The Kroger Co. (NYSE:KR) Q3 2022 Earnings Call Transcript December 1, 2022
The Kroger Co. beats earnings expectations. Reported EPS is $0.88, expectations were $0.82.
Operator: Good morning and welcome to the Kroger Co. Third Quarter 2022 Earnings Conference Call. My name is Nadia and I will be coordinating the call today. Please note this event is being recorded. I would now like to turn the conference over to Rob Quast, Senior Director, Investor Relations. Please go ahead.
Rob Quast: Good morning. Thank you for joining us for Kroger’s third quarter 2022 earnings call. I am joined today by Kroger’s Chairman and Chief Executive Officer, Rodney McMullen and Chief Financial Officer, Gary Millerchip. Before we begin, I want to remind you that today’s discussions will include forward-looking statements. We want to caution you that such statements are predictions and actual events or results can differ materially. A detailed discussion of the many factors that we believe may have a material effect on our business on an ongoing basis is contained in our SEC filings. The Kroger Company assumes no obligation to update that information. After our prepared remarks, we look forward to taking your questions. In order to cover a broad range of topics from as many of you as we can, we ask that you please limit yourself to one question and one follow-up question, if necessary. I will now turn the call over to Rodney.
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Rodney McMullen: Thank you, Rob. Good morning, everyone and thank you for joining us today. We are pleased to announce another quarter of strong results, powered by our strategy of leading with fresh and accelerating with digital. Our associates continue to create a seamless customer experience, delivering fresh and affordable food anytime, anywhere with zero compromise on quality, selection or convenience. Our associates’ incredible dedication means we have momentum entering the fourth quarter and we are continuing to consistently deliver a full, fresh and friendly experience for our customers throughout the busy holiday season. It is clear that inflation remains top of mind for our customers and for our company. We are laser focused on helping our customers by providing fresh and affordable food.
Research shows cooking at home is still 3x to 4x less expensive than dining out. And we are seeing more customers engage with Our Brands as a way to stretch their food budgets without compromising on quality. During the quarter, we continue to see many of the same shopping trends we observed throughout the year. In addition to higher engagement with Our Brands products, customers are downloading and redeeming digital coupons and continuing to showcase their cooking at home skills learned during the pandemic. Our breadth of choices, quality of fresh products and the value of our personalized promotions are helping customers navigate the current environment and our customer-focused approach is working. We continue to see overall household growth and significant loyal household growth, which drives a meaningful portion of our sales volume.
We are proud to serve as America‘s grocer, especially during the holiday season. As friends and family come together, we look forward to providing our customers the perfect ingredients to create cherished memories. At a time when 48% of customers have told us they plan to cutback on their Thanksgiving celebration due to inflation, we took action and made sure our Thanksgiving was enjoyable and memorable for everyone. To do that, we introduced an easy guide for customers to build an affordable meal of our brand’s products with all of Thanksgiving favorites that a family could enjoy for as little as $5 a person. This is just one example of how we create amazing quality at a great price when it matters most to our customers. We empower our customers to create lasting food memories by consistently executing against our go-to-market strategy, focused on Fresh, Our Brands, personalization and our seamless ecosystem.
Fresh remains important in today’s environment and we are committed to bringing the freshest products to our customers’ tables. Our Fresh for Everyone strategy is grounded in keeping products fresher, longer. Our end-to-end Fresh initiative is transforming these efforts. At the end of quarter three, we have a total of 1,252 certified stores. At these locations, we see higher fresh sales and identical store sales. With these impressive results, we continue to rollout the initiative nationwide. As part of our end-to-end fresh initiative is our supply chain, where we continue to invest and enhance operations. We are improving productivity and maximizing our fleet by controlling more product movement across our network. Most importantly, we are using our data and science to maximize freshness for our customers.
Beyond our end-to-end Fresh program, we are bringing more fresh products to our customers. During the quarter, Home Chef launched new plant-based ready-to-cook meals. They also collaborated with Kroger’s in-house dieticians to launch our new simple and nutritious healthy meal kits. Home Chef continues to be an exceptional example of how Kroger’s history of mergers helped bring new and exciting capabilities to meet our customers’ changing needs across the country. Turning to Our Brands, we delivered another strong quarter in Our Brands with identical sales growth that outpaced overall identical sales. This was led by our by our Kroger and Private Selection brands. Customers continue to engage with Our Brands portfolio, which offers high-quality products at affordable prices.
Our brand products are loved by every member of the family, including the pets. This quarter, we saw tremendous growth in our pet food brands as families continue to treat their dogs and cats. As you know, they are like a member of the family. We continue to expand and diversify Our Brands portfolio at every price point. After launching Smart Way as our opening price point brand last quarter, we introduced several new Smart Way products this quarter and plan to rollout additional products next quarter. These products are meeting the needs of our customers on a budget and we have already seen 2 million households to purchase Smart Way products. In regard to personalization, our customers are looking for opportunities to save on the products they love.
