Rob Quast:

Good morning. Thank you for joining us for Kroger's first quarter 2024 earnings call. I am joined today by Kroger's Chairman and Chief Executive Officer, Rodney McMullen; and Interim Chief Financial Officer, Todd Foley. 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 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 one question and one follow-up question if necessary. I will now turn the call over to Rodney.

Operator:

We have lost connection with today's speaker. Please stand by while we still try to reconnect with them. Thank you for your patience, everyone. We now have the speaker back on the line. Please continue.

Todd Foley:

Thanks, Rodney, and good morning, everyone. Kroger's first quarter performance reflects the resiliency of our model, which enables us to manage a variety of economic cycles. The strength of our model combined with the momentum in our Grocery business gives us confidence to reaffirm our full year guidance even as we continue to navigate an environment of economic uncertainty. I'll now take you through our first quarter financial results. We achieved identical sales without fuel growth of 0.5%. As Rodney mentioned earlier, our identical sales were driven by several positive customer metric trends, including increases in total and loyal households and increased customer visits. We continue to see sequential unit improvement and our teams remain focused on returning to positive units later this year. Inflation continues to moderate, which is consistent with our expectations at the start of the year, and towards the end of the first quarter, we began cycling the headwinds from the reduction in SNAP benefits. Digital sales grew by more than 8%, which was led by 17% growth in delivery solutions. Gross margin was 22.4% of sales and our FIFO gross margin rate, excluding fuel, decreased seven basis points. The decrease in rate was primarily attributable to lower pharmacy margins and increased price investments partially offset by favorable product mix reflecting Our Brands' margin performance. The slight decline in our FIFO gross margin rate was in line with our expectations. We expect our FIFO gross margin rate to improve beyond our first quarter result driven by the core components of our margin expansion initiatives. During the first quarter, we recorded a LIFO charge of $41 million compared to a charge of $99 million for the same quarter last year. The decreased charge for the quarter was due to lower inflation expectations for the current year compared to last year. The OG&A rate excluding fuel and adjustment items increased 22 basis points, driven by planned investments in associate wages and increased incentive plan costs partially offset by continued execution of cost savings initiatives. In the second quarter, we expect the factors identified in the first quarter to continue, leading to a similar to slightly higher OG&A rate. We expect our OG&A rate to improve in the second half of 2024. We continue to make progress on our digital profitability, delivering another quarter of improvement in our pickup cost to serve. It remains a long-term margin opportunity with runway to improve through increased volume and process enhancements. Our store associates played a key role in the cost to serve improvements and, as Rodney mentioned earlier, did so while they improved key customer experience metrics. Adjusted FIFO operating profit was $1.499 billion. Our adjusted EPS was $1.43 per diluted share, a decline of $0.05 compared to last year. Fuel continues to be a key driver of our strategy to build loyalty by providing compelling fuel rewards to customers. We continue to see more reward activity with 8% more redemptions contributing to gallon sales, which outpaced the industry this quarter. However, our fuel profitability was below expectations this quarter with our cents per gallon fuel margin down low single-digits compared to last year. I'd now like to provide a brief update on associates and labor relations. We continue to invest in our associates as part of our long-term strategy, resulting in an average hourly rate of $19 an hour and a rate of nearly $25, with comprehensive benefits factored in. During the first quarter, we ratified new labor agreements for our Houston Clerks and Meat, Mid-Atlantic Division stores in West Virginia, South Carolina stores in Columbia and Myrtle Beach and Portland Distribution Center and Drivers covering more than 21,000 associates. Turning to cash flow. Kroger continues to generate adjusted free cash flow, strong adjusted free cash flow, through consistent operating results which is enabling us to continue deleveraging in anticipation of our merger with Albertsons. At the end of the quarter, Kroger's net debt to adjusted EBITDA ratio was 1.25 compared to our target range of 2.3 to 2.5. Our strengthened balance sheet provides ample opportunities for Kroger to pursue growth and enhance shareholder value. We continue to take a disciplined approach to deploying capital with a focus on projects which drive long-term sustainable net earnings growth while remaining committed to our investment grade debt rating, increasing our dividend over time subject to board approval and returning excess capital to shareholders when we are able to do so. As part of our capital investment plans for 2024, we shared last quarter our plans for approximately 30 major storing projects focused on higher growth geographies, where we have traditionally achieved a strong ROIC and operating profit growth. We've made good progress on our projects so far and remain on track with our plans. While early, we're happy with the results from projects completed in the first quarter. We are confident these new storing projects will help advance our omnichannel strategy and be an important component to our sales growth and TSR model going forward. During the first quarter, we announced we had entered an agreement for the sale of our Kroger Specialty Pharmacy business. As part of our regular and ongoing review of our portfolio, we determined that Specialty Pharmacy was not part of our core strategy going forward and a sale would enable us to focus on our Health & Wellness strategies that revolve around our retail pharmacies. Due to the sale, a non-recurring held for sale tax adjustment of $31 million was recognized in the quarter and it has been reflected as an adjustment item in our results. The sale of KSP is not expected to have an impact on our 2024 guidance. I'd now like to provide some additional color on our outlook for the rest of the year. Today, we reaffirmed our annual guidance reflecting both positive momentum we are seeing in our business along with a more cautious customer environment in the near term. In terms of quarterly cadence, we now expect a decline in adjusted EPS for the second quarter similar to the rate we observed in the first quarter as we expect pharmacy business profitability pressures to carry over into the second quarter. This reaffirms where we expected to be through both the first half of the year as well as the full fiscal 2024. In closing, our first quarter performance reflects the strength and resiliency of our model. We are strengthening our Grocery business, which drives the data and traffic to accelerate growth in our Alternative Profit businesses and we remain confident in our ability to drive attractive and sustainable returns for our shareholders. I'll now turn the call back to Rodney.

Operator:

We will now begin the question-and-answer session. [Operator Instructions] And our first question comes from Rupesh Parikh from Oppenheimer.

Rodney McMullen:

Good morning.

Todd Foley:

Yeah, thanks, Rupesh. Great question. We talked at the beginning of the year that our expectation was to have relatively flat year-over-year gross margin and that is still the expectation. As mentioned in my comments, we do expect results for the balance of the year to improve beyond our Q1 results and that's really reflective of some of the gross margin expansion efforts that we have going on. They're going actually really well. We alluded to our Our Brands performance. Our margins in Our Brands continue to do very well and as that business continues to grow, particularly in today's environment, we talked about the budget-conscious consumer and that continues to connect with them. And so the growth in that business helps drive the margins and we expect to see that as the year goes on. Fresh is another category where we've had meaningful growth. Fresh is doing really well. We've talked a lot about produce, our end-to-end Fresh and how that business is growing. And certainly that comes with higher margins, which has a positive effect on our mix. And then when you look at Alternative Profits and in particular retail media, that business continues to grow well and especially the second half of the year. We expect retail media to continue its momentum to achieve our growth of excess of 20% for the year. A lot going on in that space. And we went to a new platform a year ago and as we went and ramped up the platform a year ago, we'll be cycling that period of time with some of the momentum we have in that business. So all of those are where a lot of our confidence comes from when we talk about reaffirming our guidance for the year. And we alluded to some of the pharmacy headwinds. Even though we expect some of those to carry over into the second quarter, I think all of the results that we're seeing from our margin expansion efforts are going to continue to drive us so that we hit our expectations to improve the result relative to Q1.

Rupesh Parikh:

Great. And then maybe just one quick follow-up question. In light of some of the competitor announcements of reducing price on certain items, just wondering how you guys feel about your price gaps today.

Rupesh Parikh:

Great, thank you. I'll pass it along.

Robert Ohmes:

Oh, hey, Rodney. I had just two follow-ups on the first question. Hey, just in terms of the price investments, and I know you guys always do them, but has anything changed with what your CPG partners are doing with Kroger to drive volumes? Because we know that they're looking to do that. And then also would love to just get further perspective on what Kroger is seeing competitively either the same or different sort of there's kind of Walmart and Target, but what are the regionals and independents doing competitively? Are they changing at all? What they're doing?

Operator:

The next question comes from Simeon Gutman from Morgan Stanley.

Rodney McMullen:

Yeah, if you look at the first quarter performance, as Todd and I both mentioned, we felt very good about where we were finished or where it turned out. One of the things I always think it's, the first quarter is so early in the year, I never felt -- it would be unusual for us to feel comfortable changing too much. If you look at things that we felt good about or the things that we outlined in the prepared comments around our customer count growth, the growth that's broad-based across all of our customer types, our store team is doing a very good job of continuing to improve the experience and in-stock positions and all those things. The couple of headwinds that we do have is if you look at like incentive plans, especially in the second quarter, we'll have significantly higher incentive plan accruals in the second quarter than what we did a year ago, which is partially what's affecting the second quarter. But overall, for the year, we feel good about where we are. We feel good about where we are relative to where we thought we would be. But it's really too early in the year to make too many changes.

Uriel Zachary Abraham:

Okay.

Operator:

The next question comes from Kenneth B. Goldman from JPMorgan.

