Kroger Company (KR) — Q4 2019 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 discussions 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 fourth 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. I will now turn the call over to Kroger's Chairman and Chief Executive Officer, Rodney McMullen.

Thank you, Rebekah, and good morning, everyone. Before we get started, I want to acknowledge that the team here at Kroger realizes that we have our work cut out for us as the market points out this morning. We recognize business transformations are hard. But I want to emphasize we are on track to deliver on our Restock Kroger commitments. We look forward to our time together to take your questions and to clarify things for you. Joining me on today's call are Mike Schlotman, Executive Vice President and Chief Financial Officer; and Gary Millerchip, who will become Kroger's CFO on April 4. As previously announced, Mike will continue to serve as EVP and a member of our senior team until the end of the year. We cannot express enough how grateful the entire Kroger team is for Mike's service, leadership, and stewardship of the company for the last 34 years, especially during the last 19 as CFO. We are also incredibly fortunate to have Gary, whose deep finance and business background combined with his successful track record of creating shareholder value makes him the right person to carry Kroger forward. This is especially true as Kroger transforms from a grocer to a growth company. I've previously discussed the need for retail companies to constantly reinvent themselves to remain relevant, a process that takes place every decade. Gary has been instrumental in helping us think through our transformation as part of Restock Kroger and beyond. During today's call, Mike will provide the financial and operations recap for the fourth quarter and full year 2018, and Gary will outline Kroger's guidance for 2019. In October 2017, we introduced Restock Kroger, our 3-year plan to create shareholder value by serving America through food, inspiration, and uplift. The plan has four main drivers: redefine the grocery experience, partner for customer value, develop talent and live our purpose. Combined, these drivers come together to create shareholder value. Specifically, we committed to $400 million in incremental FIFO operating profit growth and $6.5 billion in cumulative restock cash flow by the end of 2020. I'm pleased to report that Kroger solidly delivered on our key year 1 Restock Kroger commitments. Looking at the full year, we delivered against our FIFO operating profit and our Restock cash flow goals, which sets us up to reach our 2020 targets. We improved identical sales and delivered EPS near the high end of the original and adjusted guidance range, giving us business momentum heading into 2019. I'm especially proud that we achieved an unprecedented cost savings of more than $1 billion through process improvements in 2018. Restock Kroger is fueled by cost savings that we will invest in associates, customers, and infrastructure. We continue to make significant investments to build an omnichannel platform that will deliver customers Anything, Anytime, Anywhere. By the end of 2018, 91% of Kroger households had access to pickup or delivery. By the end of 2019, with full integration of Kroger Ship, we will reach 100% of America. We are very pleased with the growth of digital sales at Kroger. In 2018, our digital sales run rate was about $5 billion. Going forward, we are trending toward a run rate of approximately $9 billion. Kroger also grew Our Brands to reach a record 30.5% unit share in the fourth quarter. We introduced 1,022 new items in 2018, which helped drive strong year-over-year sales lift across our portfolio of brands. Simple Truth continued to lead the way, achieving 15.3% sales growth in 2018, making it a $2.3 billion brand. Kroger unveiled several transformative partnerships to create customer value in 2018. Home Chef continues to grow and shape today's meal solution space. In February, we announced Home Chef's expansion to 500 more locations and 6 new store divisions. Our pilots with Walgreens, Microsoft, and Nuro continue to generate great customer insights, with the Nuro pilot in Scottsdale nearly complete. We remain optimistic about how our partnership with Ocado will set Kroger up for accelerated growth in the future. In February, we announced Florida and the mid-Atlantic region as the locations for building the next 2 Ocado sheds, in addition to the first location planned for Southwest Ohio. In 2018, we accelerated investments in associates and significantly improved employee retention in one of the tightest labor markets in years. We were thrilled to be recognized on Fortune Magazine's Change the World 2018 list for using Kroger's scale for good, engaging our business to solve society's most complex issues through Kroger's Zero Hunger | Zero Waste social impact plan. This groundwork positions us to deliver on our 2020 Restock Kroger targets, including financials, and transform the company for long-term growth. I would like to take a few minutes to discuss our alternative businesses. Successful long-term businesses constantly explore new directions and adjacencies to grow their top and bottom lines. That's why in February we announced the appointment of Stuart Aitken to the newly created role of Senior Vice President of alternative business. In this new role, Stuart is overseeing Kroger's successful existing alternative profit businesses, including 84.51° and Kroger Personal Finance. Stuart will also lead the development of a full portfolio of alternative businesses to support Kroger's business model transformation and enhance our supermarket business. Kroger Personal Finance, 84.51°, and media all surpassed their operating profit targets for the year. This was very encouraging as these are the most significant line items in our alternative profit businesses. We used some of the excess profit to invest in other new alternative profit streams to begin seeding our margin-rich, asset-light businesses of the future. In 2019, we expect a 20% profit growth in our alternative businesses and will also launch a few more new businesses that are symbiotic to our core and deliver high margins. Simply stated, Restock Kroger is all about transforming our growth model. We will grow market share by creating a virtuous cycle built on our grocery business. At the core is a winning combination of unmatched local presence coupled with a digital ecosystem enabling us to offer our customers Anything, Anytime, Anywhere. We are enhancing the customer ecosystem with partnerships that help redefine the customer experience by building fantastic physical and digital experiences, a high-quality offering, and unprecedented convenience. A constantly improving customer ecosystem generates traffic, customer data, and insights, which fuel the growth of adjacent alternative profit streams. We see tremendous potential in these asset-light, margin-rich businesses built on the foundation of an omnichannel grocery experience. The profits generated by these businesses will create shareholder value and generate cash to invest back in Kroger's core, allowing us to further redefine the grocery customer experience. That is how Kroger's new growth model creates a virtuous cycle. Above all, Restock Kroger positions Kroger to create long-term shareholder value. We have a clear path to achieve the $400 million in incremental FIFO operating profit growth and $6.5 billion in cumulative Restock cash flow by the end of 2020. We finished 2018 with sales and business momentum. We expect earnings growth and an improving supermarket business in 2019. Now here is Mike to share more details on our fourth quarter and fiscal 2018 results. Mike?

