The Kroger Co. Form 10-Q Summary
Filing-period note: The request metadata identifies “2017 Q2,” but the provided filing is Kroger’s Form 10-Q for the quarter ended August 18, 2018, compared with the quarter ended August 12, 2017. The second quarter covers 12 weeks and the first two quarters cover 28 weeks.
Business context and reporting period
Kroger operates supermarkets, pharmacies, fuel centers, digital channels, specialty pharmacy and related businesses. During the period, Kroger sold its convenience store business, acquired Home Chef, entered an exclusive U.S. partnership with Ocado, and continued investments under its Restock Kroger strategy.
Financial performance and liquidity
| Metric | Second quarter 2018 | Second quarter 2017 | First two quarters 2018 | First two quarters 2017 |
|---|---|---|---|---|
| Sales | $27.869 billion | $27.597 billion | $65.399 billion | $63.882 billion |
| Operating profit | $549 million | $684 million | $1.577 billion | $1.314 billion |
| Operating margin | 1.97% | 2.48% | 2.41% | 2.06% |
| Net earnings attributable to Kroger | $508 million | $353 million | $2.534 billion | $656 million |
| Diluted EPS | $0.62 | $0.39 | $3.03 | $0.71 |
| Adjusted diluted EPS | $0.41 | $0.39 | $1.15 | $0.97 |
| Net cash from operating activities | Not provided for the quarter | Not provided for the quarter | $3.260 billion | $3.325 billion |
| Restock free cash flow | Not provided for the quarter | Not provided for the quarter | $1.2 billion | $1.8 billion |
- Identical sales excluding fuel increased 1.6% in the quarter and 1.8% for the first two quarters.
- Digital revenue increased more than 50% in the quarter and approximately 60% year to date, driven primarily by ClickList.
- Gross margin declined to 21.31% from 21.70% in the quarter and to 21.57% from 21.90% year to date. Management cited lower customer pricing, transportation and advertising costs, and fuel mix.
- Interest expense was $144 million in the quarter and $336 million year to date, compared with $138 million and $315 million, respectively, in the prior-year periods.
- The effective tax rate declined to 20.2% from 35.0% in the quarter and to 22.8% from 34.2% year to date, primarily reflecting the Tax Cuts and Jobs Act, tax credits, deductions and favorable settlements.
- Cash and temporary cash investments were $361 million at August 18, 2018, compared with $347 million at fiscal year-end.
- Total debt, including current and long-term portions of capital leases and financing obligations, declined approximately $1.1 billion from fiscal year-end. Reported debt excluding capital leases was $13.641 billion, including $175 million of commercial paper and a $1.0 billion term loan.
- Kroger had a $2.75 billion unsecured revolving credit facility, expandable by $1 billion, with no borrowings outstanding. Management stated that the company was in compliance with debt covenants.
- Capital investments were $1.5 billion for the first two quarters, compared with $1.6 billion in the prior-year period.
Material changes versus the prior comparable period
- Sales increased 1.0% in the quarter and 2.4% year to date, although the comparison was affected by the sale of the convenience store business.
- Quarterly operating profit declined $135 million and operating margin fell 51 basis points, reflecting margin pressure and higher OG&A and depreciation expense.
- Year-to-date net earnings benefited from a $1.782 billion pretax gain on the convenience store sale and a $252 million pretax unrealized mark-to-market gain on Ocado securities. These items materially increased reported earnings but are excluded from adjusted results.
- The convenience store business was sold for net proceeds of $2.169 billion on April 20, 2018. Kroger used proceeds to reduce commercial paper and fund a $1.2 billion accelerated share repurchase program.
- Kroger repurchased $2.0 billion of stock during the first two quarters, including 77.9 million shares at an average price of $25.41. The accelerated repurchase program was completed; $546 million remained under the March 2018 authorization at August 18, 2018.
- Home Chef was acquired on June 22, 2018, for $197 million net of cash, with potential earnout payments of up to $500 million. The acquisition generated a $91 million fair-value earnout liability and $163 million of goodwill.
- Kroger purchased Ocado securities and recorded a $252 million unrealized gain year to date. The Ocado investment was valued at $645 million at August 18, 2018.
Guidance, outlook, risks and unusual items
- Management expects 2018 identical sales growth excluding fuel of 2.0% to 2.5%.
- 2018 GAAP diluted EPS guidance was increased to $3.88 to $4.03, primarily because of the unrealized Ocado gain. The guidance excludes unpredictable future changes in Ocado’s market value and contingent consideration.
- Adjusted 2018 diluted EPS guidance remained $2.00 to $2.15.
- Capital investments excluding mergers, acquisitions and purchases of leased facilities are expected to be approximately $3.0 billion, and the expected 2018 tax rate is approximately 22%, or approximately 20% excluding adjusted items.
- Management estimates next-twelve-month liquidity needs of approximately $5.9 billion, including working capital, capital investments, interest, pension contributions and debt maturities. It expects operating cash flow and available financing sources to meet those needs.
- Turkey Hill Dairy assets and liabilities totaling $179 million and $60 million, respectively, were classified as held for sale. Management expects the sale within one year and does not expect discontinued-operations treatment.
- Risks include competitive pricing, labor negotiations, fuel-price and fuel-margin volatility, pharmacy reimbursement and payer changes, multi-employer pension obligations, economic conditions, cyber and data-security incidents, execution of Restock Kroger, integration of acquisitions and partnerships, interest rates, refinancing access and tax-law changes.
- Pending litigation includes antitrust, wage-and-hour, civil-rights and product-liability claims. Management believes aggregate exposure is not material, but acknowledges that outcomes could differ materially from current estimates.
- The new lease standard is expected to materially increase reported lease liabilities and right-of-use assets when adopted in fiscal 2020.
Most important facts for an investor to verify
- Confirm that the intended comparison is the 2018 second-quarter filing, not the 2017 second-quarter filing identified in the request metadata.
- Separate recurring performance from the $1.782 billion convenience store-sale gain and $252 million Ocado valuation gain.
- Assess underlying margin pressure, including the lower gross margin rate and higher digital-strategy and operating costs.
- Review debt maturities, including approximately $1.1 billion of senior notes, $175 million of commercial paper and the $1.0 billion term loan due within the next twelve months.
- Evaluate the sustainability of share repurchases and dividends against restock free cash flow, capital investments and debt obligations.
- Monitor Ocado share-price volatility and the Home Chef earnout liability, both of which can affect reported earnings.
- Review the potential financial impact of Turkey Hill’s planned disposition, litigation, pension obligations and the forthcoming lease-accounting change.