Kroger Company (KR) — Q3 2023 Earnings Call Transcript

Good morning. Thank you for joining us for Kroger's Third Quarter 2022 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 Company assumes no obligation to update that information. 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 1 question and 1 follow-up question, if necessary. I will now turn the call over to Rodney.

Thank you, Rob. Good morning, everyone, and thank you for joining us today. We're pleased to announce another quarter of strong results powered by our strategy of leading with fresh and accelerating with digital. Our associates continue to create a seamless customer experience, delivering fresh and affordable food anytime, anywhere with zero compromise on quality, selection, or convenience. Our associates' incredible dedication means we have momentum entering the fourth quarter, and we are continuing to consistently deliver a full fresh and friendly experience for our customers throughout the busy holiday season. It is clear that inflation remains top of mind for our customers and for our company. We are laser-focused on helping our customers by providing fresh and affordable food. Research shows cooking at home is still 3 to 4 times less expensive than dining out. And we are seeing more customers engage with our brands as a way to stretch their food budgets without compromising on quality. During the quarter, we continue to see many of the same shopping trends we observed throughout the year. In addition to higher engagement with our brands products, customers are downloading and redeeming digital coupons and continuing to showcase their cooking-at-home skills learned during the pandemic. Our breadth of choices, quality of fresh products, and the value of our personalized promotions are helping customers navigate the current environment, and our customer-focused approach is working. We continue to see overall household growth and significant loyal household growth, which drives a meaningful portion of our sales volume. We are proud to serve as America's grocer, especially during the holiday season. As friends and family come together, we look forward to providing our customers the perfect ingredients to create cherished memories. At a time when 48% of customers have told us they plan to cut back on their Thanksgiving celebration due to inflation, we took action and made sure Thanksgiving was enjoyable and memorable for everyone. To do that, we introduced an easy guide for customers to build an affordable meal of our brand's products with all of the Thanksgiving favorites that a family could enjoy for as little as $5 a person. This is just one example of how we create amazing quality at a great price when it matters most to our customers. We empower our customers to create lasting food memories by consistently executing against our go-to-market strategy focused on Fresh, Our Brands, personalization, and our seamless ecosystem. Fresh remains important in today's environment, and we are committed to bringing the freshest products to our customers' tables. Our Fresh for Everyone strategy is grounded in keeping products fresher, longer. Our end-to-end Fresh initiative is transforming these efforts. At the end of quarter 3, we have a total of 1,252 certified stores. At these locations, we see higher fresh sales and identical store sales. With these impressive results, we continue to roll out the initiative nationwide. As part of our end-to-end Fresh initiative is our supply chain, where we continue to invest and enhance operations. We are improving productivity and maximizing our fleet by controlling more product movement across our network. Most importantly, we are using our data and science to maximize freshness for our customers. Beyond our end-to-end Fresh program, we are bringing more Fresh products to our customers. During the quarter, Home Chef launched new plant-based ready-to-cook meals. They also collaborated with Kroger's in-house dieticians to launch our new simple and nutritious healthy meal kits. Home Chef continues to be an exceptional example of how Kroger's history of mergers helps bring new and exciting capabilities to meet our customers' changing needs across the country. Turning to Our Brands, we delivered another strong quarter in Our Brands with identical sales growth that outpaced overall identical sales. This was led by our Kroger and Private Selection brands. Customers continue to engage with the Our Brands portfolio, which offers high-quality products at affordable prices. Our Brands products are loved by every member of the family, including the pets. This quarter, we saw tremendous growth in our pet food brands as families continue to treat their dogs and their cats. As you know, they're like a member of the family. We continue to expand and diversify Our Brands portfolio at every price point. After launching Smart Way as our opening price point brand last quarter, we introduced several new Smart Way products this quarter and plan to roll out additional products next quarter. These products are meeting the needs of our customers on a budget, and we've already seen 2 million households purchase Smart Way products. In regard to personalization, our customers are looking for opportunities to save on the products they love. Our loyalty programs and personalized promotions allow them to do just that. We continue to use our leading data science capabilities to develop unique customer insights and offer targeted promotions on the products we know they love. This strategy is driving digital engagement with digital coupon downloads, 32% higher than last year. We anticipate these interactions will continue through the holidays with customers expected to realize more than $200 million in savings from our highly personalized digital offers. Moving on to Seamless. We're improving our Seamless experience that brings our customers fresh products anytime, anywhere with zero compromise on quality, selection, or convenience. We saw back-to-back quarters of strong digital growth led by our delivery solutions. This quarter, we introduced app enhancements that make it easier for customers to engage with our savings and promotions. We launched our first in-app flash sales and enabled our customers to clip digital offers directly from their cart. Improving the customer experience is always top of mind for us, and Kroger Pickup now offers 3-hour pickup lead times at all stores in our network, with as little as 1-hour lead time in some areas. We're investing in digital growth initiatives, including expanding our Kroger delivery network in new and existing geographies. We are also growing Boost, our one-of-a-kind membership program. This is the industry's most affordable membership program, and it is foundational to growing our delivery service. We are incredibly pleased with our customer response to Boost as we rolled out the program nationwide earlier this year. We continue to invest in our associates as part of our long-term strategy. In addition to investing in average hourly rates this quarter, we enhanced the benefits available to our associates. We expanded the eligibility for our 401(k) plan participants to encourage earlier commitments to lifelong savings, and we took steps to continue supporting working parents by increasing family lead time in our company-sponsored benefit plans. We are excited to celebrate amazing associates this quarter, who were recognized for their outstanding work and commitment to our customers. We were the most recognized employer for Progressive Grocer's GenNext honorees, with 28 of our young leaders recognized for driving change and innovation, both within the organizations and communities they serve. Additionally, our KEPASA Hispanic and Latino Associate Resource Group was honored by the U.S. Hispanic Chamber of Commerce as the Employee Resource Group of the Year. In summary, we are building momentum as we close out the year. We are excited to surprise and delight our customers this holiday season with high-quality fresh products at affordable prices, allowing customers to serve on the items that matter most.

