The Kroger Co. (NYSE:KR) Q2 2023 Earnings Call Transcript

The Kroger Co. (NYSE:KR) Q2 2023 Earnings Call Transcript September 8, 2023

The Kroger Co. beats earnings expectations. Reported EPS is $0.96, expectations were $0.92.

Operator: Good morning and welcome to the Kroger Co. Second Quarter 2023 Earnings Conference Call. Please note this event is being recorded. I would now like to turn the conference over to Rob Quast, Senior Director of Investor Relations. Please go ahead.

Rob Quast: Good morning. Thank you for joining us for Kroger’s Second Quarter 2023 Earnings Call. I am joined today by Kroger’s Chairman and Chief Executive Officer, Rodney McMullen; and Chief Financial Officer, Gary Millerchip. I want to remind you that today’s discussions will include forward-looking statements. We want to caution you that such statements are predictions and actual events or results can differ materially. A detailed discussion of the many factors that we believe may have a material effect on our business on an ongoing basis is contained in our SEC filings. The Kroger Company assumes no obligation to update that information. After our prepared remarks, we look forward to taking your questions. Given the breadth of information that will be covered on the call and our divestiture announcement earlier this morning, we will extend our Q&A session if needed to ensure that we can cover a broad range of topics from as many of you as we can.

We still 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.

Rodney McMullen: Thank you, Rob. Good morning, everyone, and thank you for joining us today. Before we begin, I’d like to take a moment to outline the framework for our discussion this morning given that we have several important topics to cover. I will begin by covering the consumer environment and how the strength of our value creation model is supporting earnings growth and generating strong free cash flow. Then Gary will cover our financial results and highlights as well as provide an update on our nationwide opioid settlement framework. Finally, I will conclude with some brief comments on the divestiture plan press release we issued earlier this morning. We are excited about sharing our plans for this important milestone and we look forward to taking your questions during the Q&A segment of today’s call.

Now turning to our second quarter. Kroger continues to effectively navigate a challenged environment and delivered another quarter of consistent results. As economic uncertainty persists, the strength of our model is enabling us to deliver value for our customers, continue to invest in our associates and deliver consistent shareholder return. Value — remains top of mind for many of our customers as they are balancing several factors that are impacting their food at home spending. The effect of sustained inflation reduced government benefits including SNAP and higher interest rates have pressured customer spending, especially for those on a tight budget. To support our customers, we are delivering increased value through our robust Our Brands portfolio, personalized digital offers, fuel rewards and loyalty discounts, including weekly specials and yellow tag promotions.

Economic instability continues to impact customer segments differently. We are seeing this in their shopping behaviors. Higher income households continue to engage more deeply with us, enjoying our customer experience with zero compromise on convenience, quality and value. These customers are especially valuable to our mix as they purchase bigger pack sizes, shop more Fresh categories and trade up to more premium Our Brands products. On the other hand, budget-conscious households are facing external spending pressures. These customers are buying smaller pack sizes and, at times, prioritizing the lowest shelf price. These customers are building smaller baskets and switching to lower-priced items to stretch their budgets. They are also exhibiting spending patterns that ebb and flow with payroll periods and SNAP benefit distributions.

We expect these broader economic headwinds to continue pressuring customer spending in the second half of the year. While the environment is difficult we are never satisfied with sales and we are focused on driving more units in the back half of the year. Our teams are sharpening store execution, identifying basket add-ons and adapting to customers’ evolving needs. We saw an improvement in our budget-conscious household trends since last quarter as we expanded our assortment of everyday staples at lower price points. And as an example, we introduced new in-store displays where every item is below $3. Additionally, we continue to improve price position relative to key competitors, demonstrating our long-term commitment to provide customers with exceptional value.

We are creating more engagement with customers through personalization, offering more targeted and effective promotions and our seamless ecosystem is resonating with customer needs and it allows us to drive increased loyalty. And customers are rewarding us for this work. The second quarter represented our ninth consecutive quarter of total household growth. And now I’ll provide more detail on how our go-to-market strategy is delivering for our customers. We are reimagining our offerings throughout our portfolio of Our Brands. With more than 13,000 products available, customers can enjoy a wide range of high-quality alternatives to fit each customer’s budget. Additionally, we are improving the profitability of Our Brands. Through our brand architect work, we are ensuring each brand plays a unique role on the shelf.

