The Kroger Co. is holding a second quarter 2023 earnings conference call, led by Rob Quast, Senior Director of Investor Relations. Rodney McMullen, Chairman and Chief Executive Officer, and Gary Millerchip, Chief Financial Officer, will also be present. The call will include forward-looking statements and discussion of the consumer environment, financial results, and highlights, as well as an update on the nationwide opioid settlement framework. The Q&A session will be extended to cover a broad range of topics.

Kroger is excited to share their divestiture plan and is navigating a challenging environment with consistent results. To support customers, they are offering increased value through their Our Brands portfolio, digital offers, fuel rewards, loyalty discounts, and weekly specials. Higher income households are engaging more deeply with Kroger and purchasing bigger pack sizes and more premium products. Budget-conscious households are facing external spending pressures and are buying smaller pack sizes, prioritizing the lowest shelf price, and stretching their budgets around payroll periods and SNAP benefit distributions.

In the second quarter, the company saw an improvement in budget-conscious household trends as they expanded their assortment of everyday staples at lower prices. They introduced new in-store displays where every item was below $3, and improved their price position relative to competitors. They are also reimagining their offerings and improving the profitability of their brands, and their digital pickup and delivery businesses have seen strong growth.

The digital team has improved the customer experience by scaling hands-free technology, providing automated pods and lockers, and reducing wait time in stores. Digital engagement has been driven by data science work and customers have clipped 2 billion digital offers. Kroger Precision Marketing, a retail media business, saw strong growth in the second quarter due to its seamless ecosystem. This diversified business model has supported earnings growth and gives confidence in navigating the future.

Kroger is committed to providing customers with quality care and experiences. To do this, they have implemented data science and custom audiences to measure return on ad spend. Kroger Health is also helping customers live better lives and their pharmacists are dedicating more time to patient care. Automation and modernized tools are being used to simplify work and lower costs, while also improving patient adherence to care plans. Kroger is also investing in wages to support their associates, and have raised wages by 30% over the past five years. They have also created training programs to help develop their future leaders, which has been recognized by the Brandon Hall Group.

Kroger announced that they had reached their goal of donating 3 billion meals by 2025 two years ahead of schedule and are now increasing their commitment to donating 10 billion meals by 2030. The proposed merger with Albertsons will benefit the communities they serve. Despite industry-wide disinflation, Kroger's second quarter results demonstrate their value creation model, with EPS growth and underlying operating results excluding fuel improving versus prior year due to strong gross margin management, tight cost controls, and growth in alternative profit businesses.

In the second quarter of 2023, the terminated agreement with Express Scripts had a slightly positive effect on operating profit and the FIFO gross margin rate excluding fuel increased by 35 basis points compared to the same quarter last year. Sales growth was driven by strength in the digital business and gross margin was 21.8% of sales. Inflation decelerated at a faster-than-expected pace, but the improvement in rate was mainly due to strong performance from Our Brands, lower supply chain costs, sourcing benefits, and the effect of the terminated agreement. These benefits were partially offset by higher shrink and promotional price investments.

Kroger achieved operational efficiencies in their supply chain during the quarter, including improved transport capacity utilization, increased productivity in warehouses, and investment in their supply chain to reduce costs and improve freshness. Shrink increased due to theft and organized retail crime, and Kroger is taking initiatives to mitigate the financial impact. The company also experienced a tailwind from a decrease in their LIFO charge due to a revised inflation outlook, and their OG&A rate was flat excluding fuel and adjustment items. Kroger is focusing on cost-saving initiatives such as simplification and utilizing technology to enhance the associate experience without impacting the customer.

Kroger is continuing to improve productivity in their stores and has achieved $1 billion in cost savings for the sixth consecutive year. Fuel is an important part of their value proposition and their fuel rewards program has been successful. Labor relations have been successful, with new labor agreements with the UFCW for Dallas Clarks, Southern Illinois Clarkson Meat, Smiths Utah Clarkson Meat, and Fry's Food and Drug Stores associates. Kroger has generated strong free cash flow and has a net total debt to adjusted EBITDA ratio of 1.31, lower than their target range of 2.3 to 2.5. They have paused their share repurchase program to prioritize deleveraging, and are being disciplined with their deployment of capital.

Kroger announced a nationwide opioid settlement framework to settle substantially all opioid lawsuits and claims against Kroger, resulting in a $1.4 billion charge and a loss per share of $1.54 this quarter. Kroger will pay up to approximately $1.4 billion or $1.1 billion after tax over 11 years in equal installments, beginning in December 2023. This settlement will not affect Kroger's ability to complete its proposed merger with Albertsons and the company remains on track to achieve a net total debt to adjusted EBITDA ratio of 2.5 within 18 to 24 months post close.