Thanks, Rodney, and good morning, everyone. Reflecting on Rodney's comments to start the call, it's surreal to know that this is my 77th and final earnings call as CFO. I'm thrilled to be transitioning the role to Gary, who is a terrific partner and will be an excellent Chief Financial Officer. Looking at our results for 2018, I'm very proud of the entire team at Kroger for delivering on the key Restock Kroger commitments we made back in October of 2017. Landing the first year of a 3-year plan is always the toughest and most critical since everything that follows builds on the foundation we set. We feel great about the foundation we've built, which positions us to create shareholder value while continuing to make strategic investments to grow the business. There were a variety of factors that affected the fourth quarter in either the OG&A or gross profit line. Due to better retention and higher average hourly rates, our vacation accrual was a $0.02 headwind in the quarter, and incentive pay because we achieved our ID sales was a $0.06 headwind. Both of these affected OG&A. Our incentive plan was primarily based on the grid of EPS and ID sales. As EPS got closer to the top end of the range, we were incentivized to continue making sustainable investments in our business to grow sales. Some of these investments were in our supply chain for both the supermarket business and Kroger Ship, combined amounting to about $0.04 per share. When you add these together, it was about a $0.12 headwind to the fourth quarter, much of which is something we will be able to build on for the future. Our cents per gallon fuel margin in the fourth quarter was $0.34 compared to $0.198 in the same quarter last year. The average retail price of fuel was $2.34 versus $2.46 in the same quarter last year, which affected total revenue. For 2018, our cents per gallon fuel margin was $0.252 compared to $0.206 for the year before. The average retail price of fuel for 2018 was $2.66 compared to $2.36 in 2017. The solid investments we've made in 2018 will help the supermarket business have a better overall year in 2019. However, we expect fuel to deliver lower operating profit margins in 2019 compared to 2018. Identical sales momentum continued into the fourth quarter, where our ID sales result was about a 10 basis points improvement over last year's fourth quarter. Weather events and the acceleration of SNAP disbursements positively impacted our ID sales results in the fourth quarter, cumulatively helping by 44 basis points. We continue to feel good about our ability to meaningfully connect with customers relying on SNAP to supplement their food purchases. Although space optimization was a slight headwind versus the slight tailwind we expected, we saw strong progress. Stores that had been open for 12 weeks and were unaffected by new competitors showed positive results in the quarter. This process is taking longer than we originally expected, but we are pleased to see this result. In 2018, we completed the most disruptive of the remodels, and as we head into 2019, the work will be more targeted and less disruptive to our customers. All in all, the tide for space optimization is turning as we enter 2019. FIFO operating profit for the fourth quarter was $621 million compared to $782 million in the same period last year without the 53rd week and 2018 and 2017 adjustment items. For the full year, FIFO operating profit was $2.84 billion compared to $3.13 billion in the same period last year without the 53rd week and excluding convenience stores. This was above our goal for the year. Gary will discuss further, but we expect to grow again in 2019 and remain committed to reaching our Restock Kroger goal by 2020. Kroger's financial strategy is to use free cash flow to drive growth while maintaining its current investment-grade debt rating and returning capital to shareholders. The company actively balances the use of cash to achieve these goals. Over the last four quarters, Kroger has invested a combined $589 million in Ocado securities and Home Chef, contributed $185 million pretax to a company-sponsored pension plan, repurchased 79 million common shares for $2 billion, which includes repurchases of $1.2 billion from accelerated stock repurchase plans. We paid $437 million in dividends and invested $3 billion in capital, excluding mergers and acquisitions. We remain committed to generating the $6.5 billion of Restock cash flow by 2020. In 2018, we delivered $1.9 billion. Kroger's net total debt to adjusted EBITDA ratio on a 52-week basis is 2.83. We intend to use our free cash flow to bring the leverage ratio back into the target range of 2.3 to 2.5x. The company's intention is to not buy stock back until we reach that range as we did in the third and fourth quarters of 2018. We are investing an incremental $500 million in our associates over the three years of Restock Kroger. This is occurring through investments in wages, training, and development. We made significant wage investments in 2018 and used tax reform dollars to support our educational systems program, Feed Your Future. We also increased the 401(k) match for nonunion associates, among other benefits aimed at improving the associate experience. This has complemented our continued efforts to rebalance pay and benefits while also focusing on certifications, performance incentives, career opportunities, and training. The average hourly rate for our store associates exceeds $18 per hour when considering our comprehensive benefits that many competitors do not offer. Regarding labor contracts, we recently ratified a new labor agreement with the UFCW covering Smith's in Albuquerque. We are currently negotiating with the UFCW for contracts covering store associates at King Soopers in Denver, Fred Meyer in Portland, Ralph's in Southern California, and Kroger in Memphis. Looking ahead, we have several significant negotiations in 2019, including UFCW store associate contracts in Seattle, Las Vegas, Indianapolis, and Louisville. Our goal is to find a fair balance between competitive costs and compensation packages that provide solid wages, quality, affordable healthcare, and retirement benefits for our associates. We aim to make our overall benefit package relevant to today's associates. Our financial results are pressured by inefficient healthcare and pension costs, which some competitors do not face. We continue to communicate with our local and international unions on the importance of growing our business profitably to create more jobs and career opportunities, enhancing job security for our associates. Before I hand it off, I want to emphasize that landing the first year of a 3-year plan is difficult. However, when reviewing the full year, we feel great about delivering on our financial commitments while continuing to invest to position Kroger for future growth. This solid foundation sets us up to transform Kroger and deliver in 2019 and 2020. Now, I'll turn it over to Gary to discuss how we'll build on this momentum in 2019. Gary?