Last year’s introduction of our opening price point brand, Smart Way, provides a great option for those prioritizing lowest price at the shelf, and it is resonating with our customers. Turning to Seamless, strong growth in our pickup and delivery businesses led to another excellent quarter in digital. This growth was underscored by a rise in both households and traffic. Our digital team’s relentless pursuit of improving the customers’ experience is driving our success. We scaled our hands-free technology across the company to improve speed and expanded pickup options with automated pods and lockers, improving productivity and providing customers with more flexibility. Our in-store associates are also playing a critical role in our success. This quarter, they reduced wait time, lowered cost to serve and improved fill rates.

Pickup has had a positive incremental contribution for some time. In multiple divisions now, our pickup business today is now profitable on a fully loaded basis. And by continuing to scale our operations, we have a clear path to sustainable profitability and pickup. Next on personalization. Personalization enables us to meet our customers’ unique needs and deliver value beyond the product shelf price. Our best-in-class data science work powered by our loyalty data is driving strong digital engagement. So far this year, customers have clipped more than 2 billion digital offers. To me, that’s just an amazing number when you think about 2 billion. We’ve also increased our digitally engaged households by 1.2 million compared to last year. This growth is important to our model as digitally engaged households are more loyal, spend nearly three times more with us and help grow our alternative profit businesses like Kroger Precision Marketing.

Now I’d like to share more about how our diversified business model continued to support earnings growth this quarter and gives us confidence in our ability to navigate the environment ahead. Starting with our alternative profit businesses. Alternative profits had an impressive second quarter led by strong growth in our retail media business, Kroger Precision Marketing. Our seamless ecosystem continues to drive track data and traffic which benefits this business. KPM applies these insights and its data science to build custom audiences and precisely measure return on ad spend delivering significant value to clients. This quarter, KPM announced a new in-house advertising platform, which allows greater flexibility to serve clients and improve outcomes for brands.

Kroger Health is another important component of our business that allows us to help customers live better lives and strengthen our model. The terminated agreement with ESI has freed up some capacity in our pharmacies and our Kroger Health teams are doing a great job of utilizing that capacity. Our pharmacists are dedicating more time to patient care and delivering better patient experiences. We are also simplifying work for our teams and lowering costs by expanding our use of automation. We are improving patient communications through modernized tools, which is driving better patient adherence to care plans and supporting growth. We are encouraged by the momentum in our health and wellness business and believe this is an opportunity for further profitable growth over the next several years.

Our amazing associates are providing customers a full fresh and friendly experience every day. We remain committed to supporting our associates through investment in wages. And over the last five years, we have raised wages by 30%. We are also committed to supporting our associates development. I often say that our focus is to make Kroger a place where associates can come for a job and discover a career. Kroger has made significant investments to support this culture and our teams have done a tremendous job creating training programs to help develop our future leaders. Their work was recently recognized with eight awards from the Brandon Hall Group, a leading human capital management firm. We are so proud of the work you are doing to help make Kroger an employer of choice.

I’m inspired every day to see how our associates bring our purpose to feed the human spirit. Our Zero Hunger | Zero Waste impact plan is a vital part of how we live our purpose in the communities we serve. Upon launching the plan in 2017, Kroger committed to donate 3 billion meals by 2025. We are so excited to share that we reached this ambitious target in the first quarter of this year, more than two years ahead of our goal. This quarter, we announced plans to accelerate our commitment to hunger relief. Upon completion of the merger with Albertsons, the combined company will donate 10 billion meals by 2030 to feed people struggling with hunger. To put that in perspective, it is enough food to feed every person in the cities of Seattle, Denver, Chicago and Boston every meal, every day for nearly two years.

This is one of many ways that this proposed merger will benefit the communities we serve. With that now, I will turn it over to Gary to take you through our financial results. Gary?

