Kroger Company (KR) — Q4 2023 Earnings Call Transcript

Good morning. Thank you for joining us for Kroger's Fourth Quarter and Full Year 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. This morning, we released a presentation to accompany our call today, which can be found on our Investor Relations web page at ir.kroger.com. We encourage you to refer to these materials as Rodney and Gary will make references to the presentation throughout the call. During our prepared remarks, we will share our fourth quarter and full year results. We will update you on the progress our team has made since our Investor Day last year on our Leading With Fresh and Accelerating With Digital strategy. We look forward to returning to a full Investor Day in 2024, where we expect to share detailed plans for how we will achieve synergies and maximize shareholder value from our merger with Albertsons. 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.

Thank you, Rob. Good morning, everyone, and thank you for joining us today. I'd like to start by sharing how incredibly optimistic I am about Kroger's future. Our performance last year demonstrates how Kroger is consistently delivering for our customers, our associates and our communities and by doing so, creating value for our shareholders. Since announcing our Leading With Fresh and Accelerating With Digital strategy at our 2020 Investor Day, we have made tremendous progress against our commitments. As you will see from the chart on Slide 6 of the presentation deck Rob mentioned, we are delivering a fresh, affordable and seamless shopping experience for our customers with no compromise on value, quality, selection or convenience. We are advancing our purpose to feed the human spirit by significantly increasing associate wages and uplifting our communities. And we are delivering on our financial commitments through our strong resilient value creation model. With this strategy, we exceeded our financial goals and delivered attractive total shareholder returns during the past 2 years. In 2022, customer preferences shifted in response to inflation and macroeconomic uncertainty. Our customers were looking for more ways to stretch their budget. The gap between food at home and food away from home spending grew in the fourth quarter as more customers gravitated toward affordable meal solutions that restaurants simply can't provide. Our research shows that cooking at home is 3 to 4 times less expensive than dining out. And as Kroger was there for our customers, innovating quickly to meet their needs and wants, our nimble and customer-focused approach helped us deliver strong results in 2022, leading to total household growth and enhanced customer loyalty. We saw an especially strong response in our higher income households as this segment grew by 1.1 million households, further illustrating the resiliency in our model and strong value proposition we offer customers across all segments. Gary will get into the specific details of our 2022 financial results and outlook for 2023 a little later. Before doing so, I'd like to spend some time reviewing how each pillar of our go-to-market strategy provided meaningful and measurable customer benefits last year and how we will accelerate those benefits in 2023. The foundation of our go-to-market strategy is fresh, our brands, personalization and seamless. By delivering on these 4 pillars, our customers win and Kroger attracts new and more loyal customers. At the center of our go-to-market strategy is a superior customer experience. We deliver that by consistently providing customers a full, fresh and friendly experience. Kroger continued to demonstrate operational excellence in 2022 as we saw improvements in all 3 metrics. We believe our go-to-market strategy is creating a unique customer value proposition designed to perform in many economic environments. We will continue to invest in our pillars and the customer experience to differentiate the value we offer. First, leading with fresh. As an important influence on where customers shop, we are constantly improving how we bring even fresher food to our stores and e-commerce experience. Our end-to-end fresh initiative is changing the way our teams deliver on our commitment to freshness and we are incredibly pleased with this success. In 2022, more than 1,400 stores implemented the end-to-end produce solution, driving measurable increases in both fresh and total store sales. In 2023, we will continue innovating the fresh experience to drive customer satisfaction and improve our product mix. We continue to improve inventory management tools, strengthen our supply chain to deliver additional days of freshness and enhance our offerings to meet customer demand. As a reminder, our merger with Home Chef brought significant capabilities in in-store and restaurant quality meal solutions. We will be expanding our home chef production facilities to meet this growing customer need. Next, Our Brands. The Our Brands portfolio allows us to offer exciting products at great value while driving incremental sales and improving margins. Our Brand's quality and value proposition is especially important when inflation is affecting so many of our customers' lives. To meet the needs of customers on a budget, we launched a new opening price point product line called Smart Way. By consolidating and simplifying several brands into one, we are making it easier for customers while creating a point of differentiation across the full portfolio. We will continue expanding Our Brands to more categories with innovative product offerings. Our goal is to help every customer find high-quality, affordable products they love from pantry staples to fresh food to ready-to-heat restaurant quality meals. Now I'll move to personalization. Our data science teams are using predictive science to serve customers the right products at the right time and at the best value. Because we know our customers so well, we were able to provide recommendations to start their baskets and deliver personalized offers on the products most important to them, saving them time and money and making their lives easier. In return, our customers reward us with their trust and loyalty, consistently ranking us among the best at being able to offer personalized savings and solutions that meet their needs. In 2022, we grew loyalty as our customers more deeply engaged with personalized coupons and fuel rewards. As customers look for more ways to save, digital coupon engagement hit an all-time high during the year. Our combined paper and digital coupons helped save our customers more than $1.4 billion on products they need and want. That's on top of our everyday promotions and all the other value we offer. To provide even more value, we launched Boost, the industry's most affordable membership nationwide in July. Early results are exceeding our expectations with incremental engagement and overall