Kroger Company (KR) — Q2 2021 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 our business on an ongoing basis is contained in our SEC filings. The Kroger assumes no obligation to update that information. Our second quarter press release and our prepared remarks from this conference call will be available on our website at ir.kroger.com. 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. After our prepared remarks, we look forward to taking your questions. Please mark October 27 on your calendar for a brief business update from Rodney McMullen and Gary Millerchip on our performance against Restock Kroger goals and how the pandemic is shaping our business model. Given the travel restrictions that are still in place, this meeting will be conducted virtually, and we plan to host a full Investor Day in spring 2021, hopefully in person, to share more on the business outlook and key drivers of our long-term growth model. Further details will be shared soon, and we hope you will join us. I will now turn the call over to Kroger's Chairman and Chief Executive Officer, Rodney McMullen.

Thank you, Rebekah. Good morning, everyone, and thank you for joining us. I'm here today with Chief Financial Officer, Gary Millerchip, to discuss Kroger's second quarter 2020 results. Every day, I am inspired by the dedication of our associates who embody our purpose to feed the human spirit. I'm proud of our team for supporting our customers during these challenging times. Our main goal is to ensure a safe environment for both our associates and customers, and as the pandemic continues, we are committed to facing these challenges. Six months into the pandemic, while uncertainties remain, we have clearer insights into many aspects of our business. Since March, we have invested over $1 billion to reward our associates and protect them and our customers through various safety measures. The total COVID-19 incident rate at our company is significantly lower than in the communities we serve. We have gained valuable experience while maintaining operations and serving customers throughout the pandemic. We have also played a crucial role in expanding COVID-19 testing, with our Kroger Health team facilitating over 150,000 tests nationwide. Recently, we expanded our testing services to more than 220 clinic locations, and with the flu season approaching, testing will be essential for diagnosing COVID-19 as symptoms may overlap. Earlier this week, we announced a comprehensive flu shot program aimed at helping Americans get the necessary vaccines during this time. Despite the challenges brought by the pandemic, we achieved strong results in the second quarter. Our customers remain central to everything we do, which has helped us increase our market share. Our robust digital business is a significant driver of this growth, as the investments we've made in our digital ecosystem are resonating with customers. Our performance demonstrates that Kroger is a trusted brand, with customers choosing us for our product quality and freshness, convenience, and digital offerings. Although we postponed certain cost-saving initiatives in the first quarter, we are now back on track to accomplish them as of the end of the second quarter. I am continuously proud of how our associates have adapted to new working methods during the pandemic to achieve strong results. We are now more confident that our strategic decisions and investments through Restock Kroger have positioned us well to meet current demands. We believe that many impacts of COVID-19 will lead to lasting changes. Our data reveals that customers are rediscovering their love for cooking at home and are motivated to eat healthier. Conversations with our customers indicate they intend to keep preparing and eating more meals at home. As children go back to school, families are telling us they plan to make breakfast and pack lunches for them. We anticipate that the return to work will look different, with many employees working part-time from home. Moreover, our data suggests a significant shift from food consumed away from home to food consumed at home during periods of reduced economic activity. Collectively, these factors indicate that there will be an increase in home-cooked meals for the foreseeable future. I’d like to share some examples of how our competitive strengths have set us up for growth both now and in the future. Before the pandemic, our digital business was growing, and COVID-19 has accelerated the demand for our seamless offerings. More customers are turning to our e-commerce solutions for grocery and household essentials, with many ordering groceries online for the first time due to the pandemic, and the majority plan to continue this trend. Kroger began investing in our digital platform years ago to create a seamless shopping experience, which now includes over 2,100 pickup locations and 2,400 delivery sites, providing services to 98% of our customers. Kroger was the pioneer in integrating pickup and delivery into a unified experience, and these investments came at a crucial time as more customers adopted these services during the pandemic. The expansion of Kroger's digital ecosystem is ongoing, and we are seeing increased engagement from customers. Home Chef, for instance, is experiencing rapid growth, fueled by the trend of eating at home, which is likely a lasting change. We've also announced that Kroger Ship will broaden its offerings with a marketplace for third-party sellers. Our technology and digital team continues to innovate, shaping the way we serve customers across the country and has been recognized as the best place to work in IT for three consecutive years. As we see a gradual return to normalcy post-shutdown, customer visits have decreased, but basket sizes have increased, as more customers continue to cook at home. This reinforces the importance of our leadership in the fresh category, which has driven sales as our fresh departments outperform our competitors and gained market share. Our brands also remain a vital competitive advantage for Kroger. We continue to cater to the evolving needs of customers, seeing significant growth across our main brands. With many customers eating more at home, we’re observing certain segments opting for larger pack sizes and premium products. Across the second quarter, our larger pack platform increased by more than 50%, Private Selection grew over 17%, and Simple Truth rose over 20%. Our brands tap into emerging trends and customer preferences, offering innovative products like our new plant-based Emerge grinds and patties. A recent third-party study confirmed that Simple Truth is the leading natural and organic brand in the U.S., outperforming competitors based on brand awareness, recommendations, and selection criteria. By consistently delivering exceptional value and innovative products that our customers love, our brands continue to be a formidable competitive edge. Personalization and data insights are crucial for Kroger’s competitiveness. We leverage customer data to understand their needs and consistently offer relevant promotions. This is especially important as the pandemic continues and after government stimulus benefits have ended, as many of our customers are facing financial difficulties that may affect their discretionary spending. Our ecosystem uniquely allows us to cater to both budget-conscious customers and those looking to upgrade to premium or larger product sizes. Regarding partnerships, while the pandemic has not fundamentally changed our e-commerce strategy, it has accelerated our commitment to a seamless approach, including our partnership with Ocado. Ocado is an essential strategic partner, providing innovative solutions and cost-effective fulfillment capabilities. We believe the future of our ecosystem will feature various capabilities and facility sizes, adapting as demand evolves, allowing us to meet customer needs for same-day or next-day delivery or pickup. Ocado's state-of-the-art automation and AI will enable Kroger to reach a broader market at a lower fulfillment cost. We are on schedule to open the first two fulfillment sites in spring 2021. Developing talent is a cornerstone of Restock Kroger, so we focus on ensuring we have the right teams and structures in place within our supermarket business and alternative profit ventures. We are committed to training and promoting internal talent as well as hiring experienced executives, which is vital for driving our retail business. Kroger has consistently invested in increasing wages for our frontline associates over the past several years. As part of our Restock Kroger initiative launched in 2017, Kroger will have invested an additional $800 million in wage increases from 2018 to 2020, exceeding our original plan by $300 million. Consequently, our average hourly wage now exceeds $15, and including our top-tier benefits like healthcare, paid time off, and retirement plans, the average hourly rate is above $20. As America's largest traditional grocery retailer, Kroger is dedicated to being a positive force in the communities we serve. Our mission to feed the human spirit drives our business operations, community support, and value delivery to all stakeholders. Last month, we released our 2020 ESG report detailing our progress towards sustainability goals. We are committed to integrating ESG metrics into our business strategy to create shared value for associates, customers, communities, and the company. Recently, we pledged an additional $20 million contribution equally divided between The Kroger Co. Foundation and the Zero Hunger | Zero Waste Foundation, along with an extra $5 million to support racial equity and justice. It's crucial that we provide resources to our communities as they face challenges due to the pandemic, economic issues, and social justice matters. Through Restock Kroger, we've made substantial investments to create a seamless digital ecosystem, enhance our brands and personalization capabilities, and improve product freshness and quality. These investments, taken together with our associates' response to the pandemic and the trend of increased home cooking, give us confidence that Kroger's performance in both 2020 and 2021 will exceed previous expectations. I will now hand the call over to Gary for more insights into our financial results for the quarter. Gary?