Rodney McMullen:

Yeah, I'll let Todd answer the second part. On inflation for the year, the first quarter was pretty much where we expected it to be. Where we, for the year, it's pretty consistent with where we thought it would be. So if I'm going off of memory, but I think we said it was slightly over 1% and we would continue to see it slightly over 1%. It's -- if you look at some of the commodity -- the commodities themselves, obviously that will bounce up and down. And as you get later in the year, we -- that some of that bounce will be driven by what kind of crop year is it relative to corn and some of those things. But really overall, what we expect inflation to be similar to where we did last year and it is starting to stabilize. We don't see deflation broad-based at all, but it is stabilizing around that little over 1%.

Rodney McMullen:

Okay. Thanks, Ken.

John Heinbockel:

Hey, Rodney, I wanted to start with, when you think about delivery and pickup profitability, I mean, I know you're losing money in those areas. Do you have an idea in mind when you can begin to approach breakeven? I know it's going to take a while, but thought on that. And then if you had to pick a couple of key drivers, right, that would get you there, what do you think they are?

John Heinbockel:

Okay. Then maybe as a follow-up on pharmacy. So what's your sense -- the pressure is coming from where? Is it solely reimbursement or something else? I mean what's your take on reimbursement longer term and are we basically going to see less capacity, right? Drugstores, right, are closing a lot of locations. But do you think between that, supermarkets getting out of the business, there will be a lot less capacity in Pharmacy three years or four years or five years from now that will help profitability?

Rodney McMullen:

And as we look longer term, three years or five years, we definitely think there'll be less capacity. And as you noted, there's a significant number of closures by the other three players in that space. And there's a lot of work that's being done from a governmental standpoint around PBMs. The thing that I get super excited about, our pharmacies and our Health & Wellness teams, they continue to do a great job of improving the experience. And I think it's amazing that a third of our customers don't even realize we have a pharmacy. And we're obviously working incredibly hard to make sure that third of our customers that don't even realize we have a custom that we have a pharmacy to get them to convert and become a patient of our pharmacy because our teams do an amazing job on service. We have incredibly quick lines and things like that and it's one less trip that somebody has to make. So thanks, John, for the question.

Michael Lasser:

Good morning. Thank you so much for taking my question.

Michael Lasser:

Rodney, between some of the comments from other food -- morning -- before -- between some of the comments from other food retailers, as well as your own discussion around increased price investments, there is a perception that the industry is becoming more competitive and that is going to disrupt the profitability of food retail in the back half of the year. So could you compare where the overall promotional intensity that you're witnessing is today versus where it's been in the past, especially around disruptive times? And how much did your price investment contribute to the improvement that you saw in more price-sensitive customers, lower income consumers, in the quarter?

Michael Lasser:

My follow-up question is that Kroger's financial formula works very well when its ID sales are above 3%. When is a realistic expectation that it could resume seeing ID sales back at that level?

Rodney McMullen:

And the other thing, it's a great question. It's hard to give a specific data other than I can assure you that our team is working really hard to get there. We're also -- and this is something I would say we've always done, but you always try to get better. And if you look at capital investments, we would also be using capital investments to support that growth. And as you know, we're starting to increase the number of stores that we're opening. And the maturity of those stores and the remodel of those stores also help with identicals over time. And we would expect that to obviously be the case now. And as Todd mentioned, it's early in the slightly higher capital spending for new stores and expansions and stuff, but we're pleased with the early results. Thanks, Michael.

Michael Montani:

Hey, thanks for taking the question. I wanted to ask if you could discuss the ID sales cadence through the quarter and then in the month of June. How should we think about ID sales for 2Q? And then I had a follow-up.

Rodney McMullen:

Yeah, and as you know, we do expect IDs to improve throughout the year and we continue -- so far we're continuing to see that and would expect that to continue.

Rodney McMullen:

I'll make a couple of comments, and Todd, feel free to add. One of the things as you get to the third quarter and early in the fourth quarter is vaccines. And as you know, last year our teams did an amazing job of increasing the number of vaccines we gave. And we have a ton of learnings that we think will be able to do that again this year. And the -- so when you look at just the pharmacy business, part of that will be that. And also on some of the supply issues, we would hope that and expect for those to get more normalized and like the one drug that Todd was talking about, the generics, as they come out and stuff, historically, that's always improved profitability. And we would expect at some point in this latter part of the year for those things to happen. Relative to the other pieces, Todd, I'll let you.

Rodney McMullen:

Thanks, Michael.

Edward Kelly:

Hi. Good morning, everyone.

Edward Kelly:

I wanted to start two questions. The first question I had is just around -- good morning -- it's just around the second quarter guidance. So in Q1, you beat on lower fuel margins and lower pharmacy. Q2, the guidance is coming down. Is that just solely based on pharmacy and incentive comp? Is there something else happening within here? I'm just trying to figure out the level of conservatism that is sitting in the second quarter guidance given what you just did in Q2 against all of this.

Edward Kelly:

All right. Then I guess a quick follow-up is just on leverage. So you continue to reiterate your leverage target. You are well below that at this point. Taking a step back, are there any advantages that you see to the business to running below the target long-term? Is this a metric that you think you would reassess post the Albertsons decision? Just curious as to how you're thinking about that.

Rodney McMullen:

We really view our lowest cost of capital is a BBB rating. And if you look at it historically, it's like 80% of the time that would be the lowest cost of capital. And as you look at the markets going forward, we don't see anything that would cause that to change. So that gives you the financial flexibility to do things like merging with Albertsons. It also creates the lowest cost of capital. And the reason we always reiterate that 2.3 to 2.5 is that really is the point that we believe creates a solid BBB rating. And the thing that, as Todd and I both mentioned, the business continues to be incredibly strong from a free cash flow standpoint and the anticipation going forward. So it gives us the opportunity to continue to invest in the business, continue to grow the business, and we can't wait to be able to merge with Albertsons, so we can do that at even a scale a little bit bigger. So thanks, Ed, for the questions.

Kelly Bania:

Hi. Good morning. This is Kelly Bania from BMO.

Kelly Bania:

Just wanted to ask about the volume and the tonnage outlook. I think you mentioned some positive momentum with the budget consumers and maybe an increasing customer count there. But how are volumes and tonnage trending year-over-year within your different customer cohorts? And how is that impacting your outlook for the full year in terms of tonnage and volume overall?

Kelly Bania:

Oh, yeah, thank you. I wasn't sure if you're done. Just wanted to ask maybe another question on the promotional and the competitive environment. It sounds like you characterize it maybe back to normal, I guess. What's different today about Kroger's kind of gross margin profile being more stable? And it sounds like maybe up a little bit in the next couple of quarters here relative to a few years ago, how much of that just rests on the Alternative Profit and the magnitude of that and the growth -- continued growth there versus anything different that you see in the gross margin for the kind of the core business?

Rodney McMullen:

Yeah. And if you look at some of the things that's in margin, like, warehouse and transportation costs, our teams are making good progress there, reducing the number of empty miles, taking and managing more of the transportation. So there's a lot -- one of the things, as you know, we've done a ton of work over the last five years or 10 years on diversifying our business model and how we create value. And part of it is the traffic that our base business creates being able to monetize that in ways that the customer actually views and finds of value. Thanks, Kelly.

Krisztina Katai:

Hi. Good morning, and thanks for taking the question. I wanted to ask about the store execution plan that you implemented with the daily scoring system. Now you're really addressing some of the underperforming stores relative to the chain average. So one is what has been the biggest opportunity for some of the store-level improvements you're seeing? Just how much are they contributing to the traffic gains that you are also seeing? And just how best to think about further upside with both your budget-conscious customers but also the mainstream and the premium customers?

Krisztina Katai:

Great. And just a quick follow-up. I hate to beat this, but just on the promo backdrop, just how should we think about your promotional basket? How much of that is proactive versus reactive that you are doing in the current environment? And I think you said that it's pretty much back to pre-COVID levels. Is it fair to assume that your vendor funding is also in line with pre-COVID levels or do you anticipate that to continue to ramp as your vendors are focusing on driving volumes? Thank you.

Todd Foley:

To your comment on reactive versus proactive, when we put our plan together for the year and our guidance in the whole nine yards, we put together our pricing strategy for the year and we're executing on the strategy that we've put in place and we think clearly customers are responding to that very favorably. We're not deviating from the plan that we have -- that we've put into place. We're executing our playbook. Rodney mentioned it earlier. It's what we've done for 15 years or 20 years and we've stuck to our playbook and we think that's what's resonating with our customers.

Operator:

The next question comes from Chuck Cerankosky from Northcoast Research.

Rodney McMullen:

Good morning, Chuck.

Rodney McMullen:

Yeah. If you look, sorry that you got cut off, but the delivery business almost doubled year-on-year. It's pretty broad based on all customer segments, but I think one of the things that's important to remember is that our technology allows us to do a better job now accepting SNAP and some of those things than what it did a year ago. So it's really across all customers. I think the thing that's driving it is our teams are doing a nice job on making sure the experience is good. I can tell you in Florida, people get ice cream that's still frozen and chocolate that's not melted because of our delivery, because of the delivery trucks. And it's really -- it's one of those things where all the things you feel good about, we still have a lot of work to make sure that we're satisfied with the profitability.

Rodney McMullen:

Yes. The short answer is yes. And there's, as you know, online and with our data and personalization, there's all kinds of things that you're learning in terms of different customers find it attractive at different times. So the short answer is absolutely yes. The other thing is, obviously online really supports the Alternative Profit business as well from a media standpoint. Thanks, Chuck.

Rodney McMullen:

Thank you. Appreciate it.

