Kroger Company (KR) — Q3 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. Both our third 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. In order to cover a broad range of topics from as many of you as we can, we ask that you please limit yourself to one question and one follow-up question, if necessary. 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. With me today to review Kroger's third quarter 2020 results is Chief Financial Officer, Gary Millerchip. When restrictions were set in place to address the spread of COVID-19 in mid-March, many underestimated the length of time that it would last and the number of families and communities that would be impacted. Many of the stories from the last 9 months have been upsetting, to say the least. Out of this grief, we've also seen the best parts of human nature. From our store teams to our warehouse associates and drivers and our digital teams, plants and offices, our Kroger family of associates have been nothing short of incredible during this period. I am proud of our dedicated associates who have continued to diligently execute our Restock Kroger transformation while serving our customers when they need us most. We delivered strong results in the third quarter. Customers are at the center of everything we do and sales remain elevated, and we continue to grow market share as we enhance our competitive moats: Fresh, Our Brands, Data & Personalization, and Seamless. I want to highlight that Kroger's digital sales are incrementally profitable today, partly supported by our rapidly growing digital media business and partially fueled by our constant improvement in operational efficiency. This is true as an incremental pass-through rate of sales, and we have a clear path to continue improving digital profitability. Gary will touch on this more in a few minutes, but I wanted to call this out as well because it demonstrates the strength of not only our Seamless offering, but the overall Kroger ecosystem and how the components fit together to deliver value to our customers and our shareholders. We are more certain than ever that the strategic choices and investments made over the last 3 years have positioned us to meet the moment. And as a result of our strong performance and consistent market share gains, we are raising our guidance for the remainder of the year. We are also positioned to deliver beyond 2020 for our customers, associates, and shareholders as we believe a number of the impacts of COVID-19 will be structural and lasting. As a result of the pandemic, we continue to see increased basket sizes and fewer customer visits. Customers across the country are still staying home, and cooking at home is now part of the new routine. We are fulfilling our customers' growing demand for premium products as they seek joy and elevated experiences. We're merchandising in new ways to both meet that demand and inspire our customers to trade up to items like premium jumbo blueberries, by the way, they're delicious, and larger-sized packages of strawberries, raspberries, and grapes. Home Chef's culinary innovation is inspiring customers with new oven-ready entrées and sides, flatbread, pizzas, salads, and sandwiches. In the Fresh soup category, we have introduced new flavorful and delicious Simple Truth and Home Chef varieties. Our efforts are also driving strong market share growth in packaged produce, fresh prepared foods, and specialty cheese. This is also where our brands really shine. Our multi-tiered brand portfolio positions us well to deliver against our customers' diverse needs and desires. Our Brand grew at 8.6% in the third quarter, and we grew market share. Private Selection grew over 17% and Simple Truth grew nearly 15%. These are incredible numbers and demonstrate that while many competitors offer private label products, Kroger's unique approach to Our Brands is a differentiator in a competitive moat. By leveraging our unique data and customer insights, we continue to be at the forefront of product innovation and new product development. During the third quarter, we launched 250 new items, the most ever in a single quarter. New items for the quarter included launches in trending focus areas such as fresh produce, frozen grocery, and expansion of our Simple Truth plant-based collection, unveiling more than 50 new fresh and flavorful plant-based foods at affordable prices. Moving now to our third competitive moat, Data & Personalization. Many retailers have transactional data, but no one has the customer data and the insights that Kroger has. The quality of our data is a massive advantage because it allows us to develop a significant alternative profit business that generates income from the traffic while benefiting our customers. Our personalization efforts motivate our customers to continue to show interest in Kroger's communications, where nearly 80% have asked to receive relevant information and offers from us. Our customer e-mail open rate is nearly 18% higher than the industry average, which illustrates our ability to offer relevant content and offers to our customers. We continue to advance our personalization technology. About 95% of customer interactions with product on our website and app are enabled by personalization, driving a significantly higher level of engagement in our offers and nearly doubling the likelihood of adding an item to a cart. Our store's competitive moat is Seamless. Kroger began investing in digital several years ago to build a seamless ecosystem that would deliver anything, anytime, anywhere. As part of our journey, we have been evolving our fulfillment network. First, taking advantage of our existing assets, our physical stores, providing flexibility and proximity to our customers with broad and relevant assortment to meet their needs. Second, expanding our network of assets and capabilities with a portfolio of various-sized facilities optimized based on volume, demand profile, and density, leveraging scale and automation to meet the rapidly changing customer needs. Our early investments lay the foundation, including over 2,200 pickup locations and over 2,450 delivery locations, which allowed us to capture the increased customer demand for e-commerce offerings during