Kroger Company (KR) — Q1 2020 Earnings Call Transcript

Thank you, Gary. 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 first quarter press release and our prepared remarks from this conference call will be available on our website at ir.kroger.com. After our prepared remarks, we look forward to taking your questions. Thank you.

Thank you, Rebekah. Good morning, everyone, and thank you for joining us. With me to review Kroger's first quarter 2019 result is Chief Financial Officer, Gary Millerchip. We started the conversation with you last quarter by acknowledging that we had our work cut out for us. We are energized by that challenge, and our team brought that energy to the first quarter. There are several examples in the first quarter results that reflect the discipline, focus, and progress we are making on our transformation plan: Restock Kroger. All of this work starts with our customer obsession focus. That is why we're building an omnichannel platform to serve customers with Anything, Anytime, Anywhere. That is why we're focused on redefining the experience grocery customers can expect to have in our stores and online, improved upon by exciting partnerships that create additional value. That said, while the second year of Restock Kroger is off to a solid start, we know we can do better when it comes to our identical sales results. To that end, it’s important that I say right up front that by further intensifying our customer focus, Kroger's quarter-to-date identical sales are trending better than the first quarter and moving toward the guidance range. One of our most powerful competitive advantages is also one of our best ongoing performers. Kroger's own brand products grew 3.3%, and unit share gained 66 basis points to reach 28.9% share in the quarter. The focus on shifting the mix to Simple Truth and premium brands, such as Private Selection, led to double-digit gains in the quarter in those brands. We know that our customers love Our Brands and that they are hungry for innovative new products that they can only get by coming to and shopping with Kroger. In our quest to put food first and serve as America's food authority, we are bringing new tastes, trends, and experiences to our customers. In the first quarter, we introduced 219 fantastic Our Brands items. Our customers' favorite new items fall in line with the key food and flavor trends we predicted for 2019, including Private Selection pork belly bites, Private Selection artisan jerky, and Kroger Deluxe Unicorn Swirl Ice Cream. New items delivered over $225 million in incremental sales during the first quarter. Customer obsession is also why we're building a platform to serve customers anything they want, anytime they want, and anywhere they want. Our customers don't distinguish between an in-store and online experience. Rather, they typically have a food-related need or a problem to solve and want the easiest, most seamless solution. Our digital sales grew 42% in the first quarter. We also expanded our coverage area to reach 93% of our customers in the first quarter. This means 93% of the customers who shop Kroger in a brick-and-mortar store can also shop with us for pickup or delivery. By the end of this year, everyone in America will have the ability through our modalities to shop with Kroger, whether they decide to come into a store, use our pickup or delivery services or ship. Our efforts are positioning Kroger to be the leading omnichannel retailer in the food industry. Since 2014, we've gone from no digital sales dollars to a 2018 annual run rate of about $5 billion, which is trending toward a $9 billion digital sales run rate in the future. I called this out because while we are only in the middle of our transformation, it's important to frame up the magnitude of the progress that we have made. 2019 is another pivotal year for our Partner for Customer Value pillar and Restock Kroger. We continue to improve the customer experience in our stores and across our digital properties by partnering with industry innovators such as Home Chef, Microsoft, Ocado, and Walgreens. All of these partners accelerate our ability to provide customers Anything, Anytime, Anywhere. We were excited to break ground last week in Ohio on America's first customer fulfillment center powered by Ocado. Kroger's partnership with Ocado will, for the first time, introduce transformative e-commerce fulfillment and logistics technology in America. This, in turn, means Kroger customers will get fresher food faster than ever before. We intend to open additional customer fulfillment facilities to create a seamless customer experience, replicating the model to serve everyone across America. We are also making progress building out our alternative business for profitable growth. We've made several organizational structural changes to allow deeper concentration on our alternative profit streams while also maintaining our laser focus on delivering for our customers in the core business. Kroger is creating a virtuous cycle, built upon the rich collection of proprietary data generated from our customer traffic, to improve the customer experience, which then supports new margin-rich, asset-light businesses. We expect alternative profit streams to continue to grow and contribute an estimated incremental $100 million in net operating profit in 2019 and continue to accelerate into 2020. This will be generated primarily from the more mature alternative profit streams such as Kroger Personal Finance, our Media businesses, and customer data insights. There are other initiatives within our alternative business portfolio that are in earlier stages of incubation. For example, we recently announced the formation of PearlRock Partners, a platform to identify, invest in, and help grow the next generation of leading consumer product brands. Initiatives such as PearlRock Partners are expected to have a small impact during Restock Kroger and then contribute more meaningfully to our results after 2020. Following up on our commitment we made in March to our financial stakeholders, Gary will provide additional transparency about where alternative profits will flow through our financial statements during his remarks. One of the challenges transforming a company is finding the right leaders at the right time to guide and coach people through complex and often difficult change. The underlying principle is to respect the company's past while creating the future. We've secured Kroger's continued success in the next chapter of retail by proactively managing several pivotal next-generation leadership successions, including the essential CFO and CIO roles. We've also focused on several senior-most executive roles, most notably leaders of our new business development, including partnerships, and Kroger's alternative business portfolio to support the transformation of our growth model. Every leadership transition is deliberate, carefully managed, and made in partnership with Kroger's Board of Directors. I'd like to again congratulate all of our new senior vice presidents and underscore my confidence in their ability to lead Kroger forward. Another important area of leadership for Kroger is in the environmental, social, and governance areas, which is a natural extension of our Zero Hunger | Zero Waste plan and is gaining recognition from a growing number of investors. As America's grocer, we are committed to setting the table for a sustainable future. A year ago, we took a deeper look at how plastic is affecting our communities and environment and became the first major U.S. retailer to announce the phaseout of single-use plastic grocery bags, starting with our QFC division in the Pacific Northwest. Earlier this month, Kroger announced our commitment to be the exclusive U.S. grocery retail partner for Loop. Loop is a new system that uses durable product packaging to help reduce single-use plastics. TerraCycle introduced Loop at the World Economic Forum in Davos in January to much fanfare and media interest. Many familiar suppliers and brands are included in the platform, and the list continues to expand. Loop hygienically cleans and sanitizes the empty packaging that was previously sold to the consumer and sends it back to the suppliers to refill for another use. Because the retail industry is transforming, we proactively launched Restock Kroger to deliver for customers and our shareholders. Plainly stated, Restock Kroger is all about transforming our growth model. The second year of Restock Kroger is off to a solid start. The entire company is focused on redefining the grocery customer experience, improving upon our exciting partnerships that create value. We are investing in our associates more than ever before and building a purpose-driven culture, and we are also on track to generate the free cash flow and incremental adjusted FIFO operating profit targets for 2019. As I said earlier, we recognize we have work to do and remain focused on delivering on our Restock Kroger commitments.

