Kroger Company (KR) — Q4 2022 Earnings Call Transcript

Good morning. Thank you for joining us for Kroger's Fourth Quarter and Full Year 2021 Earnings Call. I am joined today by Kroger's Chairman and Chief Executive Officer, Rodney McMullen; and Chief Financial Officer, Gary Millerchip. Before we begin, I want to remind you that today's discussions will include forward-looking statements. We want to caution you that such statements are predictions, and actual events or results can differ materially. A detailed discussion of the many factors that we believe may have a material effect on our business on an ongoing basis is contained in our SEC filings. The Kroger Co. assumes no obligation to update that information. We are excited to see that many of you will also be attending, either virtually or in person, our 2022 Business Update tomorrow in Florida when we will share additional details and answer questions about our long-term strategy and growth initiatives. More information about virtual registration for this event can be found at ir.kroger.com. After our prepared remarks, we look forward to taking your questions. Additionally, we would ask that you focus today's questions on our fourth quarter and full year 2021 results as well as our 2022 guidance. Now I will turn the call over to Rodney.

Thank you, Rob. Good morning, and thank you for joining us today. Our strategy of Leading With Fresh and Accelerating With Digital propelled Kroger to record performance in 2021 on top of record results in 2020. We are incredibly proud of our associates who continued to deliver for our customers through the pandemic. During 2021, our team delivered for all stakeholders by, first of all, achieving positive year-over-year identicals without fuel against very strong identicals last year and a 2-year stack of 14.3%. Also by connecting with customers through expanding our seamless ecosystem and remarkable, consistent delivery of full fresh and friendly customer experience for everyone, plus investing more than ever before in our associates to raise our average hourly rate to $17 and our average hourly rate to over $22 when you include compensation and benefits as well. We balance all of these investments by achieving cost savings of greater than $1 billion for the fourth consecutive year, and alternative profits contributed an incremental $150 million of operating profit as well. As we look to 2022, we expect the momentum in our business to continue, and we have confidence in our ability to navigate a rapidly changing operating environment. We are leveraging technology, innovation and our competitive moats to build lasting competitive advantages. Our balanced model is allowing us to deliver for shareholders, invest in our associates, continue to provide fresh, affordable food for our customers and support for our communities. We remain confident in our growth model and our ability to deliver total shareholder return of 8% to 11% over time. Kroger is leading with fresh. Our fresh departments outpaced total company identical sales, excluding fuel, during the fourth quarter. Kroger remains the number one retailer in many exciting areas such as specialty cheese, sushi and floral. As the world's largest florist, we sold over 76 million floral stems for Valentine's Day alone. And the smiles that came along with that for our customers and associates were free. We advanced our fresh strategy and strengthened our fresh offerings in 2021 by launching our Go Fresh & Local Supplier Accelerator, supporting our commitment to small businesses. As a result of the launch, we have brought a number of new products to customers, and the initial results have exceeded our expectations. We are still early in the program, and we will continue to partner with small businesses to expand our pipeline of new products. We also remain a leader in innovation through exciting partnerships with companies like Kitchen United and Kipster. We've completed the initial test phase of our End-to-End Fresh initiatives focused on bringing more days of freshness to our customers and are confident in its scalability and with plans to expand to targeted stores across the country. Our brands continue to resonate strongly with customers and maintain a culture of innovation, launching over 660 new items during the year. More than half of those new items were within our Simple Truth and Private Selection portfolios. We accelerated Home Chef's incredible milestone of becoming a billion-dollar brand, our fourth greater-than-one-billion-dollar brand, which is pretty special. As a reminder for everyone, we merged with Home Chef in 2018. At the time, we knew our customers were looking for ways to make meal time easier without compromising on taste or freshness. While Home Chef originated as a pure-play e-commerce offering, we saw immense potential to integrate and leverage it across our seamless ecosystem, scaling it within our stores and continuing to grow online. The success of this integration demonstrates our ability to integrate and scale solutions that provide value to our customers and grow our competitive moats. Kroger is focused on delivering a seamless experience that requires zero compromise by customers, and I think that's a really important point, zero compromise required by customers. And what that means is the freshest products at competitive prices and flexible lead times. Yael will go into a lot more detail tomorrow on what zero compromise means for our customers at our business update. The strength in our top line sales in 2021 demonstrates our ability to meet our customers no matter