Thanks, Rodney, and good morning, everyone. Before getting into our business results, I wanted to echo Rodney's comments from earlier and say how extremely proud I am of our associates for continuing to serve our customers and communities throughout 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 that are most relevant today and that build future loyalty. Results for the second quarter were strong and reinforce the strategic investments we have made over the last several years as part of Restock Kroger. The quarter turned out much better than we previously expected. This was due to several factors, including stronger sales results and disciplined balance between cost savings and investments while also managing cost inflation volatility in key fresh categories. Additionally, fuel performed better than predicted, and we were very pleased with our alternative profit results, which rebounded from COVID-19 impacts more quickly than anticipated. Now I'd like to provide further detail on second quarter performance. We delivered an adjusted EPS of $0.73 per diluted share, up 66% compared to the same quarter last year. Kroger reported identical sales without fuel of 14.6% during the second quarter. Sales momentum continued from the first quarter with identical sales without fuel in June and July trending in the mid-teens. During our final period of the quarter, which runs from mid-July to mid-August, identical sales without fuel were 12.5% as we saw reduced government stimulus and SNAP funding and lower back-to-school activity. Digital sales grew 127% and contributed 4.4% to identical sales without fuel. New customer engagement with our pickup and delivery services continued to grow and we continue to invest in the customer experience. This included offering fee-free pickup to provide more value for our customers in ways that are most relevant at this time. Our digital sales growth was profitable on an incremental basis, and we were pleased with the progress we made to improve profitability by reducing the cost to fulfill a pickup order during the quarter. We see a clear path to further improve digital profitability by leveraging our personalization tools to improve sales mix, continuing to reduce cost to fulfill an order via process improvements and automation and accelerating growth in media revenue generated from digital sales. Adjusted FIFO operating profit for the second quarter was $894 million, up 43% compared to the second quarter of 2019. We were pleased with the overall pass-through rate achieved from the elevated sales in the quarter, which, including the impact of digital growth and incremental costs associated with COVID-19, was approximately 10%. COVID-related cost investments in associate depreciation, cleaning, safety and supply chain totaled approximately $250 million in the quarter. Gross margin was 22.8% of sales for the second quarter. The FIFO gross margin rate, excluding fuel, increased 5 basis points, primarily driven by sourcing efficiencies, sales leverage related to shrink, transportation and advertising costs plus growth in alternative profit streams. This was partially offset by price investments as we continued to invest in delivering greater value for customers and mix changes from lower relative sales in higher gross margin categories such as deli bakery. The OG&A rate, excluding fuel and adjustment items, decreased 61 basis points due to sales leverage and execution of Restock Kroger initiatives, partially offset by ongoing COVID-19 related costs mentioned earlier to protect the health and safety of our customers and associates. Rent and depreciation, excluding fuel, decreased 27 basis points due to sales leverage. We were very pleased with the progress on our Restock Kroger savings initiatives in the quarter and now expect to achieve the targeted $1 billion of savings in 2020. Fuel remains an important part of our strategy to drive customer loyalty. Compared to the first quarter and consistent with market trends, the decline in gallons slowed to around 15% in the second quarter. We remain well positioned with our markets due to our fuel procurement practices and market-leading reward program. The average retail price of fuel was $2.14 this quarter versus $2.71 in the same quarter last year. Our cents per gallon fuel margin in the second quarter was $0.37 compared to $0.35 in the same quarter last year. While fuel operating profit was $30 million lower than the same quarter last year, this was better than expected. For the remainder of 2020, we expect fuel profitability will continue to be a headwind compared to the prior year as we cycle margins from 2019 and gallons continue to be impacted by COVID. Kroger's alternative profit model is built on a platform of leveraging supermarket traffic and data, with media and Kroger Personal Finance representing the largest contributors to growth in 2020. Thanks to our team's responsiveness to the challenges COVID has presented to our alternative profits portfolio, these businesses rebounded strongly in the second quarter, and we now expect growth approaching $100 million for the fiscal year 2020. We continue to believe alternative profit will be a major accelerator of our model in the future, and COVID-19 has not changed the long-term profit expectations previously shared as part of Restock Kroger. Kroger precision marketing drove tremendous acceleration in our media business in the second quarter. On the strength of growth in digital sales, digital customer engagement and new inventory, revenue growth doubled compared to the first quarter. In-store media also bounced back as stay-at-home orders were lifted in many of the communities we serve. Kroger Personal Finance experienced higher transactions in the second quarter compared to the first quarter as customer activity improved in gift cards, lottery and money services. While trends at KPF are improving, we continue to expect KPF profit will be lower than our original expectations for 2020 due to COVID-19. 