticity as every customer behaves differently. Going forward, I would totally expect that to continue to be the case as we evolve. The customer experience is very important, and having multiple store sizes will be essential to meet the needs of our customers.

We expect full year FIFO operating margin ex-fuel to be up or down.

Before we end today's call, I want to note the wonderful work we've done through the Kroger Zero Hunger | Zero Waste plan, demonstrating our commitment to our communities. I want to thank everyone for their hard work and dedication, and wish you a Merry Christmas and Happy Holidays.