household spend. We are evolving Boost with new benefits to further broaden its appeal and create additional customer value. In 2023, we will make significant investments to build out our personalization capabilities, including increasing the use of real-time data to predict customer needs, which will support sales growth during the next 3 years. Finally, turning to Seamless. Seamless is growing in importance among our customers, and we expect it will be a significant growth driver over the next several years. We have built a digital platform that offers a seamless shopping experience with no compromise, allowing customers to shift effortlessly between store, pickup and delivery solutions. As you'll see on Slide 12, our combination of stores and dedicated fulfillment centers positions Kroger to serve all customer trips from in-stock shopping to rapid delivery on needed now items to large stock up orders. Despite the easing of pandemic-related shopping behaviors that led to a significant increase in online shopping, more and more customers are incorporating e-commerce into their daily permanent routines, recognizing the value and convenience online shopping offers. We expect digital sales will continue to grow at a faster pace than overall food at home sales and believe Kroger is well positioned to deliver double-digit growth over the next 3 years. As we work to become the most trusted online grocery destination, we are focused on 4 key areas that will position us to deliver that growth. We start by providing a compelling Kroger owned digital destination, where we offer customers exceptional value, personalization and freshness in a single, easy-to-use online experience. Second, we are focused on delivering best-in-class fulfillment, driving trust and loyalty by exceeding expectations for quality and freshness. Our delivery approach is unique in the fact that we have a large store network conveniently located close to our customers and large dedicated fulfillment centers designed efficiently to pick large orders. Our dedicated fulfillment centers provide the most reliable experience, the highest in-stock levels, best on-time delivery and one-of-a-kind white glove experience with industry-leading Net Promoter Scores. Kroger delivery customers are more engaged across our entire ecosystem, spending more and shopping with us more often. Looking ahead, we will continue to learn through our customer fulfillment network with a focus on driving profitability and efficiencies to ensure that we are well positioned to deliver sustainable, profitable growth while delighting our customers. Next, we are focused on reaching new customers and adding more shopping occasions. Our delivery network allows us to offer enhanced service to new customers, and we will also grow our share of wallet by increasing the number of orders customers place with us. Solutions like Kroger Delivery Now enabled by our vast network of conveniently located stores can connect customers to fresh groceries and household essentials in as little as 30 minutes. This seamless ecosystem makes any shopping experience simple for our customers. Finally, we are driving our profit flywheel and improving margins by reducing our digital cost to serve and growing our alternative profit streams. To accomplish this goal, we are lowering fulfillment costs, building the density of demand and last mile routing, engaging directly with our third-party vendors and growing digital retail media. Now let me share how we are accelerating growth in our model through alternative profits. During the last several years, we invested heavily in technology to transform our business and enter new high-growth and high-return businesses. These businesses contribute meaningfully to our results with alternative profit businesses achieving $1.2 billion in operating profit in 2022. Kroger Precision Marketing is one of our fastest-growing businesses and is well positioned to win within the U.S. retail media landscape, which is projected to be a $55 billion industry by 2024. What makes our retail media business special is our ability to help brands achieve a greater return on their media investment. For the fifth year in a row, KPM was recognized as a leader in the retail media space by the Path to Purchase Institute, which collects feedback from those closest to the retail media networks and accessing their effectiveness. KPM was recognized as a leader for many of its capabilities, including maintaining its leadership in targeting and measurement capabilities, a testament to the strength of our unique product offerings and the insights we bring to this emerging landscape. Our associates enable our success, and we are committed to investing in theirs. To remain an employer of choice, we support our associates' development and holistic well-being. We provide our associates with the tools they need to grow their careers that they want at all stages. In 2022, Kroger was named a Best Place to Work in IT for the fifth consecutive year and a best place to work for disability inclusion for the third year. We also continue to support our associates through investments in wages and comprehensive benefits. In 2022, we raised our average hourly rates by more than 6% and have now invested an incremental $1.9 billion in associate wages since 2018. Our average hourly rate is now more than $18 and more than $23 when you include comprehensive benefits. We are committed to sustainably increasing associate wages and plan to invest more than $770 million in associates in 2023. We value and respect our associates and investing in their success is just one way we demonstrate that. We take seriously our role in helping to create healthier and thriving neighborhoods across the country. The centerpiece of our efforts is Kroger's Zero Hunger | Zero Waste social impact plan, an industry-leading commitment to build communities free from hunger and waste. Since launching Zero Hunger | Zero Waste, we have made continual progress toward our goals. We have directed more than $1.65 billion in food and funds to help end hunger, including donating more than 2.3 billion meals. We are making progress on our carbon emissions reduction plan and our brand's sustainable packaging goal. I'm especially proud of our incredible associates who helped us reach a key milestone this year with 100% execution of our surplus food rescue programs across each and every store across the company. Looking ahead, we will continue to focus our efforts on our ambitious goal of ending hunger in our communities and eliminating waste, especially food waste throughout the company. In summary, our proven go-to-market strategy led to enhanced loyalty and household growth as we help customers manage the effect of inflation in 2022. We are well positioned to sustain our momentum into 2023. And with that, I'll turn it over to Gary to take you through our results and expectations for 2023. Gary?