the pandemic we have today, reaching 98% of our customers with a seamless customer experience around in-store shopping, pickup, delivery, and ship-to-home modalities. We are innovating and building out a flexible network of fulfillment options and working with key solutions providers. As we recently announced, we continue to progress on our Ocado facilities program with plans to build customer fulfillment centers in Michigan and in the southern region of the country. The upcoming opening of our first 2 fulfillment centers in early 2021 in Monroe, Ohio, and Groveland, Florida, in collaboration to leverage some of their in-store fulfillment capabilities. We work extremely hard to ensure that we have the right talent, teams, and structure in the right focus areas in our core supermarket business and our alternative profit businesses. We are focused on both developing, training and promoting internal talent and hiring external industry executives, which together drives our retail supermarket business as well as our other businesses. Kroger has been investing to raise the wages of our frontline associates for the last several years. As part of Restock Kroger announced in 2017, over the period of 2018 to 2020, Kroger will have invested an incremental $800 million per year in associate wage increases. As we've noted before, this is $300 million more than the original planned investment. As a result of our continued focus on growing associate wages, Kroger has increased its average wage rate to over $20 per hour with our comprehensive and best-in-class benefits, including health care, paid time off, and retirement included. As the largest grocery retailer in America, Kroger is committed to being a force for good in the communities we serve. Our purpose to feed the human spirit continues to guide how we operate our business, care for our communities, and deliver value to all of our stakeholders. Since launching our ambitious Zero Hunger | Zero Waste social impact plan in 2017, we achieved our goal to donate more than 1 billion meals to feed hungry families in our communities by 2020. We also continue to increase Kroger's diversion of waste from landfill, reaching 80% diversion last year on our path to achieve 90% diversion or Zero Waste. This year, Kroger outlined several new long-term environmental commitments, and they can be found in our annual environmental, social, and governance report. Last month, we were proud to be included among the world's sustainability leaders, recognized by our inclusion in the Dow Jones Sustainability Index for the eighth year in a row. We are committed to continuing to integrate ESG metrics into our business strategy, driving shared value for our associates, customers, communities, and shareholders. Since March, we have invested nearly $1.3 billion to both reward our associates and protect our associates and customers through the implementation of dozens of safety measures like installing protective partitions and physical distancing floor decals. We continue to require masks and limit the number of people in our stores to allow for physical distancing and ensure frequent and proper cleaning procedures are followed. We also promote additional ways to shop using pickup or no-contact delivery. Our total COVID-19 incident rate continues to track below the rate in the surrounding communities where we operate. Our supply chain remains strong and healthy, and we are replenishing our stores daily so that the supplies and products our customers need are readily available. To ensure our customers have access to what they need, we have proactively secured an additional 5,000 truckloads of inventory and increased distribution capacity reserves by 20% within our supply chain to get ahead and avoid potential supply disruptions. Furthermore, we have flexed our national footprint by dynamically shifting volume from constrained facilities and regions to facilities and regions with available capacity to accommodate. As America's grocer, we continue to see the unique opportunity to be part of our customers' healthy journey in addition to being their grocer of choice. Throughout the pandemic, we have remained committed to helping people live healthier lives by offering in-clinic and at-home COVID-19 testing solutions, supported by our team of experienced health care professionals. The size and scale of our health care footprint with over 2,200 pharmacies and 220 clinics in 35 states provide us the unique ability to efficiently facilitate COVID-19 testing and immunize a large portion of the U.S. population once vaccines become available. Kroger Health has conducted over 250,000 COVID-19 tests since April and has recently launched rapid antibody tests, which are now available across our family of pharmacies and clinics. We are also partners with the federal government's effort to deliver hundreds of millions of potentially life-saving vaccines to our communities. We have also partnered with dozens of state health departments in preparation for the early administration of vaccines to priority populations. Once an FDA-authorized vaccine is available, we're committed to making it accessible in accordance with the federal rollout plan. All our pharmacies and clinics are staffed with professionals, licensed pharmacists, nurse practitioners, physician assistants, and technicians. Health and wellness is a critical part of our customer value proposition. Pharmacy customers are more loyal, spending three times more per customer. We have approached pharmacy from an omnichannel perspective for quite some time, allowing customers to choose the most appropriate channel in which to connect with us, whether that be in-store, on the phone, or online. For all channels, our strategy is consistent: simplify health care by creating solutions that combine health, wellness, and nutrition. I continue to be proud of the work that our associates do to serve each other, our customers, and our communities. Stories of their accomplishments and selflessness inspire me every day. The investments we have made to enhance our competitive moats are paying off, and as a result, we are growing market share. I will now turn it over to Gary for more details into the quarter financials. Gary?