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. As you know, for the last decade or more, Kroger has sought opportunities to address the funding challenges facing the pension plans in which our associates participate. We believe challenges related to pension funding can be mitigated if plans are reviewed and addressed over time. Consistent with this effort, last month, we announced a tentative agreement to improve security of future retirement benefits of over 33,000 Kroger family of company associates across 20 local UFCW unions with an investment of nearly $1 billion. Ratification of this agreement is still expected to occur in the third quarter of 2020. We ratified new labor agreements with the UFCW covering associates in Roadie during the second quarter. We are currently negotiating with the UFCW for contracts covering store associates in Las Vegas, Little Rock, Houston, Dallas and Charleston, West Virginia. Looking ahead, towards the end of this year, we will be negotiating with the UFCW for Fry's stores 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 us to create more jobs and career opportunities and enhance job security for our associates. Turning now to financial strategy. 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 investment-grade debt rating and returning excess free cash to investors via share repurchases and a growing dividend over time. We remain confident in our business model and our ability to achieve consistently attractive total shareholder returns. We will provide more color on our future approach to capital allocation and the use of excess cash during our March 2021 Investor Day. In 2020, we are being disciplined in how we deploy capital, and all aspects of our capital plan are being evaluated to make sure that our investments will deliver strong returns and position Kroger for long-term success post COVID-19. We now expect total capital expenditure to range between $3 billion and $3.4 billion in 2020. We have widened the range of our guidance due to the uncertainty on timing of when spend will occur because of COVID-19. Kroger's net total debt to adjusted EBITDA ratio is 1.7 compared to 2.46 a year ago. This is below our target range of 2.3 to 2.5. Kroger held temporary cash investments of approximately $2.4 billion as of the end of the quarter, reflecting improvements in operating performance, significant improvements in working capital and delayed tax payments as a result of the CARES Act. We expect working capital to improve for the year although not to the level experienced year-to-date, which is inflated by sales growth due to COVID-19. During the quarter, Kroger repurchased $211 million of shares under its $1 billion Board authorization announced on November 5, 2019. On September 11, 2020, the Board of Directors authorized a new $1 billion share repurchase program, replacing the prior authorization. In June, Kroger increased the dividend by 13%, marking the 14th consecutive year of dividend increases. Turning now to guidance for the remainder of 2020. As we shared last quarter, the COVID-19 pandemic has changed the outlook for food retail, and we continued to monitor, evaluate and adjust our plans to address the impact to our business. While there are clearly still many unknowns, as Rodney shared in his opening comments, we now have greater clarity in many areas of our business and the drivers of food-at-home consumption. As a result of our strong performance in the first half of the year, the expectation of sustained trends in food-at-home consumption and confidence in our ability to execute against the Restock Kroger strategy, we are updating our full year 2020 guidance. For the full year 2020, we expect total identical sales without fuel to exceed 13%, and we expect to achieve adjusted EPS growth of approximately 45% to 50%. We are providing a wider range on guidance than we would normally provide at this point in the year to account for the variety of outcomes that could materialize as a result of the pandemic. In the second half of 2020, we expect identical sales, excluding fuel, to continue at elevated levels, although tapering from the level we've experienced so far this year. Our guidance contemplates continued investments in the customer and ongoing COVID-19 related costs to protect the safety of our customers and associates, balanced with continued execution of cost-saving initiatives and growth in alternative profits. We expect fuel profitability will be a headwind for the remainder of 2020. Finally, relative to delivering on our total shareholder return growth targets, as shared at our November 2019 Investor Day, these factors also lead us to believe that our 2021 business results will be higher than we would have expected prior to the COVID-19 pandemic. As the operating environment continues to evolve, we will be transparent and communicate any important changes that could impact our outlook. I'll now turn it back to Rodney.