Thanks, Rodney, and good morning, everyone. Kroger's relentless focus on delivering value for our customers was the foundation of our strong results in quarter 3. As Rodney mentioned earlier, our consistent execution of our go-to-market strategy is resonating with shoppers and driving increased customer loyalty. We were especially pleased with the balance achieved in our results this quarter as we continue to invest in our customers and associates, while also effectively managing costs to achieve solid earnings growth. These results provide yet another proof point of the strength of our value creation model and our ability to operate successfully in different environments. I'll now provide additional color on our third quarter results. Adjusted EPS was $0.88 for the quarter, an increase of 13% compared to the same quarter last year. This growth was driven by top-line revenue and our disciplined approach to balancing investments with effective cost management. Identical sales without fuel grew 6.9%. Our Brands continue to resonate deeply with customers as sales grew 10.4%. The outstanding quality and value offered by these exclusive Kroger products are an important differentiator in our go-to-market strategy, and this is especially true during periods of high inflation. As we shared at our Investor Day in March, Our Brands products are margin accretive and represent a key pillar in our strategy to grow profitability while also delivering greater value for customers. Digital sales grew 10% during the quarter, with delivery solutions leading the way, up 34% year-over-year. Delivery solutions include the Kroger delivery network powered by Ocado delivery from our stores via Kroger and third-party platforms and our convenience offering, Kroger Delivery Now. Our industry-leading Net Promoter Scores in Kroger Delivery are driving new customer engagement and best-in-class retention rates. Gross margin was 21.4% of sales for the quarter. The FIFO gross margin rate, excluding fuel, decreased 5 basis points compared to the same period last year. This result reflected our team's ability to effectively manage higher product cost inflation and shrink through strong sourcing practices while also helping customers manage their budgets and keeping prices competitive. During the quarter, we recorded a LIFO charge of $152 million compared to $93 million in the prior year. This was primarily driven by higher product cost inflation in grocery. We still expect to see some moderation in inflation during our fourth quarter as we cycle higher inflation from a year ago. Kroger's operating general and administrative rates decreased 3 basis points, excluding fuel and adjustment items compared to the same period last year. The decrease in OG&A rate was driven by sales leverage and execution of cost-saving initiatives, partially offset by investments in our associates. We continue to identify opportunities to remove costs from our business without affecting the customer experience and are on track to deliver our fifth consecutive year of $1 billion in cost savings. Kroger Health had another successful quarter, delivering higher-than-expected sales and profitability despite cycling the impact of higher COVID vaccine revenue from a year ago. We continue to see significant growth opportunities in healthcare, and our Kroger Health team remains committed to ensuring our customers obtain medically necessary prescriptions. Recently, we announced that we are terminating our Express Scripts agreement for commercial customers as of December 31. The Express Scripts contract would have required Kroger to fill our customers' prescriptions below our cost of operation, something we could not accept as we aim to keep our prices low for customers during this inflationary period. We expect this contract termination will reduce sales by about $100 million in Kroger's fiscal fourth quarter, impacting identical sales without fuel for the quarter by approximately 35 basis points. This decision is not expected to have an impact on operating profit or EPS. Included in our results for the quarter is an $85 million pretax charge related to the settlement of all opioid litigation claims with the State of New Mexico. This amount was excluded from our adjusted FIFO operating profit and adjusted EPS results to reflect the unique and nonrecurring nature of the charge. This settlement is not an admission of wrongdoing or liability by Kroger, and we will continue to vigorously defend against other claims and lawsuits related to opioids. This settlement is based on a unique set of circumstances and facts related to New Mexico, and Kroger does not believe that the settlement amount or any other terms of our agreement with New Mexico can or should be extrapolated to any other opioid-related cases pending against Kroger. It is our view that this settlement is not a reliable proxy for the outcome of any other cases or the overall level of Kroger's exposure. Currently, Kroger has 2 active matters pending in