KROGER CO quarterly report, Q3 FY2009

Kroger Co. Form 10-Q Summary

Reporting period: Third quarter and first three quarters ended November 7, 2009, representing 40-week periods. Comparative periods ended November 8, 2008. The request metadata identifies “2008 Q3,” but the filing itself is for the 2009 third quarter and was filed December 17, 2009.

Business Context

Kroger operates supermarkets, fuel centers, convenience stores, jewelry stores and manufacturing operations in the United States. Results were affected by lower fuel prices, significant food deflation, cautious consumer spending and intensified competition. Identical supermarket sales excluding fuel increased 1.3% in the quarter, while estimated supermarket unit volumes excluding fuel and pharmacy increased 8.6%.

Key Financial Metrics

Metric	Third quarter 2009	Third quarter 2008	First three quarters 2009	First three quarters 2008
Sales	$17.669 billion	$17.615 billion	$58.203 billion	$58.853 billion
Operating profit	$(758) million	$479 million	$585 million	$1.794 billion
Net earnings attributable to Kroger	$(875) million	$237 million	$(185) million	$900 million
Diluted EPS	$(1.35)	$0.36	$(0.29)	$1.36
Operating cash flow	Not separately provided	Not separately provided	$2.375 billion	$2.357 billion
FIFO gross margin	22.71%	23.50%	23.48%	23.03%

Reported results included a $1.113 billion pre-tax goodwill impairment charge, primarily related to the Ralphs Southern California reporting unit. Management reported adjusted third-quarter net earnings of approximately $177 million, or $0.27 per diluted share, excluding $1.05 billion of after-tax asset impairment charges. Adjusted first-three-quarter net earnings were approximately $866 million, or $1.33 per diluted share.

Third-quarter total sales increased 0.3%; supermarket sales excluding fuel increased 2.1%, while fuel sales declined 7.9% because average retail fuel prices were 24% lower.
First-three-quarter total sales declined 1.1%, principally because of lower fuel prices; supermarket sales excluding fuel increased 3.3%.
Third-quarter FIFO gross margin declined 79 basis points, driven by deflation, competitive activity and investments in the customer strategy. Excluding fuel, the margin declined 88 basis points.
Third-quarter OG&A expense was $3.140 billion, or 17.77% of sales, versus 17.62% in the prior-year quarter.
Interest expense was $105 million in the quarter and $383 million year to date.
The year-to-date effective tax rate was 196.0%, primarily because the goodwill impairment charge was mostly nondeductible.

Cash Flow, Liquidity and Capital Structure

Cash and temporary cash investments were $517 million at November 7, 2009, compared with $263 million at January 31, 2009.
Operating cash flow was $2.375 billion, compared with $2.357 billion in the prior-year period.
Investing activities used $1.795 billion, including $1.766 billion of capital expenditure payments.
Financing activities used $326 million, including $176 million of dividends, $426 million of debt repayments and $130 million of treasury stock purchases.
Total debt, including capital leases and financing obligations, was approximately $8.1 billion, broadly unchanged from year-end and slightly above the prior-year quarter.
Face-value debt excluding capital leases was $7.569 billion, with $547 million classified as current; fair value of total debt was $8.359 billion.
Kroger had no borrowings under its $2.5 billion revolving credit facility, money-market lines or commercial paper at quarter-end. Outstanding letters of credit reduced available revolver capacity by $312 million.
The company issued $500 million of 3.90% senior notes due 2015, intended to refinance $500 million of 8.05% notes maturing in the first quarter of 2010.
Kroger was in compliance with its debt covenants and stated that available liquidity was adequate for anticipated working capital, capital expenditures, interest and scheduled principal payments.

Material Changes Versus the Prior Comparable Period

Sales growth slowed materially because of fuel-price deflation: third-quarter sales increased only 0.3% versus 8.9% in 2008, and year-to-date sales declined 1.1% versus 10.9% growth in 2008.
Reported profitability deteriorated sharply because of the Ralphs goodwill impairment, lower fuel margins, weaker operating profit and lower non-fuel gross margins.
Lower LIFO charges partially offset the deterioration: $10 million versus $69 million in the quarter and $48 million versus $155 million year to date.
Capital expenditure payments increased to $1.766 billion from $1.613 billion, while planned capital spending was subsequently reduced by approximately $1 billion over the next three fiscal years.
Share repurchases declined to $130 million from $626 million year to date as Kroger prioritized liquidity and financial flexibility.
Kroger contributed $265 million to sponsored pension plans, compared with $20 million in the prior-year period.
Goodwill declined from $2.271 billion at January 31, 2009 to $1.158 billion after the Ralphs impairment.

Guidance, Outlook and Management Commentary

Fiscal 2009 identical supermarket sales growth excluding fuel: 2.0% to 2.5%.
Fiscal 2009 diluted EPS guidance: $1.60 to $1.70, excluding the Southern California impairment charges.
Expected 2009 capital expenditures excluding acquisitions and leased-facility purchases: $1.9 billion to $2.1 billion; expected average annual capital expenditures over the next three years were reduced to below $2 billion.
Expected 2009 interest expense: approximately $498 million; expected annualized LIFO charge: $62 million; expected effective tax rate excluding the impairment: approximately 36.0%.
Management expected non-fuel operating margins to decline and fuel margins to average approximately $0.11 per gallon.
Management believed no additional goodwill impairment was reasonably possible in the fourth quarter, although all applicable reporting units were scheduled for annual testing.

Risks, Contingencies and Unusual Items

The Ralphs impairment was based on reduced expected cash flows, adverse economic conditions and competitive actions in Southern California. Further impairment remains sensitive to future cash flows, market values, discount rates and competitive conditions.
Kroger faces labor negotiations and potential disputes in several markets. A prolonged work stoppage could materially affect results.
Multi-employer pension plans were believed to be underfunded; Kroger stated that contributions could as much as double over the several years after 2009 and that market exits could trigger substantial withdrawal liabilities.
A pending Tax Court dispute involving a 1992 Ralphs transaction could require a cash payment of up to approximately $457 million if resolved adversely. Kroger believes its position is more likely than not to be sustained.
Various antitrust, wage-and-hour, civil-rights and other claims remain pending. Management believes provisions are adequate and does not expect a material adverse effect, but acknowledges that outcomes are uncertain.
Kroger guaranteed portions of indebtedness for certain real estate entities; disclosed potential obligations totaled approximately $7 million and $25 million, respectively.
Key operating risks include deflation, consumer caution, competitive pricing, fuel-price volatility, labor costs, pension funding, interest rates, supplier costs, liquidity-market conditions and changes in tax or accounting rules.

Investor Verification Items

Verify the period discrepancy: the supplied request says 2008 Q3, while the filing covers the quarter ended November 7, 2009.
Reconcile reported EPS and earnings with the $1.05 billion after-tax impairment adjustment and assess the sustainability of adjusted earnings.
Review Ralphs and other reporting-unit goodwill testing assumptions, including projected cash flows, discount rates and valuation multiples.
Monitor non-fuel gross-margin trends, fuel margins, deflation and competitive pricing pressure.
Assess liquidity after capital expenditures, pension contributions, dividends, debt maturities and reduced share repurchases.
Evaluate potential exposure from the Tax Court dispute, labor negotiations, litigation and multi-employer pension underfunding.
Compare subsequent annual-report results with the company’s 2009 guidance and stated expectation of no further material goodwill impairment.