Thanks, Gary. We provided specific guidance to help you understand how we see the business today. While there are still a lot of uncertainties, we are confident in our team's ability to navigate through this. We are laser-focused on winning with the customer, and our true measure of success internally will be growing market share sustainably over time. As Rebekah said earlier, we have scheduled a call on October 27. We will provide a business update relative to our November 2019 business commitments as well as our overall ESG commitments. We value the impact of an in-person meeting with you and have made the decision to reschedule the timing of our traditional Investor Day to spring of 2021. We remain incredibly confident in both our business model and TSR model and believe that not only 2020 will be strong, but as Gary mentioned, 2021 will be even stronger than we previously anticipated. Now we look forward to your questions.

This is actually Spencer Hanus on for Greg. My first question is just, can you talk about the comp trends that you guys are seeing quarter-to-date? And then we've seen ticket growth outpacing traffic growth as consumers combined trips. When do you think ticket and traffic trends get more normalized?

In terms of where we are quarter-to-date, we would still be slightly ahead of double digits. And if you look at when traffic returns to normal, it's kind of fascinating. As you look at markets where COVID incident rates are lower or less severe, what we find are people start visiting the store more often but they don't spend as much. But if you look at overall, the trends are pretty similar. That's probably really the only insight that we have at this point. We do find everything that we can tell, people are enjoying cooking at home, enjoying eating as a family. And those are things that we believe will last past COVID. I don't know, Gary, anything you'd want to add to that?

No. I think you covered it well, Rodney. I think we are seeing some gradual sort of, I guess, this return to patterns that customers get comfortable with in a COVID environment as we continue to see large basket sizes and fewer trips, but we've been encouraged certainly in the second quarter by, well, categories like deli, bakery would be significantly lower than the heightened levels of sales we'd have seen in the last quarter or so from categories like grocery and meat and produce. Deli, bakery is positive again, which I think shows that customers are starting to at least return to some of those behaviors and certainly in areas like specialty cheese and floral. It's really encouraging to see those categories turning to sort of low to mid-single-digit ID sales as well.