Thanks, Rodney, and good morning, everyone. Our first quarter results demonstrate the strength and diversity of Kroger's multifaceted business model. Overall, we are leveraging Kroger's unique assets, our scale, unmatched customer data insights, and our knowledge of food to build even stronger connections with our customers across all modalities: in-store, pickup, delivery, and shipping. As Rodney discussed, we have a few headwinds during the first quarter, including sales, which we know must be stronger. We also experienced pharmacy gross margin pressure similar to others in the industry. Because of our multifaceted business model, we delivered an adjusted EPS result of $0.72 per diluted share. I'd like to highlight a few areas of our business that were particularly strong during the quarter. Our Brands contributed both as a sales driver and a profit leader. The entire Kroger team brought discipline to controlling costs during the first quarter and delivered on our Restock Kroger savings plan. And alternative profit businesses exceeded budget, setting us up to deliver our incremental operating profit target for 2019. On that note, last quarter, we committed to providing you with greater transparency on our alternative businesses and their contribution to Restock Kroger. As Rodney said at the top of the call, we expect alternative profits to contribute an incremental $100 million in operating profit in 2019. You will see this growth reflected through the gross margin line of our financial statements. Certain amounts that we've traditionally recognized as reductions to OG&A expenses and merchandising costs are now being reflected as sales. This treatment more appropriately reflects the nature of these items and is consistent with others in the industry. In the first quarter, this affected identical sales by 3 basis points, and we have provided more detail in our 8-K filing. Please refer to Table 8 for a deeper explanation on the reclassification. Through the first quarter of 2019, alternative businesses are ahead of our expectations, with Media business and Kroger Personal Finance leading the way. We expect incremental operating profit growth to vary throughout the year, reflecting the continued acceleration of our Media business and the seasonality of certain businesses during peak holiday selling periods. For example, our gift card business is very seasonal, and therefore, growth will be most visible in respective quarters. Kroger reported identical sales without fuel of 1.5% during the first quarter. The timing of SNAP disbursement negatively affected results by 15 basis points. Several departments outperformed the company in the quarter, including key beverage categories, pet, natural foods, and we had another strong quarter from our pharmacy business. We recognize that getting into our identical sales guidance range will require an acceleration of identical sales throughout the rest of our fiscal year. We are diligently working to improve performance and build on the positive identical sales trend momentum we are seeing thus far in our second quarter. Additionally, as we move through the second quarter, we will begin to cycle investments made during the same period last year, which we expect to be a tailwind. Adjusted FIFO operating profit for the first quarter was $957 million and in line with our expectations for the quarter. Gross margin was 22.2% of sales for the first quarter, and FIFO gross margin, excluding fuel, decreased 40 basis points from the same period last year, primarily due to industry-wide lower gross margin rates in pharmacy. This represents a sequential improvement in the level of margin investments compared to the second half of 2018. The LIFO charge for the quarter was $15 million. Our associates have done an amazing job managing shrink, which improved during the first quarter compared to the prior year. This represents the seventh consecutive quarter of shrink rate improvement. OG&A cost as a rate of sales, excluding fuel and 2019 and 2018 first quarter adjustment items, decreased 12 basis points. This quarter's decrease is primarily due to the execution of Restock Kroger initiatives and planned real estate transactions. Our results highlight the continued progress we are making with the Restock Kroger savings program, building on the $1.1 billion of savings and benefits achieved in our prior fiscal year. We are committed to continuing to find additional improvements and efficiencies in our business. Retail fuel profit growth was in line with our expectations for the quarter, but we still expect fuel operating profit to be a headwind overall in 2019, particularly in the second half of the year. Our cents-per-gallon fuel margin in the first quarter was $0.23 compared to $0.18 in the same quarter last year. The average retail price of fuel was $2.62 versus $2.63 in the same quarter last year. Fuel is an important part of our strategy to drive customer engagement, especially among our most loyal households. We continue to increase our investment