Gary Millerchip: Thank you, Rodney, and good morning, everyone. Kroger’s second quarter results demonstrate the resiliency of our value creation model. The investments we have made over recent years to strengthen and diversify our business are enabling us to deliver consistent results despite the difficult environment, and this was very much evident when you consider the key trends we saw in our business in quarter two. While industry-wide disinflation continues to impact food at home sales, our team is doing an excellent job managing the effects of this trend on our business. Key highlights for the quarter include EPS growth despite a significant year-over-year headwind from fuel profitability and underlying operating results excluding fuel improved versus prior year due to strong gross margin management, tight cost controls and continued growth in alternative profit businesses.

I’ll now provide more detail on our results this quarter. Identical sales without fuel grew 1%. Underlying growth would have been 2.6% after adjusting for the effect of the previously communicated decision to terminate our agreement with Express Scripts. Similar to the first quarter, the terminated agreement with Express Scripts had a positive effect on our FIFO gross margin rate excluding fuel and the negative effect on the OG&A rate, excluding fuel and adjustment items. The overall effect on operating profit during the second quarter was slightly positive and we would expect this to continue to be the case for the remainder of 2023. Our decision to terminate the agreement with Express Scripts reflects our commitment to making decisions that we believe are in the long-term best interest of our customers and shareholders.

Turning back now to identical sales without fuel. In the second quarter, results were at the low end of our internal expectations as we saw food-at-home inflation decelerate at a faster-than-expected pace. Inflation ended the quarter approximately 350 basis points lower than the start of the quarter. Our sales growth was underpinned by strength in our digital business, which grew 12%. Our unique combination of assets, including stores and fulfillment centers, helped us achieve growth in both pickup and delivery channels. The growth in delivery was led by a continued ramp in volumes through our CFC network and Boost membership. Gross margin was 21.8% of sales. Our FIFO gross margin rate excluding fuel increased 35 basis points compared to the same quarter last year.

Our team is doing a highly effective job balancing the impact of inflation, and the improvement in rate was primarily attributable to strong Our Brands performance, lower supply chain costs, sourcing benefits and the effect of our terminated agreement with Express Scripts. These tailwinds were partially offset by higher shrink and promotional price investments. Importantly, as Rodney shared earlier, this improvement in rate was achieved while also improving our price position relative to key competitors. Supply chain efficiency is one of many components of our strategy to expand margin over time while continuing to invest in greater value for our customers. This quarter, we achieved meaningful operational efficiencies in supply chain through improved transport capacity utilization and increased productivity in our warehouses and across our network.

We continue to invest in our supply chain as we see significant opportunities to further lower costs while also improving freshness to customers by eliminating waste in our ecosystem. Shrink increased during quarter two, primarily due to rising theft and organized retail crime. We are implementing initiatives to mitigate the financial impact including increased security and new technology solutions, but would expect Shrink trends will continue to be a challenge for the remainder of the year. During the quarter, we recorded a LIFO charge of $4 million compared to a charge of $148 million for the same quarter last year. This $144 million year-over-year tailwind from LIFO partially offset the $192 million headwind we experienced in fuel operating profit during the quarter.

The decrease in our LIFO charge was primarily attributable to a downwardly revised inflation outlook for the remainder of 2023. Kroger’s OG&A rate was flat excluding fuel and adjustment items. Our team continues to do an excellent job controlling costs and after adjusting for Express Scripts, we saw underlying improvement in our OG&A rate excluding fuel and adjustment items. Our cost-saving initiatives are focused on simplification and utilizing technology to enhance the associate experience without impacting the customer. For example, we are improving productivity in our stores by expanding shelf-ready packaging and introducing data-driven enhancements to associate mobile devices that optimize the restocking process. We remain on track to deliver our sixth consecutive year of $1 billion in cost savings.