West Virginia and Texas scheduled for trial in 2023 and 2024, respectively. Kroger continues to believe that the claims are without merit and that it has strong defenses to these claims. Kroger is also differently situated from many of the other defendants in these cases. Our pharmacy operations have a much smaller footprint, both in terms of the size of the business and market share with respect to opioids, and we are proud of the outstanding work performed by our associates in delivering critical care and services to our pharmacy customers. Turning now to alternative profit businesses, which are a fast-growing and key part of our value creation model. The traffic and data generated by our supermarket business continues to create a flywheel effect for alternative profits, and growth this quarter was again led by retail media. CPG brands are finding significant value in our unique ability to build custom audiences that draw on our data to deliver precisely measured return on investment. Last month, KPM added a new channel to its suite of retail media solutions, welcoming Snapchat into the portfolio. Advertisers are now able to use Kroger's proprietary capabilities to optimize Snapchat's immersive ad formats. We are constantly innovating to expand our reach, and KPM recently increased its programmatic advertising marketplace capabilities to include video and one of the fastest-growing digital media sectors, connected TV. These new frontiers will provide exciting future growth opportunities for KPM. Fuel is an important part of our overall value proposition, and our fuel rewards program remains a key differentiator to help customers stretch their dollars during a period of high inflation. Fuel rewards engagement remained high during the third quarter and led to gallon sales, which outpaced the market. The average retail fuel price was $3.84 this quarter, versus $3.24 in the same quarter last year. And our cents per gallon fuel margin was $0.50 compared to $0.42 in the same quarter in 2021. The results we reported today would not have been possible without our incredible associates who continue to do an outstanding job executing our strategy and delivering a full, fresh, and friendly experience for our customers. We have a long track record of investing in our associates and are committed to continuing these investments to ensure Kroger remains an employer of choice. Building on $1.2 billion of incremental investments since 2018, we have raised our average hourly rates by over 5% so far in 2022. During the third quarter, we ratified new labor agreements with the UFCW for associates in Columbus, Las Vegas, Chicago, Fort Wayne, and pharmacists in Southern California, covering more than 28,000 associates. During the fourth quarter, we have also ratified new labor agreements for associates in Toledo and Nashville, as well as the Teamsters master agreement. Turning now to cash flow and liquidity. During the quarter, cash flow was affected by increased inventory balances. This was predominantly due to higher product cost inflation, particularly in grocery, in stocks improving to pre-pandemic levels, and forward buying of inventory in pharmacy. We are comfortable that our current level and mix of inventory is appropriate to support our future sales expectations and would expect to see an improvement in working capital during the fourth quarter. Regarding capital expenditures, we are committed to investing in the business to support our go-to-market strategy and continue to see many opportunities to drive future growth. As shared last quarter, various initiatives have been delayed due to supply constraints, and we now expect capital expenditures to be in the range of $3.2 billion to $3.4 billion in 2022. The net effect of higher inventory and lower capital expenditures for the year is that we continue to expect to generate free cash flow of $2.3 billion to $2.5 billion in 2022. In closing, I'd like to share additional color on our outlook for the remainder of the year. The Kroger team's consistent execution of our go-to-market strategy continues to build momentum in our business and gives us the confidence to again raise our full-year guidance. We now expect full-year identical sales without fuel of 5.1% to 5.3%, adjusted FIFO operating profit of $4.8 billion to $4.9 billion and adjusted net earnings per diluted share of $4.05 to $4.15, representing growth of 10% to 13% over 2021. This guidance assumes a LIFO charge of approximately $500 million for the full year, which represents a $300 million headwind over the 2021 LIFO charge. Our third quarter and year-to-date results highlight the strength of Kroger's value creation model, which has proven to be resilient in different operating environments. Looking ahead, we remain confident in our ability to deliver attractive and sustainable total shareholder returns, and we look forward to sharing detailed 2023 guidance during our fourth quarter earnings call in March. And now I'll turn it back to Rodney.

