The Kroger Co. (KR) Q2 2007 Earnings Report, Transcript and Summary

Perry Caicco - CIBC World Markets John Heinbockel - Goldman Sachs Mark Husson - HSBC Meredith Adler - Lehman Brothers Todd Duvick - Banc of America Chuck Cerankosky - FTN Midwest Securities Scott Mushkin - Banc of America Ken for Deborah Weinswig - Citigroup Andrew Wolf - BB&T Capital Markets

Good day, ladies and gentlemen, and welcome to the second quarter 2007 Kroger Company earnings conference call. (Operator Instructions) I would like to turn the call over to your host for today, Ms. Carin Fike, Director of Investor Relations. Please proceed. Carin Fike: Good morning and thank you for joining us. Before we begin, I want to remind you that today's discussion 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 affect on our business on an ongoing basis is contained in our SEC filings, but Kroger assumes no obligation to update that information. Both our second quarter press release and our prepared remarks from this conference call will be available on our web site at www.kroger.com. Now I would like to introduce Mr. David Dillon, Chairman and Chief Executive Officer of Kroger. David Dillon: Thank you, Carin and good morning, everyone. We're pleased you could join us to review Kroger's second quarter 2007 financial results. With me today are Rodney McMullen, Kroger's Vice Chairman; Don McGeorge, Kroger's President and Chief Operating Officer; and Mike Schlotman, Senior Vice President and Chief Financial Officer. I'll begin with the recap of Kroger's second quarter and year-to-date results. I will also update our guidance for 2007 and Rodney will then provide additional details on Kroger's second quarter results. After that, we'll be happy to take your questions. Kroger delivered another quarter of strong sales performance. Total sales for the second quarter increased 6.6% to $16.1 billion and identical supermarket sales increased 5.8% with fuel and 5.1% without fuel. This is the ninth consecutive quarter Kroger has reported identical supermarket sales, excluding fuel, in excess of 3%. Our strong identical sales growth continues to be broad-based across the company's geographic regions and merchandise departments. All of our divisions and departments experienced positive identical sales growth. In addition, our convenience stores turned in another strong quarter of identical sales growth. Net earnings in the second quarter totaled $267.3 million or $0.38 per diluted share. Net earnings in the same period last year were $209 million or $0.29 per diluted share. Our fuel business had a strong second quarter this year in sales, gallons and margin. While fuel margins for the quarter were strong, on a year-to-date basis they were more normalized. In the fuel business, it is not uncommon to see variations from quarter to quarter. To account for these fluctuations, we encourage investors to considering a longer view when analyzing fuel margins. We are very pleased with our results this quarter. Our associates understand the importance of placing our customers first in their daily decisions. These results show we are connecting with our diverse customer base in a variety of ways including service, price and products. Turning to year-to-date results, total sales increased 6.7% to $36.9 billion during the first two quarters of fiscal 2007. For the same period, identical supermarket sales excluding fuel increased 5.1%. For the first two quarters of fiscal 2007, net earnings were $603.8 million or $0.85 per diluted share. Net earnings for the same period in fiscal 2006 were $515.4 million or $0.71 per diluted share. Kroger's earnings per share growth in fiscal 2007 will be driven by strong identical sales growth, a slightly improving operating margin, and fewer shares outstanding. Our performance through the first half of 2007 exceeding our expectations and our momentum heading into the second half of the year causes us to raise our identical sales and earnings guidance for fiscal 2007. Kroger now anticipates identical supermarket sales growth of 4% to 5% for the full year, excluding fuel sales. We expect to earn $1.64 to $1.67 per diluted share in fiscal 2007, up from the previous range of $1.60 to $1.65 per diluted share. Our updated guidance equates to 12% to 14% growth from adjusted fiscal 2006 earnings of $1.47 per diluted share. In addition, Kroger's dividend currently adds slightly over 1% to shareholder return. As we mentioned at the onset of fiscal 2007, we expected the timing of certain items in 2006 would affect our quarterly earnings per share growth in 2007. We anticipated that our earnings per share growth rates in the first and fourth quarters would be lower than the second and third quarters. This has held true for the first half of 2007 and we believe it fairly describes our expectations for the second half of the year. As a reminder, the fourth quarter of fiscal 2006 benefited from an extra week that we believe added approximately $0.07 per share to our results. Looking beyond 2007, we believe our Customer First strategy will allow us to grow identical supermarket sales in the 3% to 5% range, with slightly improving operating margins, excluding fuels sales. Now I would like to turn the call over to Rodney for some additional details on our second quarter results. Rodney McMullen: Thank you, Dave and good morning, everyone. As Dave mentioned, we are very pleased with Kroger's results this quarter and we are inline with our expectations that the Company's EPS growth rate for the second quarter would be higher than the growth rate for the full fiscal year. I'll now discuss some of the income statement components that produced our earnings per share growth in the quarter. Let's begin with gross margin. Kroger's second quarter FIFO gross margin increased 47 basis points to 23.94% of sales. Excluding the effect of retail fuel operations, FIFO gross margin increased 51 basis points from the prior year. Of this increase, 23 basis points was attributable to lower shrink, lower distribution costs and advertising expense as a rate of sales. FIFO gross margin increase also reflects our decision to pass along higher product costs during the quarter. Inflation is on many people's minds these days, so we'll take a minute to comment on how inflation is affecting Kroger's business. You may recall that we also experienced inflationary pressures across several product categories in the first quarter of the current fiscal year. At that time, we made a strategic decision not to immediately pass along all of our product cost inflation in retail prices based on specific market conditions. Second quarter market conditions allowed for a general pass-through of cost increases. Kroger's supermarket selling gross margin on non-fuel sales rose 38 basis points during the second quarter. This increase primarily reflects our decision to pass along product cost increases. On a year-to-date basis, Kroger's selling gross margin excluding fuel declined 11 basis points. This slight decline illustrates the timing factor associated with product cost inflation and our retail prices in our business as well as Kroger's continued practice of strategic price investments. Delivering value to our customers remains an important part of Kroger's Customer First strategy. We estimate that our product cost inflation during the quarter was 2.6%. This figure excludes fuel and utilizes CPI to estimate our inflation for our pharmacy department. We are experiencing inflation across many core grocery and perishable categories. Inflation in core grocery is at a level not seen in several years. The current inflationary environment has caused us to increase the projected LIFO charge in our business plan for fiscal 2007. We now anticipate a LIFO charge of approximately $110 million for