Rodney McMullen:

Thank you for all the questions, as always. As you know, I always like to share a few comments with our associates listening in. Today I'd like to take a moment to celebrate Alex Spurlock. Alex is a store leader at QFC store 860 in Redmond, Washington, and recently was named the 2024 Food Industry Association Store Leader of the Year. Obviously, this is a huge honor and we are so impressed by the amazing work that Alex does at her store. With more than a decade in the grocery business, Alex understands the industry. She has a gentle spirit and a fierce attention to detail that clearly earned her this recognition. What's most impressive is Alex's passion for her associates. She is always ready to coach her team and celebrate their success in meaningful ways. Thank you and congratulations, Alex, for everything you do for our customers and your fellow associates. And congratulations on this amazing honor. And thank you to all of our teams for all the work they do every day to take care of each other and our associates and thank you for everyone for joining us today.

Gary Millerchip:

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 4 years and is positioning Kroger for growth in years to come.

W. McMullen:

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.

John Heinbockel:

Rodney, I wanted to start with since it's the beginning of a new year. As you guys think about your consumer deciles, quartiles, however you look at it, what's the wallet share opportunity right, maybe from the average consumer to your best, most loyal consumer. And where is the -- when you do sort of a gap analysis, where is the gap? Is it fresh? Where are the biggest pockets, right, where the average consumer is not spending as much as the most loyal.

W. McMullen:

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.

Gary Millerchip:

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.

Edward Kelly:

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.

W. McMullen:

Yes. If you look at inflation overall, we would expect inflation to be higher in the first half of the year than the second half of the year and the quarterly insights that Gary provided really reflected that. If you look at the thing that we feel really good about, and I shared specifics on the prepared comments, the higher income customer is really resonating with our value proposition, and we're having meaningful increases there in terms of that customer.

Gary Millerchip:

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 is -- has remained pretty stubborn in terms of the levels there.

Edward Kelly:

Okay, just a quick followup...

Edward Kelly:

Got you. Just a quick follow-up, Gary. The FIFO gross margin outlook for '23. I think there is a decent -- I mean, it seems like there's a decent impact associated with Express, given there's no P&L impact of losing the comp. Just how are you thinking about FIFO gross margin ex fuel in '23?

Operator:

Our next question comes from Simeon Gutman from Morgan Stanley.

Gary Millerchip:

Yes. I think what I'd probably say, Simeon, as I think about it, the sort of 3 bigger picture moving parts that I tried to sort of tee up the overall guidance with as well. So I think about it as the 53rd week adding, call it, $0.15 of earnings per share. So that's helping with -- think of $0.01 of about $9 million to $10 million. So I think if it's like $150 million tailwind from the 53rd week. I think of gas, so fuel being a headwind of -- in the sort of $200 million to $250 million range.

Simeon Gutman:

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?

Michael Lasser:

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.

Gary Millerchip:

Sure. Thanks, Mike. I'll try and be brief on those 2. 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.

W. McMullen:

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.

W. McMullen:

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.

Kenneth Goldman:

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.

Gary Millerchip:

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.

Gary Millerchip:

Yes. I think I would say we try to guide to what we think is a more normalized year in 2023, Ken. Part of it, I would say we probably are being a little bit conservative because of -- we want to see how this unwind of COVID exactly plays out. A couple of examples would be if inflation does remain at high levels, obviously, that could impact inventory but also as we kind of unwind accruals on things like incentive payments, assuming we're more going to be more like an on-target incentive payment than significantly higher than on-target payout, those things can create some 1-year adjustments, too.

W. McMullen:

And our incentive plan is designed -- our long-term incentive plan is designed such that we are incentivized to do better than the guidance we've given.

Operator:

Our next question comes from Rupesh Parikh from Oppenheimer.

W. McMullen:

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.

W. McMullen:

Yes. As you know, we always get it. We always provide some insight. If you look so far, we're consistent with our expectations and Gary outlined a little bit about what we would expect quarterly between quarters to be. If you look at the first period, the first 4 weeks of the year, it's trending a little bit better than [indiscernible] but both of those were lower than the fourth quarter actual. And I want to remind you that ESI -- Express Scripts, I should say, is about 1.5%. And then I always hate to talk about weather, but weather was more friendly to us a year ago than it is this year and I don't ever want to use weather as an excuse, but it is an insight if you look at the current trends, but the key point is we are trending where we expect it to be.

Spencer Hanus:

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?

Spencer Hanus:

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?

W. McMullen:

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.

Leah Jordan:

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?

Gary Millerchip:

Sure. Thanks, Rodney. Thanks for the question, [ Kate ]. Yes, we certainly believe that we -- it's a bit like our overall approach to taking cost out of the business. We started out saying, how do we make sure we're as efficient as we can be and then really become, I think, part of the culture and part of the capability in the organization and the team is working together, I'd say it's across merchandising, operations, supply chain and sourcing, all kind of collaborating on how do we design for value.

Leah Jordan:

Great. And I have one quick follow-up on SNAP. Just giving any -- the potential changes there. How did you think about that with your guidance. And also, given you have such a diverse footprint, is there any color you could provide on the stores where states they've already had that extra allotment roll off?

Operator:

Our final question for today comes from Kelly Bania from BMO Capital Markets. Please go ahead.

Gary Millerchip:

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.

W. McMullen:

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.

W. McMullen:

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 if 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...

W. McMullen:

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, [indiscernible] 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, [indiscernible] is now the center store specialist, and I can't wait to see what's next for this amazing young man.

Operator:

Thank you for joining today's call. You may now disconnect your lines.

Gary Millerchip:

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 the 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.

W. McMullen:

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 1, 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.

Michael Montani:

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.

Gary Millerchip:

Thanks, Rodney. And maybe just to confirm, so the trend in the early part of the fourth quarter has continued consistent with how we're performing in the fourth quarter -- I'm sorry, is continued consistent with outperformance in the third quarter. Michael, as to one part of your question there.

W. McMullen:

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.

Charles Cerankosky:

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?

Edward Kelly:

Gary, I'd like to ask you about the dynamic between the LIFO charge and the FIFO gross margin going forward. There's -- the FIFO gross margin have been good. And this year, there's probably $0.50 a share or more, I guess, in the LIFO charge in terms of the headwind. I mean assuming inflation eases, you get much of that LIFO charge back.

Gary Millerchip:

Yes. Thanks for the question, Ed. I think as you heard as mentioned on the call, we probably won't get into a lot of detail around 2023 guidance because we'd rather put it into context of the full picture for next year. As you might imagine, there'll be a lot of moving parts as we sort of bridge to share that color with you when we get to March next year.

Gary Millerchip:

Yes. I think again, I'll maybe just broaden it because again, I think it's a little bit dangerous to pick on one element of the model for next year. I do think that fuel margins have had obviously a very good run. And generally, I think margins are improving over time, but there is -- there has been in the last 2 years, some major volatility in shocks in the market. I think it's hard to see those being cycled. So you look at margins earlier in this year, and I think that's likely to be a headwind next year in looking at the fuel profitability.

W. McMullen:

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.

Scott Mushkin:

So the first thing I wanted to -- so the first thing I wanted to get some answers to a little bit is the market share, you guys market share. It seems to have stabilized, maybe even growing a little bit. Do you agree? And what do you think is leading to that?

Scott Mushkin:

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?

W. McMullen:

No. It's all -- as you know, it's any place you look across the country, you'll see it in different stages. And -- but overall, what we see is pretty similar to what -- how it's been.

John Heinbockel:

So Rodney, I want to start with a big picture here. When do you guys think about -- because you've got the data, if you think about growth in households, right? So if you're going to comp, let's say, I don't know, 3% or 4% longer term, household growth would be what of that and comp growth with comp households would be what? How do you think about that? And then when you -- is there any way for you to dive into your penetration, right, with your deciles and where the biggest opportunity is?

Gary Millerchip:

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.

W. McMullen:

John, as you know, we manage our business on dollars. And for us, growing dollars is what creates a sustainable business model long term. And we always view that the better offer that we can be able to afford to give to our customers the more sustainable that is, and the only way we can do that is by managing our costs and continuing to find and identify areas of waste so that we can reduce that and fund that.

Kenneth Goldman:

It's important to list my little initial [indiscernible] I'm just curious, the -- it's the second quarter in a row that you've lowered your CapEx guidance. I understand why you've been clear about that. And as Rob Moskow pointed out last quarter, you're not the only company to feel that pressure. I'm curious though, at what point is it reasonable for us to not be concerned, but sort of be aware of the potential impact on your growth from not being able to expand in a way that you'd like. I'm just curious how it affects anything in the near term, if at all?

W. McMullen:

Yes, it's a great question, Ken. And it's something that we're going to obviously manage in a very transparent way. And we wanted to go ahead and include it in this quarter, just the context of what is new, and that's what we've shared.

Operator:

And the next question goes to Michael Lasser of UBS.

W. McMullen:

Yes. It really gets back to overall. I think it's incredibly important to understand that we connect with the customer in multiple ways, and Fresh is a critical component of that. We fundamentally assume over time, the market is going to get more competitive. We've done that for 25 years. We'll continue to do that. And that's the reason why we put so much investment energy on personalizing experiences, supporting our associates in ways -- any way we can, pay, continue in education, even additional support on mental health and especially in today's environment.

Operator:

And the next question goes to Kelly Bania of BMO.

Gary Millerchip:

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.