in fuel rewards and saw positive gallon growth with our loyal customers in the first quarter. Turning now to talent development. We are supporting associates in a variety of ways, including investments in wages, training, and development. We continue to invest in our associates as part of Restock Kroger. Today, I'm pleased to share our recently updated average hourly rate is over $20 per hour with comprehensive benefits factored in, benefits that many of our competitors don't offer. The most recent example of our investments in wages was our Monday announcement of a newly ratified labor contract covering store associates in Indianapolis. The ratified agreement with UFCW Local 700 raises starting wages for most clerks, and associates will receive regular wage increases every 6 months. This is part of our continued effort to rebalance pay and benefits while also focusing on certifications and performance incentives, career opportunities, and training. We are also very energized by the significant interest we're seeing from associates in Feed Your Future, our industry-leading education assistance program launched just over a year ago. Feed Your Future is available to all associates, full or part-time, after 6 months of service. Among all the participants, more than 80% are hourly store associates. As a result of our investments in talent development, we are significantly improving employee retention in one of the tightest labor markets in years. In addition to the new labor agreement covering Kroger associates in Indianapolis, we also ratified a new labor agreement with the UFCW covering King Soopers associates in Denver and Kroger associates in Louisville, Kentucky, during the first quarter. We are currently negotiating with UFCW for contracts covering store associates in Las Vegas, Memphis, Portland, Seattle, and Southern California. Our objective in every negotiation is to find a fair and reasonable balance between competitive costs and compensation packages that provide solid wages, good-quality affordable health care, and retirement benefits for our associates. We continue to strive to make our overall benefits package relevant to today's associates. 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 international unions which represent many of our associates on the importance of growing our business in a profitable way, which will help us create more jobs and career opportunities and enhance job security for our associates. A key component of Restock Kroger is generating strong free cash flow. Our financial strategy is to use free cash flow to drive growth while also maintaining our current investment-grade debt rating and returning capital to shareholders. We actively balance the use of cash to achieve these goals. We reduced net total debt by $1.7 billion since the end of fiscal year 2018. Kroger's net total debt-to-adjusted-EBITDA ratio is 2.54, down from 2.83 at the end of 2018. The company's net total debt-to-adjusted-EBITDA ratio target range is 2.3 to 2.5. We have prioritized getting our net total debt-to-EBITDA ratio back into the target range and used proceeds from the sale of YouTechnology and the Turkey Hill Dairy business to help us do so. I'd like to take a few moments to talk a little bit more about YouTech. This is a great example of how Kroger leveraged the unique assets I mentioned earlier to create significant value for our shareholders. We acquired the business for a nominal value several years ago and developed it into a market leader in digital coupons. When the business reached a point where the potential value to someone else was higher than the future value to Kroger, we sold the business to maximize shareholder return. As part of the terms of the sale, we protected the value to Kroger through a long-term service agreement with Inmar. YouTech is a great illustration of how we are leveraging our unique assets to create new asset-light, margin-rich businesses to drive incremental value for our shareholders. Before I turn it back to Rodney, I'd like to discuss an accounting change that affects our financial reporting and reiterate our guidance for 2019. You may have noticed in our 8-K filing that we adopted the new leasing standard at the beginning of the fiscal year. This added nearly $7 billion of lease-related assets and liabilities to our balance sheet. The rating agencies already calculate and include our liability for operating leases in their ratings assessments, and this new standard is not expected to affect rent expense or earnings for the year. Finally, I would like to reiterate our guidance for the year. For 2019, identical sales growth, excluding fuel, we continue to target identical rates that range from 2% to 2.25%. We continue to expect adjusted net earnings to range from $2.15 to $2.25 per diluted share and adjusted FIFO operating profit to range from $2.9 billion to $3 billion for 2019. Kroger's EPS growth will come from adjusted FIFO operating profit growth in 2019, which positions us well to deliver on Restock Kroger.