Thank you, Rodney, and good morning, everyone. Before jumping into our 2022 results and sharing our outlook for 2023, I'd like to take a step back and remind you how Kroger's value creation model is enabling the company to deliver sustainable value for our shareholders. We believe our value creation model has been a key to delivering consistently strong results over the past four years and is positioning Kroger for growth in years to come. The go-to-market strategy that Rodney outlined earlier is the foundation of our model. Over recent years, we have invested significantly in our people, our customers and technology to create a leading omnichannel position in food retail. By executing our go-to-market strategy, we win customers in our core supermarket business, including health and fuel and drive significant customer traffic and data into our ecosystem. This, in turn, allows us to deploy our investments in technology and 84.51° to deliver even greater value for customers and create new high-growth, high-margin alternative profit businesses. The value generated from these businesses enables us to reinvest back into our supermarkets and drive further store and digital traffic, creating a flywheel effect. We are evolving from a traditional food retailer into a more diverse food-first business that we believe can deliver sustainable future growth and succeed in a variety of operating environments. As a reminder, since introducing this model in 2019, we have achieved consistent returns for our shareholders that have significantly exceeded our TSR commitment of 8% to 11%. As you can see in the table on Slide 19, over the past three years, Kroger has achieved more than 19% compounded annual growth rate in adjusted FIFO net operating profit and approximately 25% compounded annual growth rate in adjusted EPS. Over this same time period, we generated adjusted free cash flow of approximately $9.7 billion and have returned a total of nearly $5.8 billion to investors via dividends and buybacks. Overall, we have delivered nearly 3 times the expected return from our TSR model over this three-year period. Importantly, at the same time, we continue to invest in the business to support future growth. This included improving our price position relative to key competitors since the start of the pandemic, increasing associate wages and benefits by 34% since 2018 and increasing the amount of capital investments allocated to technology and digital capabilities to enable top-line growth and margin expansion. Our strong performance and progress with our model in recent years also gave us the financial flexibility and confidence to announce our proposed merger with Albertsons. Upon closing, which is anticipated to be in early 2024, we believe the merger will significantly accelerate our go-to-market strategy and deliver TSR well above our stand-alone model during the first four years post-close. I'll now walk through our full year 2022 financial results. Kroger delivered adjusted EPS of $4.23 per diluted share, an increase of 15%. We achieved identical sales, excluding fuel of 5.6%. The FIFO gross margin rate, excluding fuel, decreased 9 basis points. This reflects the outstanding work of our merchandising and sourcing teams who are extremely effective in managing higher product cost inflation while maintaining competitive prices and helping customers manage their budgets. The OG&A rate, excluding fuel and adjustment items, decreased 19 basis points, reflecting sales leverage and cost-saving initiatives, partially offset by planned investments in associates. And I'm delighted to say for the fifth consecutive year, we delivered cost savings of $1 billion in 2022. Adjusted FIFO operating profit was $5.1 billion, an increase of 18% from last year. And the LIFO charge for the full year was $626 million compared to $197 million in 2021. Turning now to our fourth quarter results. Adjusted EPS was $0.99 for the quarter, an increase of almost 9%. We saw continued momentum in our identical sales without fuel of 6.2%. Underlying growth would have been 6.7% after adjusting for the effect of Express Scripts. Our Brands contributed another strong quarter with identical sales of 10.1%, reflecting the growing importance to customers of these exclusive to Kroger products. And digital sales also accelerated during the quarter, up 12%, led by 22% growth in Delivery Solutions. Kroger's FIFO gross margin rate excluding fuel decreased 1 basis point and the OG&A rate excluding fuel and adjustment items decreased 56 basis points. Fuel remains an important part of our overall value proposition. Our loyalty program, which can save customers up to $1.25 per gallon has been one of the many ways we have helped customers stretch their dollars over the past year and contributed to our gallon sales outpacing the industry during the quarter. The average retail price of fuel was $3.39 compared to $3.30 in the same quarter last year. Our cents per gallon fuel margin was $0.51 compared to $0.44 in the same quarter last year. Adjusted FIFO operating profit was $1.27 billion, a year-over-year increase of 26%. And the LIFO charge was $234 million in the fourth quarter, reflecting sustained higher product cost inflation, particularly in grocery. This compares to a charge of only $20 million in Q4 last year. Included in our fourth quarter results was a $164 million goodwill and fixed asset impairment charge related to Vitacost.com. The talent and capabilities gained through the merger with Vitacost in 2014 have been key to advancing Kroger's digital platform and growing our digital business to more than $10 billion in annual sales. As our digital strategy has evolved, our primary focus looking forward will be to effectively utilize Kroger store pickup and delivery capabilities, and this reprioritization resulted in the impairment charge. Vitacost.com will continue to operate as an online platform, providing great value, natural, organic and eco-friendly products for our customers. Adjusted free cash flow for the year came in $800 million lower than anticipated. This was entirely due to movements in working capital towards the end of the year. The cause was a combination of factors including higher inflation affecting inventory, some forward buying to protect margins and timing of accounts payable and third-party receivable payments around the year-end. As shared last quarter, we feel comfortable with our overall level of mix of inventory, which is higher due to heightened levels of inflation and in-stocks returning to pre-pandemic levels. Looking over a 5-year time horizon and smoothing the volatility in working capital experience during the pandemic, we have seen an underlying benefit from working capital over this time period, and we would expect to see further improvement going forward. We remain confident in our ability to generate strong free cash flow. And as shared in our guidance this morning, we expect to achieve adjusted free cash flow of $2.3 billion to $2.5 billion in 2023. Turning now to financial strategy and capital allocation. We will continue to be disciplined with our capital investments, prioritizing the highest growth opportunities that strengthen our business and deliver solid returns for our shareholders. As you saw in our guidance this morning, we are anticipating capital investments of $3.4 billion to $3.6 billion this year, which is consistent with our long-range TSR model. Our priorities for 2023 are aligned with our value creation model and are expected to drive future sales growth and margin expansion. To drive sales, our focus is on enhancing our store and digital ecosystem. We apply a data-driven approach to make decisions on a store-by-store basis, prioritizing store formats and locations with the highest growth potential. Additionally, we are continually enhancing our seamless experience including investing in technology to improve the customer proposition and augmenting personalization, which will, in turn, create additional alternative profit opportunities. We continue to invest in areas of the business that will drive operating margin expansion, including enhancements to our supply chain capabilities. These investments help improve margins and differentiate our fresh offering. And finally, an essential element of our value creation model has been our ability to take costs out of our business. We remain focused on eliminating waste in areas that did not affect the customer experience and we are making investments in technology to improve store productivity, lower digital fulfillment costs and reduce waste and shrink. These improvements will drive an incremental $1 billion of cost savings in 2023, which would mark our sixth year in a row of delivering $1 billion of savings. In closing, I'd like to share some additional color on our expectations for 2023. While there is still uncertainty regarding the economic outlook, our go-to-market strategy is resonating with customers, and we believe our successful value creation model positions us well to navigate evolving market conditions. Before I go into the details of our 2023 guidance, there are a couple of unusual factors that I'd like to highlight. First, Kroger's decision to terminate our agreement with Express Scripts in December of 2022 is expected to have a negative impact of 150 basis points on identical sales without fuel. This decision is not expected to have a material effect on profitability. Second, 2023 will include a 53rd week. We expect the effect of this extra week at approximately $0.15 to our adjusted net earnings per diluted share for the year. With that important context, we expect to achieve identical sales without fuel of 1% to 2% in 2023. Excluding the effect of Express Scripts, our underlying identical sales without fuel growth is expected to be between 2.5% and 3.5%. We expect to achieve adjusted FIFO operating profit of between $5 billion and $5.2 billion and adjusted net earnings per diluted share of between $4.45 and $4.60, including the expected benefit of the 53rd week. We expect to grow revenue by continuing to invest in our customers through competitive pricing and personalization and providing fresh products and a better shopping experience across our store and digital ecosystem. We will fund investments in gross margin in 2023 by improving our product mix as we accelerate momentum with our Fresh and Our Brands initiatives and by growing our alternative profit businesses. As Rodney mentioned earlier, we will also continue to invest significantly in associate wages and this will be funded by our planned cost-saving initiatives. While we believe fuel margins will remain structurally higher than historical averages, fuel profitability is expected to be a headwind to our model in 2023 as we lap historic fuel margins from last year. Our 2023 guidance assumes a LIFO charge of between $300 million to $350 million as a result of lower product cost inflation compared to 2022. While this amount is well above historical levels, LIFO is expected to be a year-over-year tailwind and should more than offset lower fuel profitability. In terms of quarterly cadence, we expect identical sales without fuel to be above the top end of our guidance range in the first half of the year as we continue to experience heightened levels of inflation. In the second half of the year, we expect identical sales without fuel to be at or slightly below the bottom end of our range as we expect inflation to taper later in the year. We expect adjusted earnings per diluted share in quarter 1 will be slightly negative year-over-year as we cycle 22% growth in EPS from Q1 last year. Quarter 2 and quarter 3 are expected to be within our annual guidance range and quarter 4 is expected to be above our guidance range as we cycle the higher LIFO charge in '22 and benefit from the 53rd week. As you know from Rodney and myself this morning, Kroger is operating from a position of strength and the investments that we have made in our go-to-market strategy provide exciting opportunities for future growth. Our team is energized by these opportunities and we believe Kroger is well positioned to continue to deliver attractive and sustainable returns for our shareholders.

