Kroger Company (KR) — Q1 2021 Earnings Call Transcript

Thank you, Gary. Good morning, and thank you for joining us. I'm joined by Rodney McMullen, Chairman and Chief Executive Officer; and Gary Millerchip, Chief Financial Officer, and they will be providing an update on the business and discussing first quarter results. This is obviously an unprecedented time, and we are taking the additional step of providing more details on current business trends this quarter, so our prepared remarks may run a little longer than normal. But before we begin, I want to remind you that today's discussion will include forward-looking statements. We want to caution you that such statements are predictions, and actual events or results can differ materially. A detailed discussion of the many factors that we believe may have a material effect on our business on an ongoing basis is contained in our SEC filings, so 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. I will now turn the call over to Rodney McMullen.

Thank you, Rebekah, and good morning, everyone. A lot has happened in our world since the last earnings call. We've had to adapt quickly to a new way of life. The COVID-19 pandemic and the most recent instances of racial injustice have changed our country in unmistakable ways, most profoundly the devastating loss of life and livelihood that has affected so many Americans. During the crisis, Kroger has been guided by our purpose and our values. I am proud of our associates who stepped up when we were called to be there for our customers, communities, and each other. We are proud of the heroic and dedicated associates who are on the frontline, serving our customers when they need us most. As America enters the next phase of the pandemic, we know that our associates will continue to rise to the challenge, delivering Fresh for Everyone and helping our customers, communities, and America emerge even stronger. I am proud of the measures that we've taken across our business to safeguard and support associates, customers, and our communities. During the pandemic, our priority has been to provide a safe environment for our associates and customers with open stores, e-commerce solutions, and an efficiently operating supply chain so that our communities have access to fresh, affordable food and essentials. Since March, the company has invested more than $830 million to do just that. This includes the $150 million Thank You Pay for our frontline grocery, supply chain, manufacturing, pharmacy, and call center associates which we are providing to acknowledge their hard work and dedication to maintaining safe, clean, and stocked stores. We are pleased that our associates will share in the company's success with today's second installment of Thank You Pay. We continue to invest in, support, and protect our associates. We are providing emergency leave to associates. We are offering free COVID-19 testing to our associates. We have increased the contributions to our Helping Hands Fund to $15 million to provide additional financial support to associates experiencing hardship due to the virus. Our work to safeguard associates will continue as long as the pandemic threat exists, and we are proud that Kroger was named in Forbes Magazine as one of the top 10 employer responses to the pandemic. As part of Kroger's commitment to help America reopen safely, our Kroger Health team stepped up to help expand access to testing as a partner in the U.S. Department of Health and Human Services Public-Private Testing Partnership. Through this initiative, we have tested more than 82,000 patients in 15 states. We also offered free check cashing for stimulus, unemployment, and social security checks. Since launching this service, we've cashed more than 229,000 checks, totaling $244 million. Kroger has learned and continues to learn a lot while keeping our stores and supply chain open and serving America during the pandemic. The company’s total COVID-19 incident rate is tracking meaningfully below the markets where we operate, and our overall accident rate is the lowest we've ever recorded. I'm incredibly proud of how our associates have worked together to practice creating a safer environment for our customers, communities, and each other. We've been able to share our learnings with other businesses and communities to help as they begin to safely reopen through a resource guide we created called Sharing What We've Learned: A Blueprint for Businesses. Our blueprint includes actionable recommendations and learnings that we've applied as well as what we've learned through regular interaction with governments, health departments, and business leaders in other countries, including Italy, Singapore, and China, all of which were ahead of the U.S. in terms of the pandemic cycling through their countries. Under Restock Kroger, we have made significant strategic choices over the last several years to transform our business model and to redefine the customer shopping experience, partner for customer value, develop talent, and live our purpose. We've invested aggressively in technology to establish a seamless digital ecosystem, and we've made incremental investments in fresh, our brands, and personalization. These investments in our competitive moats helped Kroger build business momentum in the second half of 2019, which continued through the start of our first quarter, even before the first phase of the pandemic began in our operating markets in earnest in March. The benefits of the changes that we've been making to our business model were accelerated by COVID-19. For example, our heavy investments in technology enabled us to reliably sustain the incredible almost overnight increase in demand for our pickup and delivery services. Here are other examples of how the pandemic accelerated Kroger's transformation. As you know, we introduced Kroger's brand transformation campaign, Fresh for Everyone, late in 2019. 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 access to fresh, affordable food. This has proven to be even more important during these times. In the initial stock-up phase of the pandemic, customers purchased a lot of paper, cleaning products, and center store nonperishable items to fill their pantries. As the first new normal phase began to set in, marked by preparing for extended time at home, often with children, our fresh departments took on even greater relevance as more and more customers turn to fresh produce and proteins as staples of home-cooked meals. Fresh will continue to be an important driver of sales for Kroger as demonstrated by our fresh departments, including meat, seafood, and produce generating strong identical sales in the quarter. Our brands had a great quarter as well and grew 21.1% driven by significant growth across our three largest brands. Having identified plant-based foods as a key trend well before 2019, the Simple Truth Plant-Based platform continues to deliver strong growth, growing over 32% in the first quarter. In this way, by consistently delivering both value and innovation, our brands will remain one of our most powerful competitive advantages. Because of the continued economic anxiety, we are still offering our customers value