Kroger Company (KR) — Q3 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 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 the business on an ongoing basis is contained in our SEC filings. The Kroger assumes no obligation to update that information. Both our third quarter press release and our prepared remarks for this conference will be available on our website at ir.kroger.com. After our prepared remarks, we look forward to taking your questions.

Thank you, Rebekah. Good morning, everyone, and thank you for joining us today. With me to review Kroger's third quarter 2019 results is Chief Financial Officer Gary Millerchip. I would like to thank those of you who were able to attend our investor conference last month where we shared our progress on Restock Kroger. We believe that Restock Kroger is the right framework to reposition our business to create value for all of our stakeholders. It provides us with a clear purpose and our vision to serve America through food inspiration and uplift. It focuses us on redefining the customer experience, identifying the partners who will help us deliver customer value today and in the future and putting the right talent and teams in place to focus on growth in our supermarket business and our alternative profit businesses. We are proud of the progress we have made, and we've learned from the challenges we've experienced. We are on track with a stable and growing supermarket business as a result of our customer obsession, renewed intensity around operational excellence and continued investment in seamless. We are growing our supermarket business by focusing on three levers to drive identical sales: fresh, power brands and data and personalization. And we continue to build a seamless ecosystem that is available, relevant and accessible for our customers. All of this combined to generate positive results in the third quarter. We continued to grow identical sales, reduce costs and deliver strong free cash flow. We had a broad-based identical sales improvement. Fifteen of our divisions had increasing supermarket identical sales without fuel compared to the second quarter. We delivered a slightly improved FIFO gross margin, excluding fuel and pharmacy. Headwinds in pharmacy were offset by strong fuel performance during the quarter. We are on track to deliver $100 million in incremental operating profit through alternative profit stream growth. Kroger continues to invest in digital as we build a seamless ecosystem for our customers. We know our customers value greater convenience this provides, and our data shows it's an essential component of growing overall loyalty. Digitally engaged customers not only drive growth through our digital modalities, they also help drive brick-and-mortar sales growth as well and share of wallet. So seamless is both, not an either/or. Our data clearly shows that over time and after initial investments, the profitability of a digital customer is the same as an in-store customer. We continue to see an improving operating profit trend in digital, and therefore, our investments are maturing as expected and consistent with the graph we shared at Investor Day. Our digital sales grew 21% in the third quarter. As we shared previously, we expect our digital sales growth to moderate year-over-year primarily due to the cycling of Home Chef and as a result of our disciplined focus on growing the Ship customer. We have expanded our digital coverage to reach 96% of our customers. This means that 96% of our customers who shop Kroger in a brick-and-mortar store can also shop with us for pickup or delivery. We continue to invest in digital platforms as this is where the customers are increasingly going to meet many of their needs. Providing our customers with the ability to have anything, anytime, anywhere from Kroger sets us apart from a large segment of our competitors and will drive loyalty as well as our long-term growth and margin expansion. We continue the rollout of Ocado facilities. In November, Kroger announced plans for a new high-tech customer fulfillment center in Wisconsin. The automated warehouse will serve customers in Wisconsin, Northern Illinois and Northwest Indiana. What's so exciting about Ocado is their model to deliver to the customer is significantly less costly than our existing model and any of the other models we've examined as well. Not only will these facilities accelerate our ability to provide customers with a seamless experience, they will also help us to do it in a much more cost-effective way. We know Ocado's value is not just its current capabilities but also how quickly the company is able to innovate to serve a rapidly developing online consumer market. One of the comments we made at IR Day is that Ocado keeps learning and improving their model. Ocado's recent announcement of a micro fulfillment center in Bristol is a good example of this. We believe that the food industry is special. It is huge, a $1.5 trillion market. And not only do people need to eat, they love to eat. Food isn't a commodity, but it's the center of our lives. Customers deserve a partner like Kroger who can provide inspiration and fulfill their passion for food. And unlike our national competitors, Kroger is food first. We believe that no matter who you are, where you're from, how you shop or what you like to eat, everyone deserves to have affordable, easy-to-enjoy fresh food that tastes amazing. As we shared in November, fresh is an important driver of sales for Kroger. Our fresh departments drive trips, loyalty and gross margin. Our product standards, selection criteria and supply chain are core strengths and are built to deliver first-to-market and best-of-season fresh products across the United States. Our produce department led the way in sales for the quarter, demonstrating how our store teams are focused on improving everyday execution in ways that are highly relevant to our customers. In addition, we launched our Fresh for Everyone brand transformation campaign, and the initial feedback from both our customers and our associates is very positive. One of the many ways we demonstrate our passion for food is through Kroger's best-in-class Our Brands portfolio. While many grocers offer private label products, Our Brands is a real differentiator for Kroger because our customers tell us through blind taste tests that Our Brands' quality is better than not only the competitors' private label products but also many leading national brands as well. Kroger's Our Brands grew 3.4% this quarter. We also introduced 231 new Our Brand items during the third quarter. Kroger's third differentiating lever to drive identical sales growth is personalization. Data is a differentiator for Kroger. Many retailers have transactional data, but none have the customer data and the insights to make meaningful suggestions to their customers like Kroger. We continue to see incredible effectiveness and efficiency from a focus on loyal customers and investing in their satisfaction. One specific area I'd like to highlight is our strong fuel points program. As we shared at the Investor Day conference last month, an amazing 83% of our loyal customers engage with our fuel rewards program each year. We are increasingly targeting promotion and personalization of fuel rewards, and fuel drove trips and sales in the third quarter. We are using the power of Kroger's stable and growing supermarket business to create meaningful incremental operating profit through the alternative profit stream businesses, which adds up to a business built for long-term growth that generates consistently attractive total shareholder returns. Kroger continues to generate strong and durable free cash flow as reflected by the fact that the company has reduced debt by $1.5 billion over the prior four quarters and continues to increase its dividend to create value for shareholders. We are confident that we can deliver even stronger total shareholder returns in the future because of our strong free cash flow and sustainable net earnings growth. Restock Kroger is the right framework to reposition our business to create value for all of our stakeholders both today and the future. And now I will turn it over to Gary for more details into the quarter financials. Gary?