Thanks, Gary. Before we open up the floor to your questions, let me provide an update on our pending merger with Albertsons. During the past few months, we've spent time getting to know Vivek and the Albertsons leadership team. We are incredibly impressed with their talent, culture and commitment to their customers and communities. We look forward to bringing together our 2 highly complementary organizations to provide customers with lower prices and more choices while realizing the long-term value we expect this merger will deliver. We are working cooperatively with regulators responding to the Federal Trade Commission's second request and in discussions about the transaction, while also working to identify potential buyers for the stores we expect to divest to obtain clearance for the transaction. We are pleased with the level of interest received thus far, and we'll work towards finding a solution that benefits all stakeholders. We remain on track to close the transaction in early 2024. During the quarter, we launched our integration planning efforts with the goal of preparing for a seamless cultural and operational integration. We expect to create customer benefits beginning day 1 post close. The integration team is developing work streams with clear objectives and milestones to deliver value for our customers, associates, communities and shareholders. We are pleased with the progress we've made to date, and we'll continue to provide updates as we have them. We achieved exceptional results in 2022, building on our record years in 2020 and 2021, and we exceeded our commitments in our Leading with Fresh and Accelerating with Digital strategy. Our folks strategy focusing on our customers, our associates and our communities is working. Our customers are telling us that we're doing a better job serving their needs. We continue to improve our associate wages and comprehensive benefits with a 34% increase in the last 5 years. And we are helping to create healthier thriving communities through our Zero Hunger | Zero Waste work. We believe our momentum is sustainable and will only accelerate upon the completion of our pending merger with Albertsons.

Rodney, I wanted to start with the beginning of a new year. As you consider your consumer segments, what is the wallet share opportunity from the average consumer to your most loyal customers? In conducting a gap analysis, where do you see the gaps? Is it in the fresh category? Where are the significant areas where the average consumer is spending less than your most loyal customers?