through personalization and promotions, leveraging our mailers, mobile app, website, and weekly ads. We continue to offer promotions throughout the quarter with a focus on single-item purchases. Kroger began investing in digital several years ago to build a seamless ecosystem that would deliver anything, anytime, anywhere. As a result, we have over 2,000 pickup locations and 2,400 delivery locations, reaching 97% of our customers with a seamless customer experience that combines the best of our physical stores with digital. These investments were especially timely as customer adoption of pickup and delivery grew significantly during the pandemic. And because of our existing ecosystem, we were able to respond quickly to further expand and enhance our e-commerce services. We were able to quickly offer and promote in-demand no-contact delivery and low-contact pickup services. We expanded and improved contact-free payment solutions like Scan, Bag, and Go and Kroger Pay. We took several steps to support the higher volume of pickup orders, including hiring additional e-commerce associates, adding more order pickup slots, and increasing the frequency of communications with customers. We also began testing a grocery pickup-only location in Cincinnati. All of this contributed to a 92% sales growth in digital channels in the first quarter. In April and May, the sales grew in the top triple digits. We continue to invest in and constantly improve our e-commerce capabilities. Our partnership with Ocado remains an essential part of our evolving seamless ecosystem. Our customer fulfillment centers will accelerate our ability to serve customers seamlessly and in a more cost-effective way. Earlier in June, we identified three new regions: the Great Lakes, the Pacific Northwest, and the West for placement of our high-tech sheds. When operationally, these facilities will collectively create more than 1,000 new jobs with the potential for hundreds of additional career opportunities. As we've shared previously, we believe Ocado's value as a partner is not just in its current capabilities but also in how quickly the company is able to innovate in rapidly changing consumer markets. We are designing a flexible distribution network, combining disaggregated demand and proximity of our stores, medium-sized facilities, and large-sized facilities. You can see this strategy taking shape in the new automated CFCs which will span a range of sizes. The new facility in the West will measure 300,000 square feet. The new facility in the Pacific Northwest will measure 200,000 square feet, and the facility in the Great Lakes region will measure 150,000 square feet. The varying sizes demonstrate the flexibility of the Ocado fulfillment ecosystem to best serve the respective markets. Our network will flex as demand matures, and the optionality will allow us to fulfill same-day or next-day delivery or pickup and customer or store replenishment. Kroger has been investing to raise wages for our frontline associates for the last several years. As part of Restock Kroger announced in 2017, Kroger is increasing associate wages incrementally by approximately $800 million per year through the end of 2020, which is $300 million more than the original plan. As a result of this continuing investment, Kroger has increased its average hourly rate to over $15 per hour. With comprehensive benefits factored in, our average hourly rate is over $20 per hour, benefits that many of our competitors don't offer. Because of these investments and our established human capital management processes, we were able to expedite our hiring processes in early March to shorten the time between application and employment. Onboarding new hires in an average of 72 hours while focusing onboarding on culture and safety, we were able to generally protect associate jobs in the face of record unemployment, while also creating new jobs and new career opportunities for more than 100,000 workers nationwide. Our expedited hiring and onboarding processes also enabled us to focus on associate and customer safety. We were able to direct immediate support to the expansion of Kroger pickup availability as well as enhanced cleaning and sanitation practices in our stores and facilities where we needed the help the most. Many of those new roles were bridge jobs providing laid-off workers with a stable job opportunity while furloughed from their previous jobs, many of whom are now starting to return. Additionally, I'm pleased to note an extension of our human capital commitments. We contributed an additional $236 million to multiemployer pension plans in the first quarter. This investment will help stabilize future associate benefits. We work extremely hard to ensure that we have the right talent, teams, structure, and the right focus areas in our core supermarket business and our alternative profit businesses. Our focus is on developing, training, and promoting internal talent while simultaneously hiring seasoned food industry executives to drive our retail supermarket business. Kroger remains committed to diversity, equity, and inclusion with our workforce. We are creating more opportunities for our associates to openly share their thoughts, feelings, and experiences with discrimination and for our company and leaders to more deeply and deliberately listen. We will continue to educate and show our leaders and associates how to be more empathetic, supportive, and aware of our unconscious biases so that, together, we can build a better and more inclusive Kroger. COVID-19 also accelerated our commitment to integrated ESG or sustainability practices. What we are seeing in our communities during the pandemic confirms that our Zero Hunger | Zero Waste mission is more relevant than ever. During the pandemic, more than 80 million people in the U.S. lost their jobs and applied for unemployment benefits and/or food assistance. Many more families are struggling to put food on the table today. Kroger is using our philanthropic dollars and foundations to support our food banks and other key partners. Additionally, we are now accepting SNAP/EBT benefits as payment for our pickup service, allowing more customers to access fresh, affordable food through e-commerce. We also implemented a dairy rescue support program for farmers. Many farmers and producers did not have a market for their products as foodservice, hospitality, and restaurants remain closed. We operate 17 dairies around the country and are uniquely positioned to offer our processing capabilities. Manufacturing and dairy procurement teams rapidly scaled a program to rescue surplus milk donated by Kroger's dairy cooperative suppliers and processed by Kroger-operated dairies and directed it to food banks and families in need. Kroger is a trusted brand, and our #1 priority is to be there for our customers, associates, and communities. We understand the transition to a new normal will not happen uniformly across the country. As America enters the next phase, we're using our own customer insights and monitoring the impact of affected global markets to continue meeting customer needs. And now I'll turn it over to Gary for more detail into the quarter financials. Gary?