the full year. This is $60 million more than the projection embedded in our original earnings per share guidance for 2007. The updated EPS guidance that Dave outlined earlier incorporates the $110 million LIFO charge. Turning now to OG&A, operating, general and administrative increased 2 basis points to 17.52% of sales. Excluding the affect of retail fuel operations, OG&A increased 16 basis points. This fluctuation may appear unusual to those of you who understand the business model that supports Kroger's Customer First strategy so I'm going to provide additional color on what caused our OG&A rate to increase compared to the prior year. Kroger's second quarter OG&A rate in the current year includes pre-opening and transition costs associated with the Scott's and Farmer Jack acquisitions that we described to you during our first quarter earnings call. We closed on these transactions during the second quarter. There are obviously no comparable costs in the prior year's OG&A rate. Kroger's second quarter OG&A rate in both fiscal 2007 and 2006 benefited from adjustments that reduced our closed-store lease liability. The magnitude of this benefit was higher in 2006 than 2007. These adjustments are part of our normal quarterly assessment of lease commitments. Excluding these items, Kroger's second quarter OG&A rate on non-fuel sales would have been lower in 2007 when compared to the prior year. This is in-line with our business model objective. Compared to the prior year, we continue to expect our annual OG&A rate in fiscal 2007, excluding fuel, to decline as a rate of sales. The gross margin and OG&A factors I just discussed, plus approximately 9 basis points of leverage from rent expense, resulted in a slight expansion of Kroger's non-fuel operating margin for the second quarter. While Kroger's second quarter operating margin is consistent with our plan, we do not believe that a single quarter's operating margin is the best gauge of success of our business strategy. This is due to the timing of operational cost savings and investments in our business. Kroger's operating margin on a year-to-date basis increased 5 basis points, excluding fuel and the first quarter charges for labor unrest in 2007 and certain legal expenses in 2006. For the full year fiscal 2007, we continue to anticipate a slight increase in Kroger's non-fuel operating margin, which is one of the drivers of our annual earnings per share growth. Kroger's earnings per share growth in fiscal 2007 is also driven by fewer shares outstanding. We aggressively bought back shares during the second quarter, reflecting our judgment that Kroger shares represent a compelling investment. Under our stock repurchase program, Kroger repurchased 21.2 million shares of stock in the second quarter at an average price of $27.21 for a total investment of $587 million. At the end of the quarter, $612 million remained under our $1 billion stock repurchase program we announced in June 2007. As we told you last quarter, the financial strategy that supports Kroger's business has evolved to reflect our progress in reducing Kroger's leverage over the past few years. Our long-term financial strategy is to use free cash flow to repurchase shares and pay dividends while maintaining a solid investment grade rating. Our share repurchase and dividend programs deliver substantial value to shareholders. Over the past four quarters, Kroger has returned $1.2 billion to shareholders in the form of share repurchase and dividends. Net total debt was $6.7 billion, an increase of $362 million from a year ago. Total debt was $6.7 million, a reduction of $274 million from a year ago. You may recall last year Kroger had approximately $600 million of cash invested on our balance sheet in investments, which caused the total debt and net debt to be different a year ago. Kroger's net total debt to EBITDA ratio was 1.77 this quarter compared to 1.87 during the same period last year. Our strong EBITDA on a rolling four-quarter basis enabled us to improve our leverage ratio while investing $2 billion in capital projects and $1 billion to repurchase 40.7 million shares and pay $192 million in dividends. During the second quarter, Kroger invested $566 million in capital projects, including acquisitions. This includes the acquisition of 37 stores in northeast Indiana and metropolitan Detroit that I referenced earlier. We invested $85.5 million to acquire these stores. Excluding acquisitions, Kroger invested $481 million compared to $361 million a year ago. Total capital projects included 13 new or expanded stores and 30 remodels. During the quarter, we also closed 11 locations; all of these were operational closures. During the quarter, total supermarket square footage grew 1.6% year over year, excluding acquisitions and operational closings. We continue to anticipate supermarket square footage growth of 2% in fiscal 2007. We still expect to invest $1.9 billion to $2.1 billion in capital projects during fiscal 2007. This estimate excludes spending on acquisitions. In terms of capital allocation, our emphasis remains on store remodels and we are very satisfied with their performance. We have completed 101 remodels year-to-date through the end of the second quarter. That compares to 73 remodels during the same period last year. Kroger carefully evaluates acquisition opportunities for their potential to enhance shareholder value along with our existing business. We also focus on improving our return on capital investment. Our return on assets improved 85 basis points on a pretax basis, excluding the effect of the 53rd week in fiscal 2006. This is on the same basis that Kroger has consistently used to calculate return on assets. Before turning back to Dave, I'll discuss the progress we have made in labor relations. We recently reached agreements with unions representing our associates in southern California, Seattle and Toledo. We are currently in negotiations in Cincinnati, Memphis, West Virginia, and in southern California with Food4Less. In every contract negotiation, we work to reach a balanced agreement that meets our cost efficiency objectives while fulfilling our commitment to provide our associates with solid wages and benefits. Maintaining this balance allows Kroger to invest in our business to provide great new job opportunities for existing associates and create new jobs for more people. Fair and balanced contract settlements continue to be our objective in all negotiations. Now I'll turn it back over to Dave for some closing remarks. David Dillon: Thanks, Rodney. We made solid progress during the second quarter in achieving our business objectives for the year. We are on track to successfully execute our business plan and generate value for our shareholders. In addition to the factors we just described, I want to update you on progress we've made during the quarter on one of our key competitive strengths, corporate brands. Our corporate brands team recently launched an expanded line of private label organic products under Kroger's exclusive Private Selections brand. Organic and natural foods continues to be a growing area of our business and with this expansion, Kroger's family of stores now carries more than 60 Private Selection organic products. Items range from staples such as milk, ketchup, butter and eggs to new items like cereal, salads and snacks. These Private Selection organic products are integrated throughout our stores and are available on shelves right next to our customers' favorite products. This makes it easy for customers who want to try organic foods to do so at their own pace without having to go to a special section for the organic items they want. We're excited to expand this growing segment of our business. Now we'd like to take a few minutes to answer your questions.