Thank you for the question, John. We always approach this from the perspective of overall business opportunity. Even in areas where we perform well, there's still significant potential for growth. Our most loyal customers still allocate 30% to 50% of their spending to competitors, which presents a chance for us to strengthen our market position. In terms of Fresh, we have a larger market share compared to other segments, and we excel in this area relative to our competitors. Our strategy focuses on catering to all customer segments by emphasizing Fresh and value, without compromise. Customers on a budget can save 7% to 10% by choosing Our Brands instead of national brands. Additionally, our Home Chef offerings allow customers to enjoy meals for one-third to one-fourth of the cost of dining out. All these factors together indicate that our target market consists of value-conscious shoppers, with the importance of Fresh and friendliness playing key roles in their decisions. This is where we excel and find opportunities for growth across various markets in the U.S. Our strategy aligns with this focus, and technology aids in enhancing the customer experience.

Great. Secondly, when considering the impact of Express Scripts, how much of that is related to pharmacy and how much is not? You've mentioned before that pharmacy customers tend to be the most loyal. How do you feel about potentially losing visits because of this? Additionally, we possess data on who the Express Scripts customers are, which allows us to conduct targeted outreach to ensure we maintain those household visits.

If you look the numbers that Gary provided by far, the majority of that's pharmacy. Our teams are doing great work on using our discount cards to be able to help customers identify other alternatives. And in fact, in many cases, they're saving money. We're also going directly with some other companies to provide the benefit rather than going through a PBM. So by far, the majority of the estimate that Gary provided is pharmacy. And we're using the things that you said to make sure that we don't lose that customer connection and we don't lose the trip to the grocery store. I don't know, Gary, anything you want to add to that?

I think you said it well, Rodney. I think that John described it, but work the team has done around using our data and personalization to make sure we're protecting the customer. We think it's working.

Thanks for all the color. A question for you to start. Rodney, just kind of big picture. We're coming off of an inflationary cycle that really none of us have ever sort of seen before. And obviously, there are a lot of implications associated with that. But as you look forward into '23 and sort of thought about providing guidance, how do you think the industry is going to evolve off of the heels of that? Meaning what's the level of inflation that you've embedded within your ID guidance of 2.5% to 3.5% ex Express. How do you think about like the promotional backdrop and how that changes? Are you happy with your underlying tonnage for instance or volume given what's happened with pricing and what we've seen with comps at some like value players like Walmart, et cetera. Just kind of curious, is that how all of that played into the way you're thinking about guidance?

Yes. We expect inflation to be higher in the first half of the year compared to the second half, which aligns with the quarterly insights Gary provided. We're particularly pleased with how well our value proposition resonates with higher-income customers, leading to significant growth in that segment. It's important to note that this customer group contributes more to our profitability because they tend to purchase a broader range of products, including more fresh produce and items from our deli and bakery sections. Overall, we’re pleased with our connection to customers and our improvements in fresh offerings. We remain committed to enhancing our performance and are excited about the opportunities ahead. We believe there is still room for improvement. Gary, would you like to share the specific inflation assumption, as it covers a wide range throughout the year?

Sure. Yes. Thanks, Rodney. Thanks for the question, Ed. From an inflation perspective, what we're seeing at the moment is that we've seen in the last couple of quarters, inflation has really sort of stabilized. And what we're starting to see is in the Fresh categories, sort of deceleration of inflation, but grocery has remained pretty stubborn in terms of the levels there. So we're assuming, as Rodney mentioned, in the first half of the year that a gradual decline, probably grocery remaining fairly stubborn where it is today, but some of the Fresh categories continuing to show some deceleration. And then we're expecting sort of towards the end of the year that we get to sort of between low and mid-single-digit inflation level rates about sort of 4% to 5% would be our assumption around where we think inflation starts to come down to in the way that we build our assumptions for the year. And obviously, Our Brand...

Okay, just a quick followup...

Go ahead, Ed.

Got you. Just a quick follow-up, Gary. What is the FIFO gross margin outlook for 2023? I think there is a decent impact linked to Express, considering there is no P&L impact from losing the comp. How are you assessing FIFO gross margin excluding fuel in 2023?

We typically do not provide extensive specific guidance, but generally, our model is well-balanced and aligns with our performance in 2022. Regarding gross margin, we will continue to invest in customer value areas that matter to them, such as pricing and promotions, while rolling out Boost, which may present a short-term challenge as we build customer loyalty and derive longer-term benefits. We anticipate continued positive influences on our gross margin rate as we execute our go-to-market strategy. This includes exploring alternative profit streams and improving our Brands penetration, which supports gross margin. Overall, we expect a balanced year with significant investment in customer experience. As our model matures, we are now better at achieving gross margin improvements while managing these investments. From the perspective of Express Scripts and our efforts with Kroger Specialty Pharmacy, we are focusing on profitable growth in our health and wellness sector, which might create a slight tailwind of around 10 basis points for gross margin but also a similar headwind for operating, general, and administrative expenses. Overall, this results in a net neutral effect on operating profit, but it does alter the perception of our overall business model.

My first question is somewhat similar to Ed's. Looking at the FIFO EBIT guidance for 2023, it essentially appears flat compared to 2022. If we categorize the business into core, alternative, and possibly gas as profit pools, can you provide insight into how we reached that roughly flat EBIT year-over-year?