how they choose to engage with us, whether it's in-store or online. At the same time, we are actively encouraging customers to engage with us on our digital platforms, even when shopping in-store. That's because when a customer engages with us digitally, they spend more with Kroger within all modalities. We continue to attract new customers to our digital platforms. During the quarter, we saw new seamless pickup and delivery to household acquisitions increased 25% compared to the third quarter. We remain committed to doubling digital sales and profitability by 2023, which was announced in 2021. We look forward to sharing our glide path to this goal with you tomorrow. We do not expect digital growth will be linear, especially as we cycle the sales spike in 2020 and customers become more comfortable shopping in-store again. We are incredibly proud of the new digital modalities we launched during 2021, including Kroger Delivery Now, our Boost membership program and the rollout of new customer fulfillment centers, all of which we expect to contribute meaningfully to our long-term goals. Yesterday, we announced a new customer fulfillment center for the Cleveland region, following on heels of our announcement of a cross-dock spoke facility that will serve Oklahoma City. And just a few weeks ago, we opened our third customer fulfillment center in Forest Park, Georgia and are leveraging learnings from Monroe and Groveland to drive efficiencies and scale in the new facility. Customers are loving this new offering, and we continue to be pleased with the initial rollout of our facilities in Groveland and Monroe, and we look forward to sharing additional insights tomorrow. Now turning to the supply chain. Our teams across our stores, warehouses, plants and offices have been incredible in working together to supply fresh food and necessities for our customers while addressing the rapidly changing environment. During the quarter, industry challenges continued within the supply chain, and we remain confident in our ability to navigate these challenges. Within our supply chain, we continue to deploy a wide array of tools, including our owned and operated fleet. We are also partnering with our suppliers to improve product availability using the strength of our data science teams to provide insights that shorten lead times and optimize inventory flow across the extended supply chain. We continue to focus on expanding our transportation contracts and attracting carriers from outside our industry, which has kept product flowing predictably across our network. The teams are doing a great job managing the increased costs, and the trends within our costs are improving sequentially. We are using our data and supplier data plus leveraging technology to support future growth. We expect the supply chain to continue to improve throughout the year as a result of our actions. When I visit our stores, I often hear from our associates that what they love most about their job is that they can positively impact the lives of our customers, communities and each other every day. And it's also what I love about our business too. And it's what makes our purpose, to Feed the Human Spirit, so vital for our people. One way we live our purpose is through progress toward our ESG goals and our commitments. As part of our Zero Hunger | Zero Waste social and environmental impact plan, last year, Kroger donated 499 million meals, that's right, 499 million meals, to feed hungry families across America. And we continue to make progress toward our goal of 0 waste. As part of our commitments to helping people live healthier lives, we've administered almost 11 million doses of the COVID-19 vaccine through Kroger Health. For our more than 450,000 associates, we strive to create a culture of opportunity, and we take seriously our role as a leading employer in the United States. Kroger has provided an incredible number of people with their first jobs, new beginnings and lifelong careers. As we continue to operate in a challenging labor market, we are dedicated to attracting and retaining the right talent across the organization to be able to continue delivering for our customers. We are investing more than ever before in our associates by expanding our industry-leading benefits, including continuing education and tuition reimbursement, training and development, health and wellness as well as the continued investment in wages that I mentioned earlier. This is enabling us to navigate current labor conditions while continuing to provide America with the freshest food at affordable prices across our seamless ecosystem. We are cultivating an environment where all associates are able to thrive. For the fourth year in a row, Kroger earned top score in the Human Rights Campaign Foundation's 2022 Corporate Equality Index, the nation's benchmark in measuring corporate policies and practices related to LGBTQ+ workplace equality. Last year alone, we provided more than $5 million to support associates through unexpected hardships through our Helping Hands Fund. This includes providing critical funds for disaster relief for nearly 1,300 associates. 2021 was an incredible year for Kroger, and we are committed to continued growth. One of Kroger's greatest strengths is our relentless focus on learning and improving every day. I believe this has been key in navigating our business successfully in every operating environment. We remain customer-obsessed and focused on operational excellence to deliver for our customers, associates, communities, and shareholders. And now I'd like to turn it over to Gary. Gary?