Your first question comes from Perry Caicco - CIBC World Markets. Perry Caicco - CIBC World Markets: On the gross margins, I just want to make sure we understand the impact of passing along the higher product costs. Do you see this as essentially a one-time catch-up from Q1, or should we expect margins to be impacted for the rest of the year? David Dillon: Perry, we were trying to demonstrate by illustrating the year-to-date picture that you ought to look at Q1 and Q2 together in this regard and actually in operating profit too. One of the reasons we did is that we identified in the first quarter that as inflation occurs, depending on the items that it happens in and depending on the market conditions, it may or may not get passed through at that particular moment in time. You may as a result see some unusual fluctuations in margins at different times because of that. As a result, I think you could continue to see that same kind of a picture down the road depending on what happens with inflation and then what items occurs and what the market conditions are. Mostly what we're trying to do is make sure you understand not to expect growing gross margins and instead to look back at what our overall strategy is. Our overall strategy is to grow identical sales and have a slightly improving operating margin. That requires actually, in our opinion, that we continue to invest in each of the four keys -- not just price -- but each of the four keys on those areas where we find savings. That's the overall picture and theme that we want to make sure you take away from this call. Perry Caicco - CIBC World Markets: Do you have any picture on how the next two or three quarters might unfold on the inflation front? David Dillon: Well, the one piece of information I can give you is that based on what we know today, the third quarter looks like it will be similar to where we have been in the second quarter in terms of product cost increases. We can't speculate at this point on the gross margins as would be reflected in retail pricing, but I can tell you that based on what we've seen on product costs, that those look like they'll continue into the third quarter pretty similar to what we saw in the previous quarter. Now, that statement is in primarily dry grocery. It would not include perishables. Those are a little more unpredictable. I don't know that we have enough vision into what's happening with milk further out than a month or so to be able to comment there either. Rodney McMullen: Perry, if you look at our LIFO estimate, our LIFO estimate would assume that third and fourth quarter would look pretty similar to where we are year-to-date. One other thing to Dave's answer to the first question, as you know, when you look at gross, we also have expenses in gross. When we look at the expenses in gross, we would expect to have continued opportunity to improve those numbers. I don't know that we would normally improve as much as we did this quarter, but we do see opportunities to continue to improve on those three lines. David Dillon: On that point, we actually think of expenses, not just OG&A, as a total group of costs and we include in there those three expenses that are embedded in the gross that Rodney described: shrink and the logistics cost and advertising. So that's a really good additional point. Perry Caicco - CIBC World Markets: On a related question then, what did passing on inflated product costs do to your price competitiveness? In other words, how were you able to get prices up and still drive sales? David Dillon: We're pleased with our price competitiveness. As you know, that's a pretty strong focal point of the organization. Every market's different, so it's hard to broad brush what that position is, but we are pleased with that competitiveness. I think that the reason our sales have been able to grow has been overall all of the parts of the strategy, it's not any one thing. It's all departments contributing, it's all divisions contributing. It is the strategy we described of investing in those four areas that we think matter to the customer with the savings that we get. Certainly, inflation in the quarter caused or helped our ideas to be slightly more positive in the quarter than think otherwise would have been. There's no doubt about that. I think our strategy and the work we're doing on many fronts is the reason the sales are where they are.

