Kroger Company (The) (KR)

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Kroger Co. (KR)

October 16, 2012 11:00 am ET

Executives

Cindy Holmes - Director of Investor Relations

David B. Dillon - Chairman, Chief Executive Officer and Member of Proxy Committee

J. Michael Schlotman - Chief Financial Officer and Senior Vice President

W. Rodney McMullen - President, Chief Operating Officer and Director

Jeffrey D. Burt - Group Vice President of Perishables Merchandising and Procurement

Michael J. Donnelly - Senior Vice President of Merchandising

Robert Kaufelt

Analysts

Jason DeRise - UBS Investment Bank, Research Division

Mark Wiltamuth - Morgan Stanley, Research Division

Deborah L. Weinswig - Citigroup Inc, Research Division

John Heinbockel - Guggenheim Securities, LLC, Research Division

Andrew P. Wolf - BB&T Capital Markets, Research Division

Edward J. Kelly - Crédit Suisse AG, Research Division

Meredith Adler - Barclays Capital, Research Division

Scott Andrew Mushkin - Jefferies & Company, Inc., Research Division

Charles Edward Cerankosky - Northcoast Research

Michael Ellmann

Joseph I. Feldman - Telsey Advisory Group LLC

Colin Guheen - Cowen and Company, LLC, Research Division

Charles X. Grom - Deutsche Bank AG, Research Division

Stephen W. Grambling - Goldman Sachs Group Inc., Research Division

Kelly A. Bania - BofA Merrill Lynch, Research Division

John Harris

Presentation

Cindy Holmes

Good morning. I would like to introduce myself to those of you who don't know me. I'm Cindy Holmes, Director of Investor Relations at Kroger, and I'd like to welcome you to the 2012 Investor Relations Conference. We're glad that there's so many of you taking time out of your busy day to join us today. We also welcome those of you listening in via the webcast.

Before we begin, I'd like to make a few housekeeping -- address a few housekeeping items. The wireless network here is Network NY-2 [ph], and if you need the passcode and stuff, there's cards out at your table with the password and username on them. The restrooms are found back down the hall the way that you came in, and please be sure that your phones and BlackBerrys are in silent mode.

A quick look at our agenda today. Dave is going to open, then we'll have presentations from Dave and Mike. Then we will break for lunch around 12:30. After lunch, we'll have presentations from Rodney McMullen, Mike Donnelly and Jeff Burt. Then we will have a break. And then at the end of the day, we'll host an extended open Q&A session, then Dave will close it, and then we will end with a little -- some comments from Murray's Cheese.

Earlier this year, we conducted a perception study, and several of you took the time to participate that -- in that, and I want to thank you for your candid and honest feedback. We really took your responses to heart. We considered them as we put together today's program. I hope that you will notice the impact of this in today's message and know that you were a part of its development.

Before we begin, let me remind you that today's presentation will include forward-looking statements. We want to caution you that such statements are predictions and that 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. Kroger assumes no obligation to update that information.

Now I would like to briefly introduce the Kroger folks who are here with us today. Please just stand and stick your hand in the air when I call your name: Dave Dillon, Chairman and Chief Executive Officer; Rodney McMullen, President and Chief Operating Officer; Mike Schlotman, Senior Vice President and Chief Financial Officer; Mike Donnelly, Senior Vice President, Merchandising; Jeff Burt, Group Vice President, Perishables Merchandising and Procurement; Margaret McClure, Vice President, Deli Bakery Merchandising; Christine Wheatley, Senior Counsel; Keith Dailey, Director of Corporate Communications; and Julie Lacalameto, Executive Assistant to Mike and myself. And I'd like to take this opportunity to thank her for all that she has done to coordinate this conference, prepare slides, and all of the support she's given to me in my IR conference. Believe it or not, we've had a few belly laughs in the last couple of days. Thanks, Julie.