Thanks, Rodney, and good morning, everyone. Before discussing results for the quarter, I also want to thank our associates for their dedication and all they are doing to serve our customers and communities during this time. The pandemic brought unprecedented challenges, and I'm extremely proud of how our teams responded as America relied on Kroger as a trusted resource for their food and essential needs. As a result of the pandemic, we have seen elevated demand across our physical stores and digital channels. Our data insights show customers continue to value the convenience of our physical locations and the ease of our seamless ecosystem. As many of you know, we outlined our Restock Kroger transformation plan in 2017. And as part of that plan, we made the strategic decision to invest in digital. These investments allowed us to quickly add much-needed capacity to serve our customers by scaling the foundational capabilities we have built and continue to develop. The outcome of these efforts has been a meaningful uplift in sales across all digital modalities: Kroger pickup, delivery, and ship. We made significant investments of more than $830 million in the quarter to reward associates and safeguard associates, customers, and communities during the pandemic. We also contributed $236 million to multiemployer pension plans to help stabilize future associate benefits. Even with these significant investments and accelerated digital growth, we were pleased to achieve an improvement in FIFO operating margin, excluding fuel and adjustment items. We firmly believe that our ongoing investments will help Kroger emerge stronger, and it's clear from our recent customer data insights that our competitive moats, fresh, our brands, personalization, and a seamless ecosystem are even more important as a new normal begins to emerge in food retail. Now I'd like to discuss our quarterly results in more detail. We delivered an adjusted EPS of $1.22 per diluted share. Kroger reported identical sales without fuel of 19% during the first quarter. Unprecedented demand for products across grocery and fresh departments led to these strong results. Sales were broadly based across all retail divisions and remained heightened throughout the quarter as customers adjusted to the new restrictions and started preparing and eating more meals at home. Leading into the pandemic, our sales were strong, building momentum from the second half of 2019. February identical supermarket sales, without fuel, were ahead of our internal expectations. During the last few days of February, we started to see a shift in customer behavior as shoppers began stockpiling, and that trend accelerated into March with identical sales of approximately 30%. Sales remained elevated in April and May, both up approximately 20% as customers continued to eat more at home. In the first few weeks of the second quarter, we are starting to see some changes in demand with sales growth becoming more balanced across the store as state restrictions have started to ease. Customers remain focused on health and safety and are still stocking up but to a lesser degree than during the shutdowns. We are also starting to see a return to some splurge and impulse buying. Customers are still cooking more at home, even with the easing restrictions, and identical sales, so far in the second quarter, are trending in the mid-teens. We do expect sales to continue to taper as the quarter progresses. Digital sales grew 92% and contributed slightly over 3% to identical sales without fuel. New customer engagement with our pickup and delivery services spiked significantly during the quarter, and we have been encouraged by early customer repeat usage. Digital sales in the second quarter remain elevated, up triple digits in the first three weeks. We continue to invest in digital and offered a fee-free pickup promotion to provide more value for our customers in ways that are most relevant at this time. We were also excited to announce several new enhancements to our digital customer experience, including the launch of our check-in on arrival option for pickup customers and the launch of contactless doorstep delivery. Adjusted FIFO operating profit for the first quarter was $1.45 billion compared to $957 million in the first quarter of 2019. Gross margin was 24.3% of sales for the first quarter. The FIFO gross margin rate, excluding fuel, increased 44 basis points due to sales leverage related to shrink, transportation, warehousing, and advertising costs. Our associates continue to do an impressive job managing shrink, which saw significant improvement in the first quarter compared to last year. The OG&A rate increased 51 basis points, excluding fuel and adjustment items. No adjustment was made to this number for COVID-19-related costs. As previously mentioned, during the quarter, Kroger made the decision to contribute an incremental $236 million to multiemployer pension plans. Excluding the incremental pension contribution, fuel, and adjustment items, the OG&A rate improved 10 basis points. Rent and depreciation, excluding fuel, decreased 37 basis points due to sales leverage. We do expect some COVID-related costs to continue beyond the first quarter as we continue to invest in associate and customer safety as well as support heightened digital demand. We also made the decision to delay certain Restock Kroger cost-saving initiatives to allow our associates to focus on our most important priorities: safety and stocking shelves. We have now started to reintroduce the delayed initiatives while also maintaining our commitment to associate and customer safety. We still expect to achieve the vast majority of the targeted $1 billion of savings in 2020. Fuel remains an important part of our strategy to drive customer loyalty. We saw a significant decline in gallons during the quarter as with the national trend. We remain well-positioned within our markets due to our fuel procurement practices and market-leading reward program. The average retail price of fuel was $2.13 this quarter versus $2.62 in the same quarter last year. Our cents per gallon fuel margin in the first quarter was $0.48 compared to $0.23 in the same quarter last year. As a result, fuel profitability was a major tailwind in the quarter. For the remainder of 2020, we expect fuel profitability to be a headwind compared to the prior year as we cycle margins from 2019 and gallons continue to be impacted by COVID-19. Kroger's alternative profit model is built from a platform of leveraging supermarket traffic and data and is expected to achieve profit growth in 2020. During the first quarter, Kroger Personal Finance experienced lower transactions as customers purchased less gift cards, money services, and lottery. Customer activity has started to improve since April as states have reopened. While we would expect this trend to continue, KPF profit is expected to be lower than our original expectations for 2020. Media experienced a slowdown in late March and April as campaigns were paused to refocus messaging on store and employee safety, and certain in-store programs were impacted by stay-at-home orders. Our Media business rebounded strongly in May, and the strength of our digital sales growth has created significant momentum for Kroger Precision Marketing, which is now on track to achieve 50% growth in 2020. We remain confident in the significant potential of alternative profits, especially given the continued growth in traffic across our store and digital ecosystem. Despite short-term headwinds due to COVID-19, we continue to expect alternative profit to be a major accelerator of our model in the future. As Rodney mentioned, we continue to invest in our associates as a key 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 Food 4 Less California and South Carolina during the first quarter. We are currently negotiating with the UFCW for contracts covering store associates in Las Vegas, Roanoke, Little Rock, and Houston, as well as Dallas meat clocks. Looking ahead, we have several major negotiations later in the year, including contracts with the UFCW for store associates in Charleston, West Virginia and Fry's associates in Arizona. 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 to today's associates. Our financial results continue to be pressured by 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 create more jobs and career opportunities and enhance job security for our associates. Kroger's financial model has proven to be resilient throughout the economic cycle. We continue to generate strong free cash flow and maintain strong liquidity. We are committed to investing in the business to drive profitable growth, maintaining our current investment-grade debt rating and returning excess free cash to investors via share repurchases and a growing dividend over time. We are being disciplined in how we deploy capital, and all aspects of our capital plan are being evaluated to ensure our investments position Kroger for long-term success post-COVID-19. We still expect total capital expenditure of between $3.2 billion and $3.4 billion in 2020. Kroger's net total debt-to-adjusted-EBITDA ratio is 1.81 compared to 2.54 a year ago. This is below our target range of 2.3 to 2.5. Kroger held temporary cash investments of approximately $2.3 billion as of the end of the quarter, reflecting improvements in operating performance and significant improvements in working capital. We expect working capital to improve for the year, although not to the level experienced in the first quarter, which was inflated by the extraordinary sales growth due to COVID-19. Given the uncertainties that remain related to COVID-19 and the outlook for the remainder of 2020, we believe it's prudent to maintain financial flexibility in the short term. We remain committed to our dividend and share repurchase program. In the coming months, we will also be evaluating the optimal use of any excess free cash flow consistent with our previously stated capital allocation strategy. Turning now to guidance for 2020. The COVID pandemic has dramatically changed the outlook for food retail, and we continue to monitor, evaluate, and adjust our plans to address the impact to our business. There are still many unknown factors related to the long-term impact of COVID-19 that could influence our financial results for the remainder of 2020, such as continued investments to help our customers and associates; uncertainty surrounding consumer behavior, restrictions, and what will the new normal be; and potential long-term shifts in customers eating more food at home. In recognition of these factors, it's difficult to predict specific outcomes. As such, Kroger is not reaffirming or providing new 2020 guidance. While we do expect to exceed the outlook shared in our April 1 business update for identical sales without fuel, adjusted FIFO operating profit, adjusted EPS, and adjusted free cash flow, the company is not able to forecast the extent of such upside for the reasons mentioned. As we continue to proactively adjust our plans in response to the pandemic, we remain committed to investing to ensure a safe environment for our associates and customers, and we will also continue to use our customer insights to invest in delivering greater value for customers in ways they value most and that build loyalty. Kroger's financial model has proven to be resilient throughout the economic cycle. We remain confident in our business model as well as our ability to generate strong free cash flow and achieve sustainable and attractive total shareholder returns. In the second quarter, we expect identical sales, excluding fuel, to continue at elevated levels, although tapering from the trends we've experienced so far in the quarter. We expect EPS growth in the second quarter to be in the mid- to high single-digit range with tailwinds in supermarket sales, partially offset by continued investments and fuel headwinds. As the longer-term impact of COVID-19 becomes clearer, we are committed to providing more clarity on our expectations for the remainder of the year.