Thanks, Gary. The results we've shared with you today are a testament to our business model strength and agility to support our customers in all economic environments. This is made possible because of the hard work and dedication of our incredible associates. Before we open the floor to your questions, let me provide a brief update on our pending merger with Albertsons. As you may know, I had the opportunity and Vivek did as well to testify before the Senate Judiciary Subcommittee on antitrust, competition policy, and consumer rights this week. I shared with the senators that our merger will lower prices for customers starting day one, continued investments in our associates and stores, and customer experience and do even more in our communities than either company can do alone. We believe this merger will allow us to fulfill these commitments to our customers, our associates, and our communities well into the future. We are making early progress on our integration planning as expected and we continue to engage with all of our stakeholders and regulators. We are advancing our road map to close the transaction in early 2024. We look forward to working with the regulators as they review the transaction and do not have a substantial update at this time. We would ask that you focus your questions on our quarterly performance and our progress on our strategy. With that, Gary and I look forward to taking your questions.

Just wanted to follow up on 2 fronts. One was into the fourth-quarter guide; it appears that ID sales could be up around 4%. I just wanted to understand the deceleration there. Was that predominantly inflation and/or the Express Scripts? Or is there anything else to note? Can you share any start to the quarter information? And then I had a follow-up.

Yes. I'll start and let Gary finish it. Part of it is just cycling inflation from a year ago. We are beginning to now cycle the higher inflation a year ago. Gary, with that, I'll let you get into a little bit more asset-specific.

Thanks, Rodney. To confirm, the trend we've seen in the early part of the fourth quarter is consistent with our performance in the third quarter. Michael, regarding your question, you captured it well. As Rodney mentioned, we anticipate a rise in inflation in the last quarter of 2021, which we expect will affect the year-over-year growth in food at home during this period. We'll see how that unfolds. Additionally, we have considered the impact of the Express Scripts contract termination for January. Overall, our full-year guidance indicates we expect between 4% and 5% for the final quarter of the year.

Got it. And then just a follow-up on the margin implications. It looks like those could be flat to down slightly in the fourth quarter. So I just want to understand how do you see the competitive environment evolving? And then any cost initiatives that you could share with us there?

Relative to the competitive environment, we continue to see it pretty similar to how it's been throughout the year. All retailers are doing everything they can to minimize the impact on inflation to customers the best you can do. And we obviously would use our personalized and promotions that are directly focused on individual households because of things we know they love to try to help people stretch their budget. We're also, as I mentioned in the prepared remarks, seeing customers continuing to move to our brands. And in the past, what we find is when customers move to Our Brands, that's very, very sticky because the high quality of the product and the satisfaction there. So what we find is even when things are getting normalized, Our Brands come out of that at a higher penetration level than going in, which is long term good for our business as well. With that, Gary, I'll let you get into.

Yes. Thanks, Rodney. Just a couple of bits of extra color, Michael, on the fourth quarter for you. As you probably gathered from the guidance, it would be a lowest quarter for year-over-year growth in what we shared for EPS. I think a few things to bear in mind there. First of all, we'll be cycling the strongest quarter from last year. Last year's EPS growth in Q4 '21 was the highest growth that we had during the year. So we're cycling higher growth from prior year. We'd assume fuel margins will be flat during the fourth quarter. So no real headwind or tailwind there, where, as you know, fuel has been a tailwind for us in the last couple of quarters. And of course, as I mentioned in my prepared remarks, year-over-year, LIFO will be around a $100 million headwind in the fourth quarter of EPS because you may recall again that LIFO was only $20 million last fourth quarter. So that would be factors to bear in mind when you think about our EPS guidance. The only other thing I might mention is that you've heard me talk about on this call in previous quarters that when you look at our rolling 4 quarter sort of gross margin investment, somewhere between 10 and 20 basis points and OG&A leverage of 10, 20 basis points similarly to keep the business in balance. I would say that because we're cycling Q4 last year gross margin was relatively flat, and OG&A was relatively flat. So I would say you should probably expect our gross margin investment will be a little bit north of the 10 to 20 basis points in Q4, but our OG&A leverage should also be north of that 10 to 20 basis points as well.

Nice quarter. If you could talk a little bit about which categories did worse than inflation in terms of unit growth in which we're stronger on managing a lot of that was in the general merchandise. And also, Gary, could you comment on why identical sales growth, ex fuel was better than total sales growth ex-fuel?