Operator:

Next question is Rupesh Parikh of Oppenheimer.

Gary Millerchip:

Yes. Rupesh, thanks for the question. Maybe just a little bit more color on Q3 and Q4 as well because I think there's a little bit more to the story there as well that's worth understanding. I would say that certainly, you're right, the -- we saw a lot of benefit from sales leverage and productivity improvements during the quarter.

Operator:

And the next question is our final question to Robert S. Ohmes of Bank of America Merrill Lynch.

W. McMullen:

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?

W. McMullen:

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.

W. McMullen:

Thank you, Rob. Good morning, everyone, and thank you for joining us today.

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to Feed the Human Spirit inspires our team every day. One important way we bring our purpose to life is through Kroger's comprehensive ESG strategy. Our aim is to achieve lasting positive change for people and our planet. Our newly published 2022 ESG report called Nurturing Shared Values, outlines the entire Kroger family strong progress against dozens of environmental sustainability, social impact and governance goals and commitments.

Gary Millerchip:

Thank you, Rodney, and good morning, everyone.

W. McMullen:

Thanks, Gary.

John Heinbockel:

I want to start a little quick with the improvement you saw in IDs, can you break that out into traffic and ticket? And then maybe within ticket, right, AUR versus items per basket? And is -- I know nonfood has been a big drag. Is that still a drag? Did that get better at all?

W. McMullen:

Yes. The only other thing that might be helpful insight, John, is it's pretty consistent across the country as well.

W. McMullen:

Yes. If you look, one of the things that our teams have done a nice job is on procurement. The other piece would be, as you mentioned, mix. The fresh departments continue to help on mix. And we continue to see a lot of customers continue to add value-added products as well.

Gary Millerchip:

Yes, I think you picked up the biggest drivers with sourcing and the benefits. It's not so much forward buying but continuing to be really disciplined, John, with how we look at the designer product and how we're managing relationships with our supply partners as well.

Operator:

Our next question comes from Kelly Bania from BMO.

W. McMullen:

Gary, go ahead.

Kelly Bania:

Okay. That's very helpful. And just a follow-up with digital. So growth of 8%. I think that brings it about flat in the first half. Just wondering if you could help us understand how that compares to your expectation and how -- really, how Ocado is ramping within that? I see here this 34% growth in delivery sales. But just are you on pace with the ramp of Ocado? And just about your goal in terms of doubling digital sales, how do you feel about that today?

Gary Millerchip:

Yes. Thanks, Rodney. Just a couple of things. Overall, I would say, Kelly, we're pleased with the progress that we saw in the quarter. As you heard me mention in my prepared comments, we're certainly starting to see some traction on some of the key initiatives that we've been investing in, whether it's the Customer Fulfillment Centers that are powered by Ocado in both new and existing markets, the launch of Boost and as Boost continues to ramp up and we see about 25% of customers that sign up for Boost are completely new to digital. So that's a really good driver of the digital business as well.

Spencer Hanus:

I just wanted to talk about the price gaps for a minute. Could you talk about how comfortable you are with where you're trending today? And have you noticed any change in your ability to pass through price increases as some of your peers have been a bit more rational on that front?

Spencer Hanus:

Got it. That's helpful. And then just to go back to Ocado for a minute. What are you seeing from the facilities that are located in the new geographies versus your existing markets? And as we think about the profitability of these sheds, any updated view on when we'll get to breakeven EBITDA there?

Michael Lasser:

There was about a 50-basis point acceleration in your 3-year geometric stack. Was that all driven by an acceleration in inflation from the first to the second quarter? And it looks like your guidance implies that you're expecting your IDs to go back to that kind of high 5% run rate in the second half of the year on the same 3-year geometric stack basis. So would that also imply that you're expecting the lower contribution from inflation in the back half of the year?

Michael Lasser:

Okay. My follow-up question is Kroger's been pretty nimble in managing its FIFO gross margin, as was evidenced by this quarter. Was some of that due to the ability to pass along price increases a little faster than you're getting the price increases passed along to you from your vendor community? And it does seem like some consumable retailers are announcing that they're going to make sizable price investments in the back half of the year. So how does that influence your view of the ability to sustain this FIFO gross margin performance over the next couple of quarters?

Simeon Gutman:

My question is on the consumer to diagnose some of the changes we're seeing. It looks like there was some trade down brewing across all of consumer. And you mentioned that your business picked up from June throughout the quarter. So can you talk about if you're seeing a level of either trading down or movement to private brands you heard, is the level, is it stabilizing? Did it [indiscernible] inside with gasoline prices leveling off and [indiscernible] getting stronger now? Or would this [indiscernible]?

Gary Millerchip:

Yes. I mean I think from what we see, we wouldn't expect it to be that dramatic a change. As I mentioned, I think we would expect there to be some flattening out of inflation in the back half of the year, but there's nothing that we see right now that would cause us to believe there's going to be a dramatic change in the level of inflation in the back half of the year.

Operator:

Our next question comes from Kenneth Goldman of JPMorgan Chase.

W. McMullen:

Yes, it's a great question, Ken. And it's really broad-based. And the banner brand, I wouldn't say it's a surprise, but the banner brand continues to gain solid share. But even if you look at like private selection, which has a lot of unique and new products, the growth there continued to be strong as well. So it was very broad-based across really the whole store.

Gary Millerchip:

Yes. Thanks, Ken. I think what I would say is overall, if you think about there's probably three pieces that impacted OG&A materially during the quarter. The one you mentioned, which was the true-up for the first half of the year on our incentive calculation based on our improved performance, we calculate what the [indiscernible] would be for the year. And so we have to catch up for the first 2 quarters in the year.

Operator:

Our next question comes from Robert Moskow from Credit Suisse.

W. McMullen:

The majority is consolidating the sub-brands, just making it easier to shop. Those items are always great value for the money. The other thing that there would be incremental items introduced under the Smart Way brand in terms of just the absolute number of SKUs. So it's really a combination of introducing some new items and consolidating several sub-brands and making it easier for customers to shop.

Gary Millerchip:

I wouldn't say, Robert, really changes our view of the opportunity ahead of us. As you know, we've laid out a clear plan at our Investor Day in March, and we still feel really confident in both the growth model that we outlined and where we believe the strategic investments will make sense across the supply chain, across our store portfolio and obviously continue to invest in digital. So I wouldn't read into it that we're any less excited or have less confidence in those plans. It's far more the former point that you made. But when we look at some of the short-term supply challenges, when we look at some of the costs in the market in the short term, it just made more sense in our view to balance that plan and to adjust the schedule. So it would be far more in that camp than the other.

Unknown Analyst:

This is [ Brandon Cheatham ] on for Paul. I was wondering if you could help us a little bit on the fuel margin cents per gallon were very strong in the quarter, but it sounds like you expect fuel to be a headwind in the second half. So can you help us, how much of the fuel margin was driven kind of by internal initiatives or external market forces that I guess you're not expecting to repeat in the second half?

Gary Millerchip:

Yes. I think just a bit of color maybe to the last comment, we mentioned on this one would be that our sales growth was higher than the increase that we saw from Q1 to Q2, was higher than the increase we saw in cost inflation. So overall, we're pleased with the trajectory in our growth. And we believe compared to the market, we were able to improve our trajectory, Q2 versus Q1 compared to how the market overall performed.

Rob Quast:

Alex, we have time for one more question.

Rupesh Parikh:

So maybe just a follow-up to the prior question. Just any perspective just on market share? It sounds like your GAAP versus [ peers ] may have narrowed this quarter, but just any thoughts on the performance this quarter and then how you're looking at that for the balance of the year?

Rupesh Parikh:

Okay. Great. And one follow-up question, just on CapEx as well. So this year, CapEx is pretty significantly below your prior plan. Do you believe we could be in a period of just lower sustained CapEx spend just given some of the headwinds out there?

Operator:

Thank you for joining us today. This concludes the Q2 earnings call. You may now disconnect your line.

Operator:

[Operator Instructions] Our first question for today comes from Robby Ohmes of BofA Global Research.

Gary Millerchip:

I think you covered it well, Rodney. The only other point you mentioned around total households and loyal households growing, we also saw visits improving during the quarter as well, Robby, which was -- we were really pleased with that trend as well.

John Heinbockel:

Yes. So let me start with our own brand, right? So it looks like own brand is probably growing 2x the rate of national brand. I'm curious, price spreads there, so maybe, Rodney, talk about that. Where you think own brand momentum goes from here? And I know historically, right, you guys have always said that own brand strength leads to increased CPG promotions. Do you think that will be true this time?

John Heinbockel:

A quick follow-up to that. Forward buying, right? Normally, a big P&L benefit in inflationary times. It sounds like today, it's limited, right, because of their capacity constraints?

Operator:

Our next question comes from Simeon Gutman from Morgan Stanley.

Spencer Hanus:

Can you provide some more color on the FIFO adjusted gross margins in the quarter? Because it looks like that slowed sequentially. And then you said your price gaps are well positioned, but do you think you're going to need to invest further in price in the second half as we just see sort of inflation pick up and that consumer gets under more pressure?

Operator:

Our next question comes from Karen Short of Barclays.

Gary Millerchip:

Vaccine headwind would have been in the first quarter probably a factor, and then it would also be a factor in Q2 and Q3. But again, I wouldn't think of that as being a major headwind on what -- so that was probably a bigger factor in Q1 as any quarter. So I wouldn't think of the gross margin performance that we saw in the first quarter of the year as being dramatically different expectation in the remaining quarters based on the impact of vaccine and other factors.