Thanks, Gary. We feel optimistic at the start of the second quarter. Sales momentum is building, and we are laser-focused on serving our customers. We are clear-eyed about the challenges ahead and confident in our ability to deliver on our plans, both for the year and our long-term vision, to serve America through food inspiration and uplift. Now we look forward to your questions.

Rodney, my question is could you talk a little bit about, now that you're a quarter into this year, how your price investment plan is trending? Is it more or less than what you were expecting? And maybe remind us what kind of price investment year 2019 is expected to be, and maybe weave that into how that plays out into the expectation for accelerating IDs, and then also maybe weave in just the environment you're seeing out there competitively. We're seeing signs of the promotional environment in produce being a little more aggressive than it's been in a while. If you could weave the picture together for us, that would be great.

Thanks, Robby. If you examine our overall price investments, they're aligning well with our expectations. We are still experiencing the effects of the investments made last year, which will continue to benefit us. The investments from 2019 will amount to a reasonable figure, though it will be less than what we did in 2018. This is because, as you may remember, we advanced some of our 2019 investments into 2018 to provide customers with the benefits of the lower tax rate following the changes in tax laws. Overall, the market environment has its ups and downs, but it appears to be consistent with previous trends. While some specific areas may receive more attention, the overall picture remains stable. Regarding the acceleration of identical sales, space optimization is now becoming a benefit rather than a challenge, although it has taken longer than anticipated. Our teams are effectively enhancing the customer experience in stores, which is generating positive momentum. We are also focusing on using our data to identify the right areas for improvement. All of these elements are coming together, and we are getting better at communicating our story to customers.

Maybe, first, just a follow-up on IDs. Can you help us with the cadence throughout the quarter? It sounded like when you gave the quarter-to-date update with fourth quarter earnings that you were running better than where you finished the quarter, and obviously things are expected to accelerate. So beyond remodels, has there been enough contribution from the rollout of online grocery and the impact of inflation relative to your expectations?

Inflation was higher in the first quarter than previously, but it aligned well with expectations. Overall, sales were increasing nicely and tracking as anticipated, showing great progress leading up to Easter. Shortly after Easter, we faced some challenges, and while I dislike using weather as an excuse, it undeniably affected us, particularly around Mother's Day and related activities. As I mentioned, SNAP presented a slight challenge, though not significantly. When looking at the entire quarter, we continued to see strong growth in our loyal customer base. Spending per item showed that customers were opting for larger packs. Reflecting on the second quarter so far, which has only been three weeks, we are getting closer to our guidance from 2019.

So I think the question was asked around digital, too, as part of the overall performance, and we continue to see strong results, and certainly in line with what we expected during the first quarter from the way customers are engaging through the seamless digital experience that we're creating, both in terms of ordering online to pick up at the store and also ordering online to ship to home or deliver to home.

Okay. And if I could quickly follow up on Media. It sounds like trends are going kind of in line with or above plan there. Clearly, some of your big-box competitors have made moves in the media space, sometimes acquiring external assets. Is that something you feel like you need to do? Does their leaning into these retailer-led platforms help your conversations with vendors? Or does it serve as more competition?

Yes. We see it as additional partners assisting consumer packaged goods companies in optimizing their spending. When we analyze the situation, we recognize the common saying that half of my media budget is wasted; I just don't know which half. Our teams excel at helping media companies identify where they allocate funds and how customers behave. We believe the market is sufficiently large, allowing for substantial growth opportunities overall, and for the companies mentioned, including us, to thrive due to the size of the market. Therefore, when we assess the potential, it's extremely promising. I know some of our early partners are quite pleased with the outcomes, and we are just beginning. So far, we have successfully collaborated with top-tier companies to enhance our progress. Whether that will evolve in the future remains to be seen.

Yes. Just, first, a clarification. The planned real estate transaction in the quarter, if I look at the cash flow statement, there is about a $57 million gain. Is that the amount that we should be thinking about that contributed to the quarter?

