The Kroger Co. — 2023 Q3

Just wanted to follow up on 2 fronts. One was into the fourth quarter guide, it appears that ID sales could be up around 4%. I just wanted to understand the deceleration there. Was that predominantly inflation and/or the Express Scripts? Or is there anything else to note? Can you share any start to the quarter information? And then I had a follow-up.

Yes. I'll start and let Gary finish it. Part of it is just cycling inflation from a year ago. We are beginning to now cycle the higher inflation a year ago. Gary, with that, I'll let you get into a little bit more asset specific.

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

Got it. And then just a follow-up on the margin implications. It looks like those could be flat to down slightly in the fourth quarter. So I just want to understand how do you see the competitive environment evolving? And then any cost initiatives that you could share with us there?

Relative to the competitive environment, we continue to see it pretty similar to how it's been throughout the year. all retailers are doing everything they can to minimize the impact on inflation to customers the best you can do. And we obviously would use our personalized and promotions that are directly focused on individual households because of things we know they love to try to help people stretch their budget. We're also, as I mentioned in the prepared remarks, seeing customers continuing to move to our brands. And in the past, what we find is when customers move to Our Brands, that's very, very sticky because the high quality of the product and the satisfaction there. So what we find is even when things are getting normalized, Our Brands come out of that at a higher penetration level than going in, which is long term good for our business as well. With that, Gary, I'll let you get into.

Yes. Thanks, Rodney. Just a couple of bits of extra color, Michael, on the fourth quarter for you. As you probably gathered from the guidance, it would be a lowest quarter for year-over-year growth in what we shared for EPS. I think a few things to bear in mind there. First of all, we'll be cycling the strongest quarter from last year. Last year's EPS growth in Q4 '21 was the highest growth that we had during the year. So we're cycling higher growth from prior year. We'd assume fuel margins will be flat during the fourth quarter. So no real headwind or tailwind there, where, as you know, fuel has been a tailwind for us in the last couple of quarters.

Nice quarter. If you could talk a little bit about which categories did worse than inflation in terms of unit growth in which we're stronger on managing a lot of that was in the general merchandise. And also, Gary, could you comment on why identical sales growth, ex fuel was better than total sales growth ex-fuel?

Yes. In terms of the categories, the one you identified definitely would be the weaker category in terms of general merchandise. And that would be true at the Fred Meyer division, it would also be true across the rest of the organization as well. We continue to do well in those categories relative to the market. Our teams have done a great job of making sure they've been managing inventories relative to where the expectations themselves.

Yes. Thanks, Rodney. Thanks for the question, Chuck. Yes, the biggest part of that, in fact, pretty much all of it, Chuck, would be -- you may recall at the start of the year, we shared that we've made the decision to stop dispensing certain drugs in our specialty pharmacy business because it didn't really tie to overall customer loyalty in our broader business, and it isn't profitable business for us. So we made that decision at the start of the year, and we adjust that out of our ID. So it's a like-for-like comparison, but it does create a disconnect between total sales and identical sales.

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

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

Okay. And then just a quick follow-up. Fuel margins have been really strong. I mean there's been -- some of your peers in the industry have talked about that moderating next year? I'm just kind of curious as to whether you share that view and how we should be thinking about modeling that going forward?

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

Yes. I think when you look at Gary's points overall, it's one of the things that's so important about our overall business model because we do have a lot of moving parts, and we've invested a ton of work and effort our whole team has over the last several years to reinvent the business model and make sure the business model can be successful in every economic environment. And to me, Gary's point that he was sharing really highlight that as we look forward.

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

Yes. If you look at market share, the trends continue to improve, and we feel good about where we are, but we're not satisfied with where we are. We believe the work that we're doing on Fresh is a key part of driving that.

Great. And then my second question is a little bit more short term. I mean we've heard some retailers, not necessarily in the food industry, but some retailers that the consumers behave or kind of changed somewhat abruptly as we work through the fall. I mean, is that something you guys have seen? And if yes, do you think it's started to leak into the competitive environment?

Yes. It's a great question, Scott. And when we talk to our customers, they're telling us they're changing. But so far, they're changing on purchases other than food. So it's -- they are still prioritizing food. It gets a little bit back to one of the comments I made. It's still 3x or 4x cheaper to eat at home versus going out to a restaurant and so many more people have learned how to cook.

And the competitive environment, has it changed?

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

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

I will start and then Gary, please add any color you want. But if you look long term, we always build our business model around 1% to 2% inflation. And if you -- as you know, any given year will be different than that. But longer term, we've always felt that, that's kind of where fundamental inflation will be. Obviously, over the last couple of years, it's been completely different than that.

I think you covered it well, Rodney. I guess the only couple of extra points, John, I would maybe add, I do think, as you know, our core strategy is to grow existing loyal customers and what was really pleasing in the quarter as we saw 2.5% growth in loyal customers. So we're seeing customers move through the loyalty curve, and that's always been carry the strategy to really deeply reward customers and grow that relationship.