Thanks, Rodney, and good morning, everyone. The Kroger team delivered strong results in the third quarter and provided a further proof point of the value creation model we shared at our Investor Day last year. We grew market share and, consistent with our value creation model, were disciplined in balancing significant investments in our customers and our associates with improved productivity and accelerated growth in our alternative profit businesses. The investments we are making in our business are allowing us to deliver strong results today and, importantly, are also setting us up to deliver sustained growth in the future. I'll now provide more color on our third quarter results. We delivered an adjusted EPS of $0.71 per diluted share, up 51% compared to the same quarter last year. Kroger reported identical sales without fuel of 10.9% during the third quarter and continued to gain market share. Our identical sales growth increase was broad-based and all departments, excluding fuel, achieved positive growth over the prior year. Meat and produce departments led the way, continuing to underscore the importance of Fresh and how we differentiate in quality and assortment for our customers. Digital sales grew 108% in the third quarter and contributed approximately 4.6% to identical sales without fuel. Customer engagement with our digital solutions is driving overall loyalty. When customers engage with both our physical stores and digital channels, they visit more frequently and, on average, spend twice as much as those who shop in-store only. The vast majority of our digital customers are shopping in-store as well as online. We are, therefore, confident that the seamless experience we are building across our store and digital ecosystem positions us well for continued growth in a post-COVID world. At the same time, digital sales growth in the quarter was profitable on an incremental basis, and we continue to improve digital profitability by lowering the cost to fulfill a pickup order and accelerating digital advertising revenue. As Rodney noted, we see a clear path to further improve digital profitability by leveraging our personalization tools to increase basket size and improve sales mix, further reduce the cost to fulfill an order via process improvements and automation, and continue to grow digital media revenue. We are also excited about the value our merger with Home Chef has brought to our digital capabilities, both in terms of the extended meal solutions offered for our customers and the significant sales growth and profitability improvements the business is achieving. Adjusted FIFO operating profit for the third quarter was $871 million, up 33% compared to the third quarter of 2019. We were pleased with our ability to consistently pass-through the benefits of elevated sales in the quarter, which was in line with our expectations and guidance previously shared. Gross margin was 23% of sales in the third quarter. The FIFO gross margin rate, excluding fuel, decreased 2 basis points compared to the same period last year. We achieved improvements in gross margin during the quarter through sourcing efficiencies, sales leverage, and growth in alternative profit streams. These tailwinds were offset by changes in the sales mix as a result of COVID-19 and continued investments to deliver greater value for our customers, ensuring we sustain long-term customer loyalty and position the business for success in 2021 and beyond. The OG&A rate, excluding fuel and adjustment items, decreased 30 basis points. This reflects sales leverage and strong cost control through execution of Restock Kroger initiatives, which more than offset continued COVID-19-related investments to protect the health and safety of our associates, customers, and communities, and increased incentive costs. We were pleased with progress on our Restock Kroger cost-saving initiatives in the quarter and continue to be on track to achieve the targeted $1 billion of savings in 2020. As an example, through the implementation of multiple process and technology improvements this year, we have been able to reduce the cost to fulfill a pickup order in-store by double digits compared to the same period last year while at the same time improving the customer experience by significantly reducing customer wait times. Fuel remains an important part of our strategy to drive customer loyalty. Consistent with market trends, our decline in gallons in the third quarter slowed to around 13%. We remain well-positioned within our markets due to our fuel procurement practices and our market-leading reward program. The average retail price of fuel was $2.15 this quarter versus $2.62 in the same quarter last year. Our cents per gallon fuel margin in the third quarter was $0.37 compared to $0.30 in the same quarter last year. Kroger's alternative profit businesses are built on a platform that leverages our supermarket traffic and data. Our alternative profit businesses had a very strong third quarter, led by tremendous growth in our digital media business, Kroger Precision Marketing. On the strength of growth in digital sales, digital customer engagement, and new inventory, KPM achieved revenue growth of over 190%. Over 1,200 brands are now engaging with KPM as a better way to invest marketing dollars that were previously being spent with advertising platforms and digital media companies. CPG brands continue to leverage our audience intelligence for more effective brand-building activations that are achieving better return on ad spend. Thanks to our team's nimbleness in responding to the challenges presented by COVID, our alternative profit businesses are performing well, and we now expect profit growth to exceed $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. 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 multi-employer pension plans in which many of our associates participate. We believe charges related to pension funding can be mitigated if plans are reviewed and addressed over time. In July, we announced a tentative agreement to improve security for future retirement benefits of over 33,000 Kroger family of company associates across 20 local UFCW unions with a pre-tax investment of nearly $1 billion that will be satisfied by installment payments over the next 3 years. I'm pleased to say that that agreement is now being ratified by participating union locals, and Kroger will incur a charge to net earnings during the fourth quarter of approximately $0.98 per diluted share on a GAAP basis. This does not affect adjusted net earnings per diluted share results for 2020, which are provided on a basis that excludes adjustment items such as this contribution. We ratified new labor agreements with the UFCW covering associates in Las Vegas and Dallas during the third quarter. Last week, we ratified a new labor agreement with the UFCW covering associates in West Virginia, and we are currently negotiating with the UFCW for contracts covering store associates in Little Rock, Houston, and 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 create more jobs and career opportunities and enhanced job security for our associates. Turning now to financial strategy. We continue to generate strong free cash flow and remain committed to our previously communicated capital allocation framework. We are continuing to invest in the business to drive profitable growth while also maintaining our current investment-grade debt rating and returning excess free cash to investors via share repurchases and the growing dividend over time. We now expect total capital expenditures to range between $2.8 billion and $3.2 billion in 2020. This lower range is primarily due to the expected delay in when spend will occur as a result of COVID-19. We are being disciplined in how we deploy capital to ensure that our investments will deliver strong returns, and we continue to see many opportunities to invest in the business to support sustainable long-term revenue and profit growth consistent with our CSR goals. Kroger's net total debt to adjusted EBITDA ratio is 1.74 compared to 2.5 a year ago. This is below our target range of 2.3 to 2.5. Our strong liquidity reflects our elevated operating performance and significant improvements in working capital. This improvement in working capital includes the impact of temporary increase in warehousing and buildup of inventory during the third quarter that Rodney referenced earlier, which we implemented to minimize supply disruptions as a result of higher COVID cases forecast over the winter months. During the quarter, Kroger repurchased $304 million of shares under its $1 billion board authorization announced on September 11, 2020. Year-to-date, Kroger has now repurchased $989 million of shares. In June, Kroger increased the dividend by 13%, marking the 14th consecutive year of dividend increases. Finally, I'd like to provide additional color on our guidance for the remainder of 2020. As we shared previously, the COVID-19 pandemic has changed the outlook for food retail, and we continue to monitor, evaluate, and adjust our plans to address the impact to our business. As a result of our continued strong sales and market share performance and the expectation of sustained trends in food-at-home consumption for the remainder of our fiscal year, we are raising our full-year 2020 guidance. For the full year 2020, we now expect total identical sales without fuel to be around 14%. We expect to achieve adjusted EPS growth of approximately 50% to 53%, and adjusted free cash flow of $2.8 billion to $3.1 billion. 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. Looking towards 2021, we believe that our performance will be stronger than we would have expected prior to the pandemic when viewed as a 2-year stacked result for identical sales without fuel growth and as a compounded growth rate over 2020 and 2021 for adjusted earnings per share growth. We remain confident in our business model and our ability to achieve consistently attractive total shareholder returns. We look forward to providing detailed guidance for 2021 and updating you on our road map to deliver long-term growth in March next year. And now I'll turn it back to Rodney.