That's really helpful. And then in your prepared remarks, I think you mentioned that digital sales were profitable on an incremental basis. Can you provide some more color on that comment? And then how do you expect the launch of a marketplace with Kroger Ship to impact the profitability of the online business?

Thank you for the question. We view digital profitability by closely monitoring customer behavior and digital engagement, which leads to a notable increase in overall sales within the customer relationship. This needs to be considered alongside the additional costs involved in fulfilling customer orders. Furthermore, we are experiencing substantial growth in digital media revenue generated from customer spending, allowing us to personalize communications better and help our CPG partners determine if their advertising resulted in actual sales. When assessing the overall impact of sales, order fulfillment costs, and media revenue, we see a pass-through in profitability from a digital standpoint. While this is lower compared to in-store transactions, we are observing that profitability increasing incrementally. We believe there are significant opportunities to enhance that profitability, including improving sales mix through our personalization tools and the marketplace. We aim to increase basket size and the variety of products customers choose to bridge the gap between store and digital profitability. Additionally, there are further opportunities to boost profitability by lowering order fulfillment costs through automation and process enhancements, as well as increasing digital media revenue. We have plans to focus on these areas in the short term. As previously mentioned, Ocado will significantly accelerate these efforts by enhancing customer experience to improve mix and reducing costs through automation and AI.

Just to add a little bit, and everybody's heard me say this before, but when you look at digital overall, we've always viewed our first job is to make sure we don't lose the customer. And obviously, with our teams, they've done a fantastic job of supporting amazing growth, and that's our technology team, our digital team, our store teams and warehouse. We can now see a clear path to profitability of that. And one of the insights that Gary just shared in terms of the incremental is one piece of that path to profitability. Obviously, all the things that we're working on together, what we're expecting of ourselves is we will get to the point where we're indifferent if a customer connects with us digitally or a physical store. And everything that we can see, the customer actually will do both. And we made great progress on reducing cost to serve on a per customer basis. And then if you look at some of the other pieces of our digital offering like Home Chef, Home Chef had an incredible quarter, both sales growth and profitability as well.

So Rodney, you mentioned that you gained market share in the fresh category. How do you believe your market share in other categories has changed? Could you provide more insight into your choice to reengage in pricing investments during this period? It seems that promotions were paused in the previous period. It appears that the competitive environment has become more intense lately. Is that accurate?

No, I would express it a bit differently. We have been promoting throughout the pandemic, but we adjusted our promotions based on available supply. For instance, we didn't promote items like paper towels, toilet paper, and certain meats due to their limited availability. We focused our promotions on items that matter and continued to invest in pricing. We believe it’s crucial for customers to see that we have supported them during this time to help them stretch their budgets. As Gary mentioned, waiving the pickup fee, ongoing promotions, and investing in pricing are strategies we believe will yield positive results. Our customers will appreciate what we are doing over time. Regarding market share, I spoke about our gains in fresh, but we are also increasing our share in the center store, fresh sections, and throughout the store, with our own brands gaining share as well.

Okay. You mentioned that in the last period of the quarter, IDs increased by about 12%. It seems like that growth has slowed a bit in the most recent period. Would you say this is due to changes in unemployment benefits and ongoing back-to-school pressures? How do those pressures show up?

Yes. If you look at the back to school, there's a lot of moving parts and we think that's part of it. We also think if you look at the holidays, people celebrate holidays differently. If you look at some of the sporting events, people are celebrating those differently. So there's a lot of moving parts, so I think it's hard to say the specifics. I don't know, Gary, anything you'd want to add to that?

Yes. I think it's an interesting time right now, to Rodney's point, because we look at the trend in markets where we try and correlate results to higher levels of COVID cases, and it's become a lot more difficult to really track those trends. There's certainly a small level of correlation, it seems like, between the higher markets with COVID cases and the differentiation where you've got states and markets that have smaller levels of cases. But that being said, it seems like, to Rodney's point, I think more of the trends are being as customers are now adapting to some level of a new normal. And so as you mentioned, Michael, things like back to school certainly impacts for a period of time. I think the government's now followed in the market. We would say we saw a change there in the final period of the prior quarter and a little bit in this quarter. But then it's like what's the next trigger? So as now we're coming through the back-to-school campaign, what will happen in the final part of the year as maybe customers are less willing to eat out at restaurants in the cold and if capacity is still constrained in restaurants. I share that just because I think there's going to be almost different triggers that it's less, in some ways, what we're seeing in the trends around what's happening with COVID cases, but more about how our customers are adapting to what's the new theme and the new event that causes them to change shopping behavior. I think there's multiple different factors that are going on with the customer. And I think that the combination of all those of what led to, I think, the slightly different trajectory compared to the first two parts of quarter 2.