Thanks, Rodney, and good morning, everyone. I want to echo Rodney and thank those of you who were able to attend or view the Investor Day webcast last month. As we shared in New York, our model for a strong and durable retail supermarket business begins with the customer and our obsession with increasing customer loyalty. We believe that our intensified focus on execution and continued improvements in the value and experience we deliver for our customers is driving increased identical sales across our store and digital ecosystem. To drive sustainable sales growth for the long term, we will continue to invest in areas of the business that are important to the customer. This includes ongoing investments in talent, price, digital and store experience, with an even greater emphasis on fresh, Our Brands and personalization. We are demonstrating through the first three quarters of the year we are being very deliberate in balancing these investments with disciplined execution of cost savings that simplify our business. Our supermarket business and the traffic and data this generates serves as the foundation from which we are able to drive higher growth in our asset-light, margin-rich alternative profit businesses that we continue to expect to accelerate our results. We expect our model to deliver improved operating results over time and continued strong free cash flow, and we expect this to translate into a consistently strong and attractive total shareholder return through EPS growth driven by sustained net earnings growth and the return of cash to shareholders via share repurchase, plus a growing dividend over time. Now I'd like to share third quarter results. For the quarter, we delivered an adjusted EPS of $0.47 per diluted share. As noted in this morning's press release, that includes a $0.03 out-of-period charge that I will share more detail on in a moment. But first, I'll highlight a few areas of our business that were particularly robust. Our Brands contributed as both a sales driver and a profit leader. The entire Kroger team brought discipline to controlling costs during the third quarter, and our fuel performance mitigated retail pharmacy gross margin headwinds in the quarter. LIFO charge for the quarter was $23 million compared to $12 million for the same period last year driven by inflation in dry grocery, pharmacy and dairy. We now estimate LIFO for the year to be approximately $90 million versus our original expectation of $50 million. Our adjusted corporate tax rate for the quarter was 70 basis points higher than the same period last year due to a decrease in the benefits of federal tax credits and an increase in reserves. I'll now provide additional detail about two specific items that affected our results in the third quarter. First, the out-of-period charge of $29 million that I referenced earlier. This charge is related to a provision in a single pharmacy contract that should have been recognized over the previous six quarters. Given the complexity of the contract and the introduction of new clawback provisions, a part of the contract was misinterpreted. The required correction was identified in our standard management review process. This charge is not material to total company results, and the financial effect in each of the prior individual quarters was immaterial to net earnings per diluted share. However, the cumulative effect on our performance in the third quarter reduced adjusted net earnings per diluted share by $0.03 and gross margin by nine basis points. We, therefore, felt it was important to provide a greater level of insight into this item. There is no effect on earnings guidance for 2019 or 2020 as a result of this contract going forward. I'd now like to talk about Lucky's Market. During our investor conference last month, we committed to continue to be disciplined in prioritizing capital allocation to improve return on invested capital and create sustainable shareholder return. As part of a portfolio review, we made the decision to evaluate strategic alternatives in relation to our investment in Lucky's Market. As a result of this review, the company has decided to divest its interest in Lucky's Market and recognized an impairment charge of $238 million in the third quarter. Accounting rules require Kroger to record the gross amount in operating profit. However, the real economic interest to Kroger is a pretax charge of $131 million. Additional details are provided in the financial tables of our press release. The impairment charge is a noncash charge and reflects the write-down of our initial investment in Lucky's Market as well as additional funding provided to operate and grow the business. There is no effect on earnings guidance for 2020 as a result of this decision. Turning now to some of the highlights in the third quarter as underlying trends were very robust. Kroger reported identical sales without fuel of 2.5% during the third quarter, marking our strongest quarter since we launched the Restock program. Several supermarket departments outperformed the company, including produce, key beverage categories, pharmacy and natural foods. Digital contributed approximately 70 basis points to identical sales, with Kroger pickup and delivery continuing to show strong momentum. Adjusted FIFO operating profit for the third quarter was $653 million compared to $664 million in the third quarter of 2018. Gross margin was 22.1% of sales for the third quarter. FIFO gross margin, excluding fuel, decreased 24 basis points from the same period last year primarily driven by industry-wide lower gross margin rates in pharmacy and continued growth in our specialty pharmacy business. Gross margin rate, excluding fuel and pharmacy, improved slightly in the quarter as cost of goods savings and growth in alternative businesses offset continued retail price investments. While profitability in retail pharmacy is lower than we had budgeted this year, it remains an important part of our strategy and continues to generate good returns. We were pleased to see the decline in gross margin rate compared to last year was lower in the third quarter