Thank you, Gary. We are executing against our strategy even during the pandemic and continue to grow market share. The strong underlying momentum in our core supermarket business and acceleration in the growth of our alternative profit business demonstrates that we are successfully transforming our business model to deliver consistently strong and attractive total shareholder return in 2020 and beyond. Now we look forward to your questions.

I wanted to ask about e-commerce. It doesn't seem to be specifically mentioned as a challenge, even though sales have doubled. Can you clarify where it's reflected in the profit and loss statement? Additionally, while we expect sales to normalize somewhat in 2021, do you believe digital sales will remain high, and how will that be reflected in the profit and loss statement for next year?

Thank you for the question, Simeon. Regarding e-commerce, both Gary and I have noted that it has become profitable this quarter due to improved cost efficiencies in serving our digital customers and growth in media. We anticipate continued progress in these areas. Looking ahead to 2021, while we expect digital growth to be less than what we experienced in 2020, we believe customers will still desire digital services. What's encouraging is that digital shoppers often visit our stores for an in-store experience, and those customers tend to spend twice as much as those who shop only online. We are pleased with the seamless omnichannel experience we are creating for our customers, and we foresee ongoing improvements in the profitability of our digital shoppers. Additionally, once we move past the initial costs associated with Ocado and some micro-fulfillment centers, the costs will be significantly lower than serving customers in-store. Overall, we are excited about the progress we've made and the growth we expect to continue. It seems the pandemic has accelerated the shift to digital by about three years. While there might be a slight decrease, we believe the long-term trend of customers wanting flexibility between in-store, pickup, and delivery will persist. Gary, do you have anything to add?