Your next question comes from John Heinbockel - Goldman Sachs. John Heinbockel - Goldman Sachs: A terrific quarter. A couple of things. Number one, you talked about market conditions maybe being a little more favorable in the second quarter. Was the competitive environment or the promotional environment a little less intense? Is that what you were referring to? Related to that, what was your level of, on a relative basis, magnitude of your price investment second quarter versus first? Were they substantially less or modestly less or how would you define that? Rodney McMullen: Well on the market conditions, from a competitive point of view, I don’t think that the conditions really changed much. I think probably if I were to try to guess the reasons we saw a difference in what you are asking about is that the whole market was paying higher costs on products and as a result, competitors chose to raise some of their retail prices on selected items, based on this cost. That took a little bit of the heat off of individual items that may have kept us in the past from being able to pass through a cost increase, again, depending on the items. Some items like milk varies every week. But other items, it wouldn’t be as competitive. Once those get passed through to the market then it is certainly back to the competitive conditions it was before, even though we passed through a price increase. So that’s really what was happening there. The other question you asked was? John Heinbockel - Goldman Sachs: The proactive strategic price investments seem to be a bit less in the second quarter than the first. A general sense of magnitude of how much less? Rodney McMullen: Price investment in the quarter, I don’t think we are quantifying it, but it is pretty clear just purely based on what happened with the gross margins, that there would have been less strategic investment in the quarter than in the previous quarter. Certainly less new initiatives and less new pricing strategies would have been adopted, and that is reflected in what happened with the margins. Part of the reason for that is with the inflation and competitive conditions, we wanted to make sure that we were on a solid basis on where we were both in our pricing on our previous strategies and then our competitiveness on the items that had cost increases. So we concentrated a lot of energy on that. Plus, as you can see on the items embedded in gross, we had good success in reducing the cost in those three areas. John Heinbockel - Goldman Sachs: Secondly, you guys have pretty good loyalty card data. If you look at where you're getting your comp store growth from, you have a couple of buckets here: the primary shoppers buying more, secondary maybe transitioning more to primary; and then maybe a third bucket being totally new customers. Is the bulk of it coming from primary spending more share, or are you picking up in the other two areas as well? David Dillon: I'll see if Rodney has anymore current data than I had, but my impression is that it's much like we described last quarter. That our improved business is coming from our best customers shopping more with us and customers who previously weren't shopping as much with us becoming more of a best customer for us. So it's really all of the things you described. It's not just one area or another. Rodney McMullen: Slightly over half of it would be growth from an existing customer spending more with us in terms of overall. But you always have new customers coming in and customers moving. So it's always a constant flow. John Heinbockel - Goldman Sachs: So slightly less than half, then, would be new customers. Rodney McMullen: Right.

Your next question comes from the line of Mark Husson - HSBC. Mark Husson - HSBC: We've been looking at these numbers and noticed a couple of things. The first thing was, they weren't too bad, were they? David Dillon: Well, thank you. Mark Husson - HSBC: The second thing was, if you look back, and I went back through the models to have a look and see the last time you had a gross margin increase, because it's a bit rare, and it was about five years ago, actually the first quarter in 2002. Also in that period of time, you've managed to lose about 350 basis points of gross margin and lost about 150 basis points of SG&A. Now I think you anticipated a long journey in terms of rebuilding and rebasing the P&L account, but being as we have now seen your guidance is 165, well, includes 165, which was about what you made five years ago, finally, so while these numbers aren't very good, it's five years since you made the same number. Has that journey ended, or how is it changing? It seems unlikely you're going to lose another 350 basis points over the next five years. David Dillon: Well, I'm glad you noticed the milestone that we're reaching. We appreciate that insight. It is a long journey. I don't view this as the end of that journey. I view it as actually we're in the second half of it. But that's actually because it's almost like the cost opportunities of saving money and the cost savings that we see, when you get to the top of the peak, you look out ahead and see another mountain peak higher than the last one, you say, whoa, what at an opportunity. Every step of the way we've gone in this strategy, we've seen not only improved results, but additional opportunities. So whether or not the additional investments we will make will be in price or will instead be in shopping experience or people or products or some combination of those four, I'm not sure I want to predict that just yet. But I will predict that as we continue to save OG&A, which we expect we can and can save additional money in the expenses embedded in gross, that we will choose to reinvest much of that in ways that will help our customers continue to shop more with us, growing our sales, and therefore growing the earnings. We are recognizing and do expect to have our operating margins grow slightly and that's intended to say our thought here is to not cause our bottom line to decrease like it has done, as you pointed out, for several years from our peak. We plan instead to have it grow from here. Mark Husson - HSBC: The things that have changed since then, clearly, the fresh departments are a much bigger part of your business than they were then and general merchandise is a significant change. Just talk about general merchandise here. You have not mentioned it very much as you start to roll out the Marketplace stores and whether or not high gas prices have caused people to sort of consolidate shopping trips and whether those stores are beginning to get discount customers into your stores. David Dillon: I'll come right back to that. Rodney was going to add a point to that. Rodney McMullen: If you look at our identical sales trend, as everyone understands, our model is driven by identical sales growth and clearly our identical sales growth is on a completely different trajectory today than it was five years ago. The other point, Mark, using your numbers, if I wrote them down properly, was the 350-basis point margin investment and a 150-basis point reduction in OG&A. I don't think we would point to either one of those and give a specific direction. Rather, we would not expect you to see a net 200-basis point decline between those two versus what David said, a slight expansion in our operating margin, and that's what's really more important than the absolute change in any one of those two numbers over time. David Dillon: That's very true. Good point. Mark, back to your second point, an update on general merchandise and what do we see as the effect on the consuming public of high gas prices? Is that the gist of it? Mark Husson - HSBC: Yes and traffic patterns. David Dillon: We're of course very pleased at the progress we've made with the Marketplace stores. We've now opened the first Marketplace store in Wichita, Kansas, which is the latest that has been opened. We continue to be pleased with the results and have made plans to grow that format. That format actually has a number of attributes, one of which is general merchandise, of course, and the general merchandise sales in those facilities is good and is growing and we think over the long haul will become an important part of that format. But in addition to general merchandise, the newer Marketplace stores that we've built actually are growing the food side of the business as well. The fresh offering in these stores is quite remarkable and we're very pleased at those results also. Now as to the effect of gas prices on the consuming public, that would be a bit of speculation on our part. Obviously, gas prices are high and if you go back to four or five years ago, the customer's having to spend a lot more for fuel than they did before. While I don't know that we have any actual data that will prove this, we do believe that we benefit somewhat from this because the size of our stores is such that we are generally located within a couple of miles of customer's homes, they don't have to drive a long way to come visit us. And in the Marketplace stores too, we have a large customer base in the nearby vicinity of the store, and so we see those stores as actually pretty convenient. We actually see the combo store or the Marketplace store, either one, as providing good, one-stop shopping so the customers can consolidate their trips that way. Not to mention the fact that we have fuel at many of our supermarkets now and typically we are priced low in the market and typically customers can earn lower prices on their gas bill by shopping with us. The combination of all of those, I think, makes us as a pretty good spot to come in this environment of high fuel costs. Rodney McMullen: And it's very clear our associates are doing a much better job of providing the shopping experience for our customers that the customer wants and I think that is overlaid on all of Dave's comments.