Kroger and Albertson Companies have entered a definitive agreement with C&S Wholesale Grocers to sell 413 stores, banners, distribution centers, offices and private label brands in connection with their proposed merger. Despite the slowing sales, Kroger is confident that their value creation model will allow them to continue to deliver total shareholder returns. They are maintaining their adjusted net earnings per diluted share and adjusted net operating profit guidance and 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.

Kroger announced plans to merge with Albertsons and committed to keeping stores open, employees employed and collective bargaining agreements in place. After a thorough process, C&S Wholesale Grocers was chosen as the buyer, meeting all the criteria necessary. C&S is one of the largest private companies in the US, with over 160 stores and supplying 100,000 products to 7,500 customers. They offer a full suite of retail services, are invested in the communities they operate in, and have the financial strength to complete the transaction and invest in the business for future growth.

The divestiture plan ensures that no stores will close and all employees will remain employed with the same benefits and collective bargaining agreements. The sale includes a robust operational infrastructure with distribution facilities, regional headquarters, and deep industry expertise. The financial terms of the plan are in line with expectations and will create shareholder value. The merger is expected to close in early 2024 and integration planning is progressing well. The combined company will provide an improved omnichannel food retail experience.

In response to a question about disinflation, Rodney McMullen and Gary reminded the audience that over the last 40-50 years, there have only been two years of deflation. They also discussed the Kroger model and how it is successful in any environment, both competitively and inflation-wise. Regarding the merger process, McMullen stated that the FTC has been involved in ongoing conversations throughout the process and now that the divestiture has been announced, they will be able to share more specifics with the FTC.

Rodney McMullen and Gary Millerchip discussed the effects of inflation on their business and the success of their CPG partnerships. They anticipate that inflation will be in the low single digits by the end of the year, and they are prepared to adjust their plans if necessary. Krisztina Katai then asked a question about the Albertsons merger and its potential value.

Rodney McMullen and Gary Millerchip both agree that the targeted net-to-EBITDA ratio will maintain investment grade and be within the 18 to 24 month range, and that the synergies will be $1 billion. They are both confident in the commitments made in October and are looking forward to getting started and benefiting their associates, customers, and communities.

Gary Millerchip explains that the merger of Albertsons and Kroger is not only about synergies but also about creating a new combined company that will be able to accelerate its future value creation model. He then goes on to answer a follow-up question about the sales transaction with C&S, expressing confidence in the plan and the likelihood that it could reach up to 650 stores.

Rodney McMullen and Gary Millerchip announced that they have spent 10 months working with potential buyers to create a plan for the divestiture of stores. They have included a break point in the agreement with Albertsons in case Kroger needs to flex up the number of stores to be divested. No more work will be done for SpinCo as part of the solution. Michael Lasser asked what other basis regulators could have to push back on the merger and what steps Kroger is taking to address those concerns.

Rodney McMullen and Gary Millerchip discussed the commitments made when the transaction with C&S was announced, including selling stores, seven distribution centers, two regional offices, and five private label brands. They also mentioned that they have addressed all the questions the FTC would have and exceeded the commitments, as well as recognizing labor contracts. They are now excited to talk to the FTC about the plan.

Gary Millerchip discussed that inflation is expected to decelerate from 3.5% in Q2 to between 1-2% by the end of the year. He also noted that in Q2, there was a slight decline in inflation from the first period to the second period, which was due to an improvement in unit trends. Millerchip concluded that in order for the guidance to be achieved, there needs to be an improvement in volumes and price investments to drive share gains.

Rodney McMullen and Gary Millerchip discussed the performance of higher income and budget-conscious shoppers. McMullen noted that the higher income shoppers are more profitable due to their purchases of fresh products and bigger-sized products. Millerchip noted that the budget-conscious shoppers are still negative, but the trends have improved. Finally, Millerchip suggested thinking about the performance of shoppers in two buckets: the second half of the year and the long-term plan.

The company is expecting to achieve growth in the range of 2-4% and earn 3-5% in earnings growth, largely due to margin expansion. In the short-term, they will be managing costs closely due to the lower headline growth rate than anticipated. Regarding the Ocado process, they have seen great progress in the growth of the sheds and the base operating model, with a focus on the existing sheds and a high repurchase rate and NPS scores.

Rodney McMullen is proud of the pharmacy teams for retaining a significant portion of customers through direct contracting and discount cards. He is comfortable with the current situation, but is focused on finding a way to fill prescriptions without losing money. Gary Millerchip has nothing to add.

Michael Montani asked about the multiple implied by the transaction for the divested stores, and Gary Millerchip clarified that the multiple would be slightly lower than the number previously shared, but that it was consistent with what they were expecting. He also noted that it was a good solution for shareholders, as it would help simplify the transition services and drive future value. It would also allow C&S to be a successful operator in the future.