Rupesh Parikh:

So I just want to go back to grocery market share. Just want to get a sense of how your markets are held up in the grocery category. And I guess related to that, it sounds like the general merchandise category had some headwinds. So just wondering if that contributed maybe to the weaker ID performance.

Gary Millerchip:

Sure. Yes. Just briefly, I would say, on the EPS side of things, I mentioned a moment ago, Rupesh, that I think if you look at the guidance for the back -- the last 3 quarters of the year, it would sort of predominantly be around the sort of flat to slightly down. I would think of that, if you look at the cadence last year, it would be relatively consistent if you think about the next 3 quarters. So I wouldn't call out any dramatic year-over-year variance to that overall.

Operator:

Our next question comes from Edward Kelly of Wells Fargo.

W. McMullen:

Yes. If you look on the basket size, that's driven by units per basket. And what we're finding is customers are coming in more frequently before but they're not buying as many items on each shop. And that's what we're seeing.

Gary Millerchip:

Yes. Well, I think just to clarify maybe the comment we made, the total basket size is actually up. It's the number of units in the basket that are down. So if we look at our overall metrics, households are up, loyal households are up, visits have turned positive, basket size is up. But the number of items in the basket, as Rodney mentioned, is the item that I think customers are adapting behavior as they start to manage the inflationary environment. And that's obviously a focus area for us to use data personalization and different tools around rewards to really aim to continue to drive that up.

Edward Kelly:

Okay. And then just a quick follow-up. I think that you said that you sort of expected the gross margin trend for the rest of the year to be similar to Q1. Did you mean the year-over-year decline? Or did you mean multiyear? Just kind of curious as to what you were talking about there.

Operator:

Our next question comes from Michael Montani from Evercore.

W. McMullen:

Yes. I always think it's important to look at CPI and PPI together. And it's also the reason why we shared a little bit more details about Our Brands than normal because you have -- customers are doing their own behavior in terms of changing the way they shop.

Gary Millerchip:

Yes. The $1 billion of savings would certainly be sort of an ongoing flow of initiatives. So certainly think about it as being consistently sort of building from -- so we've got a certain number of benefits from last year that flow through, and then we're introducing new initiatives this year. So because we're on this 5-year journey, $1 billion of savings, it's very much a continual flow of new initiatives that are being implemented in the business to drive those efficiencies and savings.

Operator:

Our next question comes from Michael Lasser of UBS.

W. McMullen:

If you look, all of us, our quarters end at a little different time. So it's always difficult to be exactly comparison. And I know some of the competitors don't break out specific by category. And I know for us, obviously, general merchandise is a bigger part of our business than some of our traditional competitors, not as much as some of the big-box competitors.

Gary Millerchip:

Yes. The only other thing maybe I would add, Rodney, is that the comments we made, Michael, about digital growth and the expectation that with the investments we're making in customer fulfillment centers, the announcement -- the exciting announcement that Rodney shared this morning around Boost membership launching across the whole of the company, we feel that the momentum that we're seeing starting to build in digital will also be an important component of that growth in the future as well.

Gary Millerchip:

Thanks, Michael. Yes, I think briefly, we see that as an opportunity actually for Kroger because what we tend to see in those more economically challenged times is that the customer that's less stressed, as you described them, actually views Kroger as a high-quality place to get more value compared to maybe shopping a larger number of stores, and we even see it with some of our own brand performance. Rodney mentioned the strong value and ingredients for cooking at home, but we also saw strength during the quarter in Private Selection and Meal Solutions. So we see that as an opportunity for us to really connect with that customer as they start to maybe determine the best place to shop for quality and value combined.

Katharine McShane:

I wondered if you could talk a little bit about how conversations are going with your vendor partners currently, especially in light of the ongoing inflation to the second half. Have you been able to push back with regards to some of the cost inflation? And will you be getting more aggressive in those conversations like some of your competitors have suggested?

W. McMullen:

Yes. If you look at the test regions, it would positively affect our identicals. And the thing that's most important to us is it causes that customer to be stickier to our overall ecosystem, not just on delivery. So -- and our strategy is that if a customer thinks food, we want them to think Kroger. So we feel good about where we are and it's continued in the right direction.

Charles Cerankosky:

Rodney, if you talk about your e-commerce sales, they were down 6% overall. Can you shed some light on the components of that because I don't think it reflects what's going on with the new CFCs and spokes. So where is the negative numbers coming from? And how are the -- how is the Ocado-based facilities performing?

Gary Millerchip:

Chuck, yes, I think there's a couple of different factors just briefly in there. Overall, we've been on a plan for a number of years to continue to optimize working capital. So I wouldn't say it's a dramatic change in strategy. We're very focused on continuing to drive improvements there and have seen good tailwinds in our cash flow because of that.

W. McMullen:

Thank you for -- to everyone for joining us today. I am incredibly proud of the way we are beginning in 2022, with a continued focus on our Leading With Fresh and Accelerating With Digital strategy.

Rob Quast:

Good morning. Thank you for joining us for Kroger's Fourth Quarter and Full Year 2021 Earnings Call. I am joined today by Kroger's Chairman and Chief Executive Officer, Rodney McMullen; and Chief Financial Officer, Gary Millerchip.

W. McMullen:

Thanks, Gary. Kroger is operating from a position of strength, and we have a variety of levers and growth opportunities to continue to build on this strength. As we reflect on 2021, we are incredibly proud of our ability to navigate both a rapidly changing operating environment and evolving customer behaviors.

Operator:

[Operator Instructions] Our first question comes from Rupesh Parikh with Oppenheimer.

Gary Millerchip:

Yes. Thanks, Rupesh. As we mentioned in the prepared remarks and Rodney covered in a moment ago, really proud of the team in the way that we managed the business in Q4 and some of the changes that were happening. From I think what the team did, we're obviously laser-focused on how can we continue to be effective in managing the sourcing approach to how we are leveraging the relationships with our suppliers and using our data.

Rupesh Parikh:

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

Operator:

The next question is from Simeon Gutman with Morgan Stanley.

W. McMullen:

Yes. I'll start and let Gary get into some more of the details. I think one of the things that's -- to me, your question is great. But the thing that I think is really important to remember is the things that we continue to do to take costs out of our system all across everything. And we would expect to be able to take another $1 billion of cost out. And as you know, last year, we took over $1 billion out and that was the fourth consecutive year.

Gary Millerchip:

Well, I think you summarized it well, Rodney. I think, Simeon, we feel about it as you look at our 2021 results and then you think about our guidance '22, it really demonstrates the strength in that, the overall diversity of our model now and the different levers that we're able to pull to make sure that we're investing in our associates, investing in our customers and still able to deliver a strong return for our shareholders.

Simeon Gutman:

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

John Heinbockel:

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

Gary Millerchip:

Yes. No, I think the only thing, John, that's really accelerated over the last couple of years, I completely agree with Rodney around the sourcing benefits and the taking cost out of the operation. The one thing that, as you know, we've talked about is we invested in digital to ensure that we're winning the customer to build that $10 billion business that we talked about. And we did that sometimes, recognizing that there'll be some inefficiency in our model.

W. McMullen:

John, Gary's last point to me is incredibly important. And everybody on the call, you've all heard us talk about job 1 is don't lose the customer as they switch to being a combination of digital and in-store. And then over time, we'll figure out a way to make that customer just as profitable as a customer that traditionally shopped in the store. So I think Gary's last point is really important.

W. McMullen:

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

Spencer Hanus:

This is Spencer Hanus on for Greg. I just want to follow up on the FIFO adjusted gross margins for a minute. Did you see any change in the competitive environment that allowed you to pass through more costs? We know that Walmart's U.S. gross margins were up 54 basis points last quarter. So curious if that provided an opening for you guys. And then should we look at the 4Q performance as a good run rate for 2022?

Gary Millerchip:

Yes. Thanks, Rodney. Spencer, as you know, we don't tend to give detailed guidance on the puts and takes in gross margin rate and OG&A rate because we much more view it as how do we manage the business as a whole to drive sustainable earnings growth. I would say that I mentioned it in one of the earlier responses, that we would expect to continue to invest in the customer in 2022. And we'd also actually expect to see some accelerated advertising costs too because we're going to obviously continue to grow the business and we'll talk about it tomorrow, some of the digital growth opportunities that we're focused on as well.

Spencer Hanus:

Got it, that's helpful. And then fuel profitability is up significantly versus 2019 despite the rising prices, which is typically a headwind to that -- to profitability. So I understand that you expect profitability to be down this year a little bit. But how sustainable do you think it is, this step-up versus '19? And then could you just remind us how much operating profit the fuel business contributed in 4Q just so we can better back into how the core performed?

W. McMullen:

One other thing on fuel that our team -- 2 or 3 years ago, we restructured our procurement team in fuel, and they've also made progress relative to the market on cost of goods, which has been helpful for that business as well.

Michael Lasser:

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

Michael Lasser:

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

Gary Millerchip:

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

Operator:

The next question is from Edward Kelly with Wells Fargo.