Your next question comes from the line of Meredith Adler - Lehman Brothers. Meredith Adler - Lehman Brothers: I have a bunch of questions that kind of follow on what people have said. I would like to just start with the last thing you said, that customers are pleased with changes you've made in your business, outside of just price. At your analyst meeting last year, you actually put up a slide and showed customers' view of those four keys. Could you just update us a little bit? I think you've said you're happy with price, but what about everything else. Are you seeing customers report back to you improvement? David Dillon: We continue to improve, but if you would ask us internally, we're not making as much progress as we would like and it's certainly one of those half full or half empty. The positive is we continue to improve, but we want to improve even more. Meredith Adler - Lehman Brothers: Then sort of following on this conversation with Mark, do you see the potential ever to get back the 200 basis points of operating margin that you lost? Is that not something you're even thinking about? I know you want to drive sales, but is it reasonable to believe that? David Dillon: We really are focused on the combinations of sales and what then happens with our operating margin and the slight improvements that we're seeking. It's my personal opinion that if we were to make a drastic change in the near term in operating margins that we would soon see the sales gains that we had get dissipated and the combination of our strategy would not really work after that. So you should not expect anything in the short run that would cause that to be significantly different. I don't think I want to speculate on margins in the long run. Our focus really is on the strategy as we've described it and it certainly leads to slightly higher margins and year after year that margin would continue to grow that way. So sure, it could get bright bigger than it is today. I just don't know how much bigger that would look. Rodney McMullen: If you look at the returns on where we are currently, it's in excess of our cost of capital by a nice margin. If you look at our business model on continuing slightly improving operating margins, we would expect for that to continue to be true. Meredith Adler - Lehman Brothers: Then just a little bit more technical question. I want to make sure I understand what you said about the one-time costs that was in OG&A this quarter. If we look at the 2 basis points of increase in OG&A, if you backed out the things that probably would be considered one-time or the comparison on the store closing cost versus last year, would that have gotten you to something minus 18 basis points? Am I understanding what you said right? Rodney McMullen: If you look at it without fuel, it would have been an increase of 16 basis points. If you adjust out the start-up costs and transition costs for Scott's and Farmer Jack acquisition and the adjustments on the closed stores, that would have been a decline in OG&A rather than an increase of 16 basis points. So it would have been a negative, if you want to look at it that way. Meredith Adler - Lehman Brothers: And then more significantly negative if you include fuel? Rodney McMullen: Yes. But we always exclude fuel because the OG&A on that business is extremely low. We just think it's always important to show it without the effect of fuel because it just affects the whole number so much that we think that in trying to be more transparent for people to understand our numbers, that's the reason we exclude it. Meredith Adler - Lehman Brothers: Just one technical question. Could you tell us what square footage growth was if you include the acquisitions and the operational closings? I know why you provide the other number, but in the end the question I'm asking is probably what's driving the business, is the total growth. Rodney McMullen: If you have another question, we're looking it up, so it will take a couple of seconds. Meredith Adler - Lehman Brothers: I did want to ask you just a question about the dividend. You obviously have a choice between buying back stock and increasing your dividend. Any chances you're going to increase the dividend? David Dillon: The last statement on the dividend that we made, and I would go back to that, and I think that was probably in March. Rodney McMullen: March, when we announced the increase. David Dillon: Yes, when we announced the increase that it is the board's intention to review this roughly each year with the desire to, if the conditions are right, with the desire to have an increase in dividend. That policy is what we stated then. That's as far as actually we go on that subject. I don't think I can say anything more current than that. But that view is essentially to say that we want to look at the dividend each year and ask ourselves what's the best choice here on dividends and I'm sure our board will consider the point you're making at the time they evaluate that again this next year. Rodney McMullen: Meredith, it's actually 1.9, so it's higher when you include everything because of the affect of the Scott's and Farmer Jack acquisitions in the quarter.