Yes. In terms of the categories, the one you identified definitely would be the weaker category in terms of general merchandise. And that would be true at the Fred Meyer division, it would also be true across the rest of the organization as well. We continue to do well in those categories relative to the market. Our teams have done a great job of making sure they've been managing inventories relative to where the expectations themselves. The other categories that would be weaker than the total would be categories where we continue to have supply chain disruptions. Gary and I both mentioned, overall supply chain is getting better, but we still have categories like cat food, dog food, baby formula, and some of those types of cold remedies; some of those areas continue to have supply chain issues as well. With the identicals, Gary, go on.

Yes, thank you, Rodney, and thank you for the question, Chuck. The main part of this, in fact almost all of it, is that at the beginning of the year, we decided to stop dispensing certain drugs in our specialty pharmacy business because it did not contribute to overall customer loyalty in our larger business and it was not a profitable segment for us. We made this decision early in the year and adjusted it out of our internal data. Therefore, it's a direct comparison, but it does create a gap between total sales and identical sales. One of these instances is actually benefiting our gross margin as we make decisions to ensure we're optimizing the balance of the business.

Gary, I want to ask about the relationship between the LIFO charge and the FIFO gross margin moving forward. The FIFO gross margin has been strong. This year, there is likely a headwind of around $0.50 a share due to the LIFO charge. Assuming inflation decreases, will we be able to recover most of that LIFO charge? Should we simply add that back to our earnings, or is there something else we need to take into account when considering the FIFO gross margin? It seems some of this will still need to be reflected in pricing. I'm curious if the performance we've seen in the FIFO gross margin can be maintained when the LIFO charge lessens next year.

Thank you for your question, Ed. As mentioned on the call, we won't provide extensive details about our 2023 guidance because we prefer to present it in the broader context for next year. There will be many variables to consider as we approach March, when we can provide more information. However, the elements you mentioned will be critical in shaping the landscape for 2023. Regarding your question about gross margin, we are optimistic. We have strategies to effectively manage costs and sourcing, which will help improve our mix over time due to the ongoing momentum in our brands and opportunities for fresh performance and innovation. We believe we can achieve long-term stability in balancing gross margin, but there will be various factors to consider for next year. You noted the potential impact of inflation normalizing, which is accurate given the $500 million effect this year, translating to a $300 million year-over-year challenge since last year's LIFO was also inflated due to rising inflation in the fourth quarter. Remember, our LIFO charge is determined at a specific time of year, though we estimate it throughout. As we move into next year's guidance, we're assessing the same external views and analyst reports you are, particularly from sources like the USDA, which suggest inflation will be around 2.5% to 3% next year. We'll provide further insights as we finalize our outlook, but that's the direction most of the data is indicating.

Okay. And then just a quick follow-up. Fuel margins have been really strong. Some of your peers in the industry have mentioned that they might moderate next year. I'm curious if you agree with that perspective and how we should approach modeling this going forward.

I think it's important to look at the bigger picture rather than focusing on just one aspect of the model for next year. Fuel margins have certainly performed well recently, and overall, margins are improving over time. However, we've experienced significant volatility in the market over the past two years, making it difficult to predict future trends. If we consider margins from earlier this year, they may pose a challenge for fuel profitability next year. Additionally, as you mentioned LIFO, we're also seeing strong performance in our incentive plan, significantly exceeding our expectations, which has led us to raise our guidance each quarter. Next year, we anticipate a return to a more standard incentive plan based on typical budgetary expectations. We're committed to reducing costs and finding new ways to enhance leverage in our operations, which has been a focus of ours for the past five years. We believe that improvements in our supply chain and alternative profit sources could serve as positive influences next year as we enhance supply chain efficiency and continue to grow profits. There are many variables at play, and instead of trying to detail how everything will work together, we see it as a balance of different factors. We look forward to providing more insight in March next year.

Yes. I think when you look at Gary's points overall, it's one of the things that's so important about our overall business model because we do have a lot of moving parts, and we've invested a ton of work and effort our whole team has over the last several years to reinvent the business model and make sure the business model can be successful in every economic environment. And to me, Gary's point that he was sharing really highlight that as we look forward.

So the first thing I wanted to address is your market share. It appears to have stabilized and may even be growing slightly. Do you agree? What do you think is contributing to that?

Yes. If you look at market share, the trends continue to improve, and we feel good about where we are, but we're not satisfied with where we are. We believe the work that we're doing on Fresh is a key part of driving that. And obviously, just the continued personalization and making sure that we have a customer experience for its household to household type relationship. And then Our Brands always shines when an economic environment gets a little tougher. So it's really those things working together. And then our store teams continuing to do a good job of improving on friendliness. And I make that comment based on what customers tell us how we're doing, not just my opinion of how we're doing.