Thanks, Mike, and good morning, everyone. It's a pleasure to join the call today and more specifically, speak to Kroger's upcoming year and how it aligns with the Restock Kroger strategy. For 2019, excluding fuel, we are targeting identical sales growth that ranges from 2% to 2.25%. We expect net earnings to range from $2.15 to $2.25 per diluted share, and FIFO operating profits to range between $2.9 billion and $3 billion for 2019. The low end of our range exceeds the current consensus estimate for 2019. Kroger's EPS growth is expected to result from FIFO operating profit growth in 2019, positioning us well to deliver the incremental $400 million in FIFO operating profit by the end of 2020 through Restock Kroger. I’d like to take a moment to underscore Kroger's future growth model because the clear path to the $400 million in incremental FIFO operating profit includes alternative profit streams. Although these high-margin and asset-light businesses might not significantly impact our top line in the near term, they play a significant role in helping us achieve bottom line growth. I have made it a priority to collaborate closely with Mike and Rebekah for several investor meetings. We, as the Investor Relations team, understand and appreciate the need to better understand how to model alternative profit streams. Our finance team is currently reviewing industry best practices with the goal of providing greater detail in the future. In 2018, there were several Restock Kroger successes that we believe will provide tailwinds as we grow sales and achieve incremental FIFO operating profit in 2019. We initiated price, digital, and store investments in 2018, partly using tax reform dollars, which will create sales and operating profit tailwinds in 2019. We gained significant cost savings in 2018 and aim to accelerate this momentum in 2019. Our largest alternative businesses, Kroger Personal Finance, 84.51°, and media, all surpassed their operating profit targets in 2018 and have plans for continued growth. Alongside that, investing to build a seamless ecosystem remained a headwind to earnings in 2018; however, that dynamic is beginning to shift. As Mike mentioned earlier, fuel is expected to be a headwind in 2019 compared to last year. The strength of fuel margins in 2018 allowed us to make strategic investments that support the supermarket business for 2019, but we do expect softer fuel results this year. Looking at the cadence of EPS throughout the year, we expect the first quarter to be comparable to the first quarter of 2018, the second and third quarters to fall within our annual guidance range, and the fourth quarter to be above the guidance range, which will allow the full year to land within our overall range. We anticipate that momentum will build through the year, putting Kroger in a position of strength going into 2020. We laid the groundwork in 2018, which we will build upon in 2019 to deliver our 2020 commitments, including Restock cash flow. We achieved what we expected in 2018, setting us up to meet our $6.5 billion cumulative Restock cash flow commitment by the end of 2020. We expect capital investments, excluding mergers, acquisitions, and purchases of leased facilities, to range between $3 billion and $3.2 billion in 2019. This number will likely increase in future years as we announce more Ocado sheds. Additionally, as Mike noted earlier, in the short term, we aim to use free cash flow to bring our leverage ratio back into our target range of 2.3 to 2.5. Finally, we predict Kroger's 2019 tax rate to be approximately 22%. Before I turn it back to Rodney, let me express my gratitude to Mike, who developed an excellent transition plan. He has been the best partner during my transition to the future CFO role at Kroger. I am personally very excited to be in a sector that is evolving as quickly as grocery retail. Our perspective on the fundamentals of retail is rapidly changing, making the coming years fascinating for financial stakeholders following this space. Now I'll hand it back to Rodney.