And just one more quick thing. Just conceptually, I know you don't want to talk about anything beyond this year, but right? You've raised the EBIT guide quite a bit right now you're up in the high 4s. When you look at '22, what was in there, maybe the good guys and the bad guys that kind of work against each other. I'm sort of wondering how sustainable is that new level of profitability? Again granted, the margin is not up as much as the dollars are. How do you think about that in terms of how representative of that performance is and what goes and comes next year off the P&L from this year?

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

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

Yes. Thanks, Ken. For us, I don't think it's really something that we're concerned about. We obviously did have very ambitious plans for CapEx this year, playing some catch-up from last year. And we still believe the projects that we have on the horizon are going to be generating significant value for the company in the future and support our growth plans.

Got it. And then Rodney, I very much respect your request for us not to ask about the transaction. I won't ask about it. But I am curious, is there a plan ahead to sort of have give updates to investors on a separate kind of form just because it's obviously such a big part of the story from here. I think people don't want a black hole or a vacuum of news. So I'm just curious what the plan is to kind of update investors on progress? Is it just you'll let us know during each quarter what's new and that's kind of it. And then we won't have any Q&A around that. I'm just trying to get a sense of that kind of news flow from here.

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

Rodney, why wouldn't the grocery sector being more competitive and see more price competition in 2023 given that the consumer is going to be under pressure there's going to be your competitors who are going to want to try and gain some share given the potential distraction from the uncertainty of the merger with Albertsons? Many consumable retailers will have this LIFO gross margin benefit into '23, and there's going to be disinflation where at times, it could be easier to make price investments in an environment of disinflation than it is when there is an inflation.

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

Understood. And my follow-up question is on the outlook for inflation. What are you hearing right now from your vendor can be about their desire to raise prices into 2023. Gary, you said previously that there will be -- or some of the prognostications are for 2.5% to 3% food at home inflation next year.

Well, I'll make a couple of comments, and Gary, you can think about some of the specifics. If you look at in our fresh departments, clearly, inflation is slowing down in many categories. Chicken would be an example. You're starting to see that in some of the other categories as well. And I always make the comment high inflation solves high inflation because farmers produce more when their margins improve.

Yes, I think you covered it well, Rodney. I think Michael, as Rodney mentioned, we're seeing that Fresh is certainly starting to see some change in trajectory on inflation. So I think it is the grocery category that's the most stubborn if you like, in terms of where it's holding in inflation at the moment. And as Rodney said, I think from -- as we look forward from our perspective, if that were to continue without being sort of supported by true cost increases, then that creates an opportunity for us with our brands to improve margin and grow share over time. So I think that's the way we think about it in general.

Kelly Bania from BMO. Just a couple of simple questions. I guess, as we think about the comp here or the IDs in the back half, can you just help us understand how much inflation drove the upside there versus tonnage or -- you talked quite a bit about your fresh initiative. Is it those stores? Just helping us understand where the upside is coming from?

Gary, I'll let you talk about the -- a little color on the IDs and then on the foodservice after you finish Health. I share some things there.

Okay. Great. Kelly, I think overall, we mentioned it in their prepared remarks somewhat as well. We've seen inflation starting to level. It's still obviously at very heightened levels. But if you look at the trend quarter-over-quarter, it really narrowed down to less than 1% increase in inflation in our Q3 versus our Q2.

Yes. On foodservice, volume would actually be above where we would have been in 2019. For us, when we look at foodservice or food -- we are always -- I never know quite what to call it other than it's a great meal, easy to cook, easy to heat up, easy to assemble. It was the reason why strategically we merged with Home Chef because we thought Home Chef on its own had great trends and could continue to grow.

I just had one question just on OG&A leverage. So this quarter, there was minimal leverage on a very strong comp, and that appears to be driven by wage pressures. So as you look forward to next year, just any insight in terms of how you guys are thinking about wage crushers at this juncture and whether you think the OG&A leverage point could be lower?

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

This is Kendall Toscano on for Robbie. I just wanted to see if you could give any more color on how traffic looked during the quarter. What kind of trends you're seeing with items in the basket and number of trips to the store? And then, I guess, as you're expecting inflation to moderate a little bit in the fourth quarter, what you would expect on those items going forward?

Yes. If you look at the overall trends in traffic, it continues to be improving. Obviously, the overall basket itself is heavily driven by inflation. But as I mentioned earlier, our trends on market share are moving in the right direction and continue to go in the right direction. In terms of the last part, I don't know, Gary, on inflation?

I think probably similar to what we shared earlier, I think overall, as we're looking at the way the customer is changing behavior, as Rodney mentioned, trips improving, generally fairly consistent, I would say, over the year, but we are seeing higher trips from those loyal shoppers that have traditionally shopped in many different retailers for different categories and now seeing that trip consolidate to Kroger. I think is an important trend that we've seen throughout the year and continue to accelerate in the third quarter.

Yes. Gary, I think that's a great point, and thanks for the questions. And for everyone, thank you for joining us today. As always, I always like to share a few comments directly with our associates listening in because so many of our associates take the time to do that, which we appreciate. This is the time of year we truly shine.