Thank you, Rodney, and good morning, everyone. Kroger continues to execute at a high level and is delivering exceptional results while navigating a rapidly changing environment. Before I get into our results in more detail, I would like to start by echoing Rodney's appreciation to our fantastic associates. Their dedication to serve our customers and support each other throughout the pandemic has been nothing short of incredible. Our performance last year clearly highlights the strength of Kroger's go-to-market strategy as we achieved positive identical sales without fuel and adjusted EPS growth on top of record results in 2020. We also continued to invest in our customers and associates to ensure Kroger is well-positioned for future success. These investments were balanced with over $1 billion in cost savings and $150 million of incremental operating profit from alternative profit streams. I will now provide additional color on our full year results. We delivered adjusted EPS of $3.68 per diluted share, up 6% compared to last year. Identical sales, excluding fuel, were positive 0.2% and digital sales on a 2-year stacked basis grew by 113%. Our adjusted FIFO operating profit was $4.3 billion, up 6% over 2020. Gross margin was 22% of sales for 2021. The FIFO gross margin rate, excluding fuel, decreased 43 basis points compared to the same period last year. This decrease primarily related to higher supply chain costs and strategic price investments, partially offset by sourcing benefits and growth in alternative profits. The OG&A rate decreased 61 basis points, excluding fuel and adjustment items, reflecting a reduction in COVID-related costs and cost-saving initiatives, partially offset by significant investments in our associates. Turning now to our fourth quarter results. Adjusted EPS was $0.91 for the quarter, up 12% compared to the same quarter last year. Kroger reported identical sales without fuel of 4%, our strongest quarter of the year, with fresh departments leading the way. Kroger's FIFO gross margin rate, excluding fuel, increased 3 basis points compared to the same period last year. The stability in our gross margin rate reflects effective management of cost inflation and sourcing benefits, offset by strategic price investments and higher supply chain costs. The OG&A rate, excluding fuel and adjustment items, increased 7 basis points. This was driven by significant investments in our associates, including a year-end associate thank you reward and various asset impairments, offset by decreased COVID-related costs, sales leverage and cost-saving initiatives. The LIFO charge for the fourth quarter was $20 million compared to an $84 million credit in the same period last year and represented an $0.11 headwind to EPS in the quarter. The year-over-year increase was attributable to higher inflation in most categories, with grocery and meat being the largest contributors. One of Kroger's greatest strengths is our ability to successfully navigate many different operating environments, and our team is doing an excellent job managing the current higher inflationary environment. We continue to leverage our data and work closely with our suppliers to minimize the effect on our customers and our financial model. We are investing where it matters most to our customers using our proprietary data to be strategic in our pricing and personalization. Our brands are also an important differentiator for Kroger in this environment, offering customers an unmatched combination of great quality and great value. Our strategic approach is helping our customers manage their grocery budgets more effectively and is allowing Kroger to maintain a strong price position relative to our key competitors. Fuel also remains an important part of our overall value proposition for our customers, and we continue to invest in our fuel program in 2021. Customers that redeem fuel points spend, on average, 4x more at Kroger and visit 4x more frequently. Our investment in fuel rewards, which is reflected in our supermarket gross margin, also helps customers stretch their dollars further and allowed us to achieve gallon growth of 5% in the fourth quarter, outpacing market growth. The average retail price of fuel was $3.30 this quarter versus $2.20 in the same quarter last year. Our cents per gallon fuel margin was $0.44 compared to $0.33 in the same quarter in 2020. Turning now to cash flow and liquidity. Our operating results generated exceptional free cash flow in 2021, which resulted in a further strengthening of our balance sheet and liquidity. Kroger's net total debt to adjusted EBITDA ratio is now 1.63 compared to our target range of 2.3 to 2.5. We were also disciplined in accelerating the return of cash to shareholders in 2021. In total, Kroger returned $2.2 billion to investors via a combination of share repurchases and dividends. I'd now like to take a few minutes to discuss our continued commitment to investing in our associates and our deep experience with collective bargaining. Wages at Kroger grew before and during the pandemic. As you know, we committed to significant associate wage investments when we launched our Restock Kroger program at the end of 2017. Kroger has invested an incremental $1.2 billion in associate wages and training over the last 4 years. In addition, we have committed to invest over $1.8 billion during the same time period to help address underfunding and better secure pensions for tens of thousands of associates. Wage, health care and pensions are included in all of the more than 350 collective bargaining agreements that cover approximately 66% of our associates. These contracts are regularly negotiated by our professional labor relations team. Our objective is to negotiate contracts that balance competitive wage increases and affordable health care for associates with keeping groceries affordable for the communities that we serve. Our obligation is to do this in a way that maintains a financially sustainable business. If negotiations do become contentious, we have contingency plans in place to continue to support our communities. During the fourth quarter, we ratified new labor agreements with the UFCW for associates in Fred Meyer, King Soopers and our Michigan division, covering more than 20,500 associates. For 2022, we have contract negotiations with the UFCW for store associates in Las Vegas, Southern California, Seattle, Indianapolis, Portland, Columbus, Fort Wayne, Chicago and Toledo, in addition to continued negotiations with the UFCW for store associates in Houston, Little Rock and Memphis. We are actively proposing generous wage increases over the life of the various contracts we are negotiating, and these increases are included in our financial model and our guidance for 2022. We are also communicating to local unions that coming to the table with unrealistic proposals, proposals that do not balance associate investments with keeping groceries affordable for our customers is untenable and undermines our shared goal of growing the company to create more jobs and advancement opportunities for more associates. In closing, let me now provide additional color on the 2022 guidance that we released this morning. While we recognize there remain a number of uncertainties in the economic and geopolitical outlook, we believe the strength of Kroger's go-to-market strategy and our ability to manage multiple levers within our financial model will allow us to continue to build momentum within our business in 2022. We have shared previously that we expect to emerge from the pandemic stronger, and our guidance for 2022 creates a new baseline for FIFO net operating profit that is some $900 million higher than the midpoint of our TSR model would have projected when we announced it in 2019. Our plans contemplate meaningful investments in associate hourly rates as well as investments in delivering greater value for our customers and enhancing our digital capabilities. We expect these investments and the impact of cycling COVID-19 vaccine revenue will be fully offset by tailwinds in our model and allow us to grow adjusted net earnings per diluted share to between $3.75 and $3.85. The tailwinds in our 2022 plan include sales leverage from growing identical sales without fuel between 2% and 3%. We also expect to deliver cost savings of $1 billion, incremental alternative profit growth largely in line with 2021 and underlying improvement in Kroger Health profitability, excluding vaccine income. Fuel profitability is expected to be relatively flat year-over-year as gallon growth is offset by slightly lower fuel margins. In terms of quarterly cadence for identical sales of our fuel and EPS growth, we expect identical sales without fuel in quarter 1 and quarter 2 will be above the midpoint of our 2% to 3% range as we expect heightened inflation will continue in the first half of the year. We would expect our second half identical sales without fuel to be below the midpoint of our range as we expect the inflation to moderate later in the year as we cycle higher inflation from the second half of 2021. Regarding adjusted EPS, we would expect quarter 1 to be above the annual growth rate range of 2% to 5%, quarter 2 to be below the range and the second half of the year to be within the range. Turning briefly to our capital priorities. We will continue to be disciplined with capital allocation. As you heard this morning, we are increasing capital investments to $3.8 billion to $4 billion in 2022. This reflects some catch-up from the last 2 years, where spend was below original guidance due to COVID-related constraints as well as an acceleration of our strategic initiatives that will drive longer-term earnings growth. At the same time, we expect to generate free cash flow of between $2 billion and $2.2 billion. And consistent with our TSR model, we will continue to return excess cash to shareholders as evidenced by the acceleration in share buybacks over the last 6 months. And finally, we are looking forward to spending more time with you at our business update tomorrow when you will hear from key members of our leadership team about our strategic priorities and our path to delivering total shareholder returns of 8% to 11% over time. With that, I'll turn it back to Rodney.