Thank you, Gary. As America's grocer, Kroger has the winning combination of local presence plus a digital ecosystem, enhanced by strategic partnerships, enabling us to offer our customers Anything, Anytime, Anywhere. We are transforming from grocer to growth company by deploying our assets to serve even more customers while creating margin-rich alternative profit streams. We are well positioned to deliver on our Restock Kroger vision to serve America through food inspiration and uplift. Now we look forward to your questions.

I have a question, and I understand that you encourage us not to view your business in terms of core, fuel, and alternative profits. However, you provided a slide at the Analyst Day that makes it difficult not to consider it this way. When I look at the full year 2018 and analyze the core business, the decline appears quite significant, similar to a nearly 30% drop in the quarter. Can you clarify which components of that decline might be temporary? Additionally, while we are trying to think of your company as a growth entity, it is essential to have stability in your core to earn valuation credit as a growth company. Any insights on how you can achieve stability or growth in your core would be helpful.

I'll take that one, Karen. We made significant investments in 2018, which affected various lines. It's tough to quantify, but fuel had a strong quarter and year. When you try to distinguish the core, it’s also difficult as there are contributions from digital, which has been a headwind, and we continue to invest in digital. Ignoring that headwind and placing it in a growing new business category would drag the core down. But if you consider our digital investments alongside the new warehouses we opened to support our digital business, yes, the core saw a decline. I won’t go into a specific number, but it’s all about how you slice it. I encourage you to examine each part of the business since we must do a better job of showing you where the alternative profit streams will emerge since some of them won’t affect the top line but will contribute to profit.

That said, we recognize the question and understand it completely. As Gary mentioned, we will improve how we present this insight.

Just a follow-up, then. When we consider the $3.5 billion goal for 2020, it implies an EBIT growth of 17%, which is not something I've witnessed any grocer achieve in a year. Has anything changed in each of the streams versus where you indicated in your Analyst Day regarding the growth rate?