than the first two quarters of 2019, and this trend is expected to continue in quarter four. As a result of continued growth in pharmacy sales, improved product sourcing and initiatives that lower the cost of fill trips, our expectation is that pharmacy profitability will be less of a headwind in 2020. Our associates continue to do an impressive job managing shrink, which improved in the third quarter compared to last year. This represents the ninth consecutive quarter of year-over-year shrink rate improvement. OG&A cost as a rate of sales, excluding fuel and adjustment items, decreased 15 basis points. This was achieved through broad-based improvement of Restock Kroger cost-saving initiatives. We remain on track to achieve over $1 billion of cost savings in 2019 on top of the $1 billion savings achieved last year. We also have clear line of sight to the $1 billion of incremental savings in 2020 that we shared at our investor conference. These savings are being achieved through improved productivity and automation, elimination of waste, improved sourcing of goods not for resale and administrative efficiencies. Like many industries, grocery retail is navigating through disruptive change. As part of the company's ongoing evolution, store operating divisions recently evaluated and reduced middle management roles to ensure they have the right talent in the right roles closest to our customers in store leadership positions. As a result, Kroger incurred severance charges in the third quarter totaling $80 million. Fuel is an important part of our strategy to drive customer engagement, and our loyal customers continue to receive hundreds of millions of dollars in fuel rewards each year in the form of price discount at the pump. As Rodney mentioned, fuel is driving lower customer trips and sales, and the amount of fuel rewards paid to loyal customers increased by 8% in the third quarter. The average retail price of fuel was $2.62 this quarter versus $2.81 in the same quarter last year. Our cents per gallon fuel margin in the third quarter was $0.30 compared to $0.26 in the same quarter last year. Fuel is a great example of Kroger's sourcing teams continuing to improve buying practices. This allowed us to achieve improvement in fuel cost of goods in the third quarter. Alternative profit streams are on track to contribute an incremental $100 million in operating profit in 2019. Media and Kroger Personal Finance continue to be the primary drivers of growth this year. Kroger Precision Marketing continues to build momentum, increasing engagement to over 1,000 brands with a 90% retention rate and significantly higher spend. We have relationships with all major agency holding companies supporting their media activations as they deploy brand-building programs. Our Media business continues to release new inventory and create new publisher relationships to support the demand of advertisers. And now to update on labor relations. As we have previously shared, we are proud that our average hourly rate is over $20 with comprehensive benefits factored in, benefits that many of our competitors don't offer. As a result of Kroger's investments in our associates, we are improving employee retention in one of the tightest labor markets in years. We continue to invest in our associates as part of Restock Kroger in a variety of ways, including investments in wages, training and development. We ratified new labor agreements with the UFCW covering associates in Southern California, Portland, Seattle, and Michigan during the quarter. We are currently negotiating with the UFCW for contracts covering store associates in Las Vegas and Memphis. 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 strive to make our overall benefit package relevant today to 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 the 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 element of our capital allocation strategy is to use our free cash flow to invest in the business and drive profitable growth while also maintaining our current investment-grade debt rating and returning capital to shareholders. We actively balance the use of cash flow to achieve these goals. We committed to prioritize free cash flow in 2019 to reduce the company's net total debt to adjusted EBITDA ratio to within our target range of 2.3 to 2.5. Over the last 12 months, net total debt has reduced by $1.5 billion, and Kroger's net debt to adjusted EBITDA ratio is 2.5 for the third quarter of 2019 compared to 2.72 a year ago. We remain committed to our target net total debt to adjusted EBITDA range. Now that we are operating within our target range, and as we expect to generate strong free cash flow, we anticipate starting to buy back shares in the fourth quarter under our $1 billion Board authorization. This is not expected to have a material impact on fourth quarter EPS. Turning now to guidance for 2019. We continue to expect identical sales growth, excluding fuel, to range from 2% to 2.25% in 2019. 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. We expect underlying identical sales growth in the fourth quarter will be similar to third quarter. However, incremental SNAP dollars that were in the market in January 2019 represent about a 50 basis point headwind in the quarter. We, therefore, anticipate reported identical sales will be towards the lower end of our 2019 guidance range for quarter four as we cycle the effect of SNAP. We continue to expect the fourth quarter to deliver double-digit EPS growth on an adjusted basis. Where we land with our adjusted EPS annual guidance range will be heavily influenced by fuel margins in the fourth quarter, which were at record highs in quarter four last year. Our customers' shopping behaviors affected by the lower SNAP dollars in market in January will also influence the outcome. As you know, we typically share annual guidance when we report our fourth quarter results in March. But this year, we provided guidance for 2020 several months early. We remain confident in the 2020 guidance that we shared last month at our Investor Day in New York. And now I'll turn it back to Rodney.