Thanks, Gary. Kroger is operating from a position of strength, and we have a variety of levers and growth opportunities to continue to build on this strength. As we reflect on 2021, we are incredibly proud of our ability to navigate both a rapidly changing operating environment and evolving customer behaviors. We are obviously in an inflationary environment. Our teams are managing it well. And as Gary talked about, we are doing everything we can to keep prices low for customers, including our award-winning customer rewards program, which includes fuel rewards, our amazing and high-quality Our Brands products and personalized offers and savings for each customer individualized. As we look to 2022, we are confident in our ability to continue to differentiate ourselves, serve our customers in new and exciting ways and continue to change the definition of what it means to be a grocery retailer while never losing sight of what's most important to our customers. And when we do this, we have a clear path to delivering on our commitment of 8% to 11% total shareholder returns over time for our shareholders. Now we look forward to your questions. As Rob shared at the top of the call, we would like to focus all questions on our quarter 4 and full year 2021 results as well as 2022 guidance. We look forward to sharing additional details about our long-term strategy tomorrow at our 2022 Business Update. So with that, we'll turn it over for questions.

Congrats on a really strong quarter. So I guess just starting out, just on the gross margin line, pretty significant improvement in gross margins on a one- and two-year basis. What are the key changes? Maybe some more color in terms of what drove that improvement versus what we saw in Q2 and Q3.

Yes. Thanks, Rupesh. As we mentioned in the prepared remarks and Rodney covered a moment ago, really proud of the team in the way that we managed the business in Q4 and some of the changes that were happening. From I think what the team did, we're obviously laser-focused on how can we continue to be effective in managing the sourcing approach to how we are leveraging the relationships with our suppliers and using our data. We've been very effective in using our personalization and promotional activities to really sort of target the offers to the customer to make sure that they're seeing the value but that we're also then able to manage those cost increases effectively in the business. I think mix is also another important trend that the team is really focused on is how do we ensure that we're upselling customers to better quality products and premiumized products and whether it's adding the cedar plank to the salmon or the seasoning to the shrimp. And some of those opportunities are really important in how the merchandising team is really focused on recognizing some consumer trends in how many of our customers are moving to more meal solutions as well as continuing to look for value. So overall, we feel really good around the way the team managed our gross margin during the quarter. As we think about going forward into 2022, we continue to focus on, of course, the same elements and continue to manage those pieces tightly while also wanting to make sure we're continuing to deliver value for our customers. And I think to us, really, we look at it more of how do we manage the model overall across gross margin, OG&A and pulling the different levers. And certainly, I think we look at 2022 and think that we'll continue to invest in the customer. We'll continue to manage those different levers. I would suspect that we'll see continued investment in gross margin in 2022 and continued operating leverage in OG&A. But I think the fourth quarter is a good example of where we wouldn't expect to see some of the major volatility or the gap in gross margin and OG&A that we saw across the whole year, for example, in 2021.