That's right, Ed. As we mentioned in the prepared notes, we had this transaction planned as part of our guidance for the year and our business plan. Real estate has always been a significant aspect of our overall strategy in utilizing and leveraging the assets we have as we build stores around shopping centers and establish ourselves as anchor tenants in many locations. Over the years, we've included real estate transactions in our results, which can sometimes lead to losses as well as gains in certain quarters. This quarter, however, we felt it was important to be transparent about this transaction since it was a larger amount than usual, and it positively affected our overall operating general and administrative rate for the quarter. This transaction was anticipated and was part of our expectations in the first quarter as well.

Any other planned real estate transactions like this contemplated for the full year?

I think we are always obviously looking at opportunities and especially where it can help our free cash flow and where we can arbitrage the profitability of the real estate that we own currently. So I wouldn't get into specific details around any of the overall plans that we have, but we do certainly look for those opportunities where they exist, but they're not contemplated within the guidance that we shared.

And, Ed, this is Rodney. If it was anything material, we would share it as well so that everybody would know. And as Gary mentioned, it's in the guidance.

Rodney, my real question here is for you, and it's on the IDs. And bigger picture, you used to consistently outperform a broader peer set and industry data like Nielsen. And to me, one of the biggest issues right now with your company is that, that actually no longer seems to be happening. And your IDs are just north of 1% this quarter despite the fact that you have digital in there, specialty's in there now. You are lapping some optimization. You've invested a lot last year. I guess why do you think the share gains have slowed so much? And I know you're focused on improving momentum, but what specific adjustments are you making?

We really need to elevate our performance. Looking at the customer experience, we have made notable enhancements in some fundamental areas. However, we've noticed there's a delay in the time it takes for customers to respond to these improvements financially. Thus, part of our strategy involves analyzing the data we collect weekly regarding the friendliness of our staff, inventory levels, and other related factors. The advancements we've achieved surpass those of our similar competitors. Additionally, we are continuing to work on optimizing space and other projects while ensuring we receive returns from our remodels, using data in a more sophisticated manner and building on our past efforts.

This is actually Erica Eiler on for Rupesh. So I actually wanted to touch on food inflation. Can you maybe get a little bit more granular in terms of what you're seeing currently and your expectations going forward? And then maybe you could talk about, are you seeing prices being passed through to the shelf at this point?

Sure. I'd be happy to talk about that. So as you know, when we talked about our guidance for the year, our expectation was that we'd see inflation in the range of 0% to 1%. That was what we've built our plan around. And I would say if you look at Q1 results and exclude pharmacy and fuel from the calculation, we would be at the top end of that range. Certainly, as we are seeing those cost increases come through, we have a very robust process within our cost of goods team to really look at ways in which we can mitigate those cost increases and ensure that we're able to maintain profitability in the business. Where we are seeing the legitimate reason for those costs coming through, we are generally being successful in passing them on to the customer through the pricing strategy. And I would say that's generally what we saw during the first quarter and would be our strategy during the rest of the year. One of the things that obviously we feel is an important advantage for us is the significant market share that we have with our own brand products, and so ensuring that we're using that to really manage and balance as we see price increases come through. And of course, it's a great set of knowledge for us knowing what the true cost of product is and how to effectively manage those cost increases.

Okay. That's helpful. And then...

I believe our outlook for the year will generally remain consistent with our recent experiences, although we are mindful of certain challenges and uncertainties stemming from discussions about potential trade impacts and issues like the swine flu. There are definitely one or two factors that we are monitoring closely because they could significantly affect inflation.

And tariffs from China have a pretty minimal effect on us, and a lot of it can be managed. Tariffs from Mexico would be harder to manage. Hopefully, something works out there. As you know, overall, from a philosophy standpoint, we always believe that at the end of the day, tariffs just cause costs to go up for customers.

Okay. No. That's great additional color. And then just quickly on gross margins. Can you talk about the dynamics going on with pharmacy right now and the industry as it relates to gross margin and how you're thinking about kind of those dynamics going forward?

Sure. First of all, I'd like to just maybe give a little bit more context on our pharmacy business, too, because it's certainly a very important part of our business. It drives a lot of loyalty overall with the customer, and we continue to get extremely strong customer satisfaction ratings. It's a part of our business that generally is continuing to grow script counts and grow sales very strongly, as we mentioned, during the quarter. And it ties very closely for us to our health and wellness strategy. And as we start to think about food as medicine, we think it's a very important connection. The business today is profitable for us and generates a high ROIC. But as you mentioned, we are certainly seeing some pressure in the industry. There's a couple of things at play, really, within the gross margin pressure that we saw in Q1 which, as I mentioned, wouldn't be unique to us. The first is there is a generic supply challenge, and therefore the cost of supplying product has gone up significantly. And secondly, as we've renegotiated our PPM agreements, three of the big ones going through the renegotiation process, there's an increase in costs there that's also placing some pressure on gross margin. That being said, our pharmacy team has been extremely proactive in developing plans to mitigate that, both from how do we buy most effectively but also how do we create more efficiency in the pharmacy business. We continue to see significant efficiency improvements in the cost to fill a pharmacy order, and our pharmacy team is doing a really nice job of finding ways to offset some of those pressures.