Two for me. First, I wanted to see if you've seen any notable changes in your product sales mix since the stimulus checks have run out. At least in the scanner data that we can see, store brands are still losing a lot of share within the measured grocery channel. But I'm not sure if that sort of corresponds with exactly what you're seeing. I might have expected store brands to do a little bit better right now overall. But I'm just curious if maybe you're seeing anything that's changing in there more recently.

Ken, I wouldn't say we're noticing any significant trends. During the quarter, we observed stronger sales growth in CPG brands compared to our own brands. However, overall, our own brands continue to gain market share. There are changes in consumer behavior influenced by life circumstances, but alcohol sales remain robust, particularly in beer and wine. Big pack and premium product sales are also strong. Consumers are trading up in areas where they desire to. As Gary mentioned, deli and bakery sections continue to show improvement. It's a great question, but I find it challenging to provide a definitive answer.

No, I understand. And then my follow-up, your FIFO gross margin ex fuel in the first quarter was up, I think, 46 basis points year-on-year. It was up still this quarter, but to your point, it was up less, I think, 5 was the number. Gary, I think you were very clear highlighting price investments as one of the reasons for that deceleration. I just would love to get a sense of what you're looking at for that number going ahead, whether we should be sort of thinking about in our models something closer to the first quarter or something closer to the second in terms of year-on-year. And I know there's all sorts of puts and takes and that's a very difficult one to answer. I'm just trying to sort of poke around a bit and see what you might think about that.

Thank you for the question, Ken. Our objective has always been to maintain a balanced business model, ensuring we invest in supporting our customers, which we aim to achieve through the savings from sourcing benefits. Additionally, alternative profit can help enhance our gross margin. In the recent quarter, a key focus was on the value provided to customers through our fee-free pickup service. We believe our digital sales performance compared to traditional grocery is strong, and we think we've gained market share in the digital space during this time. This factor influences our investment levels. Moreover, we've experienced significant volatility in fresh department inflation, with higher inflation in meat, produce, deli, and bakery than retail, prompting us to invest in customer support amidst price fluctuations to build long-term loyalty. We plan to continue investing where it benefits the customer while balancing those investments with cost savings from initiatives like Restock Kroger, sourcing benefits, and achieving efficiencies in shrink, warehouse, transportation, and advertising. Overall, our key message emphasizes balance, aligning with the long-term growth model we've communicated.

I want to begin by asking about your capacity for click-and-collect. I'm interested in how you're currently positioned to meet the demand for this service. Additionally, do you believe that the temporary removal of the pickup option is playing a role in the share gains you're experiencing?

Yes. In terms of capacity, we're constantly adjusting the capacity during the day because as people get used to the new normal, the times they want pickup slots constantly change. It's one area where I've been super proud of our teams, both stores and our data and technology and operations team in that constant adjusting and incrementally hiring people. There are stores now where we're aggressively investing a little bit of capital to be able to expand what's available within that store, and when we do that, that will allow us to add slots as well. So I would say the constraints on slots would be a slight opportunity, but I think the teams have done a great job of continuing to expand. The removal of the fee for a pickup, the temporary removal, is we look at it more in terms of trying to help a customer stretch their budget and try to be helpful in this environment. Customers still tell us the reason they like our pickup experience is really the freshness of our products and the quality of that and the assortment that we offer. So it probably helps, but I think it's more driven by the experience in the fresh side than waiving the fee.

Yes. We won't dive into specific numbers, but we shared some insights on the expenses we incurred in Q2. We expect to continue optimizing our operating plan, resulting in ongoing efficiency in the initiatives we pursue, which was evident as we transitioned from Q1 to Q2. One reason our costs may have been slightly higher than anticipated in Q2 was due to mask mandates across the states we operate in. We chose to proactively adopt the use of masks before mandates took effect to emphasize safety in our stores, providing masks to ensure all customers had access during that transition, which added to our costs. We are managing these costs dynamically to prioritize safety while also striving for efficiency. We are confident in our ability to balance these costs with the cost savings we're realizing from our initial plan. The team has done an excellent job adapting our cost-saving strategies in response to COVID. Whereas we previously anticipated some challenges in reaching our original goal of $1 billion in savings, we now believe we can achieve that. While there will be ongoing investments, we are confident in our capacity to manage them effectively.