Yes. Just a couple of additional things. During COVID, as we've mentioned several times, people have learned how to cook again. And what they're finding is that they can have restaurant-quality food that they prepare at home. And in numerous categories like the specialty cheese that I mentioned, but there's numerous categories where customers have traded up to higher-quality product. And everything that we're seeing, they continue with that. And the other thing, I think, that's always important to remind all of us is that our fresh departments grew faster than the center store departments. And our fresh departments have a higher gross rate as well versus the center store. So just a couple of additional things. Thanks, Rupesh.

Great. And then maybe just one follow-up. So with a lot of inflation out there in the marketplace, how do your price gaps look today versus maybe where they were a few quarters ago?

Overall, the situation aligns closely with the cost increases we've experienced. In some key departments, retail prices haven't risen as much as costs, allowing us to maintain a balance. We are leveraging our data to understand the elasticity of our offerings. We're noticing customers are becoming more active in using coupons and starting to choose our brands, where they don't have to sacrifice quality while saving money. This indicates the beginning of some behavioral changes, although it is still early to draw definitive conclusions.

Yes. Maybe the only thing to add, Rodney. Certainly, as you know, Rupesh, the customer, as we look at our data, defines value in multiple ways. So part of it is the everyday price, part of it is the promotions. It includes our fuel rewards and all the personalization that we offer. And I would say, if we look at our position as we end the year from where we started, we feel very good about the way in which we've been able to deliver value for the customer. And when we look at our price position, we feel we've been able to maintain a very strong position with the customer in terms of how they would perceive the value of the Kroger basket and the value that Kroger's delivering.

A nice quarter and guide. My question is the comp guide is solid for next year. And we're a little surprised at how good the EBIT flow-through or the margin still looks, given all the cost pressures on the wage side. You mentioned some things on the gross margin. You mentioned tailwinds, but I wanted to put it to you holistically and hear your reaction to this question.

I'll begin and then Gary can provide more details. Your question is excellent. It's important to recognize the ongoing efforts to reduce costs across our entire system. We anticipate being able to cut another $1 billion in costs; last year, we also reduced costs by over $1 billion, marking the fourth consecutive year of doing so. This has become an organizational capability that is essential for us to undertake some of our initiatives. Additionally, alternative profit avenues and related changes are positively transforming our fundamental business model, making it less susceptible to inflation. The profitability of this segment is considerably higher than that of traditional grocery stores. Gary, do you have anything to add?

Well, I think you summarized it well, Rodney. I think, Simeon, we feel about it as you look at our 2021 results and then you think about our guidance for '22, it really demonstrates the strength in that, the overall diversity of our model now and the different levers that we're able to pull to make sure that we're investing in our associates, investing in our customers, and still able to deliver a strong return for our shareholders. And we would agree with you that 2022 is a year where we do expect to make significant investments, whether it's around continuing to support the customer and drive growth in our business, investing in our associates, investing in digital. And of course, we will be cycling some COVID vaccine revenue that will be lower in 2022 than '21. But Rodney mentioned the cost savings and alternative profit benefits that we see within the model. We do continue to expect, obviously, to generate sales leverage in our model as well. And as I mentioned in my prepared remarks, health and wellness will certainly have some headwinds from COVID vaccines, but we believe there's continued opportunity to improve the underlying profitability in health and wellness as well in 2022.

And maybe related, the value-conscious customer, are you seeing any signs of trade down? Are you seeing customers trade out? Are you seeing any decisions in the store that lead you to see that the customer is feeling a little more pinched?

Yes. Customers are telling us that they are changing their spending habits more for non-food items than for food, which makes sense. They have also discovered that eating at home is considerably more affordable than dining out. This allows them to manage their budget better. Additionally, people are starting to use coupons and similar offers more than before. However, this isn't a significant change yet, and we feel confident about our position with customers. Our connection to this customer segment actually improved in the fourth quarter compared to the previous year. Customers recognize that our fresh departments are a major strength, and they are benefiting from personalized rewards and engagement with our promotional items.

So Rodney, I want to start with, if you look at the $1 billion of cost takeout, right, how does that roughly break out between COGS and O&A? And how has that changed over the last 3 or 4 years? Has it shifted more to O&A or it stayed relatively consistent?

Yes. If you look at overall, it would be more cost-driven. Now goods not for resale, do you put it in cost or do you put it in COGS because you can argue either one. But it's more driven by process change and eliminating work. Obviously, sourcing is an important component of it. Goods not for resale is incredibly important as well. If you look at the mix, the mix has been pretty consistent over the last 4 years. If you look at our expectations for 2022, Gary, it would be pretty similar to 2021. I mean, it might be 5% difference but not much, right?