I completely agree with your overall comments, Rodney. To add some specifics, as we look at 2020 and 2021, we previously discussed the lower pass-through rates on digital, although they are slightly positive. This will reflect in our financials where we are experiencing sales growth this year. Typically, we would have seen a pass-through rate above 15% for traditional brick-and-mortar sales, but the combined rate for digital and in-store, considering COVID-related costs, may be around 10% instead. The reduced pass-through rate on digital and the additional COVID costs are contributing to this overall blended rate decline. Interestingly, we temporarily removed the fee for promotions during the quarter, which could have impacted gross margin negatively. However, the value we are generating through media revenue is effectively balancing that out. We have been able to invest in our customers while simultaneously replacing that revenue with personalized digital communications that create new revenue streams to counterbalance the promotional actions. Looking ahead to 2021, it's important to consider that as we enhance our digital operations and profitability, cutting fulfillment costs and increasing average order values through personalization will help. If we see these improvements in Q3 this year, we will benefit from them across the entire volume next year. Therefore, under similar business conditions, digital could actually serve as a positive factor in next year's financial outlook. While the growth of digital will require further investments next year, the cost savings and media revenue from 2020 will contribute positively to the profitability of our digital operations.

Maybe just one follow-up, and I think Rodney mentioned also micro fulfillment will help over time. Just to clarify, the pickup that you're doing for click-and-collect or pick-up orders, all the pickup is being done by in-house employees and I think that's a pressure in the SG&A line. The Instacart and the third-party partnerships, where does that show up in the P&L? Do any of your employees actually pick for Instacart? And then, big picture, the economics with some of these third parties, I guess, where is the pricing power? Is there pricing power with you with some of those partners?

Yes. Simeon, you'd be correct in the way in which our core pickup business would show up in our P&L as a lower pass-through rate is the labor associated with picking the product in the store. That's what drives the mid-single-digit pass-through rate versus the sort of high-teen rate, if you like, on a traditional brick-and-mortar sale. We have a fairly unique model, I think, with Instacart. They are our predominant partner. We do use other partners as well in terms of delivery. So part of that business of Instacart is still delivered through the Kroger ecosystem. So the customer would come on to kroger.com or the Kroger app and would order a grocery delivery. Instacart would pick that product for us, but we're managing it through the Kroger ecosystem. So a significant part of our volume would flow through there. And then, of course, we're compensating Instacart or another third-party for that service. And that would also appear in OG&A. So it would be a similar area of the P&L. The part of the business where Instacart is using their own digital assets and the customers going through the digital ecosystem of Instacart, that would flow through more as a traditional sale and wouldn't have the same level of impact on the P&L. We are a big partner of Instacart. And obviously, we work very closely with them to make sure we're maximizing the efficiency of the model and continue to work on where we can improve the pass-through profitability on all those modalities.

We are continuously seeking partnerships to enhance our customer experiences. The example provided by Gary is just one instance of various partnerships we engage in, which include both large and small companies. Our focus is on ensuring that we meet our customers' delivery preferences effectively.

This is actually Erica Eiler on for Rupesh. So I'm not sure how much color you can provide here, but we're trying to assess what benefits you've seen on the gross margin line in recent quarters that might go away in 2021. So as we look towards next year, with the potential for some of the recent grocery boom to reverse, should we be thinking about greater gross margin pressure than a typical year as the benefits from that sales leverage reverses? And is there anything positive or negative you can call out for us next year on the gross margin line as we think about comparisons and 2021 in general?

Thank you for your question, Erica. At this time, we won't provide detailed guidance for 2021, but we plan to share more insights about our outlook for next year during our Investor Day in March and in our Q4 update. Generally speaking, I want to emphasize that our investments in gross margin are focused on areas that truly matter to our customers, such as personalized promotions and value offers. These initiatives are designed to foster long-term loyalty, particularly around Fresh products, which are key drivers for customers choosing a food retailer. We're also increasing our advertising spend to enhance our marketing effectiveness and visibility. These investments are crucial as we aim to emerge from the COVID-19 environment in a stronger position and capture more market share. Additionally, we expect these investments will help differentiate us from traditional competitors as we move beyond the pandemic. Many of these investments reflect our commitment to everyday low prices, so they don't have to be viewed as entirely new for 2021 compared to 2020. As we introduce new promotions next year, it's part of a fresh calendar of investments. Therefore, we don't expect our investment strategy to change dramatically. There may be some unique challenges next year that could affect our sales metrics, but with ongoing improvements in sourcing and expectations for increased media revenue and alternative profits contributing to gross margin, we remain confident in our balanced model. We believe we can continue to invest in customer loyalty while achieving overall earnings growth.