I have a quick follow-up on gross margins and a larger question. Can you provide some insights on selling gross margins? I realize it's not a topic you've regularly discussed, but understanding this could help contextualize your point about driving customer loyalty during this period, especially since many competitors are not promoting. Could you share some details about selling gross margins this quarter compared to the first quarter?

Thank you for your question, Karen. It was indeed an investment. As we mentioned in the first quarter, we gained significant benefits from leveraging gross sales in warehouse, transportation, shrink, and advertising. Although sales declined in Q2 compared to Q1, we still expected to see growth in our overall sales results. Achieving a 5 percent improvement in gross margin reflects our investment in enhancing the selling growth rate during the quarter, particularly through the continued acceleration of digital pickup in fresh categories to ensure we deliver value to our customers. Additionally, it's important to note that the mix of sales, with deli and bakery contributing less to overall growth, also slightly impacted the selling growth rate.

If you look at our percent of sales, it would be a little bit higher than your estimate. If you look at mix between pickup and delivery, it's still predominantly pickup. And we find customers find pickup incredibly flexible on their schedule, much more so than delivery, and that's the reason why they continue to like pickup in a good way. If you look at basket size, basket size would be significantly bigger on pickup versus in-store and pickup and delivery would be pretty similar. On new customers, we're finding we're getting a lot of new customers, both in-store and digital both and probably the biggest change for both of those groups. In the past, a new customer would have to earn their right to start getting loyal customer mailings and digital offers and things like that. During this, we've started treating customers as loyal shoppers immediately rather than waiting for them to engage with us for a period of time. And what we're finding is we're having success on retaining those customers and repeat purchases as well.

Rodney, I was hoping, as a follow-up to Karen's question, can you give us more color kind of on what you're doing with Ocado versus the original plan? And maybe a little more color on kind of signposts we should be looking for in the back half and into next year on Ocado? And then just a separate question. Can you guys just give us color on what happened Labor Day weekend for you guys and how that was or was not similar to last year, et cetera?

Yes. I'll answer Ocado, and Gary, I'll let you talk about the Labor Day weekend. When we have our investor meeting in March, we'll get into a lot more details on Ocado. If you look at, obviously, the first initial part of the two first sheds that we'll open in Monroe, Ohio and in Florida, we'll be just scaling it and the assortment that customers have a desire for in that offering versus some other offerings. Those are two key parts. We will get into specific signposts in terms of how to hold us accountable. We're using the learnings from Ocado in terms of what they have in the U.K., obviously in Canada and France. And it will be taking all of those learnings and then making sure we manage the cost of the start-up as well. So we're excited. We can't wait, and we wish they would have opened a year ago.

And then Robby, on your second question, I would say, probably the broader comment I would make is Rodney shared, we're still trending in double-digit sales in the early part of the current quarter. It's a pretty difficult period to read, actually. It's probably the most important point, I would say, because the Labor Day weekend changed by a week, but we're also cycling weather from last year and then having some weather in this year. So it's been a really interesting, I would say, ride for the first four weeks of the new quarter and trying to interpret what's going on. If we look at the cycling and adjusting for the weeks, I wouldn't say we really saw anything materially unusual out of Labor Day, except for some of the weather events in certain markets adding some complexity to the data. But overall, as we're coming out the other side of that, as Rodney mentioned, trending in the low double digits early part of the quarter.

That's helpful. I have a quick follow-up regarding digital in markets where customers are returning to stores. Are you noticing a significant decline in digital sales? Is this decrease primarily due to delivery or pickup?

The mix between pickup and delivery is primarily influenced by available slots. The growth remains significant, still in the triple digits, but it is expected to be slightly slower, though still meaningful.

Good quarter, by the way. I feel for you guys on the gross margin, by the way, and I wanted to follow up on this because I think there's been some criticism in the market that your gross margin was not up as much as the sell side was modeling. But you're probably doing what you should with this windfall, right? You're investing in price, still delivered a large EPS beat. Others are not investing. So I'm kind of curious, what are you seeing from a price gap standpoint in the marketplace currently, both versus like bigger discount players like Walmart but also your conventional players who maybe seem to be taking advantage of the current environment.