Yes, I believe the main area that has really accelerated over the past few years is the sourcing benefits and the cost reduction in our operations, as Rodney mentioned. We've invested in digital initiatives to ensure we capture customers and reach the $10 billion business goal we've discussed. We recognized that there might be some inefficiencies in our model while doing this. One of the aspects we've improved is reducing the digital cost to serve our customers by leveraging greater efficiency at scale. This has provided momentum this year and was also beneficial last year and will continue to be part of our cost structure in 2022. That’s likely the main area that has changed somewhat over the past couple of years, but overall, I agree with Rodney that things remain fairly consistent.

John, Gary's last point to me is incredibly important. And everybody on the call, you've all heard us talk about job one is don't lose the customer as they switch to being a combination of digital and in-store. And then over time, we'll figure out a way to make that customer just as profitable as a customer that traditionally shopped in the store. So I think Gary's last point is really important.

Can you discuss how fuel rewards perform in an environment where the price per gallon may be approaching $4? How do they perform, and do you do anything differently? I don't think the program structure would change, but does your marketing change? It seems that in this environment, fuel rewards are much more important than they were a year or two ago.

Your belief and comment are correct. What we find is customers find it very helpful and as fuel prices go up, they engage in the fuel rewards more. Obviously, we continue to leverage fuel rewards in ways that make sense for different customer segments because different segments engage differently in fuel rewards. Obviously, we would prefer for fuel not to be at $3 or $4 a gallon, but we're going to do everything we can to help the customer stretch their budget as much as we can.

This is Spencer Hanus on for Greg. I just want to follow up on the FIFO adjusted gross margins for a minute. Did you see any change in the competitive environment that allowed you to pass through more costs? We know that Walmart's U.S. gross margins were up 54 basis points last quarter. So curious if that provided an opening for you guys. And then should we look at the fourth quarter performance as a good run rate for 2022?

Yes. I wouldn't say we noticed a significant change in the competitive landscape. Walmart is one competitor, but there are many others. Our focus is on balancing inflation while helping customers maximize their budgets. We've continued to invest in pricing in areas that are most important to customers. So, we don't view it as easier or harder; it's just part of managing the business as a whole. Looking ahead, I'll let Gary address that part.

Yes. Thanks, Rodney. Spencer, as you know, we don't tend to give detailed guidance on the puts and takes in gross margin rate and OG&A rate because we much more view it as how do we manage the business as a whole to drive sustainable earnings growth. I would say that I mentioned it in one of the earlier responses, that we would expect to continue to invest in the customer in 2022. And we'd also actually expect to see some accelerated advertising costs too because we're going to obviously continue to grow the business and we'll talk about it tomorrow, some of the digital growth opportunities that we're focused on as well. So I think as we look at the total year, we still expect some investment in gross margin in 2022, but we'd also continue to expect to see significant OG&A leverage as well in many areas through the cost savings that Rodney mentioned. And certainly, we wouldn't expect the gap between those two to be anywhere near as wide as it was when you look at the full year results in 2021. So I wouldn't take the fourth quarter as the sort of the number to use, but I would certainly expect us to be tightly managing those. And we do believe, as we mentioned in the prepared remarks, all the work the team has done around sourcing, connecting with customers and driving our strategy to deliver value for customers gives us confidence in the overall guidance that we shared for next year.

Got it, that's helpful. Fuel profitability has increased significantly compared to 2019, even with rising prices, which usually impacts profitability negatively. I understand you expect a slight decline in profitability this year. However, how sustainable do you perceive this improvement compared to 2019? Also, could you remind us of the operating profit the fuel business generated in the fourth quarter so we can better understand the core performance?

Sure. Yes, it's a great question on fuel. As you know, we talk about this each year, and we used to base our assumptions on a sort of a 3- to 5-year trend. And if you look at the last 3 to 5 years, really, fuel profitability has continued to improve pretty consistently as we look at the trends in our business and how our fuel reward program is connecting and what a great job our team has done in managing fuel margins. I do think there's a little bit of left pocket, right pocket in some of that, of course, as well because we spend a tremendous amount of money in rewarding customers, giving up to over $1 a gallon off for discount for customers that are highly engaged in the program. So I think it's important to remember that there are two dimensions to it, and we recognize that in our gross margin on the supermarket business and don't flow through on the fuel side because the redemption of those points is tied to when you spend at Kroger in the store online, not tied to specifically the fuel usage. So that's an important factor to remember. We believe that the fuel business has sustained improvement in profitability, so we're less focused on the historical trends now because we believe the industry has changed structurally. And we'd expect that to be maintained for us and also because of the strength in our value proposition with the customer. We don't specifically call out details on fuel and total profitability. I would say that actually, broadly speaking, the tailwind on fuel in the fourth quarter largely aligns with the headwind in LIFO, so the two of those pretty much offset each other during the quarter.

One other thing on fuel is that a couple of years ago, we restructured our fuel procurement team, and they have since made progress in terms of cost of goods compared to the market, which has benefited that business.

How much did inflation contribute to IDs in 4Q? And how much do you expect inflation to contribute to IDs in a year ahead? And as part of that, it does look like you're expecting IDs to still be positive in the second half of the year. Does that mean you expect this total number of new occasions in the second half of the year, number of new occasions at home, to remain positive?