I would say, Simeon, that there are three key factors to consider regarding our overall guidance. First, the addition of the 53rd week contributes approximately $0.15 to our earnings per share, translating to around $9 million to $10 million or about $150 million in total. Second, fuel costs are expected to be a headwind, roughly in the $200 million to $250 million range. Lastly, our core supermarket business continues to grow year-over-year, with its performance more than offsetting the impact of the 53rd week. We are executing our value creation model well, expecting underlying sales growth between 2.5% to 3.5%. Since the Express Scripts business hasn't added to our bottom line, we remain focused on customer investment and driving efficiencies to improve our overall mix. While I won't break down the individual components in detail, we view all profit as part of an integrated ecosystem, as media revenue relies on the success of our digital supermarket business.

Right. And then as a follow-up on the backdrop regarding pricing inflation, it seems like the backdrop is maybe more oligopolistic than one would have thought, not that it's not competitive out there, but in terms of price and wondering what that's a function of and maybe what could disrupt it? Is that a fair assessment?

We certainly perceive the situation differently. Over the past two decades, we've consistently invested in pricing and plan to continue doing so. We achieve this through process improvements and by identifying areas to reduce costs. Many of our promotions are now more personalized for the customer, which goes beyond just what is displayed on the shelves in stores. A substantial part of the value we deliver to our customers comes from fuel rewards and tailored offers that utilize technology and digital tools to create individual experiences. Therefore, we wouldn’t describe it that way. We recognize that every year is extremely competitive, and everyone is striving to improve, ultimately benefiting the customer.

Between the comments that you had indicated at the early start of the call, where you're working on the profitability of your digital business, along with what it sounds like a slowdown in the rollout of your Ocado shed this year, have you evolved your thinking on the long-term profitability of digital sales for Kroger because you had previously indicated that you expected the incremental margin on an incremental dollar of sales to be at or above an in-store dollar of incremental sales.

When you look at our digital business long term, we wouldn't see the profitability be any different in this supermarket when you look at it over a longer period of time. And if you look, what we find is a customer when they move online, they actually after a year engage with us more in-store than before. So what we're really focused on is having an ecosystem where the customer thinks food, they think Kroger. And what we're finding is the customer routinely moves back and forth between the different channels. If you look at each piece of it, every single day, you're working to figure out ways to improve processes and take costs out. And then on top of it, obviously, retail media is an important part of the driver. So when you look at it long term, we really see no change in the opportunity and potential. We're incredibly excited and everything that we see, we think it will be more important in 3 years, 5 years, 10 years to have where the customer engage with us through multiple ways. And the digital channel is a critical part of that, and we find the customer engages with us digitally, even when they don't shop digitally. So for us, we see it as exciting as we did before. We don't see the long-term profitability being different. And we're working continually in terms of both internally and with our partners on how to improve processes.

To add to Rodney's long-term perspective, I would say that we are witnessing benefits reflected in the profitability we discussed in previous investor meetings. Currently, if you look at our digital business, particularly through store delivery, we have achieved our best quarter ever for the cost to serve a digital order in the fourth quarter of 2022. Rodney pointed out media revenue, which is increasing per digital transaction. These are two major factors driving digital profitability, and we continue to see improvements in 2022, with expectations for further enhancements in 2023, contributing positively to the financial model I described earlier. We are committed to this path and are making solid progress.

And Gary, could you clarify why the rollout of the Ocado sheds is slowing down? Also, regarding ID sales, do you expect unit erosion by the end of the year given that we're forecasting slightly below the low end of our range with low to mid-single-digit inflation? Groceries are becoming more expensive, and in this challenging economic climate, there is a likelihood that consumer spending may decrease further. We want to ensure that you have considered some cautiousness in your outlook.

Sure. Thanks, Mike. I'll try and be brief on those two. So I think just to clarify on the first part of the question, I was describing the majority of our digital business today. So think about pickup through the stores, think about the work that we're doing in delivery to customers today. And when we share that doubling our digital profitability, that was based on those metrics. And so how do we improve the cost to serve, how do we improve digital media revenue. On the customer fulfillment centers, we're very much in the middle of that journey right now of sort of 18 months or so into those first two facilities, really kind of fully understanding the scale of demand to how the customers behave and how you optimize that model. So I'd say more to come on that as we continue to understand that sort of key phase of those first two facilities really seeing the progress there on profitability. But from a customer demand, the customer experience, we're seeing all the sort of things we have hoped to have seen around customer engagement.

And we are actively looking for sites for some preannounced locations too on those and finding the sites ended up being a little bit more difficult than what we would have expected.

In response to your second question, Michael, it's important for us to maintain flexibility. We believe we have designed our model to adapt and provide value to our customers. We shared some directional numbers regarding inflation due to the LIFO calculation, but our goal remains to continuously enhance the value we offer to customers, grow our market share over time, and ensure we meet customers where they are. We anticipate that the second half of the year will present some unpredictable challenges, so we must stay nimble and agile to adjust accordingly, as there will certainly be changes ahead.

And we feel good about our overall model being able to adapt in any situation in any market because we give a great value for the customer regardless. Thanks for the question, Michael.

You mentioned that one of the reasons why working capital was higher than usual in the fourth quarter is that you were buying a little bit ahead to protect margins, I assume as inflation rises. Two underlying questions here. First, was this mainly in the grocery department. You talked about grocery being particularly tough in terms of inflation. And then maybe more importantly, I'm just curious, is there going to be an offset to this in the first quarter, maybe as you run through that higher-than-usual inventory, I guess I'm really just trying to ascertain if you're going to buy less than usual from some of your grocery vendors next quarter or this quarter.