Gary just briefly mentioned it, and we'll get into more detail in March, but when you look at overall, we do see meaningful opportunities to continue through process change and take costs out both in goods not for resale, cost of goods and operating costs itself. And we'll get into more detail in March. But Gary mentioned, this year, we're on track to take over $1 billion out, and we still see opportunity in 2021 to take additional costs out while not affecting the customers' experience.

Okay, that's helpful. Given some recent developments in the online pharmacy industry, can you update us on Kroger's current efforts in this area? What opportunities do you see moving forward, and how is consumer adoption of your existing offerings going?

Yes. As I noted earlier, pharmacy customers generally spend three times more in our stores. Our entire team has been focused on treating food as medicine, and we are continually discovering ways to assist customers in eating and living healthier. We believe that the combination of these efforts is vital for helping customers maintain their health. Regarding discount offerings, we've been providing various cards for several years, including partnerships with GoodRx among others. We view this as part of a broader ecosystem, and we are pleased to help customers make healthier eating choices. Research indicates that approximately half of healthcare costs are influenced by dietary habits, and we are committed to promoting healthier eating. We believe this partnership will be beneficial. Additionally, we find that customers value the options for online services and delivery, but they also appreciate having direct access to a healthcare professional for one-on-one consultations to address their questions, whether in person or through telehealth.

There's a decent amount of inflation up the supply chain from you, everything from corn to freight. Your net pricing, I think it's safe to say, it's already risen, thanks to reduced discounting, even if maybe you didn't pull back as much as your peers did. But I'm curious to what extent some of your vendors are asking you now to accept list price increases on their end because of inflation, and what your appetite is to take these increases and pass them on to consumers, especially as we think about the next few months. And I get it, right, you want to be competitive on price, but an argument can be made, you do have a chance to push some prices higher in a low elasticity environment, too. So I'm just curious for your thoughts there.

When you look at the overall situation, a bit of inflation tends to make things somewhat easier for us. We are not facing significant issues with moderate inflation. However, we have developed a robust business model that remains effective regardless of inflation levels. In the third quarter, inflation was slightly lower compared to the second quarter, mainly due to trends in meat commodities, which aligned with our expectations. We consistently collaborate with consumer packaged goods companies to identify ways to reduce costs within the system, minimizing the need for our customers to experience inflation. Each partnership with a CPG company involves a unique strategy aimed at lessening the impact on customers. Gary, do you have anything to add or any specifics to address Ken's question?

Sure. Thanks, Rodney. Ken, I would say that overall, we're seeing, as Rodney mentioned, and you've probably heard us say before, we build our model based on sort of 0.5% to 1% inflation, aligned with Rodney's initial comment. We've been seeing inflation running more in the sort of 2% range, I would say, and slightly up or down, as Rodney mentioned, but generally speaking, in that kind of range. From our perspective, it's obviously hard to predict exactly where inflation goes. We don't see anything in the overall supply chain when you think about food in the system that would cause us to be dramatically different. But there are also risks, obviously, with COVID and what happened in the first quarter around meat, as Rodney also mentioned a moment ago, and there are certainly some produce categories that, because of the season, have had some supply shortages, too. But nothing that I would say that would take us dramatically today as we look forward outside of that sort of 2%, give or take, range. I think from that perspective, as Rodney said, we always look for ways to mitigate that wherever we can. Where it's justified and makes sense, then, of course, we look at how would that be passed on to the customer. And really, we try and disconnect between inflation and what makes sense to pass on and then our pricing investments, which are more focused on where do we believe customers are looking for the most value and what's going to drive long-term loyalty. So we really try and make sure that if it makes sense to pass to them, we'll do that. But we're always looking to identify ways in which we can really connect more deeply with the customer and build loyalty at the same time.

That's helpful. For my quick follow-up. We are hearing some indications and seeing some indications of consumers pantry loading a little bit over the last couple of weeks as COVID has unfortunately worsened. Can you help us with what you're seeing there? And maybe what that means for the quarter-to-date trend so far in terms of your numbers?