Thanks, Gary. As I shared when we first began the call, we believe that Restock Kroger is the right framework to reposition our business and create value for all of our stakeholders. We are on track with a stable and growing grocery business as a result of our customer obsession, renewed intensity around operational excellence and continued development of our seamless ecosystem. Our focus on the fundamentals generated positive results in our supermarket business in the third quarter, which gives us strong momentum heading into the holiday season. Now we look forward to your questions.

I just wanted to start with a question on the Q4 outlook. So you have a fairly wide range. That, I guess, implies earnings growth anywhere from sort of like mid-singles all the way up over 20%. One question, I think, that I have related to this is what are the puts and takes around that range? And I know you mentioned fuel, but a second question related to that is that to get to these numbers sort of either way, you need core grocery earnings to improve, and that's despite what is a harder comparison on SNAP and quite frankly recent pressure in grocery. So can you just kind of walk us through those puts and takes and then what you think will drive core grocery earnings to inflect positively in Q4?

Thank you for the question. I'll address that. You're right, we anticipate adjusted EPS growth to be in the double digits for the fourth quarter. As I mentioned earlier, we expect identical sales growth to remain in a similar range as Q3, although there will be some SNAP headwinds that may push it towards the lower end of that range. That’s the primary assumption regarding identical sales for the quarter. We are cycling through some investments; last year in Q4, we allocated costs to certain facilities in D.C. From a gross margin standpoint, we are looking at some tailwinds that should aid us this quarter. We also expect to continue realizing cost-saving improvements as we advance our $1 billion cost-saving initiative. Additionally, as stated in previous quarters, alternative profit streams typically trend higher in the fourth quarter, largely due to KPS's significant fourth-quarter influence and the ongoing acceleration in Media, which usually performs well during this time. The combination of this acceleration and a stronger Media presence in the fourth quarter should support the growth of our alternative profit segment. Regarding the factors that may influence our performance in the quarter, on the headwind side, we have invested in a new brand launch, which involves spending on enhancing our messaging and fostering customer connections. We also introduced a promotion for free pickup this quarter, and we are observing its impact on customer behavior. Additionally, we face a fuel headwind this quarter, as the rate was $0.34, a record high from last year. These headwinds will affect our performance compared to the earlier assumptions mentioned. The uncertainties around the range stem mainly from the record fuel prices last year; if fuel averages align with how it has been performing year-to-date, it would reflect a certain level. If it stays at last year's level of $0.34, that would significantly affect our quarter’s results. Furthermore, we are considering how customers might react due to the absence of SNAP dollars in January, which contributes to the broader range we’ve set. Nonetheless, we remain confident in our fourth-quarter model, which is why we expect to achieve double-digit growth in earnings per share.

Just to follow up, it appears that the new information in this quarter's guidance includes a $0.03 pharmacy charge that contributes to the $0.47 figure. Additionally, your LIFO charge is increasing by $0.04, which is somewhat unexpected. What adjustments are being made to help you maintain your guidance?

Ed, this is Rodney. I have a couple of comments to add before Gary speaks. Our identicals are continuing to improve and perform strongly. If you examine the gross margin excluding fuel and pharmacy, there's been a slight improvement. We achieved a good balance between cost reductions and gross investments, and these factors are coming together effectively. The core business is steadily improving and moving in a positive direction, which helps counterbalance the $0.03 pharmacy adjustment and the increased LIFO. Gary, do you have anything to add?

I completely agree with you, Rodney. The important point is that despite the headwinds, if we look at Q3 by removing those factors, the underlying EPS and operating profit would have been positive without the out-of-period adjustment. As Rodney highlighted, ID sales were very strong during the quarter. While we didn’t include it in the press release, the out-of-period impact on gross margin rate was 9 basis points. Therefore, in the quarter, even with pharmacy headwinds, the gross margin rate would have balanced out with OG&A improvements of over 15. We reported a 24 basis point decline in gross margin, excluding fuel. By removing those nine basis points, we arrive at a 15 basis point underlying gross margin investment after excluding the out-of-period adjustment. Taking into account the 15 basis points of investment alongside the pharmacy headwinds we faced, along with an equivalent 15 basis points of OG&A improvement, we believe the progress in our model has been somewhat obscured this quarter. However, we remain very optimistic about the underlying trends in the business.

Maybe first, just following up on fuel. Can you help us with the benefit you're getting from improved sourcing and the sustainability of that relative to just kind of a general step higher in industry profitability and how that's playing out?

It's a combination of really some technology investments that we've made in terms of how to buy fuel and making sure, from a market standpoint, how we're pricing on a daily basis and reacting to what our competitors are doing. So it's the benefit of the way fuel is being bought plus being much more disciplined relative to the market. So it's really the combination of those. In terms of expectations going forward, from a procurement standpoint, we don't believe that's something that will continue to incrementally get better. We do believe it's something that we'll be able to maintain, and it's something that we've reflected in our guidance going forward.