Fuel is an important part of our overall value proposition and our fuel rewards program continued to drive customer engagement in the second quarter. The average retail fuel price was $3.65 this quarter compared to $4.62 last quarter. And our cents per gallon fuel margin was $0.45 this quarter compared to $0.62 last year. While fuel profitability was a significant headwind compared to prior year, we were cycling historically high results from 2022 and fuel margins remain very healthy relative to historical trends. I’d now like to provide a brief update on labor relations. During the second quarter, we ratified new labor agreements with the UFCW for Dallas Clarks, Southern Illinois Clarkson Meat and Smiths Utah Clarkson Meat covering more than 30,000 associates.

In the third quarter, we have also ratified a new labor agreement with the UFCW for Fry’s Food and Drug Stores associates. Turning now to liquidity and free cash flow. Kroger continues to generate strong free cash flow through consistent operating results and working capital improvements. At the end of the second quarter, Kroger’s net total debt to adjusted EBITDA ratio was a record level of 1.31. This compares to our net total debt to adjusted EBITDA target range of 2.3 to 2.5. The company expects to continue to pay its quarterly dividends and expect this to increase over time subject to Board approval. As a reminder, we have paused our share repurchase program to prioritize deleveraging following the proposed merger with Albertsons. We continue to be disciplined with our deployment of capital, prioritizing the highest return opportunities that support our growth strategy and TSR model.

This discipline is reflected in our ROIC results, which have now improved in each of the last three years and is significantly above our cost of capital. This morning, Kroger announced a nationwide opioid settlement framework to settle substantially all opioid lawsuits and claims against Kroger. As a result, included in our financial results is a $1.4 billion charge related to the settlement resulting in a loss per share of $1.54 this quarter. This amount was excluded from our adjusted FIFO operating profit and our adjusted EPS results to reflect the unique and nonrecurring nature of the charge. Under this settlement, Kroger has agreed to pay up to approximately $1.4 billion or $1.1 billion after tax with approximately $1.2 billion to be paid over 11 years and approximately $177 million to be paid over six years, each in equal installments.

Initial payments will begin in December 2023 and would total approximately $140 million per year pre-tax for the first six years and approximately $110 million per year pre-tax for the following five years. This settlement is not an admission of wrongdoing or liability by Kroger and Kroger will continue to vigorously defend against any other claims and lawsuits relating to opioids that the final agreement does not resolve. We believe that resolving these claims is in the best interest of Kroger and its customers, associates and shareholders and all of those affected by the opioid crisis. Additionally, this settlement and the payment terms will not affect Kroger’s ability to complete its proposed merger with Albertsons and we remain on track to achieve a net total debt to adjusted EBITDA ratio of 2.5 within 18 to 24 months post close.

In closing, I’d like to provide additional color on our outlook for the remainder of the year. As I shared earlier, this inflation is occurring at a greater rate in 2023 than we originally anticipated and our customers are continuing to feel the effects of macroeconomic conditions. For these reasons, we believe the remainder of the year will continue to present challenges to navigate and we expect identical sales without fuel will now be at the low end of our full year guidance range of 1% to 2%. We would expect identical sales without fuel to be slightly negative in the second half of the year. As a reminder, this guidance reflects the effect of Express Scripts, which is reducing our reported identical sales without fuel by approximately 150 basis points in 2023.

Despite slowing sales, as demonstrated in our year-to-date results, we believe we have the flexibility within our model to navigate the impact of this environment through effective cost management and growing alternative profits. We are maintaining our adjusted net earnings per diluted share and adjusted net operating profit guidance and would expect adjusted EPS to be in line with the prior year in the third quarter and slightly ahead of the prior year in the fourth quarter before including the approximately $0.15 benefit at the 53rd week. Kroger delivered another quarter of consistent results built on the foundation of record growth over the past three years. While macro uncertainties remain, we are confident the strength and resiliency of our value creation model will allow us to continue to deliver attractive and sustainable total shareholder returns.

And now I’ll turn it back to Rodney.

Rodney McMullen: Thank you, Gary. Before we open up the floor to your questions, let me provide a brief update on our pending merger with Albertsons Companies. This morning, Kroger and Albertson Companies announced that they’ve entered into a definitive agreement with C&S Wholesale Grocers for the sale of 413 stores as well as banners, distribution centers, offices and private label brands in connection with our proposed merger. When we announced plans to merge with Albertsons last year, we committed to delivering a divestiture plan that would ensure the stores will remain open, frontline associates will remain employed and existing collected bargaining agreements will continue. A critical component of that plan was to identify a well-qualified buyer who would be able to operate as a fierce competitor.

