KROGER CO quarterly report, Q3 FY2014

The Kroger Co. Form 10-Q Summary

Reporting period: Third quarter and first three quarters ended November 8, 2014, covering 12 and 40 weeks, respectively. The request metadata identifies “2013 Q3,” but the filing itself is a 2014 third-quarter report and compares against periods ended November 9, 2013. Results are unaudited and stated in millions except per-share amounts.

Business Context

Kroger is a supermarket operator with fuel, convenience, pharmacy, health clinic, manufacturing, and online businesses. Results include Harris Teeter, acquired January 28, 2014, and Vitacost.com, acquired August 18, 2014. Vitacost.com revenue and earnings since acquisition were not material.

Key Financial Metrics

Metric	Third Quarter 2014	Third Quarter 2013	First Three Quarters 2014	First Three Quarters 2013
Sales	$24,987	$22,470	$83,258	$75,153
Operating profit	$651	$534	$2,225	$2,007
Operating margin	2.61%	2.38%	2.67%	2.67%
Net earnings attributable to Kroger	$362	$299	$1,210	$1,097
Diluted EPS	$0.73	$0.57	$2.41	$2.09
Cash flow from operating activities	Not separately provided	Not separately provided	$3,469	$2,917

• Sales increased 11.2% in the quarter and 10.8% year to date, primarily from Harris Teeter, identical supermarket sales growth, and higher fuel volumes.
• Identical supermarket sales excluding fuel increased 5.6% in the quarter and 5.0% year to date. Including fuel centers, identical sales increased 4.7% in both periods.
• Adjusted net earnings, excluding specified tax, merger, and pension items, were $345 million, or $0.69 diluted EPS, in the quarter versus $276 million, or $0.53, in the prior-year quarter. Year-to-date adjusted net earnings were $1,249 million, or $2.48 diluted EPS, versus $1,083 million, or $2.06.
• GAAP gross margin was 20.90% in the quarter versus 20.49% and 20.77% year to date versus 20.51%. The quarter’s FIFO gross margin rate was 21.24% versus 20.55%.
• The LIFO charge increased to $85 million in the quarter from $13 million and to $138 million year to date from $42 million, reflecting higher expected product-cost inflation.
• OG&A expense increased to 15.83% of sales in the quarter from 15.74% and to 15.67% year to date from 15.49%.
• Net interest expense was $114 million in the quarter and $373 million year to date, compared with $108 million and $336 million, respectively, in the prior-year periods.
• The effective tax rate was 32.0% in the quarter versus 29.3%; the year-to-date rate was 33.9% in both years.

Liquidity, Debt, and Capital Allocation

• Cash and temporary cash investments were $264 million at November 8, 2014, versus $401 million at February 1, 2014.
• Total debt, including capital leases and financing obligations, was approximately $11.5 billion at the end of the quarter, up $226 million from year-end and $3.3 billion from the comparable prior-year quarter.
• Debt excluding capital leases and financing obligations was $10.97 billion, including $895 million of commercial paper. The fair value of total debt was $11.98 billion versus a $10.97 billion carrying value.
• Kroger had no borrowings under its $2.75 billion unsecured revolving credit facility, which may be increased by an additional $750 million and terminates June 30, 2019 unless extended. The company was in compliance with debt covenants.
• Management estimates approximately $4.9 billion of liquidity needs over the next 12 months, including working capital, capital expenditures, interest, and scheduled debt payments. Approximately $895 million of commercial paper and $800 million of senior notes mature within the next 12 months.
• Operating cash flow was $3.47 billion, capital investments were $2.07 billion, acquisition payments were $252 million, dividends paid were $247 million, and treasury stock purchases were $1.25 billion during the first three quarters.
• Kroger repurchased 27.9 million shares for $1.25 billion year to date and declared dividends of $0.185 per share for the quarter, versus $0.165 in the prior-year quarter.

Material Changes Versus the Prior Comparable Period

• Harris Teeter materially increased sales, store square footage, gross margin, operating expenses, debt, and depreciation and amortization.
• Vitacost.com was acquired for $287 million, funded through commercial paper. Preliminary purchase accounting recorded $160 million of goodwill and $81 million of intangible assets.
• Sales, operating profit, net earnings, diluted EPS, and operating cash flow increased. Diluted EPS also benefited from lower average shares outstanding following repurchases.
• Debt and interest expense increased primarily because of the Harris Teeter acquisition, share repurchases, and refinancing activity.
• The first three quarters included a $56 million after-tax charge related to restructuring certain pension plan agreements, partially offset by $17 million of tax benefits. The third quarter included a $17 million tax benefit.
• Capital investments increased to $2.1 billion from $1.8 billion, while food-store square footage increased 8.0%, primarily due to Harris Teeter.

Guidance, Outlook, and Commentary

• Fiscal 2014 adjusted diluted EPS guidance was $3.32 to $3.36, excluding certain tax items and pension-plan-agreement charges.
• Fourth-quarter identical supermarket sales excluding fuel were expected to increase 4.0% to 5.0%.
• Management expected FIFO operating margin excluding fuel and pension-related charges to slightly expand on a rolling four-quarter basis.
• Expected fiscal 2014 LIFO expense was approximately $180 million and interest expense approximately $485 million.
• Capital investments excluding mergers, acquisitions, and leased-facility purchases were expected near the low end of $2.8 billion to $3.0 billion.
• Management expected a fourth-quarter effective tax rate of approximately 35% to 36%, excluding certain tax matters and potential regulatory changes, and did not anticipate goodwill impairments in 2014.
• Management expected to contribute approximately $225 million to $250 million to multi-employer pension funds, excluding contributions related to the first-quarter restructuring charge.

Risks, Contingencies, and Unusual Items

• Risks include labor negotiations, collective bargaining disputes, underfunded multi-employer pension plans, competition, commodity and fuel-price volatility, economic conditions, pharmacy reimbursement changes, cyberattacks, adverse weather, and integration of Harris Teeter.
• Pending antitrust, wage-and-hour, civil-rights, and product-liability matters include potential class actions and substantial claimed damages. Management believes probable and estimable losses have been provided and that aggregate exposure is not currently material, but acknowledges outcomes could differ materially.
• Product-cost inflation can materially affect LIFO expense and reported margins. Increasing fuel sales may reduce FIFO gross margins because fuel carries comparatively low margins.
• Long-lived assets with a $42 million carrying value were written down to $13 million, producing a $29 million impairment charge in the first three quarters.
• Three forward-starting interest-rate swaps with $225 million aggregate notional value mature in October 2015, and five with $300 million aggregate notional value mature in August 2017.
• The company adopted an income-tax presentation amendment without a material effect and was evaluating the future revenue-recognition standard effective in fiscal 2017.
• Management stated that disclosure controls were effective and that no material change occurred in internal control over financial reporting during the quarter.

Investor Verification Items

• Verify the filing period and comparable dates because the provided metadata says 2013 Q3 while the filing covers the quarter ended November 8, 2014.
• Reconcile GAAP results with management’s non-GAAP adjusted EPS, including the tax benefit and pension-plan-agreement charge.
• Assess whether Harris Teeter integration, Vitacost.com growth, and expected synergies support the reported sales and margin trends.
• Monitor LIFO expense, fuel margins, product-cost inflation, and the effect of fuel mix on gross margins.
• Review refinancing needs for the $895 million of commercial paper and $800 million of senior notes maturing within 12 months.
• Evaluate multi-employer pension obligations, labor negotiations, litigation exposure, and debt-covenant headroom.