Thank you for the question, Ed. I believe you've summarized it well. From our viewpoint, it's crucial that we continue to provide value for our customers, and we're committed to that strategy. When we assess pricing, as we've discussed on the call, our focus isn't only on everyday low prices; we also consider our promotional plans and investment in digital. We are confident that we are on a clear path to deliver customer value that fosters long-term loyalty. Based on our conversations with customers and our data analysis, we feel very positive about our current position and our customers communicate that we are providing significant value. This aligns with Rodney's comment on how we plan for 2021, ensuring we win long-term market share and grow our business. As we navigate the impacts of the pandemic, our aim is to emerge in a stronger position than before COVID-19. We are committed to deepening our connections with customers and delivering value. We are optimistic about our progress and the results we are seeing, which we believe will support our ability to achieve sustained long-term growth.

Can I just follow up, Gary, by the way? When you look at the gross margin, we have heard from one of your peers that the end of May, June period was tougher because there was inflation in some of your categories, particularly protein. Was there anything about the cadence of the gross margin this quarter that was notable? Was it softer earlier on?

There have been many dynamic changes in some of the fresh categories that we need to manage. I believe the team did an excellent job ensuring our customers can navigate through these changes. We likely experienced some of the same challenges early in the quarter, which may have had an impact at that time. However, your initial question about how we are balancing and investing in the business to ensure long-term growth is more critical. I wouldn't say it changes our approach to managing the business for the future.

To me, overall, Gary's last point is the critical one. We really are looking at everything in terms of what will connect us with the customer and position us best for sustainable growth over time and continue to gain market share. And that's what we're doing. Obviously, we were able to continue to manage expenses very well, which gave us the capacity to invest as well.

And we have time for one last question.

Was curious if we could talk a little bit about just price inflation mix and tonnage. I know there's been a lot of comments about traffic and basket. But I think the way that you guys tend to look at it is more tonnage. And so just curious if you can help us understand how that's played out in the quarter and what you're thinking about into the back half as you think about that kind of high single-digit ID outlook there between price inflation and tonnage.

Tonnage continues to be strong. We're still continuing to look at our supply chain, and our team has done a great job of finding alternative sources of capacity. We have access to warehouses that we manage temporarily, as well as others that keep supporting and managing the tonnage. What excites me about the tonnage is that it's showing growth across the entire store. Tonnage growth is strong in the center store, produce, meat, and all other areas. In terms of the guidance provided for the rest of the year, we anticipate this growth to continue. We expect that cost inflation will slightly surpass retail inflation, particularly in categories influenced by short-term factors. For instance, in meat, we expect inflation to normalize, and as that happens, the balance between the two will become very close.

I want to add to Rodney's comments on tonnage, which also relates to his remarks on market share that we are focused on. As Rodney stated, our primary measure of success in sales growth is primarily about increasing market share. We closely monitor this through tonnage and units in addition to revenue, ensuring we're investing in the customer. We're pleased with our growth in tonnage market share as well as dollar market share during the quarter. As Rodney mentioned, Kelly, we generally base our model on a 0.5% to 1% inflation rate. However, we are currently experiencing a bit higher than that due to cost inflation, particularly with meat prices being elevated. Grocery inflation is also likely above 2% right now, reflecting some trends we are observing.

Okay, that's very helpful. And then if I can just ask two quick follow-up ones related to digital. I think I heard you mention regarding the pickup fee that, that was a temporary removal. And I guess I was just curious under what circumstances or time frame would you consider bringing that back? Or is that a market-by-market specific thought process? And also, maybe just thoughts on membership. Obviously, a lot of competitive developments with membership and in terms of digital, whether pickup or delivery. So just curious if you're in any way thinking of evolving into something like a membership program over time.

Yes. We implemented the digital fee to assist our customers, particularly those on a budget, in managing their weekly expenses. Over time, we haven't made a definitive decision on this, but it fits into the overall value we aim to offer our customers. Regarding membership, we've been testing various types of programs for some time. Once we identify a successful membership program, we will pursue it more aggressively. As you are aware, we have had a fuel rewards membership program for many years, which customers can access for free, earning rewards effortlessly. This has proven very effective in sharing value with customers and fostering loyalty, which we've focused on for several years. Thank you, Kelly, for your questions, and thanks to everyone else as well. Before we conclude today, I would like to have a moment of silence in remembrance of the lives lost during the tragic events that took place on September 11, 2001. Thank you. As you know, I usually take time before we end our call to share a few final comments directed toward our associates. The COVID-19 pandemic continues to challenge and change our country, not the least of which is the loss of lives in America and around the world. I appreciate our associates for doing their part to keep our customers and each other safe, especially for leading by example by consistently wearing masks. We are incredibly confident in terms of the future and the things that we do to take care of our associates and customers. And together, we will get through COVID-19. Thank you for your time today, and have a great weekend.