Okay. That's helpful. And then maybe just following up on the Lucky's write-down. I don't think it was that long ago that you guys were citing double-digit ID sales at Lucky's and great trends in produce. Maybe just a little bit more on the decision to exit the investment, the write-down of the investment. And is there any commentary on that kind of subchannel of food retail, kind of the specialized fresh-led food retailers and smaller boxes that's causing you to say maybe the traditional larger store fresh-led format is the way to go?

Yes, it really relates back to Gary's comments in the prepared remarks and what we discussed at Investor Day. We are reviewing our entire portfolio and considering how much investment it would take for Lucky's to make a significant contribution to Kroger. We concluded that the level of investment required would not yield a satisfactory return. This decision was driven by our desire to focus our efforts and meet the additional requirements needed to enhance Lucky's contribution. Gary, since you are more involved in the day-to-day operations, do you have anything to add?

I think you characterized it well, Rodney. To expand on the second part of your question, we believe that as we improve our fresh offerings and continue to refine our strategy around natural and organic products, we are providing a more comprehensive customer experience than ever before. We plan to keep enhancing this as we develop our freshness strategy and strengthen our connections with loyal customers. We also believe there is still a place for small format stores. Their viability has been demonstrated, although the optimal model for such stores and the economic strategies that need to be in place to make them work effectively are still being defined. We remain optimistic and are actively searching for opportunities, while our Walgreens pilot continues to contribute to our understanding of how to integrate a small format presence. However, it is clear that developing a successful small format model is challenging.

Been looking at the Thanksgiving sales and how customers were spending, trading up. Can you talk about what that might mean for the Christmas selling season later this month?

Yes. Thanks, Chuck. If you look at quarter-to-date, our identicals would be pretty similar to where we were in the third quarter. The balancing of it is significantly different than the last few years because, obviously, there's one less week between Thanksgiving and Christmas. If you look at the way how customers spend their money, we continue to see obviously strong on people trading up, strong performance in wine, cheese, all those types of categories, and we would certainly expect that to continue to stay consistent through Christmas as well. So we really expect the business to continue where it is through Christmas. Obviously, if you look at January of next year, it's really the SNAP cycling, the SNAP impact would affect the kind of the numbers that we've provided for guidance.

Related to customers trading up, is that what you're trying to do when you invest in the customer experience? Prepared food strikes me you're making investments there. But are there other things we should think about?

Yes. It's fascinating because the customer is trading up both in terms of buying bigger package size. So what we find is when people are tied on budgets, they go to smaller package size. So we see people trading up there. We see people trading up to products that's better for you, natural and organic category. Prepared foods would be an area that we see people continuing to trade up for, and it's an area where we've focused a lot of attention on how do we get better. We view it as a huge opportunity to improve from where we are. And it's one of those things where we're just at the beginning part of that journey but certainly see customers very willing to pick up dinner at Kroger but do it with a Home Chef meal or something already prepared.

This is Antonio Tabet taking over for Mike Montani. I just wanted to ask something on the 4Q comp outlook. You guys are obviously cycling SNAP in January. But I'm curious as to what you're seeing so far now with the whole rebrand going on. And another follow-up to that is with the option of free pickup promotion going on right now until January 1, is there a possibility that, that stays? Or what are you seeing from that so far from the reception of customers?

Yes. Looking at the outlook for the fourth quarter, we are currently tracking similarly to the third quarter. Up until the SNAP period, we don’t see any changes. Regarding the free pickup option, we haven't reached a decision on whether to continue it. We've implemented it in several markets, and we are still in the early stages of our analysis. Customer adoption has been somewhat stronger than we anticipated, but we are not at a stage where we need to decide on an extension yet.

Just to add, Rodney, we are only a few weeks into the promotion. It's interesting because we're seeing both new customers starting to use the service and existing loyal Kroger shoppers using it more frequently. We will analyze and evaluate all of that data, and it could influence how the quarter plays out in terms of sales. That's another reason we want to be clear about the different factors that could still impact the quarter.

Okay. That's helpful. And just a quick follow-up on the digital side. You guys grew digital sales 21% this quarter. And just the way we're thinking about it, for the full year, we're thinking somewhere in the range of $5 billion to $5.5 billion digital sales versus 2018 value somewhere around the baseline of $4 billion. So that implies around 31%, 30% year-over-year growth. Is that somewhat reasonable to think of? Or is that an attainable target? Just want to get your color on that.

Yes. If you look at it on a run rate basis, the numbers that you shared would be very consistent with what we see. The other thing I always think is important to remember that I mentioned on our digital business and Yael shared it on a graph is the profitability of that business is maturing as we expect. And if you look at the early adopters on digital, the profitability of that customer was the same as going in store because we get such a higher share of their total spend. And we continue to see that maturity happen as well, which, for us, is something that makes it a sustainable model longer term as well.