Great. And then my second question is a little bit more short term. I mean we've heard some retailers, not necessarily in the food industry, but some retailers that the consumers behave or kind of changed somewhat abruptly as we work through the fall. I mean, is that something you guys have seen? And if yes, do you think it's started to leak into the competitive environment?

Yes, that's a great question, Scott. When we speak with our customers, they're indicating that their purchasing habits are shifting, but primarily in areas outside of food. They continue to prioritize food, which ties back to a point I mentioned earlier. Eating at home remains significantly cheaper than dining out, and many people have learned to cook. If we examine the behavioral changes beyond the shift towards our brands and the increased use of digital coupons and promotional offers, that's the extent of what we've observed in our business. This is aside from my earlier comment regarding our overall operation, which is a smaller component of our business compared to many competitors. No. It's evident that across the country, the situation varies in different stages. However, overall, what we observe is quite similar to how it has been.

Rodney, I want to start with a big picture here. When do you think about growth in households? If you're projecting a 3% or 4% growth over the long term, what would household growth look like, and how would that relate to comp growth with those households? How do you approach that? Also, can you provide insights into your penetration with your deciles and identify where the biggest opportunities lie?

I will start and then Gary can provide additional insights. Looking at the long term, we base our business model on an inflation rate of 1% to 2%. Each year may vary from that, but we believe this range represents fundamental inflation over the long term. The last couple of years have diverged from this norm. As I mentioned in my prepared remarks, we saw strong growth in our loyal households this quarter, and the trend is moving positively. When customers transition into loyal households, we observe that over time, we capture a larger share of their growth. Our seamless experience—where customers can engage with us through delivery, in-store pickup, and shopping—is key to this. As our loyal households increase, we gain a larger share, which should positively influence our comparable sales growth in the future. This is why we highlighted it, and it is a major focus for us internally. Gary, do you have any additional insights that would be helpful for everyone?

I think you covered it well, Rodney. I guess the only couple of extra points, John, I would maybe add, I do think, as you know, our core strategy is to grow existing loyal customers and what was really pleasing in the quarter as we saw 2.5% growth in loyal customers. So we're seeing customers move through the loyalty curve, and that's always been carry the strategy to really deeply reward customers and grow that relationship. I think what we're also seeing, though, is that as Rodney mentioned, we're building that Seamless capability with digital, we are starting to now attract a larger number of households too, and the investments we're making in digital are creating that capacity to grow households as well. I think the one thing on the loyal house, as I would say, too, is what we saw during the quarter has seen the last couple of quarters is that maybe that more affluent customer that has shopped maybe a larger number of retailers before that's consolidated more of their trips and total basket with Kroger as they may not need to adjust their budget because of inflation, but they feel it's the sensible and responsible thing to do, and they see Kroger as a great place to get the right quality at a great value as well, and we're seeing that consolidation happen.

And just one more quick thing. Just conceptually, I know you don't want to talk about anything beyond this year, but you've raised the EBIT guide quite a bit right now you're up in the high 4s. When you look at '22, what was in there, maybe the good guys and the bad guys that kind of work against each other. I'm sort of wondering how sustainable is that new level of profitability? Again granted, the margin is not up as much as the dollars are. How do you think about that in terms of how representative of that performance is and what goes and comes next year off the P&L from this year?

John, as you know, we focus on managing our business based on revenue. For us, increasing revenue is essential for creating a sustainable business model in the long term. We believe that offering better value to our customers contributes to this sustainability, and the key to achieving that is through effective cost management and eliminating waste. This strategy remains integral to Kroger, and we anticipate that it will continue to resonate well with our customers over time. It enables us to invest in our associates and support our communities. When we successfully balance these three priorities, shareholders also benefit. This overview reflects our overall approach, and we strive to ensure that our actions are sustainable for the long term.

It's important to note my initial thoughts. I'm curious about the fact that this is the second consecutive quarter you have reduced your CapEx guidance. I understand your reasoning behind it. As Rob Moskow mentioned last quarter, you are not the only company facing this issue. However, at what point should we be aware of the potential impact on your growth due to your inability to expand as you would like? I'm interested in understanding how this might affect things in the near term, if at all.