Thanks, Gary. I am so proud and deeply grateful for our 500,000 associates who step forward to be there for our customers and communities when they need us the most. In true Kroger spirit, they have risen to the occasion to each challenge presented with a strong spirit of agility, determination, and service to meet the needs of our customers, and these are the exact skills that will ensure the company remains relevant to our customers in the future. As I shared when we first began this call, we quickly had to adapt to a new way of life. We continue to make progress on the underlying business, even with the recent customer demand tailwinds. We are confident that Restock Kroger has allowed us to reposition our business and to create value for all our stakeholders prior to and during the COVID-19 pandemic. Now we look forward to your questions.

Gary, I would like to revisit your comments about the expected growth in Q2 EPS, which you mentioned would be in the mid- to high single-digit range. Could you provide more insights into the challenges we might face in reaching that growth target?

Yes. I believe the main factor, Rupesh, is related to fuel for the first quarter and how we anticipate the second quarter shaping up, as this is crucial to the numbers. Overall, when we consider the supermarket business, we expect to maintain strong sales momentum and feel confident about managing margins and continuing investments due to COVID-19. The key difference between the two quarters, as we assess guidance for the second quarter, is that in the first quarter, fuel provided a significant boost despite lower gallon sales during COVID. Looking ahead to Q2, we will be comparing margins to Q2 of last year, and although the trend in gallons has been gradually improving weekly, we're still experiencing a decline in year-over-year gallons. Currently, we're seeing a negative growth trend in the mid-teens range, which aligns with market observations. Therefore, regarding fuel performance in Q2, we anticipate a potential headwind ranging from $50 million to $100 million. It's important to keep this in mind when considering the Q2 guidance we provided, as it remains a primary factor despite the continued growth and improvement we expect in the supermarket business. I hope this clarifies things.

That's great. That's really helpful. I have a follow-up question regarding e-commerce. With your partnership with Ocado, how have recent developments influenced your e-commerce plans or investments moving forward?

I love the question. And if you look at the strategic decisions we've made over the last several years, it highlighted those decisions really paid off in the current environment. Our digital, delivery, and pickup business in the last 2 months grew triple digits and continues to grow at that. To have the ability to grow at that kind of level that quickly, just so proud of the whole team in terms of the foundations that were already in place but also the stores and all the other parts and supply chain on being able to supply, hire people, and support that. So we fundamentally believe the long-term trend will continue where people will continually depend more on e-commerce. We certainly have seen that be accelerated. We don't think it will stay at the higher level where it is today permanently, but we do think, fundamentally, the growth has been accelerated and will be higher than where it started before COVID-19, and then grow from there. One of the things that's incredibly important is all the pieces tied together, including Ocado, will allow us to continue to grow and improve the profitability of that part of the business. As you know, when a customer first switches to online, it typically takes 3 or 4 years before that customer's profitability is the same as when they shop in the store. What we find is we get a significantly higher share of that customer's total household spend. And there isn't anything that we've seen that wouldn't cause us to believe that the new e-commerce shopper doesn't feel that way, and a lot of those customers are telling us they intend to continue to shop more e-commerce than before, and we would expect to get a higher share of their business. We've also seen a lot of customers new to Kroger come and use our delivery and pickup business, and we're seeing nice repeat purchases from those customers. So all those things cause us to feel good about the things we have in place and feel even better about Ocado and the other pieces that we're working on going forward.