And now I would like to introduce Dave Dillon, Chairman and Chief Executive Officer of Kroger. Dave has been with this organization for 36 years serving in a wide variety of roles throughout the years. He grew up in the food retailing industry. His great grandfather first opened the grocery store in Hutchinson, Kansas in 1913. Dave is a graduate of the University of Kansas, holds a law degree from Southern Methodist University and sits on several boards. Please welcome Dave Dillon.

David B. Dillon

Thank you, Cindy. And got the clicker. Well, this is an inspiring room, and we appreciate you all joining us here. But because it's so inspiring, it may be daunting to make it as relaxed as we'd like to do. So feel free to come on in. There's plenty of spots over here on this side, more here than over here. I know we have some transportation issues, so there's going to be a number of people coming in late, and we welcome you to come in at any point. Restrooms out here, go out as you need. There's coffee in the back. We're going to serve lunch here in just a little bit, and it will be served right here at the back of this room, and we'll eat at the tables where we are now. So you can see it's going be informal, we hope.

So, Cindy, thanks. And like I said, welcome to all of you. Thank you for joining us today. We intend to make it worth your time and address topics of interest to you.

In a moment, I'll turn it over to Mike Schlotman, our CFO, but I first want to set the themes for today. Today is all about growing Kroger. You will hear how we are committed to produce higher earnings growth, a higher return to shareholders through dividend and stock buyback in addition to the higher earnings, and how this growth will be resilient and sustainable for the long term.

So now that I've gotten your attention, I first want to turn it over, then, to Mike Schlotman to give you a little bit of background and foundation. Mike?

J. Michael Schlotman

Thanks, Dave. And I want to echo Cindy's comments and thank Julie, as well as welcome you to the stock exchange. As you know, this is only the second time that Rodney and I can remember that we've done an Analyst Meeting in New York City. The last one was some 20 years ago or so. And I want to thank everybody for coming down. Hopefully, we'll have more people come in as the day goes on.

Before I begin into the -- my presentation is going to be the journey. I'm going to take us on a little bit of a trip down memory lane and go backwards a little bit to help you understand and just refreshen everybody's mind the journey we've been on the last 7 or 8 years. Before we do that, I want to start with some housekeeping items. And first off, I want to talk about where we are so far this quarter. Sales in tonnage for the third quarter are slightly better than when we updated you at the time of our second quarter earnings release, which was September 7. So both of those have shown some slight improvement from the levels we talked about a little over a month ago. This level of sales was contemplated when we raised our earnings per share guidance at that same time. And as a result, we reconfirmed our ID sales guidance of 3% to 3.5% and our earnings per share guidance of $2.35 to $2.42 a share, and we remain committed to maintaining the leverage ratio to support our BBB flat credit rating.

As I said, I'm going to go on a journey. I'm going to go all the way back to 2000 when we first, as a company and as a management team, started talking about how we were going to continue to be a viable food retailer in an ever-changing environment. And if you go back to 2000, basically, all grocers at that time continued to raise prices to increase earnings. It put many of us, including us, in an uncompetitive position against many of the new retailers out there that were coming out of that point in time, particularly Walmart. And we realized at that point in time that fixing price was an imperative. We really didn't have any choice at that point in time in our judgment if we wanted to be a viable retailer going forward. So on December 11, 2001, we announced significant price investments. As you all remember, our stock took a fairly dramatic drop that day because it came at the expense of earnings per share and gross profit margins.

In 2003, the significance of the Kroger Plus Card there is -- and that's one of the loyalty cards we have, was we formed a joint venture with dunnhumby, and called dunnhumbyUSA, and it has helped us understand where and how to make price investments that continue to be meaningful to customers, and Mike will go into more in-depth discussion on this in his section. And it allowed us to begin collecting customer habits on how they shop.

If you look at the time frame from 2004 to 2007, in 2004 is really when we first started talking about the Customer 1st strategy. We began investing in all 4 keys, not just price, but also products, people and shopping experience, because all 4 of them remain relevant, and we believe if we can compete and win on all 4 of those elements, we'll become a very difficult competitor for people to compete against.