Thank you for the question, Ken. From our viewpoint, the primary forward buying will focus on pharmacy and some in grocery, as these areas present good opportunities to protect margins, as I mentioned earlier. Regarding working capital, we anticipate that some of the year-over-year differences will continue, as we are experiencing ongoing higher inflation on inventory. As we improve our in-stock levels, we expect some of that inflation to remain consistent. We will also consider the timing of payables and receivables and expect that to normalize. In fact, at the end of the first month of the new year, our cash position increased by $1 billion, aligning more closely with the previous year, which was not the case at year-end. We believe some of the changes were due to timing and will adjust accordingly. We have strong plans for the year in terms of growth with our partners, and our main focus is on continuing to drive free cash flow, which we feel optimistic about.

And the forward buying is really driven by the economics at any given day in terms of what's available in the marketplace. If it's a good return, we'll invest the money there. If the return is not good, then you'll see the flow of benefiting working capital.

We didn't give exact numbers. I would also say, Ken, the forward buying would be a smaller part of the number, the timing of payments would be a bigger part of that than the actual forward buying.

Got it. And then a quick follow-up. Implied operating cash flow. It's one of the questions I'm getting from investors. You gave a CapEx number, so we can back into it, obviously. Just curious why given the strong EBIT growth this year, given some of the working capital reversals, why would it not be a little bit better than what guidance is suggesting. I know you talked a little bit about this. I just wanted to get a little bit more detail on some of the underlying factors there if possible.

Yes, I believe we are aiming to provide guidance for what we anticipate will be a more normalized year in 2023. I would say we might be a bit conservative because we want to observe how the aftermath of COVID unfolds. For instance, if inflation continues to be high, it could affect inventory levels. Additionally, as we adjust accruals for items like incentive payments, assuming they align more closely with targeted payments rather than exceeding them significantly, we might see some adjustments within the year. There are several factors that could create some complexities. Honestly, we are trying to take a conservative approach to ensure we properly account for any catch-up from 2022 as well. We believe we've adopted a cautious perspective on a normalized environment, but we still want to understand the unwinding process as we report in 2023.

Our long-term incentive plan is structured to encourage us to exceed the guidance we have provided.

Yes, I think it'd be fair to say our internal goal would be higher than what we shared because we do believe it's one opportunity, but we thought it was appropriate to be conservative in the circumstances.

Also congrats on a great quarter. So I just want to touch on market share. Just curious if you look at Kroger's performance in Q4, I'm not even sure if you have the full year data, just curious how your market share is performing versus your expectations? Because if I recall last quarter, you were starting to see improvement in the market share.

Yes. We're continuing to see improvement and if you look at internally, if you were at one of our meetings, you'd hear us continually focus on how to even continue to improve. Our objective and expectations of ourselves is to grow market share. And if you look at the higher-income shopper, in those customer segments, we did a great job gaining share in Fresh. We're doing a good job of gaining share. And I would say we're pleased with the progress, but we still are not satisfied.

Okay. Great. And then maybe just one quick follow-up question. Just quarter-to-date. Any color you can provide in terms of what you're seeing just throughout the quarter?

Yes. We consistently provide insights, and so far, we are aligned with our expectations. Gary shared some insights on what we anticipate quarterly. In the first period, which includes the first four weeks of the year, performance is slightly better than expected, although still lower than the actual results from the fourth quarter. It's important to note that Express Scripts is about 1.5%. I typically hesitate to mention weather, but it was more favorable for us last year compared to this year. While I don't want to use weather as an excuse, it's relevant when looking at current trends. The main takeaway is that we are on track with our expectations.

On Our Brands, you saw that outperform the overall comp again this quarter. Are you seeing CPGs get more willing to offer trade spend just given the share losses that they're seeing? And do you think the trade down that we've seen over the last few quarters accelerate as we move through '23?

Yes. If you look at a 5-year trend or a 10-year trend, Our Brands has picked up share on almost every year. And the only exception to that was a little bit of time during COVID where people had much more money in their pocket. If you look, I would say, all short statements and economics are wrong, but we still have several CPGs that are past or trying to pass through costs more than probably their inflation. We would still see that they're more focused on profit and tonnage. And when that is true, that's when Our Brand continues to gain share. And that's the reason why Our Brand is performing so strongly. And if you look at historical cycles, eventually, that what you outlined will happen, but it hasn't started happening yet.

Got it. That's helpful. And then on fuel margins, you called out $0.51 during the prepared remarks, which is up more than 50% versus what it was in 2019. So just curious how you're thinking about the sustainability of fuel margins and where those will ultimately be baseline as it just becomes a bigger part of your overall operating profit today?

Thanks, Spencer. As we noted in our prepared comments, we believe that fuel margins will remain above historical averages. We think the industry has undergone some structural changes over the last five years that support the idea of sustained higher margins. However, I mentioned earlier that we anticipate fuel profitability will face a headwind of around $200 million to $250 million in 2023. This outlook is primarily not due to a lack of sustainability in fuel margins. You might recall that when the war in Ukraine began, there was significant price volatility, and we believe that such shocks typically do not recur in a cycle. Thus, this is mainly about those one-time unusual spikes in pricing. Nonetheless, we are confident that fuel margins will remain elevated.

The other thing just to add to Gary's point. When retail fuel prices are high, customers engage in our fuel rewards a lot more and we provide significant discounts to customers through our fuel rewards. If prices come down, usually our reward costs will go down there as well. So you have to look at all the pieces together.