As I previously mentioned, one of the advantages of having a diverse business is that we experienced strong results despite the pressures. Looking ahead, we see significant potential in health and wellness, particularly in establishing alternative business opportunities and forming new partnerships to support healthier living in America. As Gary noted, our conversations with various healthcare providers increasingly highlight the concept of food as medicine. Through our OptUP app and similar initiatives, we are helping people make healthier dietary choices, and we anticipate even greater opportunities in this area moving forward.

Rodney, can you discuss the organization's ability to adapt to change? There is a lot happening, including people taking on new roles. Besides space optimization, do you believe this is affecting execution and potentially your top line growth? Looking ahead, if there are challenges, is there a way to streamline processes and prioritize to enhance the organization's capacity to manage change? I would like to hear your thoughts on this.

Yes. That’s a great question, John, and it’s something we discuss regularly. It was one of the reasons we made some organizational changes, particularly moving alternative business to its own standalone area. We wanted to ensure we had dedicated people focused on it, rather than having those responsible for daily customer interactions trying to manage both. I often ask whether it is the center of our focus or just a peripheral one. If it’s central, that’s crucial. I feel very positive about the people we’ve brought on board and the clarity we are creating in separating responsibilities. We have recruited external talent in recent months to strengthen our operating areas, including some of our vice presidents. Additionally, our digital team has brought in a lot of external talent to accelerate our digital journey.

And then I know it's early, but what have you learned with the Walgreens test in Cincinnati, particularly as you kind of look forward to opening up the Ocado sheds in non-Kroger markets? Have you learned anything definitive or not yet?

Yes. It's still very, very early, and I would say the thing that has been incredibly positive is Walgreens, their team and their store teams are a fantastic partner. And both of us are learning things, the customer likes and dislikes, together, and we really see it as something that we continue to understand the customer desires and changes and adapting to that. It's pretty early on.

Yes. Sure. I think that some of the things that we're learning and we like so far, John, with what we're seeing, first of all, by having the level of convenience now that we have with those 13 stores in Northern Kentucky, alongside 10 of our own stores with the pickup service, we're getting great feedback on both the fact that we're at a different level of convenience than we were before. And this ability to get in and out really quickly is certainly something that is resonating very well with the customers that are using the service. We're also starting to see some positive feedback from customers around the speed of in and out for those small shopping trips and the ability to be able to get what I need for today and what I need for tonight, whether it's for lunch or dinner, and that's certainly a real positive. What we find generally with the small-format stores, there is a ramp-up as customers become more comfortable with their shopping behavior. We've seen that with our own small-format stores, and we've seen it over the years with convenience stores. So the biggest thing for us now is really poring over the data and making sure that we're using a data-driven approach to continue to enhance the service and the experience.

Can you provide more clarity on how the full year operating profit guidance works? So far, you're trending slightly below your ID sales range, even in the current quarter. It seems like the pressure on pharmacy gross margins has been greater than anticipated, and despite a real estate gain in the first quarter, your profits were still down. What steps can you take from here to reach your operating profit guidance for the full year? At what point do you see increased risk that achieving that level will be more difficult?

Yes. I'll make a couple of comments, and then I'll let Gary provide more details. If we look at the positives, we had excellent expense control. It is also important to remember that we sold the Turkey Hill Dairy business, the c-store business during the first quarter, and YouTech, all of which impacted operating profit when comparing year-on-year in the first quarter. So it’s important to keep that in mind. Additionally, the alternative profit exceeded expectations in the first quarter as well. With that, Gary, I'll let you elaborate more on the details.

Yes. I think that's a very important point you made around the adjustments to get the year-over-year comparison correct, Rodney, so thank you for raising those. I think beyond what you already shared, the key components I would add, we are obviously excited about where alternative profit is heading and still see that as a potential upside. I think the other piece that I mentioned in the prepared comments is our team has done a phenomenal job of looking for how do we continue to generate cost savings and efficiency in the business, and we still believe there are more levers that we are pulling and we'll continue to pull that give us the ability to make sure that we continue to strengthen the financial model as we're continuing to drive the sales momentum that Rodney described in his opening comments as well. So for us, I think it is really about making sure that we're connecting more strongly with the customer and driving sales, but certainly very focused on how do we make sure we're creating the most efficient operating model. We continue to find additional opportunities, whether it's in-store productivity, pharmacy productivity, as I mentioned earlier. We still think there's a lot of upside in goods not for resale and cost of goods. And so as we continue on this journey to make sure we're building the most efficient retail operation, we do believe there are levers that we can continue to pull throughout the year and into 2020.