Since then, we’ve conducted a robust and thoughtful diligence process and reviewed dozens of buyers spanning from private to public, to union to non-union, domestic and international players. We are very proud today to announce the conclusion of that process which has led us to C&S Wholesale Grocers, a well-qualified buyer that meets all the criteria necessary to complete our transaction. C&S is one of the largest private companies in America today and an industry leader in wholesale grocery supply and supply chain solutions with a strong track record as a successful grocery operator retailer. Operating for over 100 years, C&S’ retail footprint includes more than 160 stores and the company services customers of all sizes, supplying more than 100,000 products to more than 7,500 independent supermarkets, retail chain stores and military bases.

C&S service offerings include a full suite of retail service offerings, very similar to what Kroger provides in house, including merchandising, e-commerce, accounting and store design for example. The company is deeply invested in the communities where it operates. And this retail expansion will continue their long-standing mission to help feed communities. C&S is led by an experienced management team with the financial strength to complete this transaction and also invest in the business for future growth. The company’s comprehensive operational infrastructure and purchasing efficiency positions them to successfully operate in today’s competitive environment. The divestiture plan ensures no stores will close as a result of the merger and that all frontline associates will remain employed.

C&S is also committed to honoring all collective bargaining agreements, which include industry-leading benefits and further investing for growth. Importantly, the company also brings experience with the merger process having been an FTC-approved divestiture buyer in prior grocery transactions with a strong record of successfully integrating union employees and collective bargaining agreements. To help support the immediate and long-term success of the divested business, the divestiture plan includes more than just a collection of stores but also a robust operational infrastructure. Included in the sale are centrally located distribution facilities regional headquarters and strong teams with deep industry expertise. In terms of consideration, the financial terms of this divestiture plan are in line with what we expected and allow us to reaffirm the compelling shareholder value creation opportunity this transaction creates.

With the announcement today, we are confident that our plans fulfill all the commitments we set out in the original merger agreement. Our proposed merger with Albertsons creates meaningful and measurable benefits for America’s consumers, Kroger and Albertsons associates and communities that both Albertsons and Kroger serve. This key step keeps us on track to close our proposed merger with Albertsons in early 2024. We encourage you to review the corresponding press release from this morning for further details. In terms of integration planning, we are progressing well, and it’s been exciting to see the talent from both the Kroger and Albertsons teams work together to plan on how the combined company will deliver an even stronger omnichannel food retail experience post close.

We are incredibly excited about the future together with Albertsons. As a reminder, given the breadth of information shared in today’s call, our divestiture announcement earlier this morning, we will extend our Q&A session if needed to ensure we cover a broad range of topics. With that Gary and I look forward to your questions.

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Q&A Session

Operator: Thank you. [Operator Instructions] Our first question is from Simeon Gutman from Morgan Stanley. Simeon, your line is now open. Please go ahead.

Simeon Gutman: Hi. Good morning, everyone. I’m going to ask one and a follow-up in case my phone gets cut off. My first is on disinflation. Wanted to talk about more specifically if there’s a chance we get to deflation around the corner in ’24 and then how it’s changing how you run the business, whether it’s pricing, and if you’re seeing elasticity. And then a follow-up, a separate question. Was the review process for the merger waiting to begin until this divestiture was announced? Or has the FTC’s process been ongoing and that allows you to close on time? Thank you.

Rodney McMullen: Thanks, Simeon. On the merger, there’s been ongoing discussions with the FTC and the related teams throughout the process. And once we announce it this morning, we will share this information with the FTC and continue that active engagement and dialogue. So it’s — along the way, there’s been ongoing conversations and there’ll be continuing ongoing conversations, but now we have more specifics in terms of the next steps that we’ll be able to share. On disinflation, I’ll start and let Gary finish on it. If you look, one of the things that Gary reminded me of is if you look in the last 50 years, I think we’ve had or 40 years, I don’t remember which one, that we had two years of deflation when you look at over the last several lifetime almost.

