The Kroger Co. Form 10-Q Summary
Reporting period: First quarter ended May 21, 2016, a 16-week period, compared with the 16-week period ended May 23, 2015. The filing metadata identifies “2015 Q1,” but the filing itself reports first-quarter 2016 results.
Business Context
Kroger operates supermarkets, fuel centers, pharmacies, convenience stores, jewelry stores, food production facilities, health clinics and digital commerce businesses. Results for 2016 include the December 2015 merger with Roundy’s, which added 151 supermarkets. The company continued executing its Customer 1st Strategy.
Key Financial Metrics
| Metric | Q1 2016 | Q1 2015 | Change |
|---|---|---|---|
| Sales | $34.604 billion | $33.051 billion | 4.7% increase |
| Operating profit | $1.200 billion | $1.102 billion | 8.9% increase |
| Net earnings attributable to Kroger | $680 million | $619 million | 9.9% increase |
| Diluted earnings per share | $0.70 | $0.62 | 12.9% increase |
| Gross margin | 22.93% | 22.06% | 87 basis-point increase |
| FIFO gross margin | 22.98% | 22.14% | 84 basis-point increase |
| Operating margin | 3.47% | 3.33% | 14 basis-point increase |
| Cash flow from operations | $2.052 billion | $1.755 billion | $297 million increase |
| Capital investments, excluding lease buyouts | $1.145 billion | $915 million | Increase |
| Dividends declared per share | $0.105 | $0.093 | Increase |
Identical supermarket sales excluding fuel increased 2.4%. Total supermarket sales excluding fuel increased 8.0%, while fuel sales declined 14.7%, primarily because the average retail fuel price fell 19.1%, partly offset by a 5.5% increase in gallons sold.
Cash Flow, Debt and Liquidity
- Operating cash flow was $2.052 billion, compared with $1.755 billion in the prior-year quarter.
- Investing activities used $1.051 billion, primarily for property and equipment.
- Financing activities used $887 million, including $1.027 billion of treasury stock purchases and $102 million of dividends paid.
- Cash and temporary cash investments totaled $391 million at May 21, 2016, compared with $277 million at fiscal year-end.
- Total debt, including capital leases and financing obligations, was approximately $12.4 billion, up $307 million from fiscal year-end, primarily because of increased commercial paper borrowings.
- Commercial paper outstanding was approximately $1.2 billion. The company had no borrowings under its $2.75 billion unsecured revolving credit facility, which could be increased by $750 million, and had $13 million of letters of credit reducing availability.
- Management estimated next-twelve-month liquidity needs of $6.7 billion to $7.2 billion, including approximately $1.2 billion of commercial paper and $1.3 billion of senior notes maturing during the period. Management expects refinancing and operating cash flow to meet these requirements.
- The company was in compliance with its financial covenants and stated that it expects to remain compliant.
Material Changes Versus the Prior Comparable Period
- Sales growth benefited from the Roundy’s merger, increased supermarket square footage and positive identical-store sales, but was reduced by lower fuel prices.
- Net earnings and diluted EPS increased primarily because of higher non-fuel FIFO operating profit, lower LIFO expense, higher fuel earnings and fewer shares outstanding from repurchases. Higher income tax expense partially offset these benefits.
- The LIFO charge declined to $15 million from $28 million.
- Operating, general and administrative expenses increased to $5.779 billion from $5.354 billion, and the OG&A rate increased to 16.70% from 16.20%. Roundy’s, credit-card chip technology costs and healthcare costs contributed to the increase.
- Rent expense increased to $262 million from $215 million, primarily because Roundy’s has a higher proportion of leased stores.
- Depreciation and amortization increased to $694 million from $620 million because of capital investments and the Roundy’s merger.
- Kroger repurchased approximately 27.1 million shares for $1.0 billion at an average price of $37.94 per share. The existing $1.0 billion authorization was exhausted; a new $500 million authorization was approved on June 22, 2016.
- Rolling four-quarter ROIC increased slightly to 14.08% from 14.03%, using Kroger’s non-GAAP methodology and excluding Roundy’s financial position and results from the 2016 calculation.
Guidance, Outlook and Management Commentary
- Fiscal 2016 diluted EPS guidance was $2.19 to $2.28; management expected results at the low end to midpoint based on fuel-margin trends.
- Identical supermarket sales excluding fuel were expected to increase 2.5% to 3.5% for fiscal 2016.
- Full-year FIFO operating margin excluding fuel was expected to expand slightly from 2015.
- Capital investments excluding mergers, acquisitions and leased-facility purchases were expected to total $4.1 billion to $4.4 billion.
- Supermarket square footage was expected to grow approximately 3.0% to 3.5%, excluding mergers, acquisitions and operational closings.
- The company expected an approximately 35% tax rate, product-cost inflation below 1.0% excluding fuel, and an annualized LIFO charge of approximately $50 million.
- Company-sponsored pension expense was expected to be approximately $80 million, with no cash contribution expected in 2016. Multi-employer pension contributions were expected to be $260 million.
- Management cited labor negotiations, competition, fuel-price and fuel-margin volatility, economic conditions, pharmacy reimbursement and healthcare-industry consolidation, pension obligations, integration of Roundy’s and Harris Teeter, cybersecurity, supply and commodity costs, liquidity and refinancing conditions, litigation, and potential impairment as key risks.
- Various antitrust, wage-and-hour, civil-rights and product-liability claims were pending. Management believed the aggregate exposure was not material, while acknowledging that outcomes could differ materially from estimates.
Unusual Items and Accounting Developments
- The Roundy’s merger affected comparability and increased sales, rent, depreciation, operating costs and supermarket square footage.
- Other comprehensive loss was $23 million, compared with comprehensive income of $39 million in the prior-year quarter, primarily because of unfavorable cash-flow-hedging results.
- The company adopted the accounting amendment simplifying measurement-period adjustments for business combinations; adoption had no effect on the balance sheet or statement of operations.
- Future standards expected to affect reporting include revenue recognition, deferred-tax classification, leases and stock-based compensation. The lease standard is expected to significantly increase reported lease liabilities and right-of-use assets.
Investor Verification Checklist
- Reconcile reported growth with the effects of the Roundy’s merger, fuel-price deflation and changes in supermarket square footage.
- Assess whether the expected low-end-to-midpoint EPS outcome remains consistent with fuel margins and identical-store sales trends.
- Review commercial-paper and senior-note maturities, refinancing assumptions and available revolver capacity.
- Evaluate the sustainability of substantial share repurchases relative to capital spending, dividends and debt levels.
- Monitor gross-margin pressure from pharmacy pricing investments, customer price reductions, shrink and increased fuel exposure.
- Review labor negotiations, multi-employer pension exposure, litigation, cybersecurity risks and the integration of Roundy’s and Harris Teeter.
- Consider the future balance-sheet impact of the lease-accounting standard and other pending accounting changes.