If you look at what Gary mentioned, we expect inflation to moderate in the second half of the year as it cycles from the previous year's inflation. Overall, we thrive in all operating environments, whether inflationary or deflationary, and we're doing everything possible to reduce the impact on our customers. We anticipate the business will continue to grow, thanks in part to our seamless ecosystem. We are finding that we capture a larger share of household spending. Additionally, we had positive figures for total households in the fourth quarter compared to 2020 and 2019. Once we gain a new customer, we can gradually enhance their loyalty through the experience provided by our associates, the seamless ecosystem, good value, and personalized rewards. Therefore, we expect to effectively move these new customers up the loyalty ladder, which will also benefit our identical sales. Gary, do you have anything to add?

No, I think you covered it well.

My follow-up question is, Rodney, the percentage of gross units that are on promotion is still about 500 basis points below where it was prior to the pandemic. And prior to the pandemic, that metric for the industry has been very consistent over time. So why is it that the industry is just going to be less promotional moving forward than it has been in the past?

I don't have as much detail on the industry's situation. If you examine our revenue and promotional sales, they are quite similar to what they were before the pandemic. We monitor this regularly. During the pandemic, there were promotions we couldn't carry out due to supply issues with certain products, and we are cautious about promoting items without sufficient inventory. This situation still exists for some products. However, overall, our level of promotional activity is much like it was before the pandemic.

I think, Michael, just to add that I think that Rodney's comments are really what causes us to believe that when we talk to our customers and look at our data, we feel we're in a very good position relative to the value that customers receiving from Kroger in this environment and our ability to continue to deliver value for our customers and maintain a strong perception as customers continue to evolve into 2022 and beyond.

And one of the things that I think it's important to remember, we would track internally on sales on promotion, not items on promotion. So it's volume weighted as well, I think, is an important point too.

I wanted to ask you about labor because you brought it up on the call. But can you just provide a little bit more color on sort of like what's going on, on the labor front right now? I mean, you have a very strong history of being fair, right? Like I think if we take an objective view here, that seems to be the case. But as we saw with Denver, these renewals now can be costly and there are other big contracts coming up. I guess how has the dialogue been? It does seem like you're poised to see some acceleration of inflation. I wonder if you agree with that and if you can quantify. And then what are you doing to offset that pressure, things like automation, in addition to some of the cost save stuff?

Yes. When we started Restock Kroger several years ago, we committed to increasing our associate wages. As Gary mentioned, we are now investing about $1.2 billion each year to support our associates. We believe that supporting our associates is extremely important. Our goal is to ensure they receive solid, competitive wages and industry-leading benefits while keeping food affordable for customers. This requires a careful balance. We work with unions, but our priority is to maintain a sustainable business for the long term, which creates jobs and career opportunities. Approximately 70% of our store leaders began as hourly associates, and most department heads were once part-time hourly employees. This progression is vital to us. Several years ago, we decided to increase our wage investments, recognizing its importance. We have observed that investing in wages over time helps reduce turnover. Reduced turnover means that a seasoned employee will be more productive than a new hire. This ties into the cost savings that Gary and I discussed. We're continuously looking for ways to improve efficiency throughout the company because even small time savings can translate into significant savings overall. We have developed a strong capability in this area, which allows us to enhance our associate wages. Over the past four years, our average hourly rate has increased by 22%, all while significantly lowering our overhead and general administrative expenses.

Certainly. Here’s the rewritten Earnings Call remark: Yes. I want to emphasize a few points, Rodney. When Rodney mentioned the past four years and our investments, I don’t see this as the conclusion of our journey since we introduced our TSR model. We anticipated that we would continue investing in our associates and our model up until 2025 when we announced the TSR model with an expected growth of 8% to 11%. We always planned to keep investing from 2021 through 2025, so this has been part of our strategy. Admittedly, the past year has altered the landscape a bit, leading us to accelerate some of that thinking. We expect that 2022 will see a higher level of wage investments compared to 2021, which is factored into our guidance. The growth in wage investment is expected to persist, aligning with our TSR model. As Rodney pointed out, we are also increasing our capital investments in 2022, not just to catch up on delays caused by COVID, but to invest more in technology. Despite the impressive savings of over $1 billion in the last four years, we believe there are still significant opportunities to leverage technology to reduce costs further. This is one of the reasons we are enhancing our capital investments, as we believe it will foster ongoing efficiency improvements in the coming years while we invest in increasing average hourly rates. Mary Ellen Adcock will provide additional details on this when we meet tomorrow.

The first question I had was just around the ID sales that you reported. I was wondering if you could discuss what kind of cost increases you all were seeing in terms of a percentage and how much you were able to pass through. And then also what your outlook would be for that same basis for 2022?