I was going to ask something different, but I wanted to ask you, Rodney. You just mentioned that it takes about 3 to 4 years to reach the same profits. Are you referring to an ongoing basis, or is that related to lifetime value? Over 3 to 4 years, I've purchased enough through the digital channel that the profits equal out. Or does this mean that after 3 or 4 years, the variable costs or the actual basket economics balance out?

It relates to each customer's household. When they initially switched to e-commerce, we had to spend labor picking their orders, whereas previously, the customers did that themselves. Over time, we've become more efficient in our picking operations, leading to an increase in the money customers spend with us. Each customer needs to be evaluated individually. Those who began shopping online three years ago are now at a profitability level comparable to when they used traditional shopping methods, but we're capturing a larger share of their spending. Moving forward, we expect to further reduce the cost of serving those customers. New customers start from scratch, which creates a challenge until we can capture a more significant portion of their total household spending, and we have found that we can achieve this.

Yes. That's helpful. And my follow-up is on the 92% growth in the first quarter. Did you say the mix? Or are you surprised by anything about the mix between delivery and pickup? And then anything you can share on how it impacted gross margins or margins broadly? It sounds like if you picked up a lot of new customers, it would be in a pretty dilutive position for that lifetime of the customer, but anything you can share on it, please.

Yes. If you look, delivery was a higher growth than pickup, especially during the peak of the COVID cases. As areas have reopened and companies have reopened their offices and things like that, the growths are starting to get more similar. Gary, on the growth, I'll let you answer the growth and the changes there.

Sure, yes. Thanks for the question. I would say that the way that we see the digital customer behavior flow through in the P&L, it's not meaningfully different mix in terms of overall pass-through in gross margin rates. Rodney's point earlier, generally, we see customers increase their spend. The basket size increases, and the mix is pretty consistent. The area that would have impacted gross margin would have been more in the fact that we run the fee waiver promotion. So that would have certainly been a headwind in the gross margin category. Really, where we see the bigger impact on digital is Rodney's earlier response around the incremental labor that's involved in picking the order. So if you think about the pass-through rate that we might see on a traditional sale through the store, which we've talked about historically being the 15% plus range, it would be significantly lower than that on the equivalent basis because you've got the incremental labor associated with those sales. So it would be more of an impact in the OG&A rate than it would be in gross margin when you think about the quarter.

Yes. Just, first, a follow-up and then a real question. As we think about Q2, could you just help us out? What are you assuming for IDs in the quarter? What are you thinking about from a continued COVID cost perspective? And how do we think about gross margin relative to what we just saw in Q1?

Thanks for the question, Ed. There are several aspects to consider. Regarding sales, as we mentioned earlier, we are closely monitoring the trends. It’s challenging to predict how customer behavior will adapt to the new normal. As states reopen, we anticipate a gradual reduction in at-home dining, but this transition will likely occur slowly rather than in distinct steps. We are starting to observe some changes in Q2, but it’s not a clear step-down as states reopen; instead, it’s a more gradual shift as customers begin to return to normal behavior. This trend isn’t uniform across states; the impact seems more related to when states initially faced significant COVID outbreaks and how sales spiked during those times. Therefore, we are keeping a close eye on this. We have noticed an increase in visit frequency, particularly in categories like daily bakery, specialty cheese, and floral products, but the overall process remains gradual. It's too early to draw firm conclusions just a few weeks in. We are expecting a slow decline from the Q1 levels and the trends we have observed so far in Q2. We are diligently monitoring the situation and maintaining flexibility to ensure we capture every dollar from our customers and continue to grow market share. In terms of gross margin, we haven’t provided specific guidance yet. We're still investing in promotions, as Rodney mentioned, and we expect this to become more standard as the supply chain stabilizes, though there will be challenges in certain categories due to ongoing supply issues. When it comes to COVID-related costs, we can categorize the total OG&A expense from Q1 into three main areas. The first is COVID-specific costs, which totaled around $830 million, mainly to reward our associates for their contributions during the quarter. There were also expenses for additional labor related to cleaning and PPE. We expect some of these costs to persist throughout the year as safety remains a priority. Additionally, we are investing in labor to support our digital growth, and this will continue as we build customer loyalty. The third significant cost in OG&A pertains to pension contributions, which we don’t expect to repeat. Thus, the ongoing costs we foresee will primarily come from safety and cleaning investments as well as the additional labor needed for our digital initiatives moving forward.

One other comment, Ed, on the first part of your question, and it's hard to assign specific numbers and specific numbers just for the second quarter versus third quarter, fourth quarter, and even 2021. But when we talk to customers, our customers still tell us they plan to eat more meals at home than before. When talking to customers about when their children return to schools, we still have a significantly higher percentage of families telling us they plan to make breakfast for the kids to take to school and lunch for the kids to take to school. All of those things in terms of what customers are telling us, we would expect there to be more meals eaten at home or prepared at home that obviously will help support growth as well.