W. McMullen:

Yes. As you know, when we embarked upon Restock Kroger several years ago, we made the commitment that we would accelerate our associate wages. And as Gary mentioned, now we -- incrementally, it's about $1.2 billion per year that we are investing in supporting our associates. We think supporting our associates is incredibly important. And what we're always trying to do is to make sure that we have solid wages, strong wages and industry-leading benefits, which we do have and making sure that we're keeping food affordable for customers.

Gary Millerchip:

Yes. Maybe just a couple of things to add, Rodney. When Rodney talked about the last 4 years and the investment we've made, I wouldn't think of that as being the end of the journey when we announced our TSR model. We were actually fully expecting, as we look out towards 2025, that we will continue to invest in our associates and our model when we announced the TSR model of 8% to 11% growth. We actually did expect that we would continue to invest not just over '18, '19 and '20 but continue to invest '21 through 2025.

Michael Montani:

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

Michael Montani:

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

W. McMullen:

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

Operator:

This will be our last question, and it comes from Ken Goldman with JPMorgan.

W. McMullen:

Yes. If you look at labor overall, it's something that we're proud. We're one of the largest union employers in the United States. And we're focused on providing additional -- we go in with the ability and assumption that we're going to continue to invest in our associates. And we have industry-leading benefits and we support their ability to come for a job and make it a career by feeding your future, providing tuition reimbursement and other things to help people continue to achieve a career.

Gary Millerchip:

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

W. McMullen:

Thank you for joining us today. We often say the holidays are our time to shine. And as we move through the holiday season, we feel great about our ability to deliver. I would like to say a huge thank you to our associates who remain engaged, energized and focused on taking care of our customers. We are incredibly proud of our third quarter results and the underlying momentum in our business. We returned to positive identical sales without fuel for the quarter. We saw triple-digit digital sales growth on a 2-year stack, and we've increased our full year 2021 guidance. Our agility and the commitment from our amazing associates is allowing us to navigate current labor and supply chain conditions and provide the freshest food at affordable prices across our seamless ecosystem.

W. McMullen:

Thanks, Gary. Kroger's strong year-to-date results are the outcome of our customer obsession, our incredible associates who bring our vision and values to life and our commitment to bringing fresh, affordable food to everyone. The strength of our teams have never been more apparent. With every new challenge, they raised to the occasion, whether by implementing solutions to minimize supply chain disruptions, delivering the freshest produce to our customers or using our data to offer personalized promotions that surprise and delight. Our team is bringing our competitive moats to life.

Operator:

[Operator Instructions] Our first question is from Robert Moskow with Credit Suisse.

Gary Millerchip:

Sure. Thanks, Rodney. Thanks for the question, Rob. Yes. I would say, Rob, obviously, when we guided at the second quarter, we said that the gross margin contraction could be similar to what we were seeing in Q2. And I would say the dynamics that are in place haven't changed dramatically. Obviously, it's a dynamic environment that we're managing, and our goal, as Rodney mentioned, is to continue to find sourcing benefit and savings to offset the cost increases where we see them and to pass on pricing where it makes sense but also to keep investing in the customer. And I'd say that we -- in Q2, we were doing that. In Q3, we've continued to do that.

Robert Moskow:

And just a quick follow-up. I think Rodney said that you're seeing your inflation kind of leveling off. Are you looking at like PPI inflation there? Because I would agree with you, it seems like in the low teens, it's leveling off. Is that what you're looking at?

Operator:

The next question is from Ken Goldman with JPMorgan.

W. McMullen:

If you look at our brands, if you look at the third quarter trends, they were better than the second quarter trends. And if you look within the quarter, it improved during the trends.

Kenneth Goldman:

And then quick follow-up. I think you mentioned that you're not passing on cost increases fully in either certain categories or certain products. Is it safe to assume that, like many of your peers, you're a little more hesitant to take pricing up on items that draw people into stores on a regular basis, things like milk and bread, et cetera? Or is it a little more strategic and nuanced than that? Just trying to get a sense for how you're thinking about which items to take pricing up on and which not.

W. McMullen:

Okay. Thanks, Ken.

Michael Kessler:

This is Michael Kessler on for Simeon. Can you hear me?

Michael Kessler:

First, I wanted to ask about any initial thoughts, if you have any, on 2022, another good quarter in Q3. It looks like the full year is going to end up basically a retention or maybe slight growth off of 2021 on earnings. So I guess any more confidence or conviction that next year could be another, call it, algo type of year on both IDs and EBIT? And I guess any puts and takes as you're starting to think through that outlook?

Gary Millerchip:

Well, I think you said it well, Rodney. I would just add where you were going. I think we're -- hopefully, we've been conveying very clearly, while we won't be getting into detailed guidance for 2022 because that's the first of March meeting, we've been trying to be clearing all of that communication, I think, around the confidence we have in the long-term prospects of the business, so not specific to '22, but thinking as we're continuing to build the business from the base that we've established through COVID that the opportunity to grow and deliver on that TSR commitment that Rodney mentioned. And specifically, we do believe that some of the food-at-home trends that we've talked a lot about. We've said for some time and continue to believe that data shows that a number of those changes will be structural in nature, and we'll continue to see sustained trends in food at home.

Simeon Gutman:

And it's Simeon for the follow-up. I thought maybe Michael might have a better shot at the '22 question than me. But my follow-up is on the puts and takes on IDs. It looks like it held pretty consistent, Q2 to Q3, and you talked about inflation lifting but leveling. Can you talk about anything, puts and takes sequentially got worse or better in terms of units, traffic, et cetera?

Gary Millerchip:

Maybe just to add, Rodney. Yes, Simeon, I mean, the trends were pretty consistent through the quarter in Q3. They got slightly better as the quarter went on, and we would be trending at the top end of the range that we shared in the quarter-to-date so far, top end of the range that we shared for guidance for Q4. And if you look at the trend so far in this quarter, I would say that the quarter would have started a little bit slower because of -- we were cycling in that week before Thanksgiving a fairly large spike in consumer behavior that I think started to signal maybe a potential increase in cases this time last year, and then Thanksgiving was very strong. We were very pleased with the results over the Thanksgiving week itself.

Operator:

The next question is from Robbie Ohmes with Bank of America Global Research.

Gary Millerchip:

Sure. Thanks for the question, Robbie. Yes. We're really proud of the team's work in those areas, as you mentioned. It started out at the beginning of Restock Kroger. There is a sort of let's grab the opportunities that are immediately in front of us, and I think it's really become a core competency within the organization to drive sustainable savings in our model.

Robert Ohmes:

That's great. That's really helpful. And one really quick follow-up question, if I may. With the changes you're making on the sourcing side and with own brands, can -- what is happening with total SKUs versus national brands SKUs versus owned brands SKUs in your stores? Are they shrinking? Are some growing? Can you give us any color on that?

Spencer Hanus:

This is Spencer Hanus on for Greg. I just wanted to ask how you're thinking about the delta between retail and cost inflation in '22. And then what is the breadth and depth of promotions that you need to hit your long-term top line targets, just given the unique opportunity the industry has had to reset promos over the last 18-plus months here?

Gary Millerchip:

Sure. Yes. Thanks for the question, Spencer. As we mentioned, we're kind of not really providing sort of an outlook for 2022 at this point around how we think about sales and investments overall. We'll be doing that, for sure, as we get to the March meeting and sharing our Q4 results.

Spencer Hanus:

Got it. That's helpful. And then in the prepared remarks, I think you mentioned that the Ocado facility is performing better than expected, the one in Florida. But could you just provide some more details on the basket size and the repeat orders relative to your targets? And then how are you thinking about the need, longer term, to build or acquire stores in that market to provide a more complete omni experience down there?

Gary Millerchip:

And the repeat usage, Rodney, is higher than we expected, right, than net promoter score.

Operator:

The next question is from John Heinbockel with Guggenheim Securities.

W. McMullen:

If you look at customer behavior, I want to broaden it a little bit on -- relative to your question. We continue to see people focus on health. If you look at early in COVID, people were not as focused on health, but they're definitely back where they're focused on health in a more aggressive way. All across the board, you see premiumization on what people do. And I always say I'm a reasonably aggressive shopper in our Murray's Cheese. Growing up, I would have never had really good cheese. And once you have a really good cheese, it's hard to go back to what you were used to when you -- before. And what we're finding is customers, when they upgrade and try higher-quality product, they find out they love it, and they become loyal to it.

John Heinbockel:

All right. Maybe just a quick one for Gary. You guys now have something on the order of $4 billion to $5 billion, right, of dry powder in terms of your leverage target. How do you think about that conceptually in terms of timing, in terms of return to shareholders versus strategic M&A. What's the philosophy there?

Charles Cerankosky:

Great quarter. Rodney, I think, as you earlier mentioned, that you chose to incur some significant costs in the -- to bolster the supply chain in the quarter. Can you give us some detail on that and whether they last into next year? And then I have a follow-up related to that.

Charles Cerankosky:

Anything on the labor side worth noting? And then also, when you're talking about the supply chain issues and product outages, is it -- are we talking about branded versus private label, fresh versus shelf-stable, edible versus nonedible products? I mean, where are you seeing the need to spend the most money and use the most management resources to make sure the shareholders that.

Operator:

The next question is from Michael Lasser with UBS.

W. McMullen:

If you look at -- as everybody knows, we go to market as a high/low merchant. So we're aggressive on promotion. We're aggressively using promotion. And we feel very good about where we stand relative to price gaps. And if you look at -- our strategy has always been to neutralize on price and win on our fresh areas and our friendliness and connection our associates have with our customers. And that continues to work well, and we continue to feel good about where we are relative to the various gaps.