Thank you, Ken. We're not particularly worried about the situation. While we had ambitious plans for capital expenditures this year to recover from last year's pace, we remain confident that the projects we have planned will deliver significant value and support our growth in the future. However, as we assess the expectations for the remainder of the year, we see that some large projects, especially in supply chain and certain stores, are taking longer to finish, and there are costs that we think justify a temporary pause until they become more reasonable. We don’t see this affecting our growth model significantly. Traditionally, our annual CapEx spending was around $3.2 billion to $3.3 billion, but we've increased that target to about $3.5 billion. That’s still likely our long-term objective, maximizing our total shareholder return model. We believe investing in the business remains crucial, and there are still numerous growth opportunities available. However, due to the delays in project completions caused by supply constraints, some projects are likely to carry over into 2023. Nonetheless, we don't currently foresee this impacting our growth strategy.

Got it. And then Rodney, I very much respect your request for us not to ask about the transaction. I won't ask about it. But I am curious, is there a plan ahead to sort of give updates to investors on a separate kind of form just because it's obviously such a big part of the story from here. I think people don't want a black hole or a vacuum of news. So I'm just curious what the plan is to kind of update investors on progress? Is it just you'll let us know during each quarter what's new, and that's kind of it? And then we won't have any Q&A around that. I'm just trying to get a sense of that kind of news flow from here.

Yes, that's a great question. We will manage this in a very transparent way. We included it in this quarter to provide context about what’s new. If there were any significant developments, we would communicate those between quarters. However, we anticipate that updates will mainly be provided on a quarterly basis. Our approach to disclosure is to consider what information would be helpful if our roles were reversed, and we strive to share that. Please feel free to give us feedback if anything feels off because we value your input.

Rodney, why wouldn't the grocery sector be more competitive and see more price competition in 2023 given that the consumer is going to be under pressure there are going to be your competitors who are going to want to try and gain some share given the potential distraction from the uncertainty of the merger with Albertsons? Many consumable retailers will have this LIFO gross margin benefit into '23, and there's going to be disinflation where at times, it could be easier to make price investments in an environment of disinflation than it is when there is an inflation?

Yes. It's essential to understand that we connect with customers in various ways, and Fresh plays a vital role in that. We anticipate that the market will become increasingly competitive over time, as it has for the past 25 years, and we intend to maintain our focus on this. That’s why we invest significantly in personalizing customer experiences and support our associates through pay, ongoing education, and other means, especially considering the current environment. Our approach of providing a complete fresh and friendly experience, along with competitive pricing and strong promotions, allows us to effectively connect with our customers. Furthermore, we expect our Fresh departments, which yield higher margins than center store, to continue growing. Our alternative profit businesses also have margins that surpass those of the center store. Thus, it's important to consider all these factors collectively over time, and we feel very optimistic about the business model we are continually developing and expanding.

Understood. My follow-up question is about the outlook for inflation. What feedback are you getting from your vendors regarding their inclination to raise prices in 2023? Gary, you previously mentioned that some forecasts predict 2.5% to 3% inflation for food at home next year. If no additional price increases were implemented from this point, how much inflation benefit would Kroger see in 2023 solely from the effects of the price increases already made this year? Additionally, when you mentioned 2.5% to 3%, will there be an additional 2.5% to 3% on top of that?

I will make a few comments, and Gary can provide some specifics. In our fresh departments, inflation is clearly slowing down in many categories, such as chicken, and we’re observing similar trends in other areas as well. I often say that high inflation solves high inflation because farmers tend to produce more when their margins improve. Currently, the situation with consumer packaged goods companies is mixed. Some of them are more willing to accept higher prices in exchange for giving up growth. When they do this, our brand strength allows us to gain market share, which benefits customers by helping them manage their budgets and enhances their loyalty to our brand. As the saying goes, all concise statements in economics can be misleading, so it’s important to consider all the moving parts. Gary, do you have anything to add regarding Michael's comments on inflation?

Yes, I believe you addressed it well, Rodney. As Rodney mentioned, we are indeed seeing Fresh begin to shift in response to inflation. The grocery category appears to be the most persistent in holding onto inflation levels currently. Looking ahead, if this trend continues without genuine cost increases, it presents a chance for us to enhance our margins and grow our market share over time. That’s generally how we view the situation.

I have a few straightforward questions. As we consider the comparable metrics or the ID figures for the latter half, could you clarify how much inflation contributed to the increase compared to tonnage? You mentioned your fresh initiative a lot; are those stores a factor in the increase? Additionally, we often discuss volume and tonnage in the food service sector relative to 2019. Can you provide insights into where you currently stand regarding volume or tonnage compared to 2019 levels?

Gary, I'll let you discuss the details on the IDs and then the foodservice after you finish with Health. I have some points to share there.