Ken, you mentioned something that I'm trying to understand better.

Pantry load.

We implemented limits on certain categories early in the quarter based on what we learned from previous experiences. As we noted, shoppers are making fewer trips but purchasing more during each visit. Regarding the holidays, we will have to wait and see how Christmas and New Year's play out, but it's clear that celebrations are happening in much smaller family gatherings compared to last year. Several factors are contributing to this situation. Our supply chain team secured additional warehouse space, and our procurement team managed to acquire some hard-to-find inventory to ensure we can serve our customers. Overall, the situation is somewhat limited, with a slightly stronger performance in the West compared to the Midwest, attributable to regional responses to COVID. In general, the challenges are not as severe as we encountered earlier in the year, but they are still present.

Ken, I want to add to the second part of your question. When examining the sales trend, I would describe last quarter as fairly steady throughout, with only minor fluctuations around the 10.9% mark that Rodney referenced. We did notice some differences between the West and Midwest, with the West generally performing better, likely due to stricter restrictions in place there. For the current quarter, we anticipate a trend similar to what we experienced in Q3, especially in the first few weeks. Initially, we observed higher spending during Thanksgiving, which, in a typical year, would have been an exceptional week. However, it did not reach the levels seen during the COVID peak weeks. The performance during these three weeks is indicative of where we were in Q3. As Rodney mentioned, we are maintaining our guidance range because we expect to benefit from our strategic execution and ongoing food-at-home trends related to COVID. However, we are also aware that the holiday season will influence spending. With two holidays upcoming, similar to Thanksgiving, and the Super Bowl taking place within our fiscal year, we anticipate these will significantly affect sales. It will be interesting to see how our customers’ spending during holiday gatherings and their purchasing behavior develop in the coming weeks and months.

It's Mark Carden on for Michael today. So you noted that you're continuing to take market share. Assuming this is relative to other retailers, where do you think it's coming from? Is it largely from small traditional players? Mass merchants? Another channel? A little more color here would be helpful.

Yes. As you know, we never really looked at market share in terms of where it's coming from. And we do everything we can to expand the market and then how are we doing within that market. So we think the market share is pretty broad-based. We're getting it by our existing customers spending more with us. Some of that is driven by our digital offerings in the seamlessness of the digital offer. Some of it's driven because we are getting new customers into our ecosystem, both digitally and in-store. So it's really very broad-based in terms of where it's coming from.

Okay. And then as a follow-up, any update on the Walgreens initiative and whether you're looking to accelerate expansion there?

I would say we continue to learn. We really aren't yet in a position to decide on expansion or anything similar. Customers are responding positively, but we are still figuring out how to connect more effectively with them. We're pleased with the progress, but it's still early.

This is Spencer Hanus on for Greg. My first question is, can you talk about how you think price investments are driving share shifts in this operating environment today? And are you seeing promotions becoming more important today than they were 3 or 6 months ago? And sort of how you're thinking about that as we head into 2021?

Yes. Overall, we think it's important to recognize that while some customers are experiencing strong and growing financial situations, others are facing more challenges, particularly due to the impact of COVID, such as job losses. We believe it’s crucial for customers to see that we did not take advantage of them during this time. We continue to invest in everyday pricing and promotional pricing, including waiving pickup fees, to help customers manage their budgets more effectively. We anticipate that customers will appreciate our efforts during COVID once the situation improves. I am also proud of the Kroger team for making progress in our Fresh and Friendly dimensions compared to our competitors. We've created a seamless experience for customers, allowing them to shop online or in-store with a fresh experience that surpasses that of our competition, along with great pricing and outstanding promotions. We see no reason for customers to shop elsewhere.

Yes. I think you covered it well, Rodney. The only point I would add, and you said it a moment ago, but as we look at the data over a longer period of time, and obviously, none of us have been through something like a pandemic like this before, but we look at periods where customers go through different economic conditions and different environments, whether that be through short-term, natural disasters that we manage or through a longer-term economic cycle. And our learnings over time are that it's really important to stay true to your values, and it's really important to continue to deliver what the customer expects consistently because over the longer term, it really does show through. And we think that's going to be very important to deliver on that expectation that we have to come out of COVID-19 stronger.

Great. That's really helpful. And then switching to online. Can you just give us an update on the basket size for online orders and how that compares to in-store orders? And would you expect that gap to widen over time? And then just an update on the incrementality, how incremental are online orders today?