Our loyalty programs and personalized promotions allow them to do just that. We continue to use our leading data science capabilities to develop unique customer insights and offer targeted promotions on the products we know they love. This strategy is driving digital engagement with digital coupon downloads, 32% higher than last year. We anticipate these interactions will continue through the holidays with customers expected to realize more than $200 million in savings from our highly personalized digital offers. Moving on to Seamless, we are improving our Seamless experience that brings our customers fresh products anytime, anywhere with zero compromise on quality, selection or convenience. We saw back-to-back quarters of strong digital growth led by our delivery solutions.
This quarter, we introduced app enhancements that make it easier for customers to engage with our savings and promotion. We launched our first in-app flash sales and enabled our customers to clip digital offers directly from their cart. Improving the customer experience is always top of mind for us and Kroger Pickup now offers 3-hour pickup lead times at all stores in our network, with as little as 1 hour lead time in some areas. We are investing in digital growth initiatives, including expanding our Kroger delivery network in new and existing geographies. We are also growing Boost, our one-of-the-kind membership program. This is the industry’s most affordable membership program and it is foundational to growing our delivery service. We are incredibly pleased with our customer response to Boost, as we rolled out the program nationwide earlier this year.
We continue to invest in our associates as part of our long-term strategy. In addition to investing in average hourly rates this quarter, we enhanced the benefits available to our associates. We expanded the eligibility for our 401(k) plan participants to encourage earlier commitments to lifelong savings and we took steps to continue supporting working parents by increasing family lead time and our company-sponsored benefit plans. We are excited to celebrate amazing associates this quarter who were recognized for their outstanding work and commitment to our customers. We were the most recognized employer for Progressive Grocer’s GenNext Honorees, with 28 of our young leaders recognized for driving change and innovation both within the organizations and communities they serve.
Additionally, our Hispanic and Latino Associate Resource Group, was honored by the U.S. Hispanic Chamber of Commerce as the Employee Resource Group of the Year. In summary, we are building momentum as we close out the year. We are excited to surprise and delight our customers this holiday season with high-quality fresh products at affordable prices allowing customers to serve on the items that matter most. And with that, I will turn it over to Gary to cover our financial results. Gary?
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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 three. 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 continued to invest in our customers and associates, while also effectively managing costs to achieve solid earnings growth. These results provide yet another proof point of the strength of our value creation model and our ability to operate successfully in different environments. I will now provide additional color on our third quarter results.
Adjusted EPS was $0.88 for the quarter, an increase of 13% compared to the same quarter last year. This growth was driven by top line revenue and our disciplined approach to balancing investments with effective cost management. Identical sales without fuel grew 6.9%. Our Brands continue to resonate deeply with customers as sales grew 10.4%. The outstanding quality and value offered by these exclusive to Kroger products is an important differentiator in our go-to-market strategy and this is especially true during periods of high inflation. As we shared at our Investor Day in March, Our Brands products are margin accretive and represent a key pillar in our strategy to grow profitability, while also delivering greater value for customers. Digital sales grew 10% during the quarter with delivery solutions leading the way, up 34% year-over-year.
Delivery solutions, includes the Kroger delivery network powered by Ocado, delivery from our stores via Kroger and third-party platforms and our convenience offering, Kroger Delivery Now. Our industry leading net promoter scores in Kroger Delivery are driving new customer engagement and best-in-class retention rates. Gross margin was 21.4% of sales for the quarter. The FIFO gross margin rate, excluding fuel, decreased 5 basis points compared to the same period last year. This result reflected our team’s ability to effectively manage higher product cost inflation and shrink through strong sourcing practices, while also helping customers manage their budgets and keeping prices competitive. During the quarter, we recorded a LIFO charge of $152 million compared to $93 million in the prior year.
This was primarily driven by higher product cost inflation in grocery. We still expect to see some moderation in inflation during our fourth quarter as we cycle higher inflation from a year ago. Kroger’s operating general and administrative rates decreased 3 basis points, excluding fuel and adjustment items compared to the same period last year. The decrease in OG&A rate was driven by sales leverage and execution of cost saving initiatives, partially offset by investments in our associates. We continue to identify opportunities to remove cost from our business without affecting the customer experience and are on track to deliver our fifth consecutive year of $1 billion in cost savings. Kroger Health had another successful quarter, delivering higher than expected sales and profitability despite cycling the impact of higher COVID vaccine revenue from a year ago.
We continue to see significant growth opportunities in healthcare and our Kroger Health team remains committed to ensuring our customers obtain medically necessary prescriptions. Recently, we announced that we are terminating our Express Scripts agreement for commercial customers as of December 31. The Express Scripts contract would have required Kroger to fill our customers’ prescriptions below our cost of operation, something we could not accept as we aim to keep our prices low for customers during this inflationary period. We expect this contract termination will reduce sales by about $100 million in Kroger’s fiscal fourth quarter, impacting identical sales without fuel for the quarter by approximately 35 basis points. This decision is not expected to have an impact on operating profit or EPS.