This is Leah Jordan. You called out sourcing again as a tailwind this quarter. How are you managing that differently today? How much of an opportunity do you still see there? And is there anything assumed within the cost savings guidance as well?

I'll let Gary get into the details. But in sourcing, it's an area where several years ago, we really didn't have a separate department and didn't have professionals that manage that organization. And a couple of leaders and now reports to Gary, they've done a great job of finding talent that understands how to source product, understands the cost of the ingredients and all the pieces. And it's really turned it into a professional organization, and it's under the leadership of Mike Donnelly and Erin Sharp and a few people that have retired and now it's under Gary's leadership. And I just think that team has done a great job of bringing professionalism to the area. In terms of the specifics, now I'll let Gary get into the details.

Thank you, Rodney, and thank you for the question, Leah. We definitely believe in our approach to reducing costs in the business. We began by focusing on efficiency and embedding this mindset into the culture and capabilities of our organization. Our team collaborates across merchandising, operations, supply chain, and sourcing to design for value. This involves not only understanding the costs of producing and delivering our products but also optimizing product design. We analyze our products from start to finish, looking for improvements in packaging and design, ensuring they align with customer demands and expectations to maximize value. Similar to our productivity savings, we have a clear roadmap for achieving additional savings and opportunities each year, and based on our experiences so far, we anticipate this trend will continue.

Great. I have a quick follow-up on SNAP. How are you considering the potential changes there in relation to your guidance? Also, since you have such a diverse footprint, can you provide some information on the stores in states where that extra allotment has already rolled off?

If you look at SNAP, we've assumed that it's a meaningful headwind for the balance of the year. We're hopeful that everybody will work together to continue or find additional money because, as you know, because of inflation, there's a lot of people whose budget is under strain, but we have assumed that, that was a meaningful headwind both in the quarter and for the balance of the year. I don't know, Gary, anything you want to add?

No, I think it ties to the point about there is still uncertainty, so we're making sure that we're allowing for that in our guidance for the year. I would say historically, and you probably or say this before that it's actually very difficult to find a correlation between SNAP in the market and spend on food at home because typically, it tends to impact more discretionary spend. But I think our view was that we've never really had a point in time where we've had so much SNAP dollars in the market. So we believe most of the models that we've looked at for the last 30 years are kind of difficult to say, well, they hold true in this environment. So we felt it was important to be conservative given that we are in a unique time.

Rodney and Gary. I wanted to ask just about what your guidance assumes regarding the broader promotional environment. And I guess particularly thinking about the back half when maybe inflation is at a little bit of a lower level, do you expect competition and promotional activity to heat up? This seems to be one of the key investor concerns as we head into next year.

Yes. Thanks for the question, Kelly. I think from our perspective, we feel that we have to be agile, and we're certainly shooting in our guidance that we'll be continuing to invest in value for the customer. I think one of the things that we believe has changed somewhat during the COVID environment is the situation of how the customer shops and engages with you is different. And what I mean by that is many more customers are engaged digitally, which gives us the ability to truly be able to personalize and bring together all the different pieces. So it's less about just what you see when you enter the store, it's about the fuel rewards that we can target for that customer. It's the personalized digital coupons. It's the Our Brands offers that, as Rodney mentioned earlier, can save the customer 10% on an equivalent basket if they decide to shift to some of those products. So we believe we've learned a lot through the pandemic of how do you really channel those dollars in the most effective way, and that's what gives us the confidence that as we think about the rest of the year. We'll continue to invest in value for the customer, but that we can do that even more effectively than the past to make sure that we stretch those dollars further to deliver value for our customers.

And one of the things that I think is always important to make sure a lot customers also decide where to shop based on how the freshness of product and the friendliness of associates, and that's part of the overall value equation. So when you look at how we go to market, we have personalized offers, we have promotions, we have fuel rewards. And the customer will engage in those to manage their budget and then they win by having incredibly fresh product and incredibly friendly associates. And that's how somebody decides where to shop. So I really think it's important for you to look at all those together.

Okay. Great. And just to follow up on the discussion of units and inflation. I think as we look at this year comps, 5% to 6% range with inflation, I believe, in the double-digit range. So maybe would imply units or tonnage down high single digit. And for next year, 2.5% to 3.5% maybe seems to assume a pretty meaningful acceleration in units. So just maybe correct me where I'm wrong on that math? Or just help us understand what would maybe drive a better unit or tonnage backdrop for Kroger in '23?

The unit change wouldn't be as much as you said because remember also, people are switching to Our Brands and other things, where the ring per item is less, but we sell more units. So when you look at overall, and if you look overall, we also look at share and when you look at units in total, they're declining as well. So we would expect to continue to make progress in improving our share and the flow-through of units would come from that. I don't know, Gary, anything...

No...

Thanks, Kelly, for the question. With that, obviously, thanks to everyone for all your questions. And as always, before we close, I'd like to share a few comments directly with our associates listening in. We invite our associates to come to Kroger for a job and discover a career. And I can't think of a better example of this than an associate at our Cincinnati, Dayton division, who came to the United States from Togo. After a few weeks as a bagger, his store manager, Brian asked him if he'd be interested in leading the dairy department in his store. Because of the dedication, determination and great job that he's done, he is now the center store specialist, and I can't wait to see what's next for this amazing young man. I'm inspired every day by the amazing work each of you do and could not be more humbled to be part of this world-class team as we enter the next year. Thank you for making Kroger the incredible place that it is. Thank you, everyone, for joining us. That concludes today's call.