Your next question comes from the line of Todd Duvick - Banc of America. Todd Duvick - Banc of America: Good morning and congratulations. I was wanting to know if you can tell me about the share buyback program? On a full-year basis, do you plan to buy back the shares strictly with cash flow, or are you also considering funding the program partly with debt? Rodney McMullen: Our long-term strategy is to fund our share buyback and dividend with free cash flow and manage our net total debt to EBITDA ratio to a level that will allow us to be a solid investment grade rating. As the enterprise expands and EBITDA continues to grow, you can see what we spent over the rolling four quarters on capital, which is why we talked about those. We spent $2 billion in capital and then bought in the level of stock we did over the rolling four quarters as well as paying the dividend. We spent quite a bit of dollars and we're still able to reduce net total debt and improve our leverage ratio. My expectation would be that you would continue to see that kind of activity happen. Debt at some point, as the enterprise continues to grow and EBITDA continues to grow, we need to balance the amount of debt as compared to the amount of equity on our balance sheet to make sure we have the right balance. But we will remain focused on our net total debt to EBITDA ratio to manage that to a very solid investment grade. Todd Duvick - Banc of America: So I take from that that as we look at the debt balance going forward, generally we should expect debt to grow inline with cash flow? Rodney McMullen: I wouldn't predict a particular number, but we will manage the net total debt to EBITDA ratio to be a solid investment grade. In our view, that's at least mid-triple B. Very pleased to have spent, in the rolling four quarters, basically $3.2 billion and still have a 10-basis point reduction or a 0.1 decline in our leverage ratio. That demonstrates the amount of cash flow generation that we have. Todd Duvick - Banc of America: A question coming from a different angle. Can you talk about geographically, are there any markets that you're seeing that are either exceptionally strong or some markets where you're actually seeing some increased competitive pressures? Can you provide us any color along those lines? David Dillon: We certainly are seeing some markets that are noticeably better than others, and we are seeing some markets that are more competitive than others. For competitive reasons, though, we choose typically not to disclose that. As a result, I apologize for not answering your question, but I'm not going to. Rodney McMullen: And it's not specific competitors, either. David Dillon: There's not a clear pattern in that regard. It's really more localized. Rodney McMullen: But it's really no different than what we would have seen over the last two or three years. David Dillon: Yes. Rodney McMullen: It's why we often talk about our geographic diversity being one of our biggest strengths. You always have markets that are pretty darn competitive, you have some markets that are probably on the other side of that competitive cycle, and then the rest fall somewhere in the middle, close to either end of that, and that's why we think our geographic diversity and our spread across the country helps balance the affect on the total company. It gives us the ability to address the competitive situations when we need to. David Dillon: That's also the reason why, if you look, all our region, we were positive identicals and that was one of the comments. That's an important thing to note, at least it's important to me to note that all the divisions were positive IDs because that's a real important indication of how we're doing.

Your next question comes from Chuck Cerankosky - FTN Midwest Securities. Chuck Cerankosky - FTN Midwest Securities: Just one cleanup item to start with. You mentioned when you're discussing the gross profit margin, Rodney, you talked about a 38-basis point item and I sort of lost what that was? Rodney McMullen: Let me go back and make sure I quote exactly right. It was supermarket selling gross. David Dillon: Yes, the supermarket selling gross in the quarter was up 38 basis points. Chuck Cerankosky - FTN Midwest Securities: If we're looking now at these acquired store, the 37 you just bought, can you tell us where they're at in terms of getting them fixed up, how many are open, and when the rest will reopen, that sort of thing? David Dillon: All are reopened except for one store that we plan to reopen. The one store that we didn't reopen, we will do a major remodel in that store and we just didn't think it made much sense to open it, because the remodel is going to be so major. They're all converted to Kroger systems and all of those behind the scenes things. Now we're going through the process of actually remodeling the stores and that will take two or three years to get through all of them in terms of remodeling the stores to the way we like. Chuck Cerankosky - FTN Midwest Securities: And those will be more basic remodels? David Dillon: It will be everything from basic to some will be pretty serious. It's a pretty wide range and if you look on both of these, we were especially pleased with some of these sites and we will make sure that we remodel these stores right, because we think the opportunity is pretty big in terms of improving the business. Chuck Cerankosky - FTN Midwest Securities: Okay. So you bought 37, 36 are open? David Dillon: Well there's five stores that we either closed their store or closed a Kroger store to consolidate the business between the two. So it would be 31. Chuck Cerankosky - FTN Midwest Securities: How's the acquisition environment looking, Rodney? Rodney McMullen: Right now it's a little bit quieter than it has been. I think part of it's probably anyone's that's selling, the valuation at the moment they probably don't like it very much. It's a little quieter than it's been recently, but it's one of those things where it will be quiet for two or three months and then all of a sudden you'll get three or four in a week. So it always goes in cycles. But it's quiet at the moment. Chuck Cerankosky - FTN Midwest Securities: Dave, can you please talk about prepared foods during the quarter? It looks like based on what I've seen in the stores, an improving category for you. How did it behave and how do you fit that into what the consumer's facing in other parts of their budget, especially fuel and maybe housing costs? David Dillon: Most of our prepared foods would fall in the deli department. I don't know that all of it would, but most of it would. Our deli for the quarter had a very good sales result. They're IDs were better than our company average and we're very pleased with what they did. We are trying a variety of different things in different stores and we're trying to learn as we go and modify that program as we go. So generally we're pleased with the direction, pleased with the progress, but we believe we also have some areas of improvement in that area that we could make.