Included in our results for the quarter is an $85 million pre-tax charge related to the settlement of all opioid litigation claims with the State of New Mexico. This amount was excluded from our adjusted FIFO operating profit and adjusted EPS results to reflect the unique and non-recurring nature of the charge. This settlement is not an admission of wrongdoing or liability by Kroger and we will continue to vigorously defend against other claims and lawsuits related to opioids. This settlement is based on a unique set of circumstances and facts related to New Mexico and Kroger does not believe that the settlement amount or any other terms of our agreement with New Mexico can or should be extrapolated to any other opioid-related cases pending against Kroger.
It is our view that this settlement is not a reliable proxy for the outcome of any other cases or the overall level of Kroger’s exposure. Currently, Kroger has two active matters pending in West Virginia and Texas scheduled for trial in 2023 and 2024 respectively. Kroger continues to believe that the claims are without merit and that it has strong defenses to these claims. Kroger is also differently situated from many of the other defendants in these cases. Our pharmacy operations have a much smaller footprint both in terms of the size of the business and market share with respect to opioids and we are proud of the outstanding work performed by our associates in delivering critical care and services to our pharmacy customers. Turning now to alternative profit businesses, which are a fast growing and key part of our value creation model.
The traffic and data generated by our supermarket business continues to create a flywheel effect for alternative profits and growth this quarter was again led by retail media. CPG brands are finding significant value in our unique ability to build custom audiences that draw on our data to deliver precisely measured return on investment. Last month, KPM added a new channel to its suite of retail media solutions, welcoming Snapchat into the portfolio. Advertisers are now able to use Kroger’s proprietary capabilities to optimize Snapchat’s immersive ad formats. We are constantly innovating to expand our reach and KPM recently increased its programmatic advertising marketplace capabilities to include video and one of the fastest growing digital media sectors, connected TV.
These new frontiers will provide exciting future growth opportunities for KPM. Fuel is an important part of our overall value proposition and our fuel rewards program remains a key differentiator to help customers stretch their dollars during a period of high inflation. Fuel rewards engagement remained high during the third quarter and led to gallon sales, which outpaced the market. The average retail fuel price was $3.84 this quarter versus $3.24 in the same quarter last year and our cents per gallon fuel margin was $0.50 compared to $0.42 in the same quarter in 2021. The results we reported today would not have been possible without our incredible associates who continue to do an outstanding job executing our strategy and delivering a full, fresh and friendly experience for our customers.
We have a long track record of investing in our associates and are committed to continuing these investments to ensure Kroger remains an employer of choice. Building on $1.2 billion of incremental investments since 2018, we have raised our average hourly rates by over 5% so far in 2022. During the third quarter, we ratified new labor agreements with the UFCW for associates in Columbus, Las Vegas, Chicago, Fort Wayne and pharmacists in Southern California, covering more than 28,000 associates. During the fourth quarter, we have also ratified new labor agreements for associates in Toledo and Nashville as well as the Teamster’s master agreement. Turning now to cash flow and liquidity, during the quarter, cash flow was affected by increased inventory balances.
This was predominantly due to higher product cost inflation, particularly in grocery, in stocks improving to pre-pandemic levels and forward buying of inventory in pharmacy. We are comfortable that our current level and mix of inventory is appropriate to support our future sales expectations and would expect to see an improvement in working capital during the fourth quarter. Regarding capital expenditures, we are committed to investing in the business to support our go-to-market strategy and continue to see many opportunities to drive future growth. As shared last quarter, various initiatives have been delayed due to supply constraints and we now expect capital expenditures to be in the range of $3.2 billion to $3.4 billion in 2022. The net effect of higher inventory and lower capital expenditures for the year is that we continue to expect to generate free cash flow of $2.3 billion to $2.5 billion in 2022.
In closing, I’d like to share additional color on our outlook for the remainder of the year. The Kroger team’s consistent execution of our go-to-market strategy continues to build momentum in our business and gives us the confidence to again raise our full year guidance. We now expect full year identical sales without fuel of 5.1% to 5.3%, adjusted FIFO operating profit of $4.8 billion to $4.9 billion and adjusted net earnings per diluted share of $4.05 to $4.15, representing growth of 10% to 13% over 2021. This guidance assumes a LIFO charge of approximately $500 million for the full year, which represents a $300 million headwind over the 2021 LIFO charge. Our third quarter and year-to-date results highlight the strength of Kroger’s value creation model, which has proven to be resilient in different operating environments.
Looking ahead, we remain confident in our ability to deliver attractive and sustainable total shareholder returns, and we look forward to sharing detailed 2023 guidance during our fourth quarter earnings call in March. And now I’ll turn it back to Rodney.
Rodney 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. We are making early progress on our integration planning as expected and we continue to engage with all of our stakeholders and regulators. We are advancing our road map to close the transaction in early 2024. We look forward to working with the regulators as they review the transaction and do not have a substantial update at this time. We would ask that you focus your questions on our quarterly performance and our progress on our strategy. With that, Gary and I look forward to taking your questions.
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