I understand the reluctance to really give ID guidance. But the only thing that I would say is that it does matter if it's mid- to high single-digit EPS growth on a double-digit ID versus a single-digit ID from an investment perspective. So to the extent that you can help out with that, that I think would matter to how people are looking at your story. The other thing that I needed to ask about is the pension contribution because I think people are getting kind of hung up here. The $200-plus million contribution that you made this quarter, I believe that relates to that group of four meat plants that you essentially kind of control and take in-house. Is that right?

That's right. So think of it as it's a green status plan. It's over 80% funded, so there's not an obligation for us to make that payment. But obviously, it's something that we're committed to making sure that, long term, we're securing that future liquidity of the plant. Especially during times like this when there's market volatility, sometimes there could be pressure on those plans to have to liquidate assets to be able to make contributions, and we wanted to make sure that the plans were not put in that risk. So we decided to basically invest those dollars now to protect the future. Over time, that will derisk the need for us to have to invest, but it wasn't a requirement to make those payments.

It seems that the funding is sufficient at this point, so we might not expect that kind of contribution moving forward. Regarding your other plans, you are clearly engaged in the traditional map alongside other grocers, which is set through negotiations, and there is no strong justification for making additional one-time contributions to those plans. Would you agree?

That's correct. The only way we would consider those examples is if we identified an opportunity to move away from the multiemployer plans and manage them similarly to how we operate the UFCW plan, provided it makes sense for us from both an investor and associate standpoint. This would allow us to reduce future liabilities and have greater control over any potential risks. However, we have no obligation to take such action unless we choose to proceed as we did with the previous plan you mentioned.

Can you provide an update on the actual liability for the multi-employer pension in dollars before tax? With the recent contribution you made, will we need to adjust our expectations? I understand that you haven't provided the annual P&L and cash impact of the multi-employer pension contribution for several years. However, when we consider modeling it starting in Q2, will the dollar amount of that actual expense decrease based on your recent contribution? I also have a completely separate question.

Yes. So it depends on which piece of the plan, just to clarify, Karen, you're talking about. As Ed mentioned a moment ago, we have multiemployer plans that we separated, and we now manage internally. As I mentioned earlier, they would be in the green status, so there'd be no obligation for us to be making those payments, but we're looking to get them over time to a fully funded status to minimize the risk to associates. So think about that as it's minimizing. If returns weren't where they needed to be, it minimizes the risk as of us having to make contributions in the future and ensures those pension plans are in a strong position for our associates. The multiemployer plans that we're a participant in but we don't have a current obligation to fund beyond the annual contributions that we're making through our negotiated contracts with the unions would be an exposure as of the end of last year. As we reported in the 10-K, it's $2.3 billion or $1.8 million after tax. They're ones where, over time, we would certainly look at if there are options to figure out different ways to structure our arrangements so that we can address those liabilities, but they would be very specifically defined and ring-fenced transactions that we would share publicly in the future if we were to decide that was the right thing to do.

But as we think about the actual expense on the P&L beginning in Q2, I know, again, you don't guide to that anymore, but how should we think about that?

Yes. As I mentioned, we will incur pension expenses related to our multiemployer plans that we contribute to as part of our agreements with the unions. We will make contributions to the internal plan as needed, although this can vary significantly. However, the potential liabilities we may face in the future are not directly related to our actions in 2020.

Could you provide the percentage of sales from digital in Q1 and how it was divided between click-and-collect and third-party services, primarily Instacart?

Well, if you look in terms of overall, digital would have been, I don't know, probably 6.5% or 7% of the total company. It would have been predominantly pickup versus delivery in terms of the mix, but the percentage growth was higher on delivery. The other thing on delivery, a lot is delivered directly to people's homes, either through FedEx or UPS. That's basically the similar number is what is delivered via Instacart and other services. On the other piece, Gary, I'll let you answer Karen's other.

Yes. Thanks, Rodney. Sorry, we were all looking to get the digital number for you there, Karen. Can you repeat the second part of the question?

Oh, just on the cash balance. I mean you guys haven't had a cash balance like that for a while. So thoughts on where you're at in terms of deployment of that?

Yes. As I mentioned a little bit in the prepared remarks, we're certainly thrilled with the cash balance that we generated during the quarter. Part of that does reflect the improved operating performance. Part of it was a significant improvement in working capital. We want to make sure that we maintain maximum flexibility in the short term, just with some of the uncertainty that still exists in the market. We also want to make sure we understand how much of the working capital benefit will continue because we do believe we've made strong progress on working capital over the last 12 to 18 months as we've continued to look at ways to free up cash flow. Some elements of that will be inflated, just because of the higher sales in the first quarter and the way our working capital cycle works. Some of it is also related to the CARES Act, where there's a delay in certain tax payments as part of the way the CARES Act was structured. So we would expect as a result of all of that still to generate incremental free cash flow this year. As we go through the next couple of months, we're really going to focus on what do we think is the optimal way to use that cash flow consistent with our overall capital allocation strategy that we shared with you in our Investor Day in November. So think about is we'll look at are there opportunities where we could continue to invest in the business to drive longer-term growth. We'll certainly be looking at any reasons to restructure any of the pension future MEPP liabilities that would allow us to take that potential liability and risk off the table longer term. And then, of course, we'll also be looking at how might we redeploy that cash to our shareholders consistent with our strategy of continuing to grow our dividend over time but also looking at buybacks to shareholders as well.

One, a little bit more long term. You guys probably have some of the best data analytics on your customer base in the industry. So when Rodney mentioned kind of the habits of newer customers and specifically new e-com customers, right, how could you see the opportunity to further monetize or kind of gain further loyalty from new and existing customers kind of beyond the pandemic, right? If you assume that people are going to eat a little bit more at home and that you have the ability to kind of incentivize your customers to do a little bit more than that, how does maybe next year look for you relative to where you may have thought it would be before the pandemic?