Just one thing to add, Rodney, you said in your prepared comments and I mentioned it briefly as well, but I think we shared before that it really is the cycling of the Home Chef merger that caused the absolute percentage growth rate to show a declining trend. The underlying progress that we're seeing in customer engagement through Kroger pickup and delivery continues to be very strong and very consistent in the underlying results that we're seeing beyond the headline number.

Okay. And does that headwind continue to 4Q?

We've cycled that now. It was partly through Q2, so you have roughly half of it in the second quarter, and now it's fully cycled through in Q3. I believe Yael may have mentioned at the investor conference that we expect year-over-year growth going into 2020 to be around 20%, consistent with what we shared this quarter.

Rodney, thank you for the update on the quarter-to-date comp. Can you provide an update on your core gross margin and fuel margin for the fourth quarter? The reason I'm asking is that there seems to be some hesitation from investors regarding your ability to meet the high end of your guidance range for the fourth quarter. I would like to hear your thoughts on this.

Yes. I would like to refer back to Gary's earlier comments. The underlying supermarket business remains strong, and identical sales continue to perform well. There is a good balance between cost reductions and investments in service and growth. The most significant fluctuation comes from the fuel margin, which can vary significantly from day to day. The value we have quarter-to-date is unlikely to change dramatically overnight. I recall being in a market recently where the margins changed from $0.40 in the morning to $0.15 in the afternoon, illustrating this variability. However, overall, it remains a great return and fosters customer loyalty. Additionally, SNAP is another important aspect. I'm not sure if you have any further insights, Gary, but from my perspective, fuel margins have been challenging quarter-to-date due to their volatility.

Yes, I think that's accurate. To provide some context, I've mentioned earlier that we've been trending around the $0.29 range year-to-date, while last year’s fourth-quarter rate was $0.34. A $0.05 change can lead to a $50 million variance in profitability. We have a clear strategy for engaging with customers on fuel and ensuring our pricing aligns with the market. This area can significantly impact our results, which is why the range appears wider than we typically prefer for the fourth quarter. It's not due to a lack of confidence in our core business, but rather the uncertainty surrounding rates, prompting us to maintain the current range.

I get that. And then my follow-up is, obviously, the government made some changes that are going to take some people in the America off food stamps, and it sounds like there's more of that coming. I'm curious, to what degree does your 2020 guidance factor that as a risk? Because, clearly, I think that if 700,000 or eventually some of the people think it will be closer to 3 million Americans get off food stamps, I can't say that as a positive for you, but I'm curious if there's any way to think about numerically how that might affect you?

Thank you for the question. Ken, this is something we are monitoring closely. We recognized this as a potential risk in our business, and we will keep evaluating it. Our goal is to build a business model that can adapt to changing circumstances. We believe in our ability to connect with customers and provide a comprehensive experience. We've observed that when customers have reduced budgets, they tend to prefer store brands, leading to shifts in purchasing behavior. However, since food is a necessity, customers will likely adjust their spending to ensure they can still buy the groceries they need for their families. We view this as a risk as we continue to develop our model and strengthen customer relationships. We will adapt our strategies based on what we learn and any changes that arise, even though these factors are largely beyond our control. Our priority remains on how to win over customers and adjust our strategy if we face challenges in 2020.

Yes. Just a couple of additions. Obviously, the overall economy continues to be strong as well, which provides support. And when you look at SNAP, we would be less dependent on SNAP than many of our competitors would be as well.

This is actually Erica Eiler on for Rupesh. Firstly, just wanted to touch on price investments. I think last quarter, you called out, I think it was about 12 basis points of price investment. Just curious if there was a similar level of price investments this quarter.

Yes, we don't usually specify our price investments. In terms of gross margin for the quarter, if we exclude fuel, we experienced a 24 basis point investment in gross margin, with nine basis points due to an out-of-period charge mentioned in our press release today. This effectively reduces our investment to 15 basis points. The gross margin pressure was primarily seen in the health and wellness sector, specifically within Kroger's specialty and retail pharmacy segments. However, our overall gross margin rate slightly improved when excluding pharmacy from our core operations. The cost savings from goods and alternative profit growth we achieved in the quarter helped counterbalance the ongoing price investments made to enhance our same-store sales growth. We are committed to investing in price. As noted during our Investor Day, our primary focus this year is on leveraging data to direct price investments in key areas for our customers. This includes personalized offers and promotions, as well as fuel rewards. While last quarter saw improved profitability from fuel, it was tempered by an 8% increase in the fuel rewards given to customers to encourage their continued shopping at Kroger. Although it's a complex approach, we remain focused on our price investments and are pleased with the positive customer response, which is contributing to the identical sales growth we reported. We are carefully balancing these investments with cost savings and alternative profit growth.

Yes. Our shrink improved for the ninth consecutive quarter, and we also saw improvements in warehousing and transportation costs.

Okay. That's helpful. And then you briefly mentioned the prepared food opportunity. Could you maybe talk a little bit more about your vision behind the recently announced ClusterTruck partnership? And does this at all impact how you're thinking about Home Chef?