Price has always gotten the most attention. We heard that loud and clear in the survey Cindy referenced that we did this summer. But the primary reason for that is we have, frankly, had the most work to do in price. So it shouldn't be surprising when you look back to that time frame that price has been the one everybody talks about because we were furthest away from where we wanted to be on that metric and on price checks.

To do that funding in price, we've been focused on sustainable cost reductions that don't affect customer service. I'm going to go through where we are in the 4 keys of our strategy in a second. But customers continue to give us credit even while we reduce operating cost for outstanding customer service. We look for process changes and things that don't affect the customer on a day-to-day basis, and we take those savings to reinvest back in 1 of the 4 keys.

2008 is called out by itself on the slide because, at that point in time, 2008 was actually our record EBITDA year. The strategy really was clicking quite well. If you look back at that point in time, the cost savings reduction we had over the period almost exactly matched the price investments we made in the reduction in gross margins.

Then the recession hit in 2009, and we call it through 2011. We made the conscious decision at that point in time to continue to play the game that had gotten us to where we were. We could've taken a different path. We felt that there was an opportunity to continue to gain market share as other competitors did different things to try -- play their game. Our ID sales remained strong. Our loyal household growth remained strong, but our earnings did drop somewhat in 2009 and 2010. Last year wound up being a record year again. And this year, we're in for another record year as well.

We emerged in a stronger position. We believe we have emerged in a stronger position than many of our competitors, whether you want to put us in the traditional food retailing category or you want to put us in wherever you want to wind up putting us. We believe that what we have done has set us a great foundation to continue to build from, and we are pleased with the results that we've had over this journey of about 8 years since we began the Customer 1st strategy. We think it has been the fundamental reason that we continue to post the results we have.

I want to -- as I said, I was going to talk about the 4 keys process. So here we are in 2012. Mike will have some more details as far as numbers on this, but we get a lot of feedback from our customers. We do this every quarter, and we track our progress in all 4 keys. If you think about where this is, just to set everybody's mindset, the base year in this chart is 2004. So everything is compared back to where our customers and how they said we were performing on a set of questions we asked in 2004 and the progress we've made so far.

So the blue section of this graph is where the progress we had made 2 years ago through 2010 when we last had a big Investor Conference in Cincinnati, Ohio. At that point in time, we were about 47% of the way to our goals. We called it about halfway there. If you fast-forward 2 more years, we're now on average a little over 60% of the way towards our goals. So we've continued to make steady progress towards our goals. And I want everybody to keep in mind what this is. This is not a graph of investments we have to make in these particular keys, so I don't want people to think, Oh, they've only invested 60% of what they need to in price. This is what customers tell us about how they think about our price position relative to our competitors.

So we're about 60% of the way to the reference point that we want our customers to tell us how we're performing. This is a lagging indicator. It takes a long time for perceptions on any of these 4 elements to change. And we're very pleased with the progress we've made so far.

Today, we're also going to commit to some metrics that we're going to report out to you on a quarterly basis. The first of those metrics we've done for a very long time, and it's ID sales, excluding fuel. If you look at this over time, obviously, this is a number that we've been very proud of, 35 consecutive quarters of positive ID fuel sales -- of ID sales without fuel. I don't think there's anybody else in all of food retailing, and we really consider the broad spectrum of food retail and when you do this, there's a lot of different competitors on here, not just what everybody wants to call traditional competitors. We look at the industry as food retailing industry, not just traditional supermarket industries. I think this speaks volumes to the connections we've made and continue to make with our customers.

The second one is FIFO operating margin excluding fuel. This is, obviously -- this is not a new metric either. But this is a metric that if you'd listen to the comments we've made about it, we are committed to growing this slightly over time on a rolling 4 quarters basis. If you look at the progress over time, just us by ourselves, it has come down. You can see it has flattened out. And recently, it -- you can't really tell at the end of that side, but it has started to tick up. And we remain committed to growing this metric on a rolling 4 quarters basis over time. And when we say growing, we mean slightly. It's not going to double, it's not going to go up 100 basis points in any particular year, slightly is slightly. I won't define slightly, but we want that end of that graph to start tipping up on a rolling 4 quarters basis. We think it's very important.