Your next question comes from the line of Scott Mushkin - Banc of America.

I just wanted to kind of pick on the issue of going back to the gross margins, but also a comment you made that there was a little less price investment during the quarter. Vis-à-vis clearly Wal-Mart, a big competitor of you guys have been vocal in the other direction. With the second quarter it seems like Wal-Mart, they did it in October, it didn't have an affect. They started doing this again in June, maybe even on a bigger basis. Are you just not seeing any impact from their actions, or they're thinking that the consumer's in a different place? Are you seeing any consumer reaction to what seems to be a more difficult economic macro economic environment? David Dillon: Scott, I look at lots of different competitors and certainly Wal-Mart is one of them. I'm pleased with, actually, our price competitiveness as to Wal-Mart on a relative basis compared to where we've been over time. I don't think that we've let that position deteriorate. On the other hand, we have similar questions on other competitors too, as to how we're faring those and we watch those pretty closely. Overall our price position, we are generally pleased with it. I've said before and I think it's still true that there are plenty of opportunities to improve on that position, but relatively speaking from whence we came several years ago, we've really improved on that situation. I don't think that changed in the quarter, because really the costs that we described in our inflation were costs that many others, in fact everybody else, would have experienced too. So they would have had to figure out what they would do with their own pricing and in their own situations. Rodney McMullen: And also, some of their price investments or comments are on categories where we don't carry the items, too. Certainly, when you look at back-to-school, there's a lot of categories that we would not carry. David Dillon: That would be true. As to whether or not we're getting business from Wal-Mart or not, I'm really not going to speculate on that. I think one of the key messages for us is this is about Kroger's strategy. We're pursuing our strategy and it's having a good success and we'll take customers wherever we find them. And it may be some from Wal-Mart, but may also be some from traditional grocers, some from independent, some from other chains, some that were actually getting from restaurants. We didn't really talk much about that change, but it's reasonably clear, I think, in the data in the restaurant industry that the trend towards eating out more often, at least the rate of growth of that, has subsided some. Now whether that's because of costs and people just know that it's less expensive to eat at home, that's certainly one reason and I know it's true and I'm sure some people react to that. In addition to that, we've commented before about the trend towards families eating together. Of course, some of the families eating together maybe to reduce the cost, but it also may be because of the findings we've talked about before at the Columbia University that families that eat together on a regular basis have all kinds of good things happen with regard to their kids growing up. There's more on that. In fact, Family Day is coming up later this month. I don't remember the exact date, but it's later this month and you'll see a lot of advertising around that to encourage families to think about that. I think that is something that's going on in society today and I think it works certainly to our advantage, but more importantly it works to the advantage of the families.

Just for what it's worth, our pricing survey with Wal-Mart are showing gaps widening again, for what it's worth. The second question I had was regarding growth, and I think it goes back to a question Mark was asking or looking at it historically. Historically you guys, if I go back in my model, it looks like you used to grow square footage net of about 4%. As we look out to '08, '09, and look to maybe transition from the value story, are there opportunities to grow organically or do you still favor the acquisition fill-in? Rodney McMullen: At this point, our preferred method, obviously, is growing identical sales. Because we've had great success in that and we think when you look across the enterprise, we still have a lot of capacity to grow identical sales even better than where we are and then some of the slightly improving margins and buying back stock. You'll see us over time to continue being a little bit more aggressive, but it will be more in terms of replacing good stores with Marketplace stores will really drive the organic growth. To go into new markets, you probably won't see too much of that unless it's finding the right company to merge with.

Your next question comes from the line of Deborah Weinswig - Citigroup.

Congrats on the impressive quarter. My question relates to your Kroger personal finance initiative. We noticed that you guys have added a few more products on your website. Can you give us an update on that strategy and how has that impacted traffic or just the overall results? Rodney McMullen: Overall, we're very pleased with where we are in Kroger personal finance. As you know, we have a partnership with Royal Bank of Scotland and it's working out great for us. When you look at the business model overall it continues to develop where we expected if not better than what we originally expected. Our customers continue to reward us with more and more loyalty on some of the products. So overall we're very pleased with where we are and we are very pleased with where we see it going and it really is just one more thing to eliminate another stop for the customer to make it easy for them. We have some great products at very good values for the customer.