I’ll address the end of your question first. Our perspective on Home Chef remains unchanged. If you consider our overall strategy of providing customers with anything they want, anytime and anywhere, you'll see that a significant portion of food spending goes towards already prepared meals. Our market share in that segment is much lower compared to traditional supermarkets. We envision a blend of Home Chef, physical meal options available in stores, and ClusterTruck as part of our ecosystem. ClusterTruck has excellent technology that allows for quick made-to-order meals, and they will utilize some of our physical assets for scalability as we run tests. Ultimately, this is about delivering what customers want, when and how they want it, and we recognize the tremendous opportunity in the prepared food market.

So you said you've been encouraged by some of the early learnings from your expansion of the free digital pickup initiative. Can you give us a sense for how that initiative has impacted the P&L? So is the financial performance in line with what you expected?

Thank you for your question. It’s still very early in our journey with the promotion, as we only launched it a few weeks ago. Naturally, part of our analysis involves understanding customer behavior over time, looking not just at individual transactions but also at how engagement levels change. This will require a longer time frame, as mentioned earlier. We’re already witnessing some promising early signs. New customers are beginning to use the service and engage with Kroger pickup, while existing customers are increasing their frequency of use. Much of our financial modeling will focus on these metrics over an extended period to determine their impact on value creation and customer loyalty. Additionally, we will consider these factors alongside the investments we are making in the business and how customers perceive this aspect of their experience compared to other value-creating elements like price investments, fuel discounts, and in-store experiences. It’s a complex area that we will analyze over time. We are seeing the behavior we anticipated, which has been encouraging, but it will take longer to truly assess its impact on our customer model.

And just to clarify, Gary, you have assumed that in your 2020 guidance that you've provided, the test will be limited to 2019 so it will not continue into 2020 at this point. And then I have a quick follow-up.

We haven't really gotten into specifics around what our pricing strategy will be in 2020. As we talked about, obviously, I would think about it more much as you think back to the chart that I shared at the investor meeting in New York and how we're balancing the investments that we're making in the cost savings in the business. So we certainly have a clear view of how much we believe we want to invest in the business next year and how that will be supported by the $1 billion of cost savings that we're expecting. So if we were going to see the value in pickup driving more value in our model, it would be because either we expect it to drive higher sales and support the investment or we believe it would be a better way to invest the dollars that we think are important to driving value for the customer in 2020.

That's helpful. My follow-up question is, Rodney, you've seen some pretty good momentum in your ID sales. There's probably a variety of factors that are contributing to that, including a healthier overall environment, being further away from some of the disruptive changes that you've made and better execution in the business. If you had to rank those factors and maybe any others in order of importance and magnitude that they've contributed to driving this improvement, how would you do that?

Yes, great question, Michael. We view those factors as being pretty equal. Additionally, we are focusing on personalization and data to tailor our offerings to each customer individually. For example, the approach we take with fuel rewards can also be applied to other offers by personalizing them for each household. All these elements combined are what we believe is driving and enhancing our momentum. It’s not just one single factor.

This is Josh Kamboj on for Simeon. So sales trends are improving and the grocery gross margin increased slightly in the quarter. How sustainable do you think that combination is in the near term? And then more broadly, what changes in the competitive landscape would you need to see to undergo a deeper round of price investments over the next three years than what's currently embedded in your plan?

Yes. Thanks for the question. I think on the first part of the question, I would kind of draw back again to what we talked about at the investor conference. The way we think about the model going forward is, certainly, we're going to continue to invest in price. We're going to continue to invest in the customer experience because the long-term sustainable growth in loyalty, we think that's critical to our plan. What we're doing very deliberately is being very disciplined in how we're managing costs within the business, both cost of goods savings but also OG&A cost efficiency, which obviously was strong during the quarter. And then alternative profit streams continues to accelerate and obviously offset the gross margin investments that we're making as well. So I think we look at it much more of an overall ecosystem, if you like, is how do we use food as the foundation for customer loyalty, which drives the traffic. And then fuel obviously builds on that in terms of causing customers to shop more frequently. And then you think about the health and wellness business and alternative profit streams layering on together to create this overall ecosystem that drives customer loyalty and drives total profitability of the customer. And the way we think about it is how do we pull those levers together in a way that allows us to continue to invest and build loyalty. And we're using the different dynamics there around alternative profit and cost savings to be able to continue to invest. I think when we look at the market, certainly, obviously, there's always high competition. We expect that to continue. We always assume that within our model. And we feel very good about the plans that we're implementing around driving costs out and continue to grow alternative profit that we can make the investments that we need to, to be able to continue to grow customer loyalty.

Yes. I would like to add a couple of things. First, as Gary briefly mentioned, our ongoing commitment to enhancing the customer experience is crucial, as we recognize that there are still opportunities for improvement even after making good progress. I have been pleasantly surprised to note that in 2018, we managed to reduce costs by over $1 billion, and we are on track to surpass that achievement incrementally in 2019, with further plans for 2020. We continue to identify significant opportunities for cost reduction. When considering these factors alongside the business's free cash flow, we feel confident in the statement Gary made at the investor meeting regarding a total shareholder return of 8% to 11% per year.