W. McMullen:

If you look at Florida, I think the growth in the market is so strong that I think every -- all boats are rising in Florida. So to say that we're taking share away from somebody, I really don't think of it that way because I just think the market is growing so much.

Rob Quast:

Thanks for your questions, and that will end our question-and-answer session.

W. McMullen:

Thank you, Rebekah. Good morning, everyone, and thank you for joining us. With me today to review Kroger's third quarter 2020 results is Chief Financial Officer, Gary Millerchip.

Health and wellness is a critical part of our customer value proposition. Pharmacy customers are more loyal, spending 3x more per customer. We have approached pharmacy from an omnichannel perspective for quite some time, allowing customers to choose the most appropriate channel in which to connect with us, whether that be in-store, on the phone or online. For all channels, our strategy is consistent:

simplify health care by creating solutions that combine health, wellness and nutrition. I continue to be proud of the work that our associates do to serve each other, our customers and our communities. Stories of their accomplishments and selflessness inspire me every day. The investments we have made to enhance our competitive moats are paying off and as a result, we are growing market share.

Gary Millerchip:

Thanks, Rodney, and good morning, everyone. The Kroger team delivered strong results in the third quarter and provided a further proof point of the value creation model we shared at our Investor Day last year. We grew market share and, consistent with our value creation model, were disciplined in balancing significant investments in our customers and our associates with improved productivity and accelerated growth in our alternative profit businesses. The investments we are making in our business are allowing us to deliver strong results today and, importantly, are also setting us up to deliver sustained growth in the future.

W. McMullen:

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

Operator:

[Operator Instructions] Our first question is from Simeon Gutman with Morgan Stanley.

W. McMullen:

Yes. Thanks, Simeon, for the question. If you look at e-commerce, as Gary and I both mentioned, incrementally, it is profitable this quarter on the incremental growth, and it was driven by the continued improvement in reducing the costs to serve our digital customer and the incremental growth in media. And as both of us mentioned, we would expect to continue to make progress on both of those fronts.

Gary Millerchip:

Well, I agree completely, Rodney, with your overall comments. Maybe a couple of specifics, I mean, into 2020 and 2021, just to build on some of Rodney's comments. First of all, as you think about 2020, we talked about the pass-through rates, obviously being lower on digital although being incrementally positive. So the way it would show up in our P&L is where typically on the sales growth that we're seeing this year. We might have normally seen a pass-through rate of north of 15% on a traditional brick-and-mortar sale. The blended rate between digital and store and having in the COVID cost may be coming in around 10% versus that 15% or higher. So a combination of lower pass-through rate on digital and the incremental COVID cost will be bringing down that overall blended rate.

Gary Millerchip:

Yes. Simeon, you'd be correct in the way in which our core pickup business would show up in our P&L as a lower pass-through rate is the labor associated with picking the product in the store. That's what drives the mid-single-digit pass-through rate versus the sort of high-teen rate, if you like, on a traditional brick-and-mortar sale. We have a fairly unique model, I think, with Instacart. They are our predominant partner. We do use other partners as well in terms of delivery. So part of that business of Instacart is still delivered through the Kroger ecosystem. So the customer would come on to kroger.com or the Kroger app and would order a grocery delivery. Instacart would pick that product for us, but we're managing it through the Kroger ecosystem. So a significant part of our volume would flow through there. And then, of course, we're compensating Instacart or another third-party for that service. And that would also appear in OG&A. So it would be a similar area of the P&L.

W. McMullen:

And we would look constantly at people to partner with to help accelerate our experiences for our customers. So the example Gary gave is just one of many different partners and some are larger companies, some are smaller companies, but it's really how do we make sure we get -- deliver for the customer the way they want it delivered for them.

Erica Eiler:

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

W. McMullen:

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

W. McMullen:

Yes. As I mentioned in the prepared remarks, pharmacy customer typically spends 3x more in our stores. And the pharmacy customer, for us, we've been working hard, our whole teams have, by treating food as medicine. And we're increasingly learning how to help customers eat healthier and live healthier. And for us, it's really the 2 working together is how we help customers stay healthy.

Operator:

The next question is from Ken Goldman with JPMorgan.

W. McMullen:

When you look at -- and I'll let Gary get into some of the details. But when you look at overall, a little bit of inflation always [ makes this ] a little easier. And we don't have [ anything ] when we have a little inflation. But as you know, we've built a business model that is strong, whether inflation is high or low or anything in between. If you look at the third quarter, inflation was a little bit lower in the third quarter than the second quarter, and that was primarily driven in the meat commodity, which was consistent with what we expected.

Gary Millerchip:

Sure. Thanks, Rodney. Ken, I would say that overall, we're seeing, as Rodney mentioned, and you've probably heard us say before, we build our model based on sort of 0.5% to 1% inflation, aligned with Rodney's initial comment. We've been seeing inflation running more in the sort of 2% range, I would say, and slightly up or down, as Rodney mentioned, but generally speaking, in that kind of range. From our perspective, it's obviously hard to predict exactly where inflation goes. We don't see anything in the overall supply chain when you think about food in the system that would cause us to be dramatically different. But there are also risks, obviously, with COVID and what happened in the first quarter around meat, as Rodney also mentioned a moment ago, and there are certainly some produce categories but because of the season have had some supply shortages, too.

Kenneth Goldman:

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

Unknown Executive:

Pantry load.

Operator:

The next question is from Michael Lasser with UBS.

W. McMullen:

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

W. McMullen:

I would say we continue to learn. We really aren't yet in a position where we would decide whether to expand or whatever. It continues -- the customers react positively, but we are continuing to learn how to better and deeper connect with the customers. So happy, but still early on.

Spencer Hanus:

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

Spencer Hanus:

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

Gary Millerchip:

Yes. I would say, on incrementality, we're seeing -- and I mentioned some of this in my prepared remarks, but we're seeing very similar consistent patterns in incrementality. It would still be north of 50% in terms of when we look at what customers are buying, when they engage with us digitally. And then we look at it for a longer period of time and look at the categories and the products they were buying from us before engaging in digital, and you combine the total purchasing behavior between store and digital for that customer, we're seeing new categories and new products, and there's a -- on the basket that Rodney mentioned, it was significantly higher. The north of 50% of that basket is incremental when we look at the customers' shopping behavior over a longer period of time.

Renato Basanta:

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

Renato Basanta:

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

W. McMullen:

Thank you for your questions today. I wish all of you and your friends and family happy holidays, Merry Christmas and a Happy New Year and encourage you to stay safe.

Operator:

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.

Rebekah Manis:

Thank you, Gary. Good morning and thank you for joining us. Before we begin, I want to remind you that today's discussion will include forward-looking statements. We want to caution you that such statements are predictions and actual events or results can differ materially. A detailed discussion of the many factors that we believe may have a material effect on our business on an ongoing basis is contained in our SEC filings. The Kroger assumes no obligation to update that information.

Gary Millerchip:

Thanks, Rodney, and good morning, everyone. Before getting into our business results, I wanted to echo Rodney's comments from earlier and say how extremely proud I am of our associates for continuing to serve our customers and communities throughout the pandemic. We remain committed to investing to ensure a safe environment for our associates and customers, and we will also continue to use our customer insights to invest in delivering greater value for customers in ways that are most relevant today and that build future loyalty.

W. McMullen:

Thanks, Gary. We provided specific guidance to help you understand how we see the business today. While there are still a lot of uncertainties, we are confident in our team's ability to navigate through this. We are laser-focused on winning with the customer, and our true measure of success internally will be growing market share sustainably over time.

Spencer Hanus:

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

Gary Millerchip:

Yes. Thanks for the question. So the way we think about digital profitability is -- I know we've shared some of this color before, but essentially, we track very closely how a power customer behaves and when they engage digitally, and we see a significant level of incremental sales overall in the customer relationship. Obviously, you have to offset that against the incremental costs that we incur in filling the order for the customer.

Michael Lasser:

So Rodney, you mentioned you took share in fresh. How do you think your share in other categories trended? And can you give us more detail behind your decision to reengage in price investments during the period? I think that was something that -- or at least promotions were put on hold in the prior period. It sounds like the overall environment has gotten a bit more competitive in the most recent period. Is that fair?

W. McMullen:

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

Kenneth Goldman:

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

Kenneth Goldman:

No, I understand. And then my follow-up, your FIFO gross margin ex fuel in the first quarter was up, I think, 46 basis points year-on-year. It was up still this quarter, but to your point, it was up less, I think, 5 was the number. Gary, I think you were very clear highlighting price investments as one of the reasons for that deceleration.

Gary Millerchip:

Yes. I think -- thanks for the question, Ken. I think as we've shared kind of consistently, our goal is really to be balanced in the business model and continue to balance the investments we'll be making in supporting the customer, which is certainly our continued intent with the savings that we achieved through sourcing benefits and then, of course, alternative profit being accelerator of gross margin as well.

Operator:

The next question is from Rupesh Parikh with Oppenheimer.

W. McMullen:

Yes. In terms of capacity, we're constantly adjusting the capacity during the day because as people get used to the new normal, the times they want pickup slots constantly change. It's one area where I've been super proud of our teams, both stores and our data and technology and operations team in that constant adjusting and incrementally hiring people. There are stores now where we're aggressively investing a little bit of capital to be able to expand what's available within that store, and when we do that, that will allow us to add slots as well. So I would say the constraints on slots would be a slight opportunity, but I think the teams have done a great job of continuing to expand.