And then my follow-up question is on your price investment. Recognizing that there's been a lot of noise in your IDs over the last couple of quarters given the disruption from the store remodels, do you think your price investments are as effective as they might have been in the past? And if they are, will you have to reaccelerate your price investments in the coming quarters to drive higher IDs this year?

Yes. It's important to remember that customers choose where to shop based on factors beyond just price, and we are confident in how our prices compare to the market and our competitors. Customers also consider regional players when evaluating prices. Overall, shopping decisions are influenced by the shopping experience provided by our associates, the freshness of our perishable items, and we continue to perform well in areas like produce, meat, seafood, and delis, as well as in providing a great and quick checkout experience. We excel at delivering rewards that are tailored to each customer by using our data to create targeted offers. Additionally, fuel offers play a significant role in this equation. Ultimately, customers select where to shop based on the total experience, and we feel positive about the progress we’re making in enhancing that experience. Furthermore, as previously mentioned, we have seen solid growth among our loyal shoppers.

I had a couple of questions on operating profit. First, wanted to ask just about your 3-year plan. I didn't really see anything specific in the release about it, and I don't want to read too much into it. But can you comment on your thoughts on that $400 million plan? As you've pointed out in the past, I think The Street is skeptical of getting to that given the huge acceleration it implies next year. But maybe just could you comment on that?

Sure. Yes. I think as you think about the Restock Kroger Plan, as you know, when we built the plan out, we've identified $4.45 billion of overall savings and value that we expected to create and then would invest $4.05 billion to support the business growth, whether that was in our associates or in pricing or the customer experience and digital capabilities. I would say as we look at where we are in the journey, we're feeling very good about what we've learned through the process around where we unlock and how we create that $4.45 billion of value. As you've heard us talk about, alternative profit streams are right where we expected them to be, if anything, slightly ahead of plan at this point, and we see continued great upside for growth there. As we look at the cost savings, we obviously were successful in exceeding our plan last year at $1.1 billion of cost savings, and we are identifying, I would say, more cost savings as we are working through the plan this year that we believe can continue to accelerate our progress there in becoming a more efficient operator. I do think, as we've shared all the way along and Rodney has been consistent in his comments, that we do have to make sure that we are continuing to build momentum in sales. That's an important part of generating more leverage through the growth in sales that we're committed to achieve in the second half of this year and obviously into 2020. So I think as you pull those three pieces together, we still feel we have a very clear path to get there. And I would say in the levers that we intended to pull, where we are in the journey with those levers, we're feeling very confident around them.

And then on your other comments about Turkey Hill and there's a lot of moving pieces between the Turkey Hill divestiture, the Home Chef acquisition and now with this real estate transaction. That was $57 million, I think. So that's about 14% of the $400 million plan that we weren't aware of. So can you help us understand these moving pieces, how much they add or subtract to that operating profit plan, so we can kind of model this out a little bit more clearly?

Yes, we will likely need to perform some calculations to ensure we are starting from the correct baseline. We were at $3.1 billion in 2017, and are looking to increase that to $3.5 billion. There may be a few changes that will require us to clarify what the baseline is, considering the various developments, and what that implies for the incremental $400 million by 2020. We do not anticipate that one-off transactions will significantly impact the value we expect to generate in 2020 when we consider the run rate. Our Restock Kroger plan is designed to build momentum beyond 2020, and we are not merely aiming for a specific figure for 2020 that does not contribute to overall value. The Home Chef certainly isn't in the $400 million, and the Turkey Hill sale gains certainly is included in there. So none of these one-off transactions are, that's why we've kind of stripped those out from the performance and what we've shared as our progress in the year. None of those, or in 2020 would we expect there to be individual asset sales or disposals that are going to create a gain that would be, if you like, filling the gap between where we are today and where we expect to be in 2020.

Okay. Maybe just a couple of follow-ups to that. I guess can you share with us where you see your FIFO operating profit with all the adjustments these, I guess, five quarters through the plan? And then in terms of alternative profit. So I think you said in the past, there was a 20% increase this year. Does that equate to the $100 million that you're now talking about? And can you remind us what the last year and next year is kind of planned at?

The growth in alternative profit for the quarter was just above 20%, compared to last year's growth of 20%. Looking back to 2017, it was around 13%. We're continuing to accelerate as we gain expertise in this area. In our Media business, we have brought in professionals who understand how to drive growth, and this is contributing to our acceleration. For more detailed insights about the past five quarters, it would be best for Gary and Rebekah to follow up so we can provide more specific information.

Absolutely.