That's helpful. And then in general, maybe you could just quickly touch on your price gaps versus some of your key competitors. Have they been widening or narrowing? And are you pretty happy with where they sit at the moment?

Yes. We believe it is essential to understand that customers choose where to shop based on the freshness of our departments. Our customer feedback indicates that our fresh offerings are performing better than those of our larger competitors. Additionally, we provide a variety of personalized offers that deliver value to customers, including individual mailings, emails, and fuel rewards. All these factors contribute to our positive outlook regarding our current position.

I have two follow-up questions. First, regarding the increase in LIFO, you mentioned improving procurement, but LIFO is coming in higher than expected. In the press release, you noted grocery and dairy inflation. Is this solely driven by commodities, or are consumer packaged goods companies implementing price increases? Additionally, could you provide details on the inflation component of IDs for the third quarter? It would be helpful to understand the overall situation regarding these factors.

Sure, thanks for the question, Robbie. It's an interesting topic regarding LIFO and inflation. I'll address the questions separately. From an inflation perspective, we've previously indicated that we expected inflation to be between 0% and 1% for the year, and I would say it is currently trending slightly above that range. For the third quarter, the inflation rate hasn't changed significantly compared to the second quarter. There have been minor fluctuations, such as a slight decrease in produce and a slight increase in meat, but nothing dramatic in terms of overall inflation change. We're just slightly ahead of that 1% assumption for the year. While we anticipate an increase in our LIFO charge, we haven't observed any significant shifts in the overall inflation rate across categories. It's important to note that this excludes fuel and pharmacy, which typically follow a different trend compared to most food categories. With LIFO, it is a specific data point at the end of the year that we follow to comply with accounting regulations concerning LIFO adjustments. The data we used in the third quarter led us to believe we should raise our rate based on its indications, which is why we mentioned that it is expected to be a headwind for the year. It's worth noting that this is a noncash item and doesn't affect the business's underlying performance but will influence our earnings for the year based on current trends. I wouldn’t consider this a significant change in what we're seeing with inflation. As we have mentioned previously, when faced with price increases, we generally push back based on our knowledge of our brand products and managing those. However, where we do see price increases, we will typically look to pass those on to customers where it makes sense in those markets.

I have a follow-up question regarding fuel rewards. It appears that you're anticipating the profitability from fuel in the consumer packaged goods sector to stabilize next year. However, it also seems like you will be making a stronger effort to leverage the fuel rewards program to drive more customer interactions and enhance loyalty. Can you clarify how we should perceive this, and has there been a shift in how customers respond to fuel rewards that has led you to focus more on this strategy to increase customer engagement?

Yes. It is a crucial aspect of our connection rewards aimed at giving back to our customers for choosing to shop with us. Part of our strategy involves continually exploring new ways to engage with customers. Over the past six to twelve months, we have conducted various tests to discover more effective methods to connect with them, and many of these strategies are proving successful, leading us to expand those efforts. The extent to which we scale these initiatives will depend on how strongly they resonate with our customers and their impact on our business. Customers still appreciate great value for fuel, and our numerous convenient fuel locations benefit both them and our business.

Rodney, how should we consider funding the 8% year-over-year growth in 2020 if the profitability of your fuel business does not increase at the same rate?

Yes, when we discuss fuel cents per gallon, we do not account for any rewards in that measure. That information is not reflected in our internal financials. Looking at the overall guidance provided for 2020, we will incorporate our expectations for fuel rewards. However, it ties back to Gary's point regarding improving sales by this degree, implementing process changes, and reducing costs. It's about the capacity that allows us to invest in service and pricing. We consider fuel rewards as part of that pricing investment because that’s how our customers perceive it. Thank you for joining us today and for your questions. I hope my and Gary's comments convey that our underlying business results remain robust. Our identical sales are progressing positively. We have struck a good balance between investing in growth and enhancing cost efficiency, and our strong free cash flow positions us well for potential stock buybacks. Overall, I'm pleased with our results this quarter and our direction moving forward. I’d like to share some final remarks aimed at our associates about how we embody our purpose daily. Last week, I had the pleasure of visiting our store associates in Collierville Kroger, Memphis. A customer approached me as I entered the store and expressed why he shops at Kroger. He highlighted exceptional customer service from an associate and commended Kroger for generously donating food and funds to support hungry families in the community he mentioned. This interaction reminded me of our privilege to serve our customers, communities, and one another. Whether through our commitment to helping neighbors in need or supporting the over 11 million customers who visit our stores and shop online daily—especially during the bustling holiday season—we open our doors to all. Each celebration and tradition is distinct, and we strive to be there for our customers when they need us most. We believe that everyone, regardless of who they are, how they prefer to shop, or what they enjoy eating, deserves access to affordable, fresh food. Each of our 460,000 associates plays a vital role in making fresh food accessible to everyone. Thank you for your hard work every day and especially during this busy holiday season. Wishing you and your loved ones happy holidays, a Merry Christmas, and a Happy New Year.