Rodney McMullen answers a question from Kenneth Goldman of JPMorgan regarding changes in consumer behavior in terms of which departments they are shopping. He explains that there has been an increase in the purchase of hamburger meat, chicken, and other entry-level items, which has affected CPGs. He also notes that CPGs are becoming more aggressive in partnering with retailers to move their tonnage. The trends are improving, but there is still a lot of focus on supporting customers on a budget.

Rodney McMullen addresses the concern of investors about possible deflation and the potential for competitors to become less rational. He explains that their long-term model assumes the market will be more competitive than it is now, and that their diversified income streams include alternative profit businesses which did not exist during the last deflationary period. He also points out that even in a deflationary environment, the company is still generating economic value and cash flow which they use to pay dividends, buy back stock, and balance their debt.

Ed Kelly from Wells Fargo and Kelly Bania from BMO asked questions about Kroger's divestiture package. Gary Millerchip explained that the SpinCo option was always part of the plan to take to the FTC, but it would not cover the whole store footprint geographically. He also mentioned that the valuation for the package was slightly below the three times four-wall EBITDA that the SpinCo was structured at, and he did not share the estimated EBITDA or EBITDA margin for the 413 stores.

The original plan was to put together SpinCo with another buyer, but Kroger was open to finding a single buyer that could bring a strong plan, management team, balance sheet, and commitment to investing in the business. They wanted a solution that would be effective and beneficial for Kroger in the long-term, and they assumed that the valuation they announced with C&S would be in line with what they expected. When they announced the deal in October, the only plan they could share was SpinCo as they hadn't had a chance to talk to other buyers yet.

Gary Millerchip and Rodney McMullen addressed a question from Kelly about the additional 200 potential stores and the financing structure. They discussed the package they have put together, which they believe addresses all the questions and feedback they have received. They also discussed the flexibility built into the agreement and C&S' financing strategy. Finally, they discussed the promotional competitive backdrop, noting any changes on the competitive front and the waning inflation in the industry.

Rodney McMullen and Gary Millerchip discussed the expected promotional activity in the coming months and quarters, which is close to pre-COVID levels. They also discussed the consumer backdrop for the rest of the year, with the expectation that it will be tougher due to student loan repayments. They believe the impact on grocery will be less than other categories.

In response to a question from Edward Kelly of Wells Fargo about the potential for continued improvement in margin and earnings growth in the future, Gary Millerchip of Kroger commented that they typically do not provide forward guidance until later in the year, but that the areas they have identified as tailwinds during the quarter are long-term drivers of their model that could help improve gross margin rate.

The Kroger team is working to maximize value in their private selection, Simple Truth, Kroger brand, and Smart Way product ranges. They are investing significantly in their supply chain to optimize routes and capacity, and are in the early stages of exploring the potential of alternative profits through digital engagement and Kroger Precision Marketing. They are confident that their plans will continue to improve profitability.

In October, Albertsons and Kroger outlined a deal that would include two regional headquarters and five private brands, which were part of the consideration. However, the specifics of the deal were not known until a buyer was found. For SpinCo to be a viable solution, it had to be set up as a full separate company and have meaningful assets that would move across from Albertsons or Kroger.

Rodney McMullen and Gary Millerchip discussed the details of the C&S announcement, which included Kroger and Harris Teeter stores as part of the plan. There is not yet a specific number of Kroger banner stores in the C&S announcement, and the expected dilution in year one would be consistent with the guidance given in October. The focus is on the 413 store plan, as it is believed to be the most effective solution in addressing all areas of divestment.

In response to a question about the divested stores, Gary Millerchip clarified that C&S will be provided with three banners as part of the divestiture package: Mariano's, QFC and Carrs. He also mentioned that C&S operates 160 retail stores, but there is little geographic overlap between existing Piggly Wiggly stores and the locations of the divested stores.

Rodney McMullen and Gary Millerchip discussed C&S's plans to operate under the Albertsons banner in four states (California, Colorado, Wyoming, and Arizona). They will also have the right to use the other three banners in any states they choose to operate stores. C&S will introduce a new competitor in the markets where they have infrastructure and capability. Finally, Rodney McMullen shared a few words of encouragement to associates, wishing them luck on the upcoming school year and acknowledging the associates taking advantage of their continuing education benefit, Feed Your Future, which provides up to $21,000 for each associate over their career.

Kroger has seen success in managing costs and growing alternative profit streams, leading to earnings growth and strong free cash flow. They are thankful for their associates and customers, and remain committed to fulfilling their merger commitments with Albertsons. The call is concluded.

This summary was generated with AI and may contain some inaccuracies.