The quarter showed consistent performance. In the fourth quarter, weather factors will have an influence. So far this quarter, the trends appear similar to the fourth quarter regarding ID sales. Most cost increases were passed on, but there were some exceptions within the department. It’s about managing the various factors related to cost increases while striving to lessen the impact on the customer.

And then I guess just the outlook for '22, like if we look at the U.S. FDA, they're calling for, I think, 2.5% to 3.5% full year inflation for this year. Is that a good benchmark for us to use without any better information, would you say?

Well, yes, we would be using the same data source. But we would expect within the year, it would be meaningfully higher in the first half versus the second half. But somebody on Gary's team probably got a PhD on the amount of time that he's spent on trying to estimate inflation. And at the end of the day, you basically end up in that spot. We would expect SNAP, just a pure number of SNAP households, to be a headwind. But what we find on SNAP is some people switch to buying items with credit cards, cash, and other things as well. And the other piece of our guidance would reflect in our health and wellness business. There's some third-party plans that weren't profitable that we also are going to move away from or have moved away from that's impacted our number on our guidance as well.

The only other thing I would add is that Rodney mentioned earlier in the Q&A that we are hearing from customers that although inflation in food is certainly higher, which we are all aware of, prices are increasing in various areas of the economy right now. A few months ago, customers expressed that they were consuming more food at home due to concerns around COVID. However, this sentiment has shifted. While food prices for at-home consumption are elevated, when considering other inflation increases, spending on food at home becomes more appealing as it helps manage budgets effectively. Many factors are influencing this outlook, and we are using the best information available to make our forecasts. We feel confident about the guidance we've provided and our ability to adjust our strategies if necessary. However, we understand that our predictions are not infallible, and we will continue to adapt our management approach accordingly.

Great. And just the follow-up question in terms of expense outlook was in light of the $1 billion-plus of gross cost-out, is there a certain kind of ID sales level that you would need probably to leverage that you could discuss? And how much vaccine contribution did you have in '21 that needs to cycle now in '22?

As Gary mentioned on the vaccines, that is something we factored into the guidance overall and it's just part of the total puzzle. We would also expect some of that to be offset because we're able to provide more of the regular vaccines that we always have. And some of that focus that went on vaccines, we'll be able to acquire additional customers to offset some of that. So all of that is factored into the guidance we gave. On the identical sales, right now, as long as we can continue to get the cost out, we're able to leverage a pretty modest amount of identical in terms of being able to leverage.

Yes, there's lots of puts and takes, as you heard us mention in our 2022 guidance overall, and we would expect there to be cost increases, obviously, from our investment in average hourly wage. And we continue to invest in the customer experience. But overall, factoring in all the elements of our model, we would expect to generate leverage and our OG&A rate would improve in 2022 over 2021 based on all the different pieces coming together in our model. So within 2022, specifically with that 2% to 3% IDs, we would expect to be able to improve the OG&A rate in the year.

I'll make it quick. Just to build on Ed's question. Can you elaborate a bit, if possible, on how we should think about the risk of labor this year? I was struck a little bit by how much time Gary spent on the subject and a little bit of the tone. It kind of felt like a warning to investors, frankly. So if there's any data you can provide on what percentage of your workers are up for renegotiation this year or whatever metric is appropriate, that would be great.

We take pride in our labor practices as one of the largest union employers in the United States. Our commitment is to continue investing in our associates, providing industry-leading benefits to help them build careers. Initiatives like tuition reimbursement support their growth and success. Our associates are key to our long-term viability, and we aim to ensure they can support their families. It's truly inspiring to hear stories from our associates, like one I recently heard at Ralph's about sending four children to college, with one becoming a doctor and another an attorney. These stories highlight the impact we have on our associates' lives.

And Ken, I think just one thing to add. We are obviously trying to listen to feedback carefully, and we've got a sense that there was a desire to hear more about our overall strategy. As we shared in the prepared comments, we feel really good about the investments we have made and are continuing to make in our associates. And we have a team that's very experienced in managing those relationships. But we wanted to make sure, as we had some feedback that you'd like more color, that we try and listen to investor feedback and wanted to make sure we addressed that in the prepared remarks.

Thanks, Ken. Thank you all for joining today's call. We are eager to connect with you again tomorrow during our business update in Florida. As I usually do, I would like to wrap up our call by acknowledging our associates who may be listening. I am incredibly proud of the achievements we have made this year, and we have celebrated many important milestones. Thank you on behalf of the entire team for making Kroger better every day. I am truly proud of you. As America’s grocer, Kroger is taking steps to demonstrate our support and solidarity with Ukraine. Today, we are providing emergency food assistance for refugees through a grant from the Kroger Co. Zero Hunger | Zero Waste Foundation to the UN World Food Program Ukraine Emergency Fund. We will match all donations made by our associates and customers up to $250,000. That concludes our fourth quarter earnings call. Thank you, and as I mentioned before, we look forward to seeing many of you tomorrow. Take care.