The next key metric that we're going to do, which is something we haven't talked about for quite a while, is return on invested capital. We're going to talk about this on a quarterly basis. We'll report out our calculation of this. It's going to be more of a textbook calculation. In the past, we've had different return metrics that were created internally that's caused some confusion. We stopped talking about ERONOA. This isn't really that different than ERONOA, but we're actually going to show those calculation on a quarterly basis on our earnings report, and we expect to grow this over time.

Now keep in mind, as you start looking at a return invested capital metric, and if you look at the slide for this, you can see that we're the bold red line in the middle, so we're kind of in the middle of the pack, not really stellar, not horrible. But we need -- we believe we need to grow that above the level that, that currently is. This won't change on a dime. As you know, the denominator of this is a huge number. It will take some time to have this grow, but we are committed to the fact and understand the fact that if we're going to get the permission to continue to invest the capital that we plan to invest, that we have to grow this metric to reward you all in the proper way.

The fourth is we're going to continue to report market share. The market share numbers we report are based on Nielsen Homescan Data. It's a very broad base. We are the dark blue chart, and you can see there on 2011, we're kind of cut out of the pie chart. This talks about the different segments of people who sell the products that we sell. So if you look at this, in 2007, our share in the total overall food industry was 19.7% -- or 19.1%. It is now 21.1%. So over this time frame, we've grown our market share 200 basis points. And you can see what the other folks that sell food and do what we do, what has happened to their market shares over time. We're very proud of our position in this. You can see in the red slice of that pie, yes, traditional food retailers define the way many people define them has gone down. But when we look at our share, not just in that group, but overall food retailing, our share continues to grow.

The important thing, I think, that we want to -- the other important point we want to make in this slide is there are winners and losers in every one of these segments. The conventional wisdom out there is that the traditional food retailing is going to go by the Wayside, and it's going to go to one of the other slices of the pie. Our belief is this slide refutes that. And if you look at some of the other slices of this pie, there've been winners and losers in virtually every one of the segments of this slide.

So if you look at traditional food retailers, there's those out there that are having their own lows right now. If you look at more of the upscale retailers, the natural and organics, while those, obviously, a few years ago sold themselves out to Whole Foods. And even if you look at the hard discounters, the segment that on all these Save A Lot would be in. The first time Save A Lot numbers were put out publicly, it was not a stellar number. So our view is that there are winners and losers in every segment. We can -- we expect to continue to be -- this is some of the informal nature of this, as I get some water to get that frog out of my throat. Thanks, Julie, I owe you. And Rodney, too, because I saw you go get it. People in the webcast are wondering right now what the heck is going on.

There are winners and losers in every segment of this. We firmly believe that there will be a space for a company that does what we do and how we go to market to interact with our customers on a day-in, day-out basis. We know our customers better than anybody. We've grown our sales better than anybody. And our market share is growing in a way most of our competitors can't match. And that's an important thing that we want you all to think about, is that it's not just traditional food retailing where there's losers, there's really been losers in every one of these segments.

Another point on Kroger that we don't get a lot of credit for sometimes is innovation. There's a lot of different items on this slide. We believe we're one of the most innovative companies in the food retailing business. We're actually a huge science lab, if you think about it. And since my section here is the journey, I'm actually going to go back a little further in time, all the way back to 1995 when we introduced our first U-Scan on a store in Louisville, Kentucky. It was kind of unheard of at the time that you're going to put a machine in a store that people would go up to and interact with rather than a human being, which was always one of the things that people thought about that was important part of customer service in our industry. Well, if you -- at that point in time as we were rolling this out at the beginning of this in 1995, utilization was around the 15% category. If you look at it today, we have over -- we have almost 11,400 robots in almost 2,000 of our different stores and our enterprise average utilization is in the low 40% rate.