This is Gary. We feel, as I mentioned in the prepared comments, very good about the 2019 plan we have in place for the business. Referring back to your question, Karen, a lot of noise emerged in 2018 as we transitioned. Heading into the second year of the plan, as all parts come together, we have a robust plan positioned to better facilitate growth across the organization and improve results. I believe we appreciate the need to provide clearer insights into how all these pieces fit together without substantial changes in our three-year plan.

Karen, one more point I would add regarding your calculation of the decline. You may recall last year included a 53rd week, which is essential to factor in when comparing 2017 to 2018. That extra week was worth around $0.09 or so.

Yes, we considered everything.

Okay, because I wouldn’t arrive at the number anywhere near where you are.

I want to follow up on what Karen addressed. On the $400 million goal, starting in year one, which you reiterated is on track, EBIT fell over $200 million. It would have declined more without the exceptional fuel year. The most significant decline occurred in Q4 even adjusting for the extra week. You're reaffirming this target, yet 2019 guidance indicates about a $100 million improvement. The implication is a $550 million improvement in 2020. Why isn't there more progress in 2019 given the investments we fostered? Could you provide more assurance around the anticipated growth in 2020? The stock is down significantly because the market isn’t perceiving progress, rather the opposite.

The progress we made is reflected in what Gary mentioned in his opening comments where operating profit guidance for next year is above Wall Street's current consensus estimate. As for why 2019 wouldn't grow more given the investments from '18, we anticipate a more typical year for fuel margins compared to '18. We decided it wouldn't be prudent to budget 2019 fuel margins to replicate those of 2018. The core business and alternative profit streams will help us grow off of a slightly softer fuel margin. With the 2019 EBITDA and ID sale guidance of 2 to 2.25%, we're optimistic about operating margins exceeding those predicted by Wall Street for 2020.

We understand your question fully. As Mike pointed out, we expect digital to shift to a tailwind instead of a headwind. We invested significantly in 2018 and anticipate those will begin paying off in 2019. Also notable is that while Mike discussed space optimization as an area of focus, we continue to believe we are making substantial progress in reducing costs, paving the way for further growth going forward.

A brief follow-up regarding gross margin. The 93 basis point decrease was unexpected. Can you offer further details on what transpired? What is 'mix'? What actions did you have in the supply chain? And how should we forecast 2019's gross margin? Achieving your EBIT guidance appears challenging without flat or positive FIFO gross margins excluding fuel.

Regarding the fourth quarter decline, roughly one-third stemmed from price investment, mirroring our year's ongoing experience. The remaining two-thirds emerged from startup costs of new warehouses that negatively affected the warehouse and transportation line, alongside strong growth in our Kroger Specialty Pharmacy team—a high-growth business with notably lower gross margins compared to our core business. However, the expense from this sector does produce high operating profit dollars. These factors collectively contributed to our margin erosion. While I can't provide guidance for OG&A and gross profit, ID sales and earnings per share guidance determine where we expect OG&A and gross profit to trend.

What about next year?

I won't provide guidance for OG&A and gross profit for next year. However, based on ID sales, earnings per share guidance, and our operating profit forecasts, you're expected to infer where OG&A and gross profit are likely to trend.

When considering the next few years, will alternative profit streams mainly influence the gross margin line or the expense ratio line? When you mention ex-fuel margins, do those calculations include alternative profit streams today? Will they in the future or be separated?

Currently, we're assessing how best to share our alternative profit story since they have developed as a significant part of Kroger's business. We want to ensure we convey their contribution effectively. We want to ensure that clarification is consistent as we anticipate growth in 2019 and 2020.

As for the OG&A and margin rates, excluding fuel, those will include the alternative profit streams. If we approach it the other way, we would have a long list of items to exclude.

Given your insights, will there be a separate segment for alternative profit streams?

We are not dismissing any options at this stage. We want to consider thoroughly how to manage the business effectively while clearly delineating the value its drivers provide to the bottom line.

Regarding the core business, maintaining an EBIT growth of 2-3% should yield the desired outcomes. For the next few years, the attainable goal might be closer to the lower end due to cost pressures. However, the sustainability of the model hinges on steady growth in the 2-3% range.

It’s crucial to highlight our productivity gains this year. Our efforts to reduce turnover have significantly improved our retention. We see these productivity enhancements nearly neutralizing the higher expenses we invested in associates.

I want to delve into the top line. Over the past year, IDs hovered around 1.5 to 1.9. Can you clarify your expectations for reaching above 2? Share insights on your stores that underwent optimization.