If you look at the basket size, it's significantly higher. Over time, I've always assumed that it will get smaller as the customer gets more comfortable with shopping across multiple channels. But I would say, if we take an average of our guests together, that will probably be the closest comparison. Gary, do you want to answer the last part?

Yes. Regarding incrementality, we are observing very consistent patterns. When we analyze what customers are purchasing and their digital engagement, the incrementality remains above 50%. If we examine their purchasing behavior over a longer timeframe and consider both their in-store and digital purchases, we are noticing new categories and products being added. The total basket size is significantly higher, and over 50% of that is considered incremental when we look at customers' shopping behavior over an extended period.

This is Renato Basanta on for Karen. So I wanted to follow up on next year, pretty high level, with respect to how you're thinking about the P&L. And appreciating sort of some of the color you've given already. If IDs are down mid-single digits next year, our math implies something like 200 basis points of margin deleverage. I mean you presumably lose some COVID costs and you had some cost savings flowing through. But I'm not totally sure that, that makes up for the deleverage. So just wondering if you could help us think about the P&L in that scenario? Specifically, what sticks in terms of COVID costs next year? And then any color on any other P&L levers you have to pull?

Yes, thank you for the question. I won't go into specifics on the sales figures since we'll cover those at our Investor Day. However, we believe that based on customer behavior changes and structural shifts, our two-year stacked sales will exceed the traditional levels our model is based on. This is due to our enhanced customer connections, market share growth, and various external factors. Regarding next year's financial model, we anticipate significant nonrecurring costs, such as rewards and incentive plans based on business performance, as well as one-time costs we incurred during the early stages of COVID. The costs we're running now are much lower than those at the beginning of the year because we've optimized our plans. We are hopeful that by the latter half of the year, vaccines will be available to help improve the situation. Consequently, we expect certain costs not to carry over into next year, and we foresee continued profit growth. This area of our business should not experience a slowdown in momentum, as we recognize substantial growth opportunities. As previously mentioned, through our cost-saving initiatives under Restock Kroger, we aim to deliver $1 billion this year, similarly to previous years. We anticipate sharing further plans next year about ongoing cost reductions. In the health and wellness sector, while we've successfully grown the pharmacy business, we have encountered challenges due to fewer customer visits to doctors, which affects new prescriptions and may present a headwind compared to what could turn into a tailwind next year. We acknowledge that some COVID-related costs might carry into the next year. We will continue to invest in the business to enhance customer loyalty and achieve long-term market share gains. Fuel costs could also be a headwind next year due to unique circumstances affecting prices this year. Given these complexities, we believe it's crucial to provide a more comprehensive overview in March once we have greater clarity about next year's overall situation. Nonetheless, we are confident in our ability to achieve compounded earnings per share growth on a two-year basis and that our in-depth sales growth will exceed what we initially estimated in our TSR model last November.

Okay. That's great color. And then just wanted to get your perspective with respect to labor costs. You mentioned you're all-in average wages. But can you give some color on what your actual entry-level wages and how many associates are actually at that level? And presumably, the federal minimum wage could go to $15 an hour. So wondering how you're thinking about managing that possibility for next year?

Yes. We have very few associates earning minimum wage, and around 90% of them are under 18 years old. These individuals are primarily in their first job. As you know, many start with us and eventually turn their positions into careers. We aim to offer excellent career opportunities that allow for income growth. We are comfortable with the federal minimum wage and do not take a stance on it. As long as our competitors face the same costs as we do, we are fine with operating on an equal basis. It's not beneficial when we carry costs that they do not. Therefore, we leave the discussion on federal minimum wage to the politicians. As part of our Restock Kroger initiative, we initially allocated $500 million for pay increases. To date, we have provided $800 million in additional pay raises for our associates, along with great benefits like paid time off and sick vacation.

Thank you for your questions today. I wish all of you and your friends and family happy holidays, Merry Christmas, and a Happy New Year, and encourage you to stay safe. At Kroger, our purpose is to feed the human spirit, which means that we are called to do more and help make the lives of those around us better. When we see our associates, customers, and neighbors affected by systemic racism, discrimination and injustice, we are called to speak out and act in accordance with our values. Over the past several months, we've listened closely to our 0.5 million associates in countless communities across the nation to learn what we can do better to accelerate and promote greater change and equity in our workplace and the communities we serve. We recently shared our framework for action, diversity, equity, and inclusion plan. This plan is just the beginning. We are approaching this effort with humility, knowing that we can't do it alone and don't and won't have all the answers. But we are committed. I am committed to continuing to listen, to speak out and to take action. That concludes our call for today. Thanks again for your questions, and thanks for your time. Goodbye.