The Kroger Co. Form 10-Q Summary
Reporting-period note: The request identifies “2017 Q3,” but the supplied filing is Kroger’s Form 10-Q for the third quarter and first three quarters ended November 10, 2018, with comparisons to November 4, 2017. The third quarter covers 12 weeks and the year-to-date period covers 40 weeks.
Business Context
Kroger operates supermarkets, fuel centers, pharmacies, digital and specialty businesses. During 2018, the Company sold its convenience-store business, acquired meal-kit company Home Chef, and formed an exclusive U.S. partnership with Ocado to enhance digital and automated fulfillment capabilities.
Financial Performance and Position
| Metric | Q3 2018 | Q3 2017 | First 3 Quarters 2018 | First 3 Quarters 2017 |
|---|---|---|---|---|
| Sales | $27.672 billion | $27.749 billion | $93.071 billion | $91.631 billion |
| Operating profit | $647 million | $747 million | $2.225 billion | $2.062 billion |
| Operating margin | 2.34% | 2.69% | 2.39% | 2.25% |
| Net earnings attributable to Kroger | $317 million | $397 million | $2.851 billion | $1.053 billion |
| Diluted EPS | $0.39 | $0.44 | $3.43 | $1.15 |
| Net cash from operations | Not separately provided | Not separately provided | $3.733 billion | $3.054 billion |
- Identical sales excluding fuel increased 1.6% in the quarter and 1.7% year to date.
- Digital revenue grew more than 60% in the quarter and approximately 60% year to date, primarily driven by ClickList.
- Gross margin declined to 21.59% from 22.41% in the quarter and to 21.57% from 22.05% year to date. Management cited lower prices, transportation and advertising costs, specialty pharmacy growth, and a higher quarterly LIFO charge.
- Adjusted operating EPS was $0.48 in the quarter, up 9.1%, and $1.63 year to date, up 15.6%. These measures exclude specified unusual items.
- Cash used in investing activities was $630 million year to date, compared with $2.035 billion in the prior-year period, primarily reflecting proceeds from the convenience-store sale.
- Cash used in financing activities was $3.021 billion, including $1.996 billion of treasury-stock purchases and $324 million of dividends.
- Cash and temporary cash investments were $429 million at November 10, 2018, compared with $347 million at February 3, 2018.
- Total debt, including current and long-term portions of capital leases and financing obligations, was approximately $15.0 billion at November 10, 2018; debt excluding such obligations was $14.119 billion.
- The Company had $635 million of commercial paper outstanding, no borrowings under its $2.75 billion revolving credit facility, and $5 million of letters of credit reducing facility availability.
- Capital investments excluding mergers, acquisitions, and leased facilities were approximately $2.3 billion year to date.
Material Changes Versus the Prior Comparable Period
- Quarterly sales declined 0.3%, principally because the convenience-store business was sold; retail sales excluding fuel and supermarket fuel sales increased.
- Year-to-date sales increased 1.6%, while reported net earnings increased substantially because of the convenience-store sale gain and a lower effective tax rate.
- Operating margin improved year to date but declined in the quarter because of gross-margin pressure and higher rent and LIFO costs.
- The effective tax rate decreased to 22.8% from 35.6% in the quarter and to 22.8% from 34.8% year to date, primarily because of the Tax Cuts and Jobs Act and other tax items.
- The average diluted share count declined to 807 million from 893 million in the quarter and to 822 million from 910 million year to date, primarily reflecting share repurchases.
- Kroger completed the sale of its convenience-store business for $2.169 billion and recorded a pretax gain of $1.782 billion, or $1.360 billion after tax.
- Kroger acquired Home Chef for $197 million net of cash, with potential earnout payments of up to $500 million over five years. The preliminary purchase-price allocation included $163 million of goodwill and a $91 million fair-value earnout liability.
- The Company invested in Ocado securities. Their fair value was $544 million at quarter end; Kroger recorded a $100 million third-quarter unrealized loss and a $152 million year-to-date unrealized gain.
- Kroger repurchased $2.0 billion of common stock year to date, including a $1.2 billion accelerated share repurchase program funded partly with sale proceeds.
Guidance, Outlook, Risks, and Unusual Items
- 2018 GAAP diluted EPS guidance was reduced to $3.80–$3.95 from $3.88–$4.03, reflecting the $0.09 per-share third-quarter Ocado mark-to-market loss and excluding unpredictable future changes in Ocado’s market value.
- Adjusted operating EPS guidance remained $2.00–$2.15. Management maintained its identical-sales outlook and expected second-half results to be similar to the first half.
- Management continued to expect more than $6.5 billion of Restock Kroger free cash flow over 2018–2020, approximately $3.0 billion of 2018 capital investments, and an approximately 23% 2018 tax rate, or approximately 21% excluding adjusted items.
- Management estimated approximately $6.6 billion of liquidity needs over the next 12 months, including working capital, capital investments, interest, and scheduled debt maturities. Approximately $1.6 billion of senior notes, $635 million of commercial paper, and the $1.0 billion term loan mature during that period.
- Management believed operating cash flow, commercial paper access, and bank facilities would be adequate to meet liquidity needs and stated that the Company was in compliance with its debt covenants.
- Key risks include labor negotiations, competitive pricing, fuel and commodity-cost volatility, pharmacy reimbursement and benefit-manager consolidation, pension obligations, cyber and data-security events, adverse weather, execution of the Restock Kroger plan, and integration of acquisitions and partnerships.
- Pending antitrust, wage-and-hour, civil-rights, and product-liability matters were considered by management not likely to have a material effect, although outcomes remain uncertain and antitrust damages may be trebled.
- Assets and liabilities totaling $172 million and $57 million, respectively, were classified as held for sale, including Turkey Hill Dairy and You Technology. The Company subsequently announced an agreement to sell You Technology, expected to produce a material gain upon completion.
- The Company expects adoption of the new lease standard in fiscal 2020 to materially increase reported lease assets and liabilities, but not materially affect net earnings or cash flows.
Investor Verification Checklist
- Confirm the applicable period: the supplied filing is Q3 2018, not Q3 2017.
- Reconcile GAAP EPS of $3.43 year to date with adjusted operating EPS of $1.63 and identify all excluded items.
- Assess whether gross-margin pressure and lower quarterly operating margin are temporary or structural.
- Review the valuation volatility and strategic rationale of the Ocado investment and partnership.
- Evaluate refinancing requirements for the next 12 months and continued access to commercial-paper and credit markets.
- Monitor Home Chef earnout exposure, purchase-price allocation changes, and integration results.
- Verify the timing, proceeds, and gain recognition for the planned You Technology sale and other held-for-sale businesses.
- Assess the effect of the upcoming lease-accounting adoption on leverage, liquidity measures, and covenant analysis.