Great question. If we examine the last part of your inquiry regarding space optimization, as Mike mentioned in his remarks, this challenge has lingered longer than expected. Nonetheless, stores that have been open or remodeled for over 12 weeks show positive impacts on our identical sales. While this transition is taking longer than anticipated, we are pleased with the progress. We seek continuous improvement based on investments made in 2018. Assessing tonnage in 2018 reflects stronger performance than what our identical sales growth indicated. Additionally, customers are increasingly trading up on products and sizes. Based on the maturity stage of the remodels we've executed and the continual enhancement of in-stock inventory in critical areas, we’re confident in our guidance of 2% to 2.25%.

In assessing our quarterly performance year-to-date, we stand in close alignment with where we were in Q4. The balance between our core supermarket business and alternative profit sources remains consistent with Q4 results. There has been a narrative stating the pull-forward effect from SNAP has resulted in a slower start, but in reality, we are in line with our performance from last quarter.

SNAP has indeed exerted a pull-forward effect; however, observing the overall metrics demonstrates that any adverse impacts were mitigated by other sales channels.

To add more context, we implemented numerous initiatives throughout 2018 stemming from Restock Kroger, which created the noise Mike mentioned. These efforts should gradually shift to tailwinds in 2019. The significant investments made in 2018 are expected to yield tangible benefits as we advance through subsequent fiscal periods.

I’m interested in your recent insights on inflation. What trends have you observed, and how are you adapting price points to meet rising input costs? Are you witnessing a general increase in price points? Could you describe the current pricing environment?

Our expectations for inflation in 2019 are relatively mild. Pricing strategies depend on where inflation originates. In a category with specific pricing commitments, we aim to maintain consistency, while in others, we leverage competitive pricing dynamics. In the fourth quarter, when excluding fuel and pharmacy, cost inflation was around 39 basis points. Including pharmacy, that figure rose to approximately 1.08%. Throughout 2018, excluding pharmacy, our costs saw slight deflation, which may contrast with overall sentiment surrounding price hikes.

Moreover, we have observed some competitors raising prices beyond actual cost increases, leading to market share losses as a result. Kroger’s strong private label offerings capitalize on such opportunities as we continue improving customer value.

Let’s touch upon the 2019 guidance. How much of the anticipated EBIT growth, ranging between $100 million and $200 million, will derive from your core grocery operations versus alternative revenue streams? Moreover, what is your outlook for fuel margins in 2019? I understand your hesitation to disclose line-by-line guidance, but given the negative 93 basis point gross margin results, any guidance as we progress into the first half of the year regarding gross margins would be appreciated.

I understand your desire for clarity regarding guidance, but we'll adhere to the previous guidance we provided without specifying gross margin expectations. Significant growth in operating profit margins in 2019 is expected primarily from the core business despite anticipated challenges from fuel margins.

When evaluating fuel expectations, we generally consider our 3-year margin averages to inform our expectations. We tend to lean towards recent trends but consider our historical averages as a baseline. You shouldn't project a similar 93 basis point reduction in gross margin moving forward.

I also agree with that point.

Just to clarify, if we don’t receive any material tailwind from fuel, we can expect sequential improvements to gross margin ultimately, correct?

Correct.

I’ve been attending Shop Talk in Las Vegas and have discussed micro fulfillment concepts with various representatives. Rodney, can you share your perspective on why you believe Ocado is the right technology moving forward? Have you been in discussions with them regarding their micro fulfillment option, known as Zoom? Does this provide you flexibility concerning the 20 CFCs you committed to with them?

Yes, someone from the Ocado team is in daily contact with our team. While broader strategic discussions occur on a monthly basis, we have immense confidence in our alignment with Ocado. Their team pushes themselves continually and strives for improvement. We signed our agreement with Ocado based on their future potential rather than their current offerings, given their talent and commitment to innovation. If there exists a more efficient model that meets customer needs, we believe our partnership will ensure we leverage that opportunity.

Mike, it's wonderful to see you; congratulations on your retirement. In light of that, could you share insights into market share performance throughout the year?

In terms of market share calculated traditionally, our market share grew over the past year, as Rodney indicated. We noticed tonnage exhibiting stronger results than our ID sales, suggesting continued growth despite tactical pricing investments.