As far as the financial contribution to your earnings, can we expect that to be significant five years from now, or is this more for traffic building? Rodney McMullen: It certainly has the opportunity if you look five years out, to be something that would be willing to talk about, but we're looking at it one step at a time.

My last question is related to your in-store clinic strategy. Can you give us an update on how that's going? Rodney McMullen: Currently, we have in-store clinics, I believe, in 30-some stores. We've partnered with several different companies on our in-store clinic strategy. So far, the customers seem to like it and it continues to grow, but the growth is reasonably slow. But we continue to look at it and look at how it will become part of our overall pharmacy strategy and try to understand how to make it a more important piece. It's still pretty early in the process, but it's something we are spending some energy on trying to understand and look at in a little bit more serious way.

Your next question comes from the line of Andrew Wolf - BB&T Capital Markets. Rodney McMullen: Andrew, this will be our last question, I think. Andrew Wolf - BB&T Capital Markets: I've got two for you and congrats on the momentum. Do you give out or can you give out the change in penny profit per gallon at your fuel stations? I think you mentioned you had a good quarter there in profits. Rodney McMullen: We do not and we always think it's more important to look at it over a longer period of time than quarter-to-quarter, but we do not give out the specifics. Andrew Wolf - BB&T Capital Markets: The other question regards inflation crept up from 2% in the first quarter and whatever it was last year, looks like it was running around 1%. You're passing through more of it and sales are very impressive, but they're on a nominal basis at about the same number, 5% plus comp. So that implies either your tonnage or volume is sort of decreasing or there's some trading down, which I guess you would expect in this environment. In lieu of that, if you agree to that kind of logic, would you discuss trends in tonnage and in trading down? David Dillon: Well, the trading down is hard to track, at least in a very precise way. Certainly, we believe some of that would occur. People trading to a lower priced product, buy more Kroger brand, which certainly has been true in the quarter. Whether that's driven by inflation or driven by national brands raising prices, it's hard to say. But to that extent, we certainly believe the customers will tend to shift as they need to shift, but they also will shift, as I mentioned earlier from restaurant business to our business. So that works to our advantage in that regard. Tonnage also, while it may seem at first easy to track, it's sometimes hard to track and as a result, we don't have real confidence in the actual numbers. We do track it, but I don't have confidence enough in them to be publishing the numbers. We look at the trends because we want to understand really what's happening with our business. I think we'll stick with the statement that I made earlier that it's certainly clear that our quarter identical sales in the second quarter were more positive as a result of inflation than they would have otherwise been. There's certainly some impact there. Andrew Wolf - BB&T Capital Markets: In a typical trading down situation, let's say from an inflating brand to a Kroger brand, can you just kind of discuss how the profitability on a penny profit per unit compares, in a Kroger brand versus a national brand? David Dillon: Generally speaking, we make a higher percentage margin on Kroger brand products and while not always, we often make a higher finished profit too. Although sometimes the price difference is significant enough that at the higher percentage margin, the finished profit is still not any higher. But overall my objective as a pricer, as I think about pricing strategy is, I like to make more pennies a unit sold in a Kroger brand product than in a national brand product. I think that works well for us and it works well for the customer as they trade. So that's how, when I'm looking at pricing, that's how I'm always looking at it. Rodney McMullen: As you've header heard us say before, as a general rule, our margins about 10% higher on corporate brands than a national brand when you look at everything added together. As you know, one of the things our corporate brand team has been focused on is making our brands so good that our customers want to buy it, and it's not trading down to it, it's trading to it. David Dillon: Or even trading up to it. On that point, we can all laugh a little bit about it, but I challenged our merchandise team, we do blind taste tests, you may know that. We do blind taste tests to determine if our product is viewed by the consuming public as good or better than the national brand. I said to the team a few years ago, we'll really be getting somewhere when it's not a blind taste test, that is when they see the results. We started doing those in the stores. And the results where we do that with customers that come by in the stores, and we have done thousands of them. When we do that, even when they know the brand, we are winning on the same basis that we were winning before when it was blind taste test. And that's actually quite remarkable. It is a little tongue-and-cheek to say they're trading up, but in fact they are trading up. Anything else, Andrew? Andrew Wolf - BB&T Capital Markets: That was it. Thank you. David Dillon: Well, let me close with this. I want to thank you all for joining us, but before we sign off, I would like to offer some additional thoughts to our associates who we encouraged to listen in with us today. As expected, 2007 is shaping up to be another successful year thanks to you. Many of us in senior management have had the opportunity in the last few weeks to visit many of you in stores or during visits to plants, distribution centers and offices and I always come home inspired by your enthusiasm and engagement with our customers. I had another great experience this past weekend while visiting a store we recently expanded. During my visit, I was inspired by one gentleman who was spot cleaning the floor and proud of his work. Next I saw a cheese steward introducing new varieties of cheese to customers who have never tried them. Throughout my visit in the store, I saw numerous examples of talented associates engaging customers, from the creatively stocked salad bars to the wonderful prepared foods to the delicious pastry bar. [Audio transmission ends]