One of the things about the Kroger model is that we’ve found and we’re able to be successful operating in any environment both from a competitive standpoint and from an inflation standpoint. And we would expect it to be no different. We are beginning to see some volume improvements as inflation has slowed. We believe that there would continue to be a lag there. We’re also finding CPGs, in many cases, are partnering in more aggressive ways on helping us move tonnage as well. With that, Gary, I’ll let you finish for the — any additional comments you want to make?

Gary Millerchip: Yes. Thanks, Rodney. Well, I think you covered it well. All I would say, Simeon, maybe is relative to our expectations. You may recall at the beginning of the year, we shared that we thought inflation might end in the year in sort of the 3% to 4% range. And certainly, as we’ve seen, trends continue to evolve throughout the year. As I mentioned in my prepared remarks, we would now expect it to be at a lower level than that, which is partly why we’ve guided to the low end of our sales range for the year. So we would expect inflation now to be in the low single digits, the 1% to 2% range would be our sort of base assumption for the end of the year. And we believe, as Rodney said, that certainly there’s always a risk that the scenarios can turn out differently.

And we’ll continue to adapt our model if we needed to reflect that. But our base assumption would be that we’d expect to sort of return to more normalized very low single-digit food inflation which, of course, is what our long-term model is based upon of that sort of 1% to 1.5% inflation rate.

Simeon Gutman: Okay. Thank you for both answers. Good luck.

Rodney McMullen: Thanks.

Gary Millerchip: Thank you.

Operator: Thank you, Simeon. Our next question is from Krisztina Katai from Deutsche Bank. Krisztina, your line is now open. Please go ahead.

Krisztina Katai: Hi. Good morning and thanks for taking the questions. So I have a strategic question regarding the Albertsons merger. So I guess historically M&A hasn’t added that much value. We look at the businesses now. Margins have remained higher post-COVID, but I think there’s a natural question that as ID sales slow, maybe there will be a greater reinvestment needed into the business. So I’d be curious to get your views on the level of reinvestment versus your targeted synergies and if anything has changed regarding your approach versus the October view.

Rodney McMullen: Yes. If you look at the view today versus October, I would say the biggest positive is I’ve been incredibly impressed with the talent of the Albertsons team, it doesn’t surprise me, but actually getting to know people and working with them and the excitement that there is for the merged company together. If you look at it from a shareholder standpoint, we would feel very comfortable with what things we shared in October of last year in terms of we would expect from a cash flow perspective that it would be 30% accretive by year four, that the targeted net-to-EBITDA ratio that will maintain investment grade and be within those ranges within 18 to 24 months. If you look at the synergies, we still are comfortable with $1 billion.

Obviously, we’re going to work really hard to make sure and identify savings beyond that. And we’ve also committed and remember that those are net of investing in our associates and investing for the customer to lower prices. And that’s always been part of the plan from day one and would expect to. So when you look at overall, we still remain confident in terms of the commitments that we outlined in October. And at this point, we just want to get started and start benefiting our associates benefiting the customers and benefiting the communities.

Gary Millerchip: Yes. Maybe, Rodney, just a couple of things to add, if I can. I would completely agree with your comments. And we, obviously, we’ve had almost a year now since the announcement. And so while there’s only certain conversations you can have as Kroger and Albertsons is talking about planning for the merger I would say we’ve only gained more confidence in the synergy expectations that we’ve had. So we have been able to continue to validate the assumptions that Rodney outlined a moment ago. I think the only other thing that I would mention is way back to when we announced the merger, we talked about this wasn’t just about synergies. It was about essentially fueling the flywheel of the new combined company. And if you think about the results we’ve announced so far this year, the strength in our results in growing digital sales in our digital ecosystem, the strength in Our Brands performance, the growth in alternative profit streams, they’re the sort of the future value creation model for the company.

And I think the combination of Albertsons and Kroger to combine really creating opportunities to significantly accelerate that flywheel effect across those elements of the model that we see is working very well now and we think can work even better in the future when we combine the two companies.