Indeed, our market share experienced a slight improvement during the year.

When analyzing tonnage, you're excluding about 50 basis points related to specialty pharma contribution, correct?

Yes, we did start that process at the beginning of the year.

When reflecting on tonnage, we aim to track the absolute volume of units in our stores. A single unit of toilet paper, for example, counts as one, whether it’s a single pack or a bulk package. Our focus remains strictly on the units flowing through our outlets.

We achieved notable growth in alternative profits year-over-year, primarily driven by media and Kroger Personal Finance. Both these segments outperformed operating profit targets by over 20% in 2018. As previously referred, we're refining how to deliver a complete picture concerning alternative profits moving forward, recognizing their increasing significance to our overall business. Mike has previously highlighted the growth trajectory of alternative profits, which is outlined in a slide shared during the investor conference, showing ongoing expected growth that will manifest in the coming years.

Following up regarding food inflation; you mentioned it was reported at 39 basis points. How do you foresee that trend developing in 2019? Moreover, how do you plan to pass on this cost increase, if necessary?

I would characterize our inflation expectations for 2019 as relatively benign, with the feasibility of passing it on varying based on the category where it occurs. In the fourth quarter, inflation without fuel and pharmacy was approximately 39 basis points. When adding pharmacy it escalated to 1.08 basis points. For the year, excluding pharmacy, we actually saw slight cost deflation, which may conflict with broader narratives concerning input pricing. Our operations team has effectively pursued strategies to mitigate elevated procurement costs through a range of initiatives.

Additionally, several competitors have surged their prices beyond actual cost. This presents market share opportunities, especially with our compelling private label offerings, which often outperform competitors seeking to raise prices unduly. Customers switching to our private labels reflects their preference, and in turn, we benefit more from our brands versus traditional national brands.

To start, regarding 2019 guidance, how much of the projected $100 million to $200 million EBIT growth is attributed to your core grocery operations versus alternative revenue streams? Furthermore, what’s your forecast for fuel margins in 2019? While I understand your reticence to disclose specifics regarding guidance, given the negative 93 basis point gross margin results, a rationale to comprehend gross margins in the first half of the year, especially as alternative revenues become a greater component of EBIT, would be greatly appreciated.

I acknowledge your request for clarity regarding the guidance. However, we will maintain our initial guidance without including specifics on gross margin expectations. The bulk of the anticipated growth in next year’s operating profit will derive from the core business, even though we foresee fuel being a significant headwind.

On the subject of fuel, our estimates will closely reflect our 3-year average margin based on historical trends while we remain hopeful that the margin won’t mirror the 93 basis point reduction experienced last quarter.

Yes, I concur with that sentiment.

To clarify, assuming no material tailwinds from fuel, we can anticipate some sequential improvements to our gross margins, correct?

Correct.

Lastly, I spent some time at Shop Talk in Las Vegas discussing micro-fulfillment. Rodney, could you share perspectives on why you believe Ocado represents the right technology moving forward? Also, have you discussed their micro-fulfillment option, Zoom? Does it afford you flexibility concerning the 20 CFCs you committed to?

In terms of dialogues, our teams coordinate daily, while broader discussions occur monthly. We have tremendous confidence in our alignment with Ocado's mission and technology. Their innovation trajectory excites us; we signed our agreement grounded in future developments rather than current capabilities, considering Ocado’s skill and commitment to continual enhancement. Should more efficient models arise, our collaboration will facilitate those adaptations seamlessly.

Mike, congratulations on this milestone. I can’t believe it’s your final call. I’d like to discuss market share; could you provide insights regarding market share throughout the last year?

To assess our market share, which is traditionally measured, we've seen growth throughout the year, as Rodney mentioned earlier. Notably, tonnage in terms of volume has shown stronger performance compared to ID sales, reflecting our commitment to continuous improvement despite pricing tactics.

Yes, our market share has experienced slight growth throughout the year.

When considering tonnage, are you excluding about 50 basis points attributed to specialty pharmaceutical contributions?

Correct, we included specialty pharma beginning earlier this year.

As we previously noted, strong growth in alternative profits year-over-year emerged, majorly due to media and Kroger Personal Finance. Both of these segments achieved over 20% growth in operating profit in 2018. As addressed earlier, we are currently working on presenting a more comprehensive picture of alternative profits since their significance in our overall business is expanding.