Rupesh Parikh:

Great. And then I guess one quick follow-up for Gary. What's the right way to think about COVID expenses in the back half of the year?

Karen Short:

Just actually on the gross margin, I had one quick follow-up and then I had a bigger question. Can you just give a little color on selling gross margins? I know that's not a topic that we've -- you've talked about on a consistent basis, but I think it would just help from the context of -- you said it drives customer loyalty to continue to promote during this time period and a lot of your competitors are not promoting. So I was wondering if you could give a little color on selling gross margins this quarter versus the first quarter.

W. McMullen:

If you look at -- our percent of sales would be a little bit higher than your estimate. If you look at mix between pickup and delivery, it's still predominantly pickup. And we find customers find pickup incredibly flexible on their schedule, much more so than delivery, and that's the reason why they continue to like pickup in a good way. If you look at basket size, basket size would be significantly bigger on pickup versus in-store and pickup and delivery would be pretty similar.

Gary Millerchip:

Maybe I can help you with that, Karen, on the comment about pickup and delivery. As Rodney mentioned, pickup is a significantly larger portion of the overall volume. I would say both of them are growing triple digits, so we are seeing very strong growth in both, but there isn't like a major change in the mix, if you like. Both have continued to grow significantly in the COVID period.

Robert Ohmes:

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

W. McMullen:

The mix between pickup and delivery is more driven by available slots. We do not -- the growth, it's still triple-digit growth but it would be a little bit slower growth, but it's still meaningful growth.

Edward Kelly:

Good quarter, by the way. I feel for you guys on the gross margin, by the way, and I wanted to follow up on this because I think there's been some criticism in the market that your gross margin was not up as much as the sell side was modeling. But you're probably doing what you should with this windfall, right? You're investing in price, still delivered a large EPS beat. Others are not investing.

Gary Millerchip:

Yes. Thanks for the question, Ed. I think you summarized it well. From our perspective, we believe it's very important that we continue to deliver value for customers and we're staying very true to that plan. And when we look at prices, as we've shared a couple of examples on the call, for us, it's not just about everyday low price but it's about the promotional plan, it's about the investment in digital. And we feel like we're on a very clear path to deliver value for the customer that will drive long-term loyalty.

Edward Kelly:

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

W. McMullen:

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

Operator:

And that question will come from Kelly Bania with BMO Capital Markets.

W. McMullen:

We -- tonnage would continue to be strong. We have -- we're still continuing to -- if you look at our supply chain, our team has done a nice job of identifying other sources of capacity. And we are -- have access to warehouses both that we manage on a temporary basis and others that continue to support and manage the tonnage.

Operator:

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.

W. McMullen:

Thank you, Rebekah, and good morning, everyone. A lot has happened in our world since the last earnings call. We've had to adapt quickly to a new way of life. The COVID-19 pandemic and the most recent instances of racial injustice have changed our country in unmistakable ways, most profoundly the devastating loss of life and livelihood that has affected so many Americans. During the crisis, Kroger has been guided by our purpose and our values. I am proud of our associates who stepped up when we were called to be there for our customers, communities and each other. We are proud of the heroic and dedicated associates who are on the frontline, serving our customers when they need us most. As America enters the next phase of the pandemic, we know that our associates will continue to rise to the challenge, delivering Fresh for Everyone and helping our customers, communities and America emerge even stronger.

We've been able to share our loans with other businesses and communities to help as they begun to safely reopen through a resource guide we created called Sharing What We've Learned:

A Blueprint for Businesses. Our blueprint includes actionable recommendations and learnings that we've applied as well as what we've learned through regular interaction with governments, health departments and with business leaders in other countries, including Italy, Singapore and China, all of which were ahead of the U.S. in terms of the pandemic cycling through their countries.

We continue to invest in and constantly improve our e-commerce capabilities. Our partnership with Ocado remains an essential part of our evolving seamless ecosystem. Our customer fulfillment centers will accelerate our ability to serve customers seamlessly and in a more cost-effective way. Earlier in June, we identified 3 new regions:

the Great Lakes, the Pacific Northwest and the West for placement of our high-tech sheds. When operationally, these facilities will collectively create more than 1,000 new jobs with the potential for hundreds of additional career opportunities.

As many of you know, we outlined our Restock Kroger transformation plan in 2017. And as part of that plan, we made the strategic decision to invest in digital. These investments allowed us to quickly add much needed capacity to serve our customers by scaling the foundational capabilities we have built and continue to develop. The outcome of these efforts has been a meaningful uplift in sales across all digital modalities:

Kroger pickup, delivery and ship.

Operator:

[Operator Instructions] Our first question comes from Rupesh Parikh with Oppenheimer.

Gary Millerchip:

Yes. I think the biggest factor, Rupesh, would be that -- I mentioned it earlier, but just to maybe to give a bit more color on fuel for quarter 1 and how we see quarter 2 potentially shaping up because that would be the -- I think the biggest factor in the numbers. Overall, as I mentioned earlier, when we think about the supermarket business, we're expecting continued strong sales momentum, and we feel good about the ability to manage the margin and the investments that we'll continue to make as a result of COVID-19.

W. McMullen:

I love the question. And if you look at the strategic decisions we've made over the last several years, it highlighted those decisions really paid off in the current environment. Our digital and delivery and pickup business in the last 2 months grew triple digits and continues to grow at that. And to have the ability to grow at that kind of level that quickly, just so proud of the whole team in terms of the foundations that were already in place but also the stores and all the other parts and supply chain on being able to supply and hire people and support that. So we fundamentally believe the long-term trend will continue where people will continually depend more on e-commerce. We certainly have seen that be accelerated. We don't think it will stay at the higher level where it is today permanently, but we do think, fundamentally, the growth has been accelerated and will be higher than where it started before COVID-19 and then grow from there.

Simeon Gutman:

I was going to ask something different, but I wanted to ask you, Rodney. You just made the comment, it takes about 3 to 4 years to achieve the same profits. Do you mean that on an ongoing basis? Or is that lifetime value because over 3 to 4 years, I've purchased enough through the digital channel. And therefore the -- I guess the profit becomes equal? Or on a go-forward basis after year 3 or 4, the variable cost or the actual basket economics of each become even?

Simeon Gutman:

Yes. That's helpful. And my follow-up is on the 92% growth in the first quarter. Did you say the mix? Or are you surprised by anything about the mix between delivery and pickup? And then anything you can share on how it impacted gross margins or margins broadly? It sounds like if you picked up a lot of new customers, it would be in a pretty dilutive position for that lifetime of the customer, but anything you can share on it, please.

Edward Kelly:

Yes. Just, first, a follow-up and then a real question. As we think about Q2, could you just help us out? What are you assuming for IDs in the quarter? What are you thinking about from a continued COVID cost perspective? And how do we think about gross margin relative to what we just saw in Q1?

Edward Kelly:

I understand the reluctance to really give ID guidance. But the only thing that I would say is that it does matter if it's mid- to high single-digit EPS growth on a double-digit ID versus a single-digit ID from an investment perspective. So to the extent that you can help out with that, that I think would matter to how people are looking at your story.

Gary Millerchip:

That's right. So think of it as it's a green status plan. It's over 80% funded, so there's not an obligation for us to make that payment. But obviously, it's something that we're committed to making sure that, long term, we're securing that future liquidity of the plant. And especially during times like this when there's market volatility, sometimes there could be pressure on those plans to have to liquidate assets to be able to make contributions, and we wanted to make sure that the plans were not put in that risk. So we decided to basically invest those dollars now to protect the future. And obviously, over time, that will derisk the need for us to have to invest, but it wasn't a requirement to make those payments.

Gary Millerchip:

That's correct. Yes. The only way that we would approach those examples would be if we identified an opportunity to be able to pull away from the multiemployer plans and bring them into the same way that we run that UFCW plan if there was a -- if it made sense for us to do that from an investor and associate perspective because we could derisk the future liabilities and be able to take more control of that potential exposure in the future But we have no obligation on those, unless we were to make -- take that action like we did with the plan you described earlier.

Gary Millerchip:

That's right. Exactly, yes. That's fully funded.

Karen Short:

Just following up on that. So the actual -- can you give us an update on what the actual liability is on the multi-employer pension in dollars pretax? And then with this contribution that you just made, is there -- do we adjust -- and I know you haven't given the annual P&L and cash impact of the multiemployer pension contribution for many years. But -- are we think -- like when we think about modeling it, beginning 2Q, does that actual expense dollar amount come down based on the contribution you just made? And then I had a totally separate question.

Gary Millerchip:

Expense related to what, I'm sorry, Karen, I'm not sure I'm following.

Gary Millerchip:

Yes. So we -- as I mentioned, we would have pension expense related to our multiemployer plans that we pay into as part of the negotiated contracts with the unions. And obviously, where we need to continue to fund the plan that's internal, we'll make those contributions when we need to. But we -- obviously, that can vary significantly. But most of the most of the pull -- if I call it, pull forward may be a potential liability in the future, it doesn't relate to what we would do in 2020.

Karen Short:

Oh, just on the cash balance. I mean you guys haven't had a cash balance like that for a while. So thoughts on where you're at in terms of deployment of that?