Okay. Great. Kelly, I think overall, we mentioned it in their prepared remarks somewhat as well. We've seen inflation starting to level. It's still obviously at very heightened levels. But if you look at the trend quarter-over-quarter, it really narrowed down to less than 1% increase in inflation in our Q3 versus our Q2. So what we were pleased about was in that context, the continued momentum in our overall ID sales when we look at our Q3 performance versus our Q2, and I think a lot of that ties to some of the prepared remarks that Rodney also shared around household growth that we're seeing and really some of the defying more share of wallet from loyal customers and seeing lower customer growth. So that's the piece that I think we've been the most pleased around. And we continue to perform really well with winning that first large basket with customers. We continue to see strong momentum there. And even as customers have continued to adjust their behavior as they kind of wrestle with inflation and decide how to balance budgets, we've been really pleased with how our overall pinning that first basket has continued to maintain strong momentum.

Yes. In foodservice, our volume is actually higher than it was in 2019. We see foodservice as an excellent option for easy-to-cook, easy-to-heat, and easy-to-assemble meals. This was a key reason for our merger with Home Chef, as we recognized its strong growth potential and thought their capabilities could enhance our meal offerings at Kroger, including restaurant-quality meals. For instance, we are the largest sushi restaurant in the United States and collaborate with many third parties and local entrepreneurs on products like sandwiches. We view foodservice as a significant part of our growth strategy, particularly looking beyond 2023. As we consider 2025 and the future, providing amazing quality meals that are convenient, along with leveraging our delivery and pickup networks, will be crucial for long-term growth.

I just had one question just on OG&A leverage. So this quarter, there was minimal leverage on a very strong comp, and that appears to be driven by wage pressures. So as you look forward to next year, just any insight in terms of how you guys are thinking about wage pressures at this juncture and whether you think the OG&A leverage point could be lower?

Thank you for the question, Rupesh. I’d like to provide a bit more detail about Q3 and Q4, as there's more to consider. You’re correct that we saw significant benefits from sales leverage and productivity enhancements during the quarter. The team excelled in managing costs despite the inflationary pressures we encountered. We also faced increased incentive plan costs and technology expenses compared to last year. We're directing investments into areas that show year-over-year growth, and some expenditures are shifting from capital to operating expenses as we transition more towards cloud-based activities. Additionally, as we did in Q2, we engaged consultants and advisory services to support future growth. Overall, the productivity improvements were more substantial than the quarter's results alone might indicate, and we remain confident in our ability to leverage OG&A and accommodate the average hourly rate increases we're experiencing. As noted earlier, for Q4, we anticipate a fairly flat OG&A rate, projecting over 20 basis points of leverage as we approach next year.

This is Kendall Toscano on for Robbie. I just wanted to see if you could give any more color on how traffic looked during the quarter. What kind of trends you're seeing with items in the basket and number of trips to the store? And then, I guess, as you're expecting inflation to moderate a little bit in the fourth quarter, what you would expect on those items going forward?

Yes. If you look at the overall trends in traffic, it continues to be improving. Obviously, the overall basket itself is heavily driven by inflation. But as I mentioned earlier, our trends on market share are moving in the right direction and continue to go in the right direction. In terms of the last part, I don't know, Gary, on inflation?

I think probably similar to what we shared earlier, I think overall, as we're looking at the way the customer is changing behavior, as Rodney mentioned, trips improving generally fairly consistent, I would say, over the year, but we are seeing higher trips from those loyal shoppers that have traditionally shopped in many different retailers for different categories and now seeing that trip consolidate to Kroger. I think is an important trend that we've seen throughout the year and continue to accelerate in the third quarter.

Yes, Gary, I think that's a great point, and thanks for the questions. And for everyone, thank you for joining us today. As always, I always like to share a few comments directly with our associates listening in because so many of our associates take the time to do that, which we appreciate. This is the time of year we truly shine. Our special holiday film made clear. We create the opportunity for our customers to transform today's holiday moments into tomorrow's memories. We've had the pleasure to hear from countless associates former associates and customers about just how touching this film has been. I know I can't watch it without getting a tear in my eye. And just reminding all of us how special it is to share favorite meals with those we love most. Thank you to our teams who put this together. Thank you for our teams who make the memories happen. It's a wonderful way to kick off the holiday season. As we all prepare together with our loved ones, I am so incredibly proud of our associates across the Kroger family of companies. We have accomplished so much this year. Thank you for the many ways you serve our communities and uplift our customers and each other. This concludes our call for today. We wish everyone a happy holiday season. Merry Christmas, Happy New Year and encourage you to stay safe. Thank you.