Most people don't even remember that we were the first retailer, certainly in the food retailing industry, to even introduced U-Scan. And now it's almost news if somebody doesn't have a U-Scan in their stores because of the successes this has had. Some of the other items on here, you're going to hear more about later. The dunnhumby and some of the Simple Truth in the organic products that we've introduced, you're going to hear more about those over time. Have all these worked? Not all of them have worked as fast as the U-Scan has worked. Some of them are still in that science lab as we try to refine that process. But we keep trying, and you don't have to have that many of these that wind up being a huge success to be able to pay for the ones that you still continue to test.

Obviously, one of the reasons we're here today is this next slide. We get a lot of questions about this. We often get as confused to some of the questions that I get about why our stock hasn't performed. Sometimes I answer that with almost a rhetorical response, that if I knew, I ought to be let go because I should've been doing it if I had that magic bullet to change the results of this slide. We really do believe we built a solid foundation. And the biggest explanation I can -- I have for this is the fact people don't believe we have a future, because this doesn't even give us credit for flat performance from where we are in today's multiple. It just doesn't make sense in our stock performance. That's one of the reasons that we continue to invest dollars in our own buyback program. We've been very aggressive, as you know, over the last several years of buying in our own stock, because we do believe the stock is undervalued. Hopefully, you all will come to that conclusion. One of our goals for today is to drive that element home. And when you leave here, you leave here with expectation that our stock is undervalued today, the same way we view that.

So in summary, we built a very stable foundation, and Dave kind of gave a teaser at the beginning of this, and I'm now going to bring Dave back up to go through the metrics that we want to announce today. And off of this foundation, we intend to grow over the next several years. Thank you. And Dave?

David B. Dillon

Well, Mike, thank you. I'm going to bring my own water up here. I don't know about that. Mike, thanks. As you can see from what Mike established, he talked a little bit our foundation, trying to give you a sense of the journey and its importance. I'd like to glance at that journey through the eyes of all the constituents that we deal with.

First, from the point of view of the customer. I think it will not be a surprise you that our customers feel like they have won these last 10 years at Kroger. You can see it in our metrics. You see it in our identical sales. You can see it -- in addition to identical sales, you can see in our tracker results. Identical sales, by the way, Mike mentioned it, but 35 quarters in a row, all the way through the recession and well before the recession, we've had positive identical sales. That tells me that we have connected with customers, and that's essential.

In addition, the customer tracker results, that Mike also showed, have improved over the last several years as well. That shows that connection. So the customers have won in this journey. Our associates have similarly won. Our associates have won -- one way to measure that is our associates survey that we do every year. It measures the engagement of our associates. We call that -- refer to that as our engagement score. The engagement score is real important to us. And we just got the results for this year's survey, and we went up substantially. At a time when it's hard for businesses to improve engagement of their associates, we were able to improve it. We see that as a really positive result and believe that it's a strong result for our associates.

Then the constituents for the shareholder, all of you. Well, certainly, our dividend has improved, that's a good sign, but our stock price has not. And on that metric, we're not particularly happy, just as you're not happy. Go back one here. Here we go. Good. Just as you're not happy. And the shareholder results have not been strong for a variety of reasons, but we think they do not adequately reflect the growth we've had in our earnings. I've got my own theories. You might have yours. My 2 favorite are that publicly-owned supermarkets are out-of-favor; and second is that many of you have told us that at Kroger, our long-term earnings growth is not aggressive enough. And I will be happy to discuss those during Q&A, but we want to start by addressing some of these issues, and we have identified new targets to reflect our confidence in the future.

The first of which is on the screen here now. It's the new long-term earnings per share guidance growth rate of 8% to 11% rather than the 6% to 8% that we previously had been using. Second is a new higher dividend, which we announced in September of 30%. And each year, our intention is to review the dividend. But also to that, we add stock repurchase, and we are reloading today. Our board acted today to reload our stock purchase authority up to $500 million. We had not completely use the previous authority. I think we've used about -- we had about $340 million left, I think, in that ballpark. But it's reloaded effective today at $500 million.

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