So I guess, firstly, on the composition of gross margin, the change year-over-year and maybe the cadence for the rest of the year, a couple of components to that. So how much of the 40 basis point nonfuel decline can be attributed to pharmacy? Should we expect a similar headwind for the rest of the year? Will that improve? You mentioned alternative profits can be lumpy. Anything to keep in mind from a margin contribution seasonally? And then you're lapping some supply chain investments in the fourth quarter. I understand that. Any sense for mix shift towards Our Brands and the contribution there?

I'll start, and Gary will finish. In the first quarter, we continued to incur significant start-up costs for our facilities in Las Vegas, Michigan, and Northern Kentucky that support our online business. The investment in these facilities during the first quarter was fairly comparable to the fourth quarter. Those facilities are currently in the process of ramping up. As I often mention, the margin for Our Brands is typically 600 to 800 basis points higher than that of national brands, reflecting their higher sales share. When examining the gross margin per item, it's generally $0.01 or $0.02 higher on a cents-per-item profit basis. Gary, I'll let you delve into the details regarding Rx and the remainder of the year.

Yes. So certainly, as we mentioned in the prepared remarks, a meaningful part of the gross margin decline in the quarter was the gross margin pharmacy pressure you mentioned and also Kroger Specialty Pharmacy with its continued growth. Those two, combined, would have been a meaningful portion of the reduction. We're feeling really good about the fact that we saw a significant deceleration in gross margin decline in Q1 versus the second half of the year. And as we guided to for the whole year, we do expect that to be the case. We don't expect to have another quarter like we had in Q3 and Q4 last year. That being said, obviously, we manage the business very dynamically. It's important that we're able to adapt on pricing, continue to invest where it makes sense and where the customer tells us they really value it, and it will drive retention and growth in our loyal customer base. So we tend to really focus on how we're managing the business to make sure that we're achieving the overall operating profit guidance and EPS that we shared. We do think there will continue to be some pressure in the Rx margin as the year progresses on. As I mentioned earlier, the team there is doing a very good job in making sure that we're finding ways to manage that pressure and also introduce cost-saving initiatives that balance out the impact of that. So we certainly would expect the impact to be less in the rest of the year as the team continues to execute on a plan to drive strong sales growth and drive improvements in overall profitability.

And alternative profit is always strongest in the fourth quarter because of the gift cards and the other related items. We have time for one more question.

Just on the core gross margins for the grocery and consumable business, can you talk about what you saw after you back out some of the supply chain investments in the pharmacy? What are you seeing in the core there? And then the follow-up is on tonnage. Did you have growth there in the quarter given the 1% inflation, 1.5% comp? Just give us some color there incrementally on the trend, if you could.

Yes. If you examine the tonnage in equivalized units, there would have been continued growth. We are seeing customers opting for larger packs across the entire category. When considering core gross margin, it would require some investment. However, as Gary mentioned, we experienced meaningful improvements in the cost of goods through negotiations and other strategies, which supported a significant amount of investment as well. Gary, do you have anything to add?

No. I think you said it well, Rodney.

Okay. Good. Thanks, Michael. Before we end today's call, one of the things that's exciting about our earnings call is that many of our associates listen in to better understand and gain insights into our business. And of course, many of our associates are shareholders as well. So as always, before we end today's call, I'd like to share a few final comments directed to our associates and how all of us live our purpose every day. As America's grocer, Kroger takes seriously our role in celebrating our uniquely American heritage during the patriotic season between Memorial Day and Independence Day. It always makes me feel incredibly proud that Kroger employs so many men and women who have served or currently serve in the Armed Forces. I got a chance to personally live our purpose last Saturday with our Veterans Associate Resource Group who put on a 5K run to raise money for veterans. While I certainly didn't finish first and wasn't close to last either, I would like to add, in the race, I did have a different kind of first: touring a specifically designed tiny house that our caring associates dreamed up and then built for a deserving local veteran and his family. The home was built to green technology standards, made from recycled materials and features solar panels, demonstrating our associates' commitment to and passion for Kroger's Zero Hunger | Zero Waste social impact plan. In addition to the home, our Cincinnati/Dayton division donated a Kroger gift card and a bag of Our Brands products to turn a new tiny house into a home, and it really felt great. One of the many ways Kroger shows our gratitude and appreciation to all of our service members and their family is through our long-standing commitment to the USO. Kroger is the single-largest donor to the USO, contributing over $22 million over the past decade. In keeping with this commitment, we will be presenting the USO with a $1 million donation and a Barbecue for the Troops event we are hosting at Fort Stewart in July. It is our honor and privilege as America's grocer to serve America's heroes. Thank you to all of our customers, associates, and suppliers who make our business successful every day of the year.