We appreciate the question, and it's an area we're investing significant resources in. We've seen as many new customers in just a few weeks as we did all of last year, and this trend continues. We're implementing our typical customer welcome strategies but in a much more proactive manner. It's essential for us to ensure they have a positive experience. Our supply chain team is collaborating with our merchants to restore store inventories to pre-pandemic levels, which enhances our in-stock position. We are also emphasizing fresh products, ensuring customers receive items that meet high freshness standards, complemented by excellent service and a seamless digital experience. We value this opportunity and have gained a substantial market share during the pandemic. Our focus remains on maintaining and nurturing our customer relationships and encouraging them to increase their spending with us compared to other options.

Judah, I would like to add that we have spent considerable time analyzing our data alongside the available market data from the past two decades, including government statistics and broader market insights, in addition to our internal shopping data. We are focused on understanding the potential future behavior of customers, looking beyond just the next one or two months, but for the remainder of the year and into the following year, and possibly even further ahead. We believe that the investments we are making through Restock Kroger will position us strongly moving forward. While it's difficult to predict the future, our analysis suggests that during economically challenging times, combined with certain restrictions, there will likely be a prolonged shift toward more food being consumed at home rather than dining out, similar to trends observed in previous recessions. Our strategy is centered around utilizing personalization and tools to create value, ensuring that as we look ahead 12 to 18 months, we exit this period in a stronger position, with increased home food consumption and enhanced market share, which will facilitate the acceleration of our long-term plans with Restock Kroger and enhance shareholder value. We are optimistic about our ability to achieve these goals in the long run, and we find it somewhat easier to project long-term outcomes than to predict trends over the next six months.

Okay. That's helpful. And if I could just follow up on kind of 2 items that maybe we could clean up a little bit. Just first on the pension. In terms of go-forward expense that's hitting the income statement, that hasn't changed at all. Just what's running through the income statement is what you're required to contribute to those external net plans? Is that right?

The payment we made in the first quarter was a one-time decision, taken because we were in a strong position both in terms of performance and cash flow. We are not obligated to make this payment, and it does not require us to incur any future commitments or payments later in the year. It was a strategic choice aimed at leveraging our solid performance to mitigate future risks and ensure our associates' pension plans remain strong. This reflects our proactive approach to securing our future and that of our associates while we had the opportunity.

And then second, for the gross margin in Q2, is there still a headwind from alternative profits being a little bit slower than they would be? And is there also some benefit from promotions not being fully back to where you'd expect them to be?

Sure. On the alternative profit side, I mentioned it earlier. On the Media business, we're seeing a tremendous pickup in growth. So I wouldn't believe that we would see any headwinds from media. That's continuing to bounce back very strongly from a very temporary delay that we experienced in the first quarter, really during the lockdown period and as things were reset. Kroger Personal Finance is the biggest element of alternative profit from a profit contribution perspective, and that is sort of more, I guess, dependent on some of the broader recovery in the market when you think about gift card sales, restaurants are an important part of that category. When you think about credit card spend, those elements are all tied to continued improvement in the economic situation. So while we are still able to tap into opportunity in KPF because we have low penetration of our customer base, we would expect that to continue to be a headwind in terms of impacting gross margin and performance for the year. But media, certainly, we wouldn't have that same view there.

And we would expect to continue to do promotions. One of the things when you look at the details behind the first quarter, almost basically all the gross margin improvement was driven by leverage and marketing expenses from the higher sales, warehouse and transportation, and shrink, and our team had an incredibly strong quarter on shrink. So it’s really those leverage factors, and we would expect to continue to have some of those leverage benefits at the higher sales that we're expecting.

Recognizing that it takes several years for a digital customer to become as profitable as an in-store customer, what will be the margin impact over the next 3 years if your digital penetration remains where it is today?

It's a great question. Before COVID-19, our digital business had become a significant benefit in terms of improvement from its previous state. Looking ahead, we expect this trend to continue as our customers mature. It will involve total customer spending, not just new customers alone. As customers allocate more of their overall spending to us, and as our teams work on reducing costs related to serving these customers, along with our Ocado sheds becoming operational alongside other facilities, we anticipate that digital will continue to be a positive factor for us moving forward, especially given that the business essentially doubled overnight.

And you mentioned that you're building all different types of Ocado shed. The first one are large ones in different parts of the country. What has the learnings from this experience influenced how it has influenced the sheds that you're going to create moving forward?

If you look at our work overall, Ocado has put in significant effort to make the economics feasible for smaller sheds. This development will enable us to enter smaller markets with these sheds. It is an integral part of our supply chain design, and things are unfolding as anticipated. Ocado is also enhancing their capabilities. We are eager for Ocado's sheds to start operating in Canada and France, which will offer us additional insights.

And if I could add one last one. I know this is hard to tease out from the data, but you have a lot of really good information. What have you been able to discern about different meal occasions that are now being eaten at home? So as consumers return to work and eat more of their meals at restaurants around where they work, to what degree is that going to result in the slowdown in the IDs that you're experiencing? Similarly, maybe you can tease out how soups and salads are doing versus something you might eat at dinner, where dinner could also slow as we go to those families more.

Yes. Overall, we're still seeing people shop at fewer stores and, as Gary mentioned, a large spend per basket. If you look at the department, that's probably the easiest directly to talk about is our deli department. Our deli department trends over the last 4 or 5 weeks have been significantly improved from where it was in the height of the lockdowns. We would expect a lot of those meals are things where people are preparing at home and taking to work. Our customers tell us they’re still minimizing the different places they go and minimizing their exposure. So that's something that we want to make sure that we're there for the customer.

This is Spencer on for Greg. I understand that the situation still remains pretty fluid. But can you just provide some additional color on what you think the new normal looks like for food retail? And do you think COVID has accelerated a structural shift towards sort of eating at home channel?

Yes. First of all, if you look at things that we think, for sure, is the digital channel and people eating via that accelerated the trends that we're already on. For example, our Home Chef business had an incredible quarter with picking up new customers as well. The thing that I get most hopeful about is when we talk to customers, customers tell us they like eating at home as a family and eating together and having meals together at home. One of our responsibilities is to help them keep it fresh and innovative and new ideas, and we continue to work on that. But everything that we can see, the customer likes that, and they like learning how to cook and cook as a family. So that trend is something that we focus on a lot and try to make sure we're supportive of it.

That's helpful. And then we've seen promotions tick down across the industry throughout this crisis. Has COVID changed your philosophy on price investments at all? And then would you expect an acceleration in promotions in the back half of the year?

Yes. One of the things that I'm super proud of our teams is we've had an ad and promoted every week during the pandemic to try to help our customers' budget go as far as possible. The only change that we made was we stopped doing the buy 10 for 10s and things like that, which incentivized multiple purchases on items that we're in short supply because we wanted to support as many customers as possible getting those. We would continue to use our data to understand what's important to the customer and some customers are in different financial situations, whether they lost their jobs or they were able to work from home. We’re supporting both of those customer segments with promotions, loyalty mailings, and other offers that are one-to-one, in addition to what you can see in an ad, and we think that's an important component to continue to support.

I think the other thing I would add, Rodney, is that we mentioned earlier about the pickup fee being an investment in price with the promotion there. But we also did adapt our plan around making sure we're giving value to customers where the product was more available. The team did a really nice job in promoting on HBC and general merchandise products. While it's very true to say that grocery and fresh led the way, we saw significant double-digit growth in both of those categories and would have seen some lower gross margin in those 2 categories because we were more promotional in making sure that as a business that was opened through the pandemic that we were delivering value for customers. I think that's been the case, and the team did a really nice job of creating and delivering value there.

I'll just ask 1 because I know we're late. You talked about some of the trends in states that reopened first. Maybe too early, but what are you seeing in states where there are headlines about a second wave or cases increasing? Have you seen any upticks there? Or again, is it just too early to say for sure?

I think it's still too early to say definitively, and those were states where people were generally more comfortable going out, even during lockdowns. So it's really early to determine any significant changes, but we're not noticing large shifts.

Just want to see if you can hear me?

Yes.

Okay. Great. Sorry about that. So the question I have was two parts. The first was on traffic and ticket. I know you don't typically disclose that, but if you could give some incremental color around the 19% ID sales on that line? And then secondly, related to that was just if there's a sense of what percentage of that comp is being generated by existing loyal households versus the new households. Obviously, you had mentioned, Rodney, there was some strong growth in new customer acquisition.

Yes. If you look at ticket growth, we had significant double-digit increases in the average basket size. We’re finding that customers are going into the store less frequently, and so well over 100% of the growth is driven by basket size. If you look at new customers and existing customers, it’s a meaningful number, but it’s maybe one-fourth or one-third of the total when you look at all the pieces because we also have a lot of new customers to pick up and where we've launched where customers can pay a SNAP at pickup and things like that, new customers there as well.

Okay. And then I guess the other one I had was a lot of the questions I've been getting relate to how you all would be positioned to cycle this kind of comp in a year from now. I was just wondering if you could provide some incremental color around the Ocado partnership and I guess, in particular, as it relates to some of the c-store fulfillments and also like center store potential efficiencies that you could gain and reinvest back into competitive positioning.

Yes. That's a question we're spending a lot of time discussing internally to gain a better understanding. Gary mentioned it briefly, but we expect 2021 to be better than the trend for that year before COVID. We see meaningful changes in how people eat, which we believe are likely multiyear shifts, though not necessarily permanent. Therefore, we anticipate 2021 will exceed what it would have been without COVID. It’s challenging to give more specific details at this point. As we approach next year, we expect our in-stock positions to improve, which will help us, especially as people return to a more normal lifestyle. We are committed to taking care of our existing customers and increasing our share with new customers. In summary, we foresee 2021 being better than it was pre-COVID. Thank you, Michael. I appreciate the last question; it was an excellent note to end on. Looking at Restock Kroger and our related initiatives, we believe we are well-positioned, having experienced good growth before COVID, and that pandemic has accelerated the infrastructure and foundational work we had in place. As we prepare for 2021, we expect it to be an improvement over what we experienced before COVID. The other comment that I want to make is, as you know, we always like to share a few final comments directed toward our associates and how we live our purpose every day. The senseless killings of George Floyd, Ahmaud Arbery, Breonna Taylor, and so many more, too many more across our country have shaken me to the core. We share in everyone's feelings of sadness and outrage for the victims and their families. I am compelled to use Kroger's voice to express that we're against racism and the injustice toward the Black community. To become a greater part of the solution, we believe the most important next step is to listen. Recently, I was proud to be invited by Dr. Bernice King of The King Center to listen, learn, and participate in open dialogue about how companies like ours can drive real tangible change. We also held the first of several listening sessions to hear directly from our associates about how we can better support them. Informed by deliberate listening, we intend to take more action. As the first step, our company is establishing a $5 million fund to support the advancement of racial equality and justice. This new investment will be earmarked within The Kroger Foundation for improving diversity, equity, and inclusion. We know there's more work to be done, and we will continue to share our progress. Thank you for all you have done and will do for each other and our